My brother and I started a very successful specialty foods business a couple of years ago. We’re not rich, but we’re making enough to support ourselves and our families. Recently, a major distributor that wants to take our products nationwide approached us, selling them in supermarkets, gourmet groceries and specialty food stores.
Needless to say, we’re very excited by the idea, especially since the distributor is willing to put more than $1 million of its own money into the venture. The problem is that the distributor wants 30 percent of our stock in return for the $1 million investment. We’ve checked out the distributor, and they’re very reliable, with a good reputation in the industry. We’re just not sure about giving them 30 percent. Our concern is that if the products are successful, the distributor will put more and more of their money into our company, and we will eventually end up working for the distributor. Is there any way to avoid that? We don’t want to lose the deal with the distributor, but we don’t want to lose our control in the process.”
“Getting diluted” is an inevitable part of the process of growing a successful company. When a company is first started, the founders own 100 percent of the stock. You are entitled to 100 percent of the business profits, you have all the voting power and you make all the management decisions. But then an investor buys a piece of your company. Since you cannot own more than 100 percent of anything, the founders split whatever’s left after the new investor comes in.
For example, if Joe and Emily are fifty-fifty partners, and then sell a 30 percent interest in the company to Sam, Joe and Emily are left owning 70 percent of the company (35 percent each), and Sam owns the remaining 30 percent. If Emily and Sam become friendly and start voting together as a 65 percent block, Joe will be left out in the cold.
The reduction in Joe’s and Emily’s percentage ownership of the company (from 50 percent to 35 percent each) is called “dilution.” The mathematics of dilution is quite simple, but the emotional impact of dilution is often very hard to swallow. Your business is no longer “your baby.” It has left the roost, and while you still have a role in its future, you have to share that future with others. Many company founders don’t partner well with others and have difficulty accepting dilution, but dilution is an inevitable part of life when the founders of a growing company don’t have enough capital of their own to grow the business themselves.
In this case, the new investor is not just putting in money; they are a reputable nationwide distributor that will be able to land your products on supermarket and grocery store shelves. This is a very, very good thing for a specialty foods company. Chances are that if the new product rollouts are successful, this company will be worth more — much, much more — than it was before. You will own less of the company, but your lower share will be worth a lot more than your bigger share does today.
Here’s a question for you: If someone offered you the choice between $10 million in cash, or 1 percent of Microsoft Corp. stock, which would you accept? Before you grab the cash, do a little research on Microsoft’s market capitalization these days. That 1 percent is worth a lot more than $10 million. Some of the richest entrepreneurs on planet Earth own only a fraction of their company’s stock. If your specialty foods business becomes the next Ben & Jerry’s or BearNaked and all you own is 1 or 2 percent of the stock, I think you will be quite happy with that.
Having said that, though, there are ways you can protect yourself from being diluted too far, too fast and maintaining as much control of your company as you can. Talk with your attorney about the following possibilities:
• Requiring that new investments and other major company decisions can only be made by 100 percent of the owners, giving you and your partner the power to veto them (lawyers call this a “supermajority voting” provision).
• Creating a separate class of stock (owned by only you and your partner) with veto power over “product quality” type decisions.
• Putting a “floor” on your dilution (for example, requiring your consent if dilution would leave you and your partner with less than 15 percent of the company).
• Having the company sign employment agreements with each of you that cannot be terminated without the payment of a huge sum of money (called a “golden parachute”).