Gazelles and giving up equity

I have been thinking a lot lately about the lack of ‘breakout’ SMEs in New Brunswick – firms that build something interesting here – a product or service – and then take it into wider markets and move from smallish sales base of let’s say $1M per year to $100M per year.   People that know about these things say that these ‘gazelles’ in New Brunswick are reluctant to give up equity – they would rather try and fund growth through cash flow or government grants – or if they can get some other kind of debt financing.

I think this is essentially right on – I could rhyme off a number of good looking firms that have reached a kind of growth plateau because their owner/owners don’t want to give up any equity to a third party.

But when you do the numbers – you see the challenge.  Take a company that is worth $1M today and has one owner at 100% equity.   Let’s further say the company generates $1M in sales each year.  The company generates a healthy 15% profit margin so she receives a $150,000 pretax income stream off the small business each year.

Now, she decides to grow the business and gives up 40%  of the value ($400k) to fund growth.

Let’s say with that $400k she hires an intl. sales guy, implements a marketing plan and buys new technology.   Because of this investment she grows her sales, profits and the value of her firm by 50% within a couple of years.

Now she owns 60% of a $1.5M firm – so her equity is only worth $900k and she only takes home $135k per year in profits (her share of the 15% profit margin).

So, she gave away 40% of her equity – and needed to grow her sales, value and profits by more than 50% just to get back to the same value and profits she was enjoying before.

It’s a simple example but it shows that firms with high growth potential should take on equity but those with moderate growth potential may be better off focusing on organic growth.