May 14, 2018

The Pros and Cons of Giving Up Equity

The Pros and Cons of Giving Up Equity

Delusions abound when it comes to raising equity capital, aka selling a piece of your company for cash.

I was talking with a (non-delusional) founder the other day. He’s building a capital-efficient, verticalized SaaS business targeting to do about $1.5m ARR this year, up ~4x from last year. He has two angels and one accelerator on his cap table and feels pretty good about that.

It’s not that he couldn’t raise more money from his angels or that he’s not receiving inbound investment interest from VCs who have been getting his regular monthly updates. It’s that he believes in what he’s building, is excited about its potential, and wants to hold onto as much of it as possible (i.e., not be diluted) to retain the long-term benefits from his substantial ownership. Greedy and shortsighted? It’s possible. Prudent and thinking long-term? Let’s hope!

Basically, he likes the way things are going and doesn’t feel he’s putting his market capture at risk by not bringing a bunch of non-customer money into the business. So, what’s he missing out on and what’s he gaining if he decides not to sell more of his equity for cash? Here are The Pros and Cons of Giving Up Equity.

Missing Out on Dilution (this can be a YUGE gain)

The most common way, and often the first time, founders encounter dilution is when they raise angel and/or venture capital. When you raise angel or VC money, you issue and sell new shares. This means existing shareholders, the founders, and the previous folks you may have sold equity to, get diluted due to this simple equation:

[same number of shares owned / larger number of shares outstanding]

It’s important to note that we’re talking about dilution regarding % of company-owned, not the value of those shares. If you raise money at constantly higher valuations, the value of existing shares increases. [ctt template=”3″ link=”oMaN6″ via=”yes” ]Sure, you end up holding a smaller piece of a larger pie, but this may be just fine if your shares are increasing in value (share price) and your overall equity position is becoming more valuable.[/ctt]

3 Benefits of Not Being Diluted

  1. Retaining more control and optionality (you’ll have less “bosses”)
  2. Retaining long-term upside as you continue building equity value
  3. Preserving equity that you can sell (or dole out to your valued current and future employees) in the future, when you’re further down the road, can command a higher valuation, and therefore, have to take less dilution

Missing Out on Network Expansion

Many investors can open up doors that you would have had to pry open on your own. If they’re worth their salt, they have deeply developed networks in their focus areas, and they’ll be eager to work you into them to grow the equity value of the company they have invested in. This can short-circuit your sales, recruiting, product integration, and future fundraising efforts in a meaningful way.

Missing Out on Operating Expertise

Many investors have been operators themselves and many have sold businesses. Their experiences and learnings, even if it was not directly in your space, can be very helpful to bring into your business. Even if they have not been operators, experienced investors have worked with a lot of companies. They’re in the pattern recognition game—this worked really well for this type of company, this blew up for every company I saw try it, except for the three that did X. They should have a meta-view that you lack. Cliche time! It’s easier to see the forest from the trees and the potholes on the road to success when you’re looking across a number of companies, rather than being fully focused within one.

Gaining Optionality

Selling equity capital often puts founders on a path they didn’t realize they had gotten onto. Professional equity investors don’t dole out money just for fun. They have high return expectations for the money they’re putting into your company, so it’s generally go big or go home time and the clock’s ticking. When those expectations are compromised, things can go sideways. They may pressure you to do things you don’t want to do or don’t believe are best for your business. If you don’t act how they want you to act, they may replace you. They may write you off as one of their investments that isn’t going to break out and thus does not deserve any more of their capital, which can leave you in a very precarious position. Without this money in your business, you may grow at a slower rate, you may have to hustle harder, you may not become famous, but you will maintain your optionality to grow your business how you want.Managing one’s equity capital and cap table is often overlooked by less experienced founders who have not been through it before. It’s an extremely important aspect of your business to be on top of and understand. Don’t outsource these decisions to someone else because you’d rather focus somewhere else. If you do that, you may miss out on great capital partners opportunities or you may get into a capital relationship that you will regret for years.

After reading The Pros and Cons of Giving Up Equity, what seems better for you?