Offer equity and power with utmost caution

Hoard equity like gold and protect it accordingly.

When a business begins, all it may have is equity and a little startup capital. When a venture capitalist offers professional support and a sizable financial boost for a marginal 3% ownership share, many entrepreneurs feel honored by the attention given to their fledgling business and measure the 3% only by what they have in the bank - not much. The entrepreneur may think, “I have 97%, and the venture capitalist has 3%. I’m in control of this business.” But the entrepreneur may be completely wrong.

As Wang points out, Ford Motor Company is family-owned with less than 2% of the total equity (loc. 129). They control the company, not because they own greater than half the equity, but because the corporate power has been legally vested in them by contract. In the same way, a venture capitalist can gain enormous control by taking a sliver of the ownership but negotiating critical powers in the contract.

Entrepreneurs are at their most vulnerable in the early stages of their startup. Focused on iterating towards a profitable business model, they rarely pause when presented with lucrative offers to invest. While their vision for the business may be enormous, the loss of a tiny fraction of their equity for a major boost to their business is a nigh impossible offer to refuse. “If my business doesn’t succeed because we don’t have the resources,” the entrepreneur reasons, “then it won’t matter whether we have 100% or 1% of the business equity.” It is critical that entrepreneurs be educated about the unseen risk. If the entrepreneur gives even the smallest sliver of equity to a venture capitalist without an attorney’s painstaking review of the rights of shareholders, the entrepreneur may have signed over critical bargaining power to the venture capitalist that cannot be revoked. This could include the right to decide when to sell the business, receive investment, and more. Moral of the story-treat equity like the most important business resource, and if you must sell any of it, grant power sparingly.

The venture capitalist’s arguments are mathematically sound. Why not give a tiny fraction for the power to kick-start your business? Dense legal documents, much of which feels like red tape hurdles to get the incorporation paperwork through, are the last place I would think to look for danger. After all, shouldn’t the owner of 51% call the shots? My practical application is to encourage entrepreneurs to take longer on their core business documents and hire a lawyer so that they can move fast and intelligently when investment opportunities arise. I’ll tell them not to wait until they’re contacted about investment, which will likely happen when they’re too busy or anxious to make a wise decision, but to handle the details while they can make rational, long-term decisions.

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