14 Jul TOP FIVE MISTAKES OF NEW ENTREPRENEURS (THIRD IN A SERIES)
Anyone who watched the much-acclaimed The Social Network directed by David Fincher begins to grasp these issues when cheering on for Eduardo Saverin, who is played by Andrew Garfield. The tech revolution brought on an expectation of wider ownership by more employees and consultants. This is a good thing, but I have seen this desire for ownership manipulated by more senior players who realize that small minority shareholders have limited rights at law. Yes, the management owes fiduciary duties, but these are somewhat “gray” obligations on an issue where you may want to address rights more directly.
In particular, two of my clients received verbal representations that each of them would be 5% owners in the LLC that operated the new website. On one level this was fundamentally true as they each received 5% of the Units of the LLC. Several years later, however, the 90% owner wanted to raise additional capital and to do so meant diluting every member of the LLC.
Although my clients did not agree with this strategy, if the 90% owner met its fiduciary duty, there is nothing inherently wrong with this strategy as raising additional capital could permit the LLC (or any company for that matter) to become much larger. As I’ve explained to many entrepreneurs, I would rather own 10% of a $100 million dollar company than 50% of a $2 million dollar company. So, although it’s tempting, it doesn’t necessary make sense to revert to iron clad restrictions against any dilution.
The Lesson. This area is tricky and there is no one answer. For the promoting entrepreneur, be careful about promising ownership as a percentage of the company, particularly if you are in a business where you will need to raise a lot of capital. For other members of the senior management, make sure you understand what rights you have and when the company can dilute you.