How to Avoid Giving Up Too Much Equity, Too Early

I’M A BIG FAN of children’s literature. In terms of sage advice for entrepreneurs, it’s hard to top Aesop’s fable about the dog and his bone. And Dr. Seuss’s Yertle the Turtle can’t be beat for conveying an invaluable lesson about how to treat the other turtles in your pond.

But then there’s The Giving Tree. Some people view it as a beautiful tale of a tree’s selfless love. Who are they kidding? Shel Silverstein’s story about a tree that gives up everything it has to a self-centered boy is one of the most depressing children’s books ever. Unfortunately, it also happens to be a pretty accurate representation of many relationships between venture capitalists–the boy–and founders who give away more and more equity until there’s nothing left.

At our firm, we see this problem time and again. In the past year, we talked with nearly 40 startups whose founders no longer have a controlling interest in their companies. More than half own 20 percent or less. Because of their inexperience, they’d sliced out equity as if it were imaginary cake at a child’s pretend party. In their minds, equity may not have had any real value at that point. Naturally, the vulture … er, venture capitalists always reached for a big piece.

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In return, these founders got more money than they’d ever seen in their lives, and many were inclined to squander it because they didn’t have a real business plan. Although VCs tout a vast network of advisers, they are typically bankers who lack real business experience, so they often prove to be of little help. We met one poor guy who, unlike that gnarled old giving tree, barely had a even a stump left to sit on. By the time he met with us, he retained only 1.6 percent of his startup. You want to help them, but often it’s too late.

These are all smart people. They came up with great ideas–or at least good ones. But they assumed that once they’d made a successful pitch and someone handed them millions, they’d figure out what to do. That’s not how things usually play out.

Great Idea, Poor Execution

Another person we talked to had a great idea for a healthy snack food. He had raised more than $20 million, but used the money to lease and fit out, in grand style, a huge production facility. But because he had no experience in manufacturing, he didn’t understand the complexity and wound up with idle machinery and sidelined employees. When we met him, his stake had dwindled to 10 percent.

This guy’s experience is hardly unique. We met another founder who had raised $100 million over two rounds. He’d immediately built a $65 million manufacturing palace. Because he hadn’t carefully thought out the best way to use the money and just presumed massive success, he had to raise more and more to keep going. He’s now down to 20 percent ownership, he says; closer to 11 percent, according to our research. With so little equity left, it’s difficult to persuade new investors to provide more funding, since your business model isn’t creating self-sustaining sales.

Why do equity percentages appear as imaginary numbers to most founders? Because if a VC offers you $4 million for 40 percent of a business that isn’t making money, that chunk of equity doesn’t feel like a cost. It seems like you’ve lucked into a free lunch. But, like the old Twilight Zone episode about aliens who come to Earth not to serve man but to serve man, you’re the one on the lunch menu.

Money is exciting. It’s flattering as hell when someone tells you that your business is worth $10 million, and they’ll give you $4 million to grow it. But VCs are not in the flattery business; they’re in the make-money-for-the-people-who’ve-invested-with-them business.

They get in over their heads by assuming the business world is a welcoming place, that VCs have their best interests at heart, and that, because they’re smart, they’ll be able to figure things out on the fly.

So if you take their money but aren’t breaking even, it won’t be long before you’ll have to go back and ask for more, and that 40 percent investor stake turns into 60 percent or greater. VCs will tell you this is a good sign, that your company is worth even more. But that’s only because the inevitably higher valuation allows them to tell their own investors that they’re picking winners, not because it’s true. At that point, you’ve lost control of your company. Good luck getting more money the next time you run low.

Founders who give up stakes to suppliers or distributors are in an even worse predicament. Imagine that you founded a food startup and a big distributor held a majority stake. What happens when you want to pivot and sell your product through a competing group? That’s a rhetorical question–we know the answer. Distributors’ and suppliers’ interests are totally separate from the maker’s. That’s obvious to anyone in manufacturing, but not to people new to that world. Or, when they’re desperate, those who know better may choose to overlook it.

As an early proponent of direct sales, I never dealt with distributors, but I can only imagine what might have happened at my old company, Big Ass Fans, if the suppliers of our gearboxes had held a controlling stake. Our move into fans that didn’t use gearboxes would not have sat well with them, I’m pretty sure.

Expertise Is More Valuable Than Money

I often say that if somebody had handed me a million dollars when I was starting Big Ass Fans, I wouldn’t have had a clue what to do with it. It’s true–although by the time I started the company, I already had decades of experience.

Everyone we met with in the past year who got themselves into trouble with equity is a first-time founder. They’re still quite young. They get in over their heads by assuming the business world is a welcoming place, that VCs have their best interests at heart, and that, because they’re smart, they’ll be able to figure things out on the fly. In fact, business is complicated, the VC world is a meat market, and without a good plan and good advice, your startup faces a steep climb. Even if you manage by some miracle to reach the top, your early decision to give away the vast majority of your business means you won’t get nearly as big a reward. Sure, 15 percent of something is better than 100 percent of nothing–we hear that a lot–but that’s hardly what I’d call a can-do spirit. It’s more of a no-can-do spirit.

So, what do I advise rookie entrepreneurs? Easy: Before lunging for VC money, sit down with someone experienced and calculate exactly what your expenses should be over the next couple of years. You’ll probably see that if you proceed with caution, you actually need much less money than you thought. (Whatever you do, don’t start by leasing massive factories or buying real estate.)

Bootstrap early on if you possibly can. My wife and I maxed out our credit cards and jumped on every zero-interest balance transfer offer. By paying your own way, you’ll learn an amazing amount. Once you’ve proved your model and have a well-thought-out plan for growth, then consider seeking an investor, but vet them thoroughly. Don’t just fall for any banker with deep pockets–they’re a dime a dozen. Find someone who understands the guts of a business and who can help shepherd you through the process of growing yours. Someone who doesn’t see only dollar signs, and who wants you to retain a majority stake.

I also tell them that while business is complicated, it’s also very simple. Read Aesop’s fables instead of giving and giving and giving, like that poor tree, and you’ll be way ahead of the pack.

From the May/June 2021 issue of Inc. Magazine 

About Tips Clear

Tips Clear is a seasoned writer and digital marketing expert with over a decade of experience in creating high-quality, engaging content for a diverse audience. He specializes in blogging, SEO, and digital marketing strategies, and has a deep understanding of the latest trends and technologies. Tips Clear's work has been featured on various prominent platforms, and he is committed to providing valuable insights and practical tips to help readers navigate the digital landscape.