By definition, capital can be equity or debt. Loans to companies (debt) are hard to justify until the company has a stream of profits coming in to repay debt. If your company has a stream of profits, you are probably better off getting a loan from a lending institution. 

In most cases lenders want security in something they can sell, if the loan doesn’t get repaid. This is called “collateral,” and often lenders take collateral in the business owner’s home. In my opinion, this is not a good idea, unless you are certain your company can repay the loan! The last situation you want is for a lender to force you to sell your home when your business is going through a tough time.

Friends have made loans to my companies on an unsecured basis, but I’ve made it clear that the loans would be converted into equity (stock) at some future time, when the value of the stock is ascertainable.

Once a company is well capitalized with equity (a topic I will explore in a future blog), debt is a better way to go. However, most companies are undercapitalized, so seeking equity capital is necessary.

Equity investors will want to know how much of your company they will own for their investment. This is something you need to think through very carefully before you propose the investment. At the moment you sit down with your potential investor to discuss investment specifics, you must have a clear vision of current and future equity needs. 

To approach the issue of ownership percentage, I think about the future and what my company will look like in 5-10 years. And I set up an ownership structure that allows me to stay in control of my company during the risky period of establishment. The easiest way to do this is by defining capital structure in two timeframes: 

  1. The number of shares that will be issued initially;
  2. The number of shares that will be outstanding when the company is fully capitalized.

In the following example I want to raise $1 million to capitalize a new company:

  1. I set shares to be issued initially as 1,000,000 shares.
    1. I want to own at least 600,000 of these shares (60% of the outstanding stock).
    2. Other investors can own up to 400,000 shares.
    3. My proposal is that each share would be issued at a price of $2.50/share, so the first round of equity financing is $2.50/share x 400,000 shares = $1,000,000.
    4. Within this $1,000,000, a $100,000 investment would purchase 40,000 shares ($100,000 divided by $2.50/share), which is equivalent to 4% of the equity when the entire $1,000,000 is placed in the hands of investors ($40,000 divided by $1,000,000).
  2. I set shares to be ultimately outstanding (when the company is fully capitalized) as 10,000,000 shares.
    1. This leaves 9,000,000 shares available for growth after the initial capitalization.
    2. As the company grows I always take as much of my salary in the form of stock as possible, using the last valuation ($2.50/share in this example) to calculate how many shares I earn each year over and above a nominal salary. The nominal salary is just enough to pay my bills and to live modestly. For the sake of this example, let’s say I earned 50,000 shares/year, which is equivalent to $125,000/year in salary forbearance.
    3. When the next round of capital is needed (let’s say another $1,000,000 four years after the initial capitalization), we will have made enough progress to sell new shares at $5.00/share, using 200,000 shares. And I will have earned 200,000 shares in salary forbearance, thereby keeping my ownership percentage at 60%.

(The above example ignores important tax implications, and so my actual ownership might be structured as stock options rather than direct ownership of stock. It is important to get good tax and legal advice on ownership especially as tax laws change.)

Now is the time to plan the amount of ownership that you are willing to give up, so that there will be enough ownership available in the future for other investors that will be needed for growth. Proposing an investment includes a clear definition of what the investor will own. There are all kinds of ownership structures and shareholder rights that we can explore in future blogs.

I chose the image of the happy investor on the seesaw. She (and others you recruit as investors) will get a nice lift, while supporting your new business at the other end of the seesaw. 

An important point to consider when structuring your company’s capital: if you plan adequately and live modestly, your ownership will not be diluted!

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CLEVECAP helps business owners, company managers and entrepreneurs grow and sustain their enterprises with experience in finance, marketing, product development and operations. For specific help or a confidential assessment, please call John Finley on (303) 204-5375 or email at jfinley@clevecap.com.