In 1969, Mel Brooks won the Oscar for Best Original Screenplay for his irreverent and outrageously funny movie The Producers. An unscrupulous producer and his mild-mannered accountant team up to profit from raising more money than they need to produce a play on Broadway. For their scheme to work they need only to produce a total flop of a play that will leave the investors expecting no return. Then, they can keep the extra they raised for the play.
The producer targets little old ladies, selling them each a fixed percentage in the profits of the play.
When they open their musical - Springtime For Hitler (the "mother lode" of sure flops) - the initial audience reaction is horror and disgust, raising the expectation of a quick profit from a total flop and early closing. But something unexpected happens and the play becomes a great success, dooming the producer and his accountant to financial ruin.
So, what's the reason for the producer's impending doom? After all, a successful play should generate plenty of profits to share with investors.
The answer is in their fundraising process. The producer sold percentage interests in his play instead of selling fixed units of ownership. Expecting a flop, he sold percentage interests adding up to more than 100%, meaning for every dollar of profit they would owe more than a dollar to their investors.
For the entrepreneur, selling percentage interests instead of ownership units can be just as dangerous. The effects are more subtle - unless, of course, you sell more than 100% of the company - but can be very damaging to a company's prospects.
The process makes it harder to raise more money. This is because it protects the percentage investor
from dilution in future rounds at the expense of other shareholders, which usually includes
management and the founders. This means, literally, that the company has less ownership to sell in later rounds. It also means future investors will be disproportionately diluted in rounds after they invest. This is not something most thoughtful investors will agree to. It also makes it harder for management to retain enough ownership interest to motivate themselves or attract needed talent.
This can put an expanding company with growing cash needs in a crunch. The company's success, like the producer's play, can spell the doom of the venture. Not because the company has to pay out more than it makes to investors but because the ability to raise needed investment to fund growth is impaired by a capital structure modeled on The Producers.
The cure is to sell the investor who wants to buy X% a number of ownership interests that equal X% of the company at the time of the sale. But when the sale is a percentage of the company that won't change when more ownership is sold, the company has mortgaged its future to raise current cash.
Remember, Mel Brooks is not your venture investor and selling percentage interests isn't a good idea even if Will Ferrell and Uma Thurman are promoting your product. Sell units of ownership instead of percentages.