Sherman said many entrepreneurs need to turn to the equity markets to solve cash flow problems, reaching out to angels, angel networks, online funding or private placements, especially when they lack real estate or inventory or equipment to pledge as collateral. In the short term it can be attractive, since it does not need to be paid back, but in the medium and long run it can be "a very costly source of capital" for a business that is growing and can expect its equity to increase in value, Sherman said.
One hybrid strategy is to partner with an angel for a bank loan, where the angel provides a guaranty with its personal balance sheet to secure the loan and receives equity or warrants in return. The business owner is still giving up equity, but far less equity than in a straight sale, since the risk to the investor is much lower, Sherman said.
There is an operating principle of entrepreneurship that makes it likely that business founders will face this situation at some point in a company's development. Owners plow profits back into a business, and the business itself is often 80 percent to 90 percent of their net worth, Stumpf estimated. In a fast-growth business, retained earnings should be low because the owner is reinvesting in the business.
"They will do whatever they can to keep the business alive," Stumpf said. His prime example is himself. "What I took out of paycheck in the first few years was insignificant. I was buying new computers or subscribing to information services or doing marketing programs. I don't have a million dollars' worth of a factory behind me, but I was still doing same thing — reinvesting in the business rather than taking big paychecks home."
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As CEO and co-founder of small-business finance company Biz2Credit, Rohit Arora has a lot of experience with business founders facing the decision to sell as a result of early success. Owners of quickly growing business are barely paying themselves and can only withstand so much of a lack of equity in the business before it becomes a cash flow challenge. "While you're doing great on paper, just to keep operating at the expanding scale, we have seen owners have to get an equity infusion," Arora said.
Entrepreneurs can raise money in the debt market, but after a certain point debt gets very expensive. "It's a classic mousetrap," Arora said. "A growing business that looks good and there's lots of money going in and out, plenty of cash flow, but any time there is a hiccup, all the cash flow gets sucked up."
One of Arora's clients, an entrepreneur in his 30s who rapidly grew a series of franchised smartphone stories in New York City, borrowed often from the Biz2Credit platform as the business grew to 50 stores over four years. The expansion was so swift that it turned into an asset-rich, cash-poor situation, with the entrepreneur needing more money to run the 50 stores, and for reasons from payroll to stocking expensive smartphones. The notorious Samsung Galaxy Note 7 fire recall put this owner in an immediate cash crunch — he had to wait three to four months for compensation from Samsung.
He really only had two options: Sell a stake or sell the entire operation. He ended up doing both, initially selling a stake but ultimately selling the entire business to a large distributor of phone accessories who was keen to reach customers directly.
"I've seen it so many times," Arora said. "He needed to give up equity, and once he got it, it stabilized the company. But as an entrepreneur, it was difficult working for someone else. He decided it was better to get totally out."
"In any high-growth business, I don't think you can do anything much different to avoid it," Arora said, though he does suggest that geographic expansion beyond an existing successful footprint be considered with caution.
For entrepreneurs, the good news is that there's always another business to create with the proceeds from a sale. The smartphone store entrepreneur could have sold to a bigger chain or even at a higher price if his hand hadn't been forced, Arora said. But he made good money and is now back with several new businesses, including one in the smartphone accessories market.
He took what he learned about selling accessories and doing smartphone repairs to the online world, where margins and volume are higher. And instead of lamenting the loss of physical stores, the entrepreneur has eliminated the risk of a cash crunch associated with retail locations.