Small business founders may be hesitant to pursue equity dilution as a means of raising capital from investors due to concerns about losing control over their company or receiving a lower return on investment. However, there are several reasons why small business founders should not be afraid of equity dilution when raising capital from investors, and why choosing the right early-stage investors is essential.
- The Capital to Grow: One reason why small business founders should not be afraid of equity dilution is that it allows them to raise the capital they need to grow and expand their companies. Small businesses, especially in their early stages, may not have the revenue or profits to finance their own growth. By issuing new shares and selling them to investors, small businesses can raise the funds they need to invest in new products, equipment, or employees. This can help the business grow and become more successful, which ultimately leads to a higher valuation and greater returns for the original shareholders.
- New Perspectives: Equity dilution often means bringing in new people, which can bring new expertise and perspectives to the company. When investors buy shares of a company, they often bring not just capital but also their experience and connections. This can be particularly valuable for small businesses that may not have the same resources and networks as larger companies. For example, an investor with experience in a particular industry or market may be able to provide valuable advice and guidance to the company, or help it make important connections. This could help the company to grow and be more successful, which will also benefit existing shareholders.
- Mitigates Risk: Equity dilution can help small businesses to mitigate the risk of the company. Investors usually require a minority stake in return for their capital and thus limiting the dilution for existing shareholders, but providing a cushion for the company in case of unexpected events. This can help the business to be more sustainable in the long term, which will also benefit the shareholders.
While dilution does reduce the percentage of ownership held by existing shareholders, it does not necessarily translate to a loss of control. A well-structured capital raise can provide a balance between raising the needed capital and preserving the control of the small business founders.
A well-drafted Operating Agreement can protect founders when raising capital from investors by outlining the percentage of ownership and control retained by the founders, establishing protocols for decision-making, setting up protective provisions such as rights of first refusal, co-sale rights or buy-sell agreements, and providing dispute resolution mechanisms for any issues that may arise. It can provide clarity on the roles and responsibilities of all parties involved and establish a balance of power between the founders and investors, helping to ensure that the founders maintain control and ownership of the company even as they raise capital.
It’s also important to note that the potential return on investment for existing shareholders is not necessarily lower when a company issues new shares. It’s a common misconception that dilution means lower returns; while it’s true that the percentage of ownership decreases if the company grows and its valuation increases, the existing shareholders can still see significant returns on their investments.
Crucial Decision: Choosing the Right Early-Stage Investors
The right investors will not only bring capital but also valuable expertise and networks that can help the company grow and be more successful. A good investor can also provide guidance and mentorship to the small business founder and align with their vision for the company. On the other hand, the wrong investors can cause misalignment of interests, which can lead to conflicts and have a negative impact on the company’s growth and success.
Small business founders should not be afraid of equity dilution when raising capital from investors. While it’s true that it reduces the percentage of ownership held by existing shareholders, it also allows them to raise the capital they need to grow and expand their companies, bring new expertise, perspectives and can help mitigate risk, attract more sophisticated investors, and increase the valuation of the company. The team at Forte has the experience and expertise to help guide you through this process and we’re passionate about helping founders navigate the many challenges of small business ownership.
