How to avoid the ‘negative equity’ trap

The fallout from the 2017 Grenfell disaster is still ongoing. There are thought to be 3 million people trapped in flats with unsafe cladding, unable to sell or move. The £5bn set aside by the Government to help offset the cost of making these buildings safe, is not even close to covering the cost. Owners face bills of many thousands of pounds. As one resident said when asked for payment, ‘if I had a spare £90,000 I wouldn’t be living in a one bedroom studio flat.’ This predicament raises the terrible spectre of negative equity, when the value of a home is less than the outstanding mortgage debt. Fortunately, this happens less than it once did, as homeowners are dissuaded from taking out risky mortgages and the housing market continues to grow. But the threat is there and can be devastating when it strikes. 

Negative equity can also happen in businesses. When a company is deemed to be worth less than what it owes, it must be restructured or liquidated. In a commercial context, negative equity occurs when a company’s liabilities exceed their assets. There can be lots of reasons for this, such as accumulated losses, excessive dividends and un-repayable debt levels. Liabilities can be managed over time, especially if you are generating cash, but if they are all due at once, then businesses would be bankrupted.

It doesn’t have to go that far. Most start-ups exist precariously, poised on a financial knife edge. Perceptions of a different kind of ‘negative equity’ are enough to kill them. Investors continually make assessments about the value of their equity. They cut their losses when they feel a company is not going to be valuable enough to return the returns they need on the equity share they own. Although they don’t owe your company’s debtors anything, this perception is of a loss of value is deadly. Investors take flight and you suffer irreparable reputational damage. The signs you are approaching trouble is when your investors lose enthusiasm for your business, disengage and focus their attention elsewhere. This is the surest indication that they have seen the writing on the wall and they are not only opting out of any future funding rounds, but are set to write off your business as a total loss in their portfolio. This happens a lot, with investors expecting around 65% of the investments they make to yield nothing.

There is another kind of ‘negative equity’ that we would like to alert founders to: finding yourself in a situation where the value of your equity is short of your minimum expectations. Sometimes this is unavoidable: the pressure of fundraising forces you to yield more than you want to give. You have to do what it takes to not only help your company to survive, but also to give it a chance to prosper. The old rule that it is better to have a smaller share of something bigger than a large share of something smaller, is still valid.

What we are concerned about are the unintentional occurrences of negative equity, when founders make unintentionally harmful decisions, unaware of the longer term implications. There are lots of entrepreneurs out there who have reached the finishing line, only to find the juice wasn’t worth the squeeze, and they have wasted the last three years’ investment of time and emotion.

How do you avoid this trap?

Firstly, set clear expectations about what you want to take away from the business. Most founders want to create something of value, have a positive impact on the world, and to cash in on this when they sell. Don’t be coy. If money is at all motivating, how much is enough? If you can’t answer this on day 1, you will struggle because you are ignoring a foundational rule of entrepreneurship: businesses should work for the founder, not the other way around. If you want to altruistically devote yourself to a cause, choose a better, less risky and more certain course of action. If you want to do good and make money, write down three numbers: what is the minimum you want from the business?; what would make you sell straight away?; and what is your fantasy number (this will help you design and configure your business, and if it remains unattainable, it is still good to dream)?

Next, make sure you get your initial equity split right. There is a big debate about the pros and cons of being a sole founder. We are in the ‘it helps to have more than one’ camp, not least because companies with more than one founder tend to find it easier to raise money and are more likely to succeed. In the flush of matchmaking you are likely to be at your most generous and egalitarian. But the key questions are all of a longer-term nature: what is the ultimate role of each founder? Will they make equal commitments and contributions? What value will they create for the business? A HBR study showed that the percentage of founders unhappy with the equity split increases by 2.5 times as their start-ups mature. Lots of founders get this wrong.

Unless you are a clairvoyant, you have no way of knowing answers to these questions. There are two rules to guide you. If you are equal in all things, the equity split must also be equal (because perceived unfairness and founder unhappiness are lethally toxic). Shares must vest. Don’t give everything away on day 1. Vesting links equity to successful future performance. If things don’t work out, the shares are bought back by other co-founders. This process is called founder or reverse vesting. And prepare yourself for a shock: VCs expect founders to re-vest their shares at a new fundraising round. 

Discuss what your expectations and deliverables are likely to be over the years ahead. And, if you can, agree a mechanism for future adjustment that takes into account unexpected divergences. This discussion can be softened by the knowledge that while some people can continue to grow indefinitely, others have firm limits and won’t perform beyond a certain level. It happens in every busy all the time, so it will probably happen in yours. We can’t all be top CEOs.

You must be aware of dilution. If you have one equal co-founder, you will only own 50% of your company on day 1. This sounds like a lot, but it means you must sell for at least twice your minimum financial target. Your share will fall from this start point. One recent US survey revealed the median founder ownership of SaaS start-ups at exit is 53%. Founders jointly owned just over half their companies. This means that if everything goes according to plan, you can expect to dilute your starting shares by at least 50%. It may be much more if things don’t go well, and early stage investors try to offset their risk with larger equity shares.

All founders need to give up equity to retain the top talent that you want to stay loyal. Options pools usually start at 10%. Investors will want these in place to incentivise key staff, and they increase to about 20% at Series A. If you get pre-seed investment, then this will cost 10% equity, or 6-7% if you use an accelerator. By the end of Seed fundraising you will do really well to have only given up 30% to investors. Series A and B will cost you another 20% each time. Not all this comes just from your share, as everyone who holds equity should be equally diluted at each stage. But the net effect is pretty stark: the more investment you take, the less of your company you own. The latest Atomico Start-Up report showed that European founders had on average 31.5% at Seed and only 16.9% at Series A. Ouch.

Finally, you need to become an active equity manager. In practice this means keeping a Cap table, planning the likely equity dilution over time, and doing regular valuations of your company and your equity share. This is time away from creating value for your business, but it is time well spent achieving the most important objective of all, creating value for yourself.

UP AND TO THE RIGHT.
 

Further reading:

https://hbr.org/2016/02/the-very-first-mistake-most-startup-founders-make

https://2020.stateofeuropeantech.com/chapter/state-european-tech-2020/