Two times in the past year, I’ve been close to making an investment in two separate micro-cap growth equity opportunities only to have the opportunity go sideways deep into the process. The two businesses share a lot in common; they are similar in size, profitability, and growth prospects. Both are capital-intensive; the first being asset intensive, the second being customer acquisition expense intensive. Both are examples of businesses where capital is a necessary, but insufficient, ingredient for growth; no capital, no growth.
We were excited about both investments. We offered a fair-valuation and structure in both cases; on market with other proposals the companies had received. In both cases management communicated that we were their preferred investor. In neither cases did our proposal require investor control of the Board, but in neither case would management have had control either; each Board would be balanced between investors, founders, management and independent directors who could act as a swing vote. Pretty good landscape for a deal to come together, right?
I thought so too. But, in the end, both groups of entrepreneurs chose not to take our money or any institutional money for that matter. In the first case, the entrepreneurs wanted to prevent dilution and were protecting a prior, too-high price per share that had been set by high net worth individual investors and an unwieldy gridlocked board structure. They decided to raise a small insider round with their existing high-net worth investors at a price per share that is above market. In the second case, the entrepreneurs wanted to prevent dilution and a loss of control at the Board level. They decided to raise a much smaller round from friends and family; also at a valuation that is above market.
I’m a huge fan of entrepreneurs who bootstrap their business to success without institutional capital. I recognize that raising institutional capital is risky business – new investors, new board, etc. I encourage entrepreneurs to choose their investors wisely. But, unfortunately, capital-intensive businesses can’t be bootstrapped. Eventually, capital-intensive businesses must raise capital and grow or whither. There is no future as a sub-scale player in capital-intensive sectors. These are not lifestyle businesses; staying small is a recipe for slow failure. Eventually, the market passes these companies by as larger, better capitalized competitors crowd out the small guys.
Entrepreneurs in these situations face a difficult choice. They have two things they can sell; one obvious, one hidden and difficult to quantify. What do I mean? It is obvious that if you raise capital, you are selling stock. Via the sale of stock the company gets capital and with that capital, the company funds growth initiatives creating the opportunity to grow and become more profitable. To simplify, such a company has sold stock and bought growth. By choosing not to raise capital or to raise less capital, the reverse is true; the company has essentially sold future growth potential by not selling (essentially buying) stock.
If the company has great growth prospects and management is confident in those growth prospects, it’s better to sell stock and buy the growth. In that case, management will get a smaller piece of a bigger pie and come out ahead in the end. If the growth prospects are uncertain or management does not have confidence in its growth projections, it may be better to “sell the growth potential” and keep more ownership. After all, if management is not confident in its growth prospects, why take the dilution from selling stock (and the associated loss of control) to capture growth that may not materialize.
I sympathize for entrepreneurs that face this choice. There is no right answer here; much if this should be left to personal preference. But make no mistake, in capital-intensive businesses, entrepreneurs that choose to raise insufficient capital may be unwittingly selling something of tremendous hidden value – the future growth prospects of the business. And although it is counterintuitive, I’d argue there are greater risks in under-capitalizing a capital intensive business than the risks inherent in an institutionally financed deal (lower ownership, less control). In any event, the old big piece-small pie, small piece-big pie conundrum is alive and well.
(Cross-posted @ Non-Linear VC)
