Imagine that business is going great. Sales are up dramatically, the company and its products are getting a lot of traction thanks to social media campaigns, and a well-known celebrity is offering to endorse your product. A potential investor has approached the company and wants to buy-in, offering a $1 million capital infusion and line of credit on very favorable terms. The founding members are thrilled and are already looking for ways to invest the money back into the business (and maybe start collecting a nice paycheck themselves). The sky seems to be the limit. Or is it?
Even getting a meeting with a potential angel investor is exciting enough, let alone the prospect of getting significant funding. But there are many challenges that can arise both in the investor vetting and onboarding process. Just look at the case of Facebook. Having informally agreed to be business partners to develop the famed social networking site, Eduardo Saverin lent $15,000 to Mark Zuckerberg for the purpose of developing Facebook. For the first 6 months, Facebook grew by leaps and bounds, but differences between Saverin and Zuckerberg as to operating the business drove a wedge between the two. Zuckerberg’s and Dustin Moskovitz’s decision to bring on Peter Thiel as a new investor accelerated the downward spiral, culminating in substantial dilution of Saverin’s ownership interest, loss of valuable intellectual property rights, and his eventual ouster from Facebook.
Reading the tea leaves from the Facebook investor debacle, there are many valuable lessons that an entrepreneur can learn to avoid incurring legal liability and sullying both their and the business’ reputation. It may seem counter-intuitive, but some of the difficulties with bringing on a new investor can be softened or eliminated entirely if certain steps are followed during the formation and early growth of the business.
Casting Characters: Put Together a Strong Team
When you think about it, a business in some ways is no different from a relationship between two people. That may sound like a tired cliché, but compelling parallels can be drawn. A business, like a friendship, is formed by people that have common visions, want to use this relationship to further these visions, and want to grow personally and professionally. Businesses can start off with just two friends and grow to include many more. When that network of friends grows and one friend decides to add another, differences of opinion are bound to arise. And, of course, two friends can disagree just as vehemently as a group of friends.
Given that a business is an advanced friendship, an entrepreneur should be mindful when forming the business and putting together the management team and advisors. Most of the time you have to enter into a business with “eyes wide open,” being mindful of potential personality conflicts or personal issues that could bring down the business. One common dispute, as was seen in the case of Facebook, is the feeling that one member is lagging and not completing all of the work. This was likely the result of Zuckerberg not truly understanding Saverin’s background and strengths (Zuckerberg assumed that Saverin was business savvy based on his appearance and socio-economic background). If business members are aware of the strengths of other members and have some background history with a new member, the relationship is likely to form a strong foundation for the business. If members do not have the luxury of having a long-lasting prior relationship, the company will have to form a team based on the strengths of the partners alone, so close scrutiny of prior experience is a must.
After forming the management team, it is often beneficial to reach out to mentors to provide input on further developing the business. Indeed many if not most successful businesses are the result of input from many sources. These sources can be mentors or other influencers such as teachers, fellow business owners, or investors who contribute to the direction of the business. Besides providing input, advisors can also provide extra legitimacy to the company, especially if the advisor has a strong track record of success advising other companies. Just as business members scrutinize each other’s qualifications prior to beginning a relationship, so too should advisors be evaluated based on their experience, any prior business dealings with one of the business members, and access to potential investors.
At this early stage, it is often easy to overlook the formalities of entering into these relationships. Business owners often assume that because they are forming the business with a trusted contact or even a friend, there is little to fear in the way of work obligations not being upheld or ownership interests remaining intact. Even before opening the doors or making a product, members should have some type of written document that describes duties of the members to each other, describes money or other items of value that a member is contributing into the business, treatment of intellectual property created by the business or its members, and procedures for allowing a member to prevent their financial interest in the company from being damaged.
Opening Act: Make Sure That All Partners are Following the Same Scripe
After putting a team together, it falls on the business members to formulate a plan for operating the business. Members may have come to some kind of informal agreement as to what they want the business to do (“Increase user base by 50% every year for the first 5 years”), but there may not be an appropriate division of duties between the members to reach those goals or even a clear understanding of how to reach those goals. Goals of the business, division of duties, and methods for reaching these goals should be committed to some kind of plan, set along whatever kind of timeline the members feel appropriate. The team may find it helpful to define the goals in the short-term (2-5 years) and long-term (5-10 years). Responsibilities of each member should similarly be defined and clearly understood by each partner, with a clear explanation of how a member’s responsibilities will contribute to the defined goals.
If the members, who each have different strengths and visions for the company, are tasked with simply working on the product or business without reference to how this work will contribute to the business’ goals, there may be doubt amongst the members as to the importance of the work of each member. Indeed, the complaint that one member is not handling their fair share of work or contributing enough to the bottom line is a very common dispute among business owners.
Returning to the example of Facebook, one of the key breakdowns between Zuckerberg and Saverin was a failure to outline the business and responsibilities from the beginning. This contributed to a declining relationship between Zuckerberg and Saverin as the two doubted the efforts of the other. Zuckerberg, being in Silicon Valley was a world away from Saverin in New York City, and it appears that there was no mutual understanding as to how the two would work together. Zuckerberg was in charge of “making something cool” while Saverin was asked very generally “to set up the company, get funding, and make a business model.” This ambiguity as to operating goals of the company contributed to a huge falling out later when Saverin, in a bid to boost traffic to Facebook and generate revenue, posted ads with links to another website started by Saverin, Joboozle. The other partners at Facebook saw Saverin’s move as self-serving and the relationship between Saverin and Facebook was permanently tarnished.
Committing the goals of the business to paper, clearly outlining each members’ role in reaching these goals, and making sure that everyone is on the same page operationally will prevent disputes between business partners later when the business seeks to bring on a new member or seek investment. To be sure, there will be fewer bruised egos or misbeliefs about why a new member is being brought on, and the founding members themselves will be in a better position to pitch themselves for additional capital.
Intermission: Bringing Supporting Actors Onstage
If business is strong and those pitches are finally starting to stick, the company may find itself getting interest from investors and others who want to catch the train before it leaves the station. Whenever new capital is brought into the business, founding members will be faced with important decisions that will affect both the business’ and their own financial positions. Depending on the legal structure of the business, bringing in new capital may require existing members to take a haircut on their existing financial interest in the company, perhaps through a dilution of their ownership equity or sacrifice of voting rights. Dilution of an ownership interest is always a sticky issue for business members and can create a lot of resentment, especially if each member is kept in the dark about terms of a new capital infusion.
Bringing on a new investor, especially one that will provide a large capital infusion, could also bruise egos of at least one of the founding members. For example, one member may think that the company should be targeting one consumer segment with specific types of advertising while the new investor may think that the platform should be “clean” with little advertising and more “buzz” generated by users themselves. Such differences of opinion are healthy for driving business strategy and there should be some consideration of both sides’ arguments, but at the end of the day the managers of the business will need to come to a final decision. Depending on the legal structure of the business, a dissenting member may attempt to stop the implementation of the decision, perhaps letting personal differences with the new investor get in the way. At this stage, the company should carefully consider whether it could move on with the dissenting member in a management role and the nature of that member’s management role.
If the potential investor is bringing a lot of money to the table, she may further demand a large equity stake in the company and the power to make certain decisions about product development or expenses. The founding members should confer with each other to discuss the impact on their economic interests in the company prior to deciding whether to entertain an investor’s offer. “Going behind the back” of a member is never a good idea and straying from the procedures outlined in the founding document is unwise, even if the potential investment is large. If bruised egos are the result of a new investor “stepping on the toes” of a member, who has expertise in one area, maybe the investor’s control of decisions in that one area could be dialed back.
At the end of the day, the founding members form the core of the company. The idea originated with them and most of the magic that got the company to the financing stage was a result of each member’s efforts. When it comes time to bring on a new investor who may also be a new member of the team, the house should be righted. Certainly, having a solid business plan, ensuring that all members are on the same page to achieving the goals of that plan, and making sure each members’ talents are somehow integrated into that calculus will ensure that the show goes on.