I am on the board of a company that recently hit breakeven. The business is low on cash, and last year it didn’t make money — but outside of paying bonuses and some one-time expenses, they have the happy position of finally starting to turn a profit each month.
The founder recently received an inbound offer to sell a low double-digit stake in the business at a reasonable valuation (not way out of market, but also a markup from the last valuation). And the founder is leaning towards taking in the money (which would obviously dilute all shareholders).
I was speaking to one of the other board members a few days ago, who’s current reaction is:
“NFW! Equity is so expensive, why sell it right when the company has hit a new inflection point and is likely to become even more profitable throughout the rest of the year?”
This other board member is one of my favorite people — super smart, and logical. And on paper he’s right.
The company has outstanding receivables it could factor (it also has some liabilities that are unlikely to become payable… but could in the case of certain events). So net-net, they have some alternative ways to get financed, but not in a significant way.
And on an Expected Value basis, he’s absolutely right. The entrepreneur should not sell equity at this time.
BUT — here is where the misalignment of an entrepreneur and its board comes into play.
The board member I was talking to spends his life building models to make the best possible financial decisions on a PV basis. But he has multiple investment positions. And while this particular investment is a concentrated position for him, if the company goes bankrupt it’s not the end of his career — or the elimination of nearly 100% of his assets.
For the entrepreneur, the story is very different. While the entrepreneur knows that with an 80% certainty everything will be fine, the idea that there is a 20% chance something horrible could happen is intolerable.
And while he knows that by taking the equity capital into the deal is expensive, and perhaps isn’t the academic thing to do from a capital allocator’s perspective, from a life perspective, he can’t tolerate the risk of his entire net worth, reputation, and network going up in flames.
And so for that reason, he’s not evaluating this offer as a CEO. He’s paying for “Net Worth Insurance.”
When we pay a premium on insurance, we all know we’re on the wrong side of the trade. If we were on the right side of the trade, insurance companies wouldn’t be selling the policy. But they have the Comparative Advantage of risk diversification that individual policy buyers don’t have.
In our scenario, Equity Investors have the Comparative Advantage of diversification of risk (they have portfolios).
Whereas the entrepreneur has the Comparative Advantage of an outsized position in the business already.
And often, those Comparative Advantages can lead to an equity offering that feels more like paying an insurance premium, that might frustrate other equity investors, but was the right thing to do for the entrepreneur.
And it’s these complicated, soft-skill problems that define how boards are run.