Tag Archives: investments

Do Founder Investments Dilute Earlier Investors?

ScalesAs president of Offtoa, a company committed to assisting entrepreneurs succeed, I am often asked by first-time entrepreneurs if their “investments” after founding dilute the ownership stakes of their earlier investors. The answer is always “it depends.”

Specifically, it depends on the type of legal entity that the company is; it depends on the terms laid out in the articles for the company; and it depends on what the founder means by an “investment.”

I’d like to explain the various implications of a founder “investing” money in a company subsequent to its creation and acceptance of earlier investments.

First of all, let me explain how the question is usually posed:

The Starting Conditions

“When I started the company a few years ago, I invested $20,000 and owned 100% of the company. Later, two outside investors made cash investments and purchased 10% and 20% of the company, respectively. Now I want to make another investment of $20,000. Will that dilute the ownership positions of the two outside investors?”

The Answer if your Startup is a Corporation:

If your startup is a corporation, then the outside investors did not purchase a percentage ownership stake; instead they purchased a number of shares.

Investment. If you are purchasing additional shares with your new $20,000 investment, these shares always come from the company’s treasury. Thus, the total number of outstanding shares will increase, and the percentage ownership represented by the outside investors’ fixed number of shares will indeed decrease. So, yes, they will be diluted.

Loan. If you are just lending the company $20,000, then this has no effect on the number of outstanding shares, and outside investors will not be diluted. You become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before shareholders.

Convertible Loan. It is common practice for insiders who lend the company money to convert those notes into equity if a major investment round occurs in the future. That is, the note is retired, and the outstanding principal including accumulated interest becomes part of the next investment round.

The Answer if your Startup is a Partnership:

Capital Account. Typically, if you invest cash in a partnership, it has no effect on ownership distribution; instead, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the partnership to the partners, you would be eligible to receive that amount from your capital account.

However, because partnerships allow for “special allocations,” both allocation of profit and loss to a capital account and subsequent distributions is negotiable. So, no, the “outside investors” (i.e., partners) will not be diluted.

Increasing Your Stake. Notice that if you did want your investment to dilute the partners, you would pay the other partners to acquire their positions. This would not provide cash to the company to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before partners.

The Answer if your Startup is an LLC:

Because most LLCs are treated as partnerships for tax purposes, the manner of priority, allocations, and distributions are negotiable. However, here is how they typically work.

When you as a founding member invest additional capital in the LLC, it could be treated in either of two ways, based on the LLC’s articles of organization:

  1. Capital Account. Like in the case of a partnership, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the LLC to the members, you would be eligible to receive that amount from your capital account. So, no, the “outside investors” (i.e., members) will not be diluted.
  2. Like in the case of a corporation, the cash could be used to add to your ownership interest, diluting other members (in this case, the “outside investors”), with their approval.

Increasing Your Stake. As in the case of a partnership, most LLCs also allow you to pay other members to acquire their positions. This would not provide cash to the LLC to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the LLC. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before members.

Summary:

It is extremely common for founders to want to make additional infusions of capital into companies after starting. But notice that the implications of making such an investment are non-trivial. This is one of the many reasons why almost all startup mentors recommend that first-time entrepreneurs consult with an attorney experienced with entrepreneurial matters prior to creating their companies.

The type of legal entity that you decide upon and the terms you include in your incorporation/organization/partnership agreement will have significant effects on many aspects of your business. The above example of re-investing in the company is just one small example.

Please note that I am neither a CPA not an attorney. If you want to understand how investing in your company will affect your earlier investors, please consult with your CPA or attorney.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of Cover

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com,.

6 Reasons You Should Never Start a Company

Do Not EnterIf you are looking for reasons why you should not start a company, read on!

1. You Could Lose All Your Savings

As a founder, you are investing in your startup. You’re investing your time and your energy; you’re investing yourself. In addition to that, it’s also wise to invest financially in every round if you can. That way when you are raising money and potential investors ask “do you have skin in the game?” you can honestly answer “yes,” and when they ask or “if I say yes, will I be the first investor?” you can honestly answer “no.”

Putting you own money into the company demonstrates commitment. If this requires you to take out a second mortgage or a personal loan, so be it.

If you can’t commit to losing your savings, how can you expect others to put their assets at risk?

2. You Could Lose Other People’s Money

I thought that losing my own money was painful, but that was before I lost other people’s money. Now that’s painful! After all, when investors give you their cash in return for equity in a company you have founded and are leading, they are making a loud and clear statement that they believe in your idea and they believe in you.

Even when you involve your stakeholders and keep shareholders informed of all decisions being made, even when the vast majority of investors bear no hard feelings whatsoever, you spend considerable time looking back at past decisions wondering “what if I had done things differently?”

Bottom line: When you accept other people’s investment dollars, be prepared for the possibility that pain might follow if you fail. That pain might be self-induced, or might come from the investors.

3. You Could Hire the Wrong People

You can’t do it all yourself. You need to hire others to help make the dream come true. If you make the wrong hires, quality will be compromised, too much money will be spent, customer service will go down the tubes, the morale of the “good hires” will suffer, and so on.

4. You Could Lose Control

You like control. After all, the company you are envisioning is “your baby.” You want to control it. When you need to raise cash, you will be telling potential investors how much cash you need and what you plan to do with it. The percent of the company they get for that investment will be up for discussion.

Let’s say you need $500,000. You want to maintain control so you have no intent to sell more than 49% of the company. But the investors value your company at just $800,000. That means if you want their $500,000, you’ll need to sell them 5/8 of the company.

5. You Could Build the Wrong Product

You raise $500,000 from investors and build the “perfect product” for the market. You execute an expensive product launch with a major media presence. And nobody buys the product. The product is a total flop. You either misunderstood the needs of the market, you were too early or too late in the market window, or the competition outsmarted you with an even more impressive product.

6. Your Customer Acquisition Cost Could Be Much Higher than Expected

You did extensive financial planning, and that included modeling the sales process. Only one problem: you think it will cost you $250 to acquire each new customer. What happens if it actually costs you $750 to acquire each one? Now everything in your financial plan falls apart.

In summary

If the above situations scare you, you have an easy way to avoid them: Don’t start a company. Starting a company is not for the pessimist or for the risk-adverse. Nor is starting a company for those who want to get rich quickly and live on a beach.

Starting a company takes courage and optimism.  It requires stubbornness and the ability to rewind and clinically assess mistakes. It tolerates failure but demands success. As crazy as it may sound, if that excites you, you might be about to take your great idea and start your own company!

Let me close by sharing with you three of my favorite quotes:

 “Far better to dare mighty things, to win glorious triumphs, even though checkered by failure, than to rank with those poor spirits who neither enjoy much nor suffer much.  [They] know not victory, nor defeat.”

Theodore Roosevelt

“It is good to have an end to journey toward; but it is the journey that matters, in the end.”

Ursula K. Le Guin

“First, say to yourself what you would be; then do what you have to do.”

Epictetus

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?