When business owners are looking to raise capital through equity financing, they are planning to sell off a portion of the ownership of their business to someone else in exchange for a cash payment. This sale of ownership can be of a controlling or non controlling nature, but unlike debt financing where you pay back the money borrowed, ownership can have very long term connotations.
That’s one of the reasons why many people equate equity investing to marriage in that you’ve got to plan whether you want to be in the relationship for an extended period of time and under what conditions.
And while marriage agreements can be made going into the relationship in the form of prenuptial agreements, business financing scenarios involving equity capital should go one step further and have both an entry and exit agreement in place.
Especially for small businesses, it makes very little sense to take on an equity partner with no clear exit strategy for either partner. Many businesses get trapped in a situation where either a owner wants to leave the ownership group or the owners can’t get along anymore and someone needs to buy out the other.
Without an upfront agreement as to how an owner can exit, the process can be grueling to complete and financially damaging to both parties, but particular to the trusting and naive that get taken advantage of by the remaining owner or owners.
While any equity investment will clearly outline what you get for the cash you’re paying, it also should have its own form of prenuptial agreement and states exactly how things ARE going to end. There is no misconception here that everyone’s in it until death do us part, and even if that was the case, what happens to the ownership shares on passing? Failure to plan out the end right at the beginning is a bad idea in virtually any situation I’ve come across.
But in the hast to secure financing and the excitement of getting going or getting things back on track, the exit strategy is many times over looked or over simplified.
And the exit strategy you’re prepared to consider will also better align you with sources of financing that are better fits for what you’re looking for. For instance, there are many equity investors out there that want to double their money in three to five years and then get all their money back along with the required gain. This speaks to a very specific exit strategy that has to work for both sides at the outset of discussing the deal.
For investors that want to ride the wave of opportunity there should still be an exit plan to really protect both sides as the longer the relationship goes on the more likely something is going to happen with respect to ownership and ownership objectives.
The other part to keep in mind is that the more sophisticated the investor or investor group, the more the exit plan is going to be stacked in their favor, taking advantage of the entrepreneurs financial ignorance or sheer desperation.
So, yes equity financing is very much like marriage, but with a contract going in and one going out with the divorce or funnel preplanned.