Why would a founder agree to take $500 for 40% equity in their startup?

For most entrepreneurs in Nigeria’s technology scene, success comes sometimes as a trade-off between letting go of a chunk of their company to investment deals or letting the ship sink due to lack of funding.

Consider a market that has seen a few established players (such as Flutterwave, Andela, Paystack and more recently, TeamApt) raise mouth-watering sums, it’s unlikely such deals happened without equity trade-offs.

These days though, it is more of a market that is filling up with new entrants. And with many having problems of structure, business model and limited funding opportunities, success requires going the extra mile.

Speaking of which, consider ₦200,000 ($554) for 40% stake in your startup as an example of going an extra mile.

Quite laughable, when you consider the investment terms. But you would be surprised to know that some behind-closed-doors ‘angel investments’ are typically not too far off from this.

From a fairness standpoint, there are questions about this investment idea, more so when the equity give away in the startup is at a staggering 40%.

So we decided to take the question to some selected entrepreneurs who are either in the middle of raising investment or have successfully navigated the murky waters of startup investment.

A not too surprising response came from Adeitan Abimbola, co-founder of Pickmeup, who explains that they’ve been in and out of several investment talks for their young startup and that ₦200k investment for 40% equity cannot be considered.

Foodlocker CEO, Femi Aiki’s comment isn’t different, insisting he will never enter or remain in such a contract.

“I must have thought I heard $200,000 at first,” says Chy Onwuka, founder of FabricsNG. “Even for that amount, 20% equity to a single investor is still considered a bad deal. ₦200k for 40% equity is not what I’d consider a bad deal, it is a no deal”.

Clearly, one reason why the above founders shun the idea is because the amount is too small. Especially after considering what impact it could have on the overall milestone journey of their respective startups.

“Between my co-founder and I, we’ve personally spent more than that amount on just brand development and looking at what’s ahead, it seems we’ve barely started,” says Abimbola.

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Presumptuous as the idea may seem, the consequences are far too devastating for the unsuspecting startup founder.

Apparently, the danger is that such an arrangement guarantees no exit potential because the equity value is already maxed out, thus leaving no room for future investment in the startup.

A case in point is the sudden death of OyaPay. It appears though the ex-CEO of the defunct startup, Abdulhamid Hassan has learnt the hard way.

When asked what he thinks of such an investment idea, Abdulhamid said the equity take is too high and that he would instead negotiate down to 20% and to something that offers a $1 million post-money valuation.

Unlike Femi who sees such arrangement “as a scam”, Abimbola and Abdulhamid give conditions that would bind them to such an agreement.

While Abimbola says he would be party to the agreement if only he is allowed to pay back over a period of months, with a stipulated percentage as ROI, Abdulhamid says that he will rather the person floating such amount comes in as a co-founder, not an investor.

Of a truth, equity valuation is extremely tricky. And especially here in Nigeria where there’s hardly any locally relevant data that helps calculate metrics such as discounted cash flows (DCF) inputs or VC valuation parameters; one has to tread with caution.

In general, all the respondents offered numerous advise on ways to navigate equity negotiations but the most proactive ones are that startups need to hire transaction advisors who will protect their interests. Or simply acquire the skills themselves by getting an MBA in VC financing and related fields from a top school.

But let’s be clear on one thing, it’s not only the founder that needs to apply to the process of relearning. There’s a need for the investors as well.

Depending on how one looks at it, 40% equity for a mere ₦200k cash investment calls the level of sophistication of the investor into question.

As Chy helps clarify, “₦200k cash exchange for 40% equity means that the overall startup is worth just ₦600,000 ($1,659)”.

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Can one call that a sound business decision? Or could such investor be just plainly overreaching?

Abimbola corroborates her observation.

“A lot of people see investment as a scheme whereby they must make instant returns on investment. They end up putting the brand owners into an unhealthy race of finding avenues of making profit so as to pay back. Again, most investors don’t like small percentage as returns on investment, forgetting that investment is also a risk they must be willing to face.”

As Femi rightly notes, this opens up a good business opportunity in Nigeria where advice is provided to startups through a non-greedy revenue model. But is this not already in existence?

What do you think about a ₦200k ($554) investment for 40% equity in your company and if you must, do share your experience with us in the comments section.

Photo Credit: majjed2008 Flickr via Compfight cc

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Nigerian startups raised $178m from 166 deals in 2018. Find out more when you purchase Techpoint’s Nigerian Startup Funding Report 2018 here.

Lead Venture Analyst at Techpoint. Eager to tell startup stories that offer Nigerians the much needed creative solutions to relate-able problems. Get in touch.

This content was originally published here.