Do you, as a magazine entrepreneur in urgent need of angel investment, give up a majority equity stake in your new company or not? How much equity does money buy? Here are a few things to keep in mind: Capital is not necessarily directly proportional to equity, ending up with a minority equity stake doesn’t mean loss of operational control and, conversely, keeping a majority stake as founder comes with its own sacrifices.
The capital you have to contribute to your new venture and the capital your investors ultimately put into the business do not necessarily buy an equal percentage of equity. Formulas vary widely according to how an entrepreneur structures the initial investment strategy and how that ultimately changes as the funding comes in.
In one sense, founders can breathe a sigh of relief knowing that they don’t necessarily have to come up with $500,001 dollars of their own money to retain control of their $1 million idea. However, the trick is to retain control even as you campaign for investors to put in the lion’s share of capital. Because unless you’re hitting up wealthy angels highly experienced in the magazine industry, you should think twice about allowing them to buy operational control. “You can create a nightmare by having somebody else who sits on the sidelines who is just a boutique investor having any say in what you do because they’ll mess it up,” says Jerry Powers, president and CEO of regional publisher Sobe News Inc. “You should always, whether you’re feeling very strong or very desperate, maintain control of the company. The simple rule of thumb is never give away more than 49 percent.”
Defining 49 Percent
That 49 percent has a couple of meanings, however. An entrepreneur can negotiate away 60 percent of the company, for example, and still retain control through the issuance of Class A and B stock. “The smart thing to do,” says Powers, “would be to give the investor Class A stock and the founder gets Class B stock. The only stock that votes is Class B.”
Those classes of stock can also have other benefits. Neil Rouda, who founded MedTech Publishing, sold 30 percent equity to a non-profit society. Rouda convinced them to trade a specific, and shorter term, exit plan for a bit more management oversight and a long-term exit according to the class of stock they received. “In my particular case, we have two classes of stock, the A Class does not have an exit clause and the B Class does. So that means my society owner doesn’t have an exit clause and instead they have management oversight. We traded an exit clause.”
Again, this rule varies according to how an entrepreneur sets up the investment, but since angels typically want anywhere from a 25 to 40 percent return in about five years, Rouda’s strategy, where the society owner gets their payout when the company liquidates, is one of give-and-take.
Yet smart investors will want some assurances, too. If they’re putting in majority capital for a minority stake, the founder will likely give up some portion of control. Rouda gave his society’s president a seat on the board and a “train wreck” clause. “A train wreck provision means that if we run it off the tracks, they could take over the board. They can fire me. We defined ‘train wreck’ as missing the pro forma by so much because the pro forma is what determined the rate of return and the investment value.”
Other forms of control that an investor can insist on are non-dilution clauses, where if there was to be a second round of financing, the shares that get diluted would be the founder’s. Investors can restrict the founder’s salary, which, by the way, can then swing to the founder’s favor. “Sweat equity,” where the founder works for a salary well below standard industry compensation, has real value, which can be advanced toward the founder’s equity.
Projected revenues and EBITDA help, too. If a founder can show that the company will produce EBITDA of a certain percentage, then a rate of return can be established that might help convince the investor to take a smaller stake. Imagine if $100,000 bought a ten percent equity stake. “If the company produces EBITDA in a couple years and suddenly it’s throwing $500,000 a year, an 8 times EBITDA is worth four million bucks,” says Rouda. “And that $100,000 has created 10 percent of four million bucks which is $400,000. In that is an inherent rate of return. The question is, is it a good rate? And is it worth the risk?”
Says Powers, “The closer I can get to assuring you the plan’s going to work, the less I have to give up.”