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Negotiating Startup Equity Splits (Valuing Sweat vs. Capital) - YouTube
Channel: Brett Cenkus
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Hi there. This is Brett Cenkus, the
right-brained business lawyer; and thank
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you for joining me in another video in
our series of mastering business
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partnerships. Today, we're going to talk
about something I call the capital and
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calories problem or dilemma.
Business is people, right? When you're in
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business you're dealing with people all
the time and people are emotional and
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unique and confusing at times and
unpredictable--we all are, but we're also
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highly predictable in certain ways.
There's certain human emotions and
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motivations that are universal and one
of the strongest human motivations, I
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believe, drivers, something you could just
take to the bank, is that we all want
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what we can't have; and we over value the
things we don't have, that we want; we
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undervalue and take for granted that
which we do, you know the things we have.
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So capital and calories refers to, in case of
capital: money; and calories refers to
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labor. So every business, to thrive, to
succeed needs plenty of both; they need
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plenty of labor and effort; they need
plenty of money. Those are the two
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resources a business needs. Now, when an
entrepreneur, who doesn't have any money,
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wants to start a business, they're going
to highly value the capital piece, right?
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They'll do anything to get a check. They
don't have any money; they need money;
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they're gonna obsess and crave and
overvalue it. On the other hand, they have
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a lot of time and they will undervalue
their time and their effort at this
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point. This problem, by the way, is
exacerbated in that they don't have the
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money and they're about to get
it now and the effort we're talking
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about is expended over the long haul. So
we tend to make decisions for the short
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run and value things in the short run, as
humans, like a piece of chocolate cake,
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rather than going to the gym, because
it's got immediate gratification, right?
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So not only are you overvaluing in this
case the money you don't have, but that
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money's gonna arrive right now. So the
problem would be a little less of one, if
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I had to do the work today to go get the
check, but when you're raising money for
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a business, you just get the check and
then you have to do the work.
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So this problem comes up and you see it
in a lot of different contexts, but I'm
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gonna just kind of outline one and
something I've seen court of quite a few
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times, is where the entrepreneur gives
away way too much of the company upfront
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for the amount of money they're raising
and the valuation. So for example, I had
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an entrepreneur in my office trying to
raise some money who had given up half
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of their company, in the very first round,
for a couple hundred thousand dollars. So
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it's not uncommon for me to find an
entrepreneur who struck a deal like that,
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who gave away half their company upfront,
because they really valued the capital,
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because they didn't have the capital and
they needed it now; and they undervalued
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all that work they were gonna put it
after the fact. So in that case, there's
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not a lot of good solutions later on.
Sometimes the entrepreneur has to go back
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and try and renegotiate that deal with
the investor, who I can promise you is
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gonna think, 'but that's the deal you cut',
right? Look at it from their perspective,
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they're thinking that's the deal, but
you're thinking four or five six years
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in; this isn't fair; it's all my work.
Every year and it starts to be
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very demotivating, you're very
disincented. This is a problem that
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savvy investors understand, which is why
they would never take half of your
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company, they're not gonna walk into this
problem. If the amount of money you're
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raising and the valuation of the company
don't justify that amount of money for
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for more like 20% of the company, then
they're just not gonna do the deal;
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they'll walk away from it. It just
doesn't make sense to take half your
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company, it's not a situation that's set
up for success for anyone. Now let me
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distinguish though, this is a problem, I'm
describing the context of running a
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business for you know the mid to long
term. If what we have here is me coming
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to you with a short term opportunity,
having identified some asset we can buy
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that's below market, and I say I don't
have any money,
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I found this opportunity, it's mine
only, if I bring in, how much do you
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want? You say 50%; well that's a different
deal. That's a totally different deal,
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because there's not that much labor on
this deal. The problem comes in
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fundamentally, the capital and calories
problem comes in in the fact that
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entrepreneurs upfront don't value,
they're just not thinking about all that
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work and how this deal is gonna feel in
a couple of years.
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So ways to deal with that issue, right;
let's say you still need money and the
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valuation of your company, that
you could justify, doesn't really, you
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know, you're in a world, where
you have to give up something like that
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amount of money or someone
offers that to you, let's say. So let me
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give you four ways you could address it.
The first is, just don't take the money
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right, you just don't do that deal; and
again a savvy investor shouldn't want
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you to do that deal, unless they're
really trying to take your company or
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they've got some ulterior motive and
that's not, I mean most investors have
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other things to do in the world. So
maybe you have to look for more savvy
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capitals, number one. See if you can't
justify evaluation that with that person
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that gives up less of your company, you
maintain more of it. Number two, you could
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think about doing a tiered investment; so
instead if you need a half a million
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dollars to execute your plan, maybe you
just get a quarter of a million dollars,
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maybe you give up 25% your business
rather than 50; and after performing a
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certain, after hitting certain milestones,
you go back and you get more money at a
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different valuation. That's something you
can think about you, you tier your
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investments and that by the way is why
technology startups
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typically raise just as little as
possible in their friends and family and
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then their seed round; the idea is
they're going to do multiple rounds.
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You've seen it many times, it's a
predictable path of friends and family
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seed A, B. The point is, at each stage of
fundraising the company has achieved more
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compared to the last round
and so they de-risked the profile of the
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business and they're able to justify
higher valuation to give up less money.
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So you can think about that, maybe you
don't need a half a million dollars
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today; maybe you can do this in stages
and figure out something else. A third
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way to address the issue is salary; so
it's possible to pull a salary out of
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your business. Let's say you and I are, I
give you 50%, I take 50% of your business
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for a half a million bucks; I'm passive,
you're active, we come to a deal that
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you're going to get a salary out of the
business. That's fair right, you're
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working in it; and that's meant to
compensate you over time for those
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efforts. And maybe we say look for the
first six months, no salary or you tell
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me, look Brett I've taken no salary for
two years, so I say okay I understand
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you've put in some sweat.
This is a way to make sure that your
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labor is being compensated separately
from your ownership percentage. Now
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that's not always easy to do and
completely counter the capital/calories
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problem. The reason is because it would
be likely at the time that I'm cutting
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you a check that any salary that would
make you happy is going to start to look
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like a little too much, from my
perspective; but that same salary, from
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your perspective in a few years, when
that business is killing it is going
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to look like a pittance. So it's like, you
still have this issue about overtime,
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does the salary get you everywhere you
need to go? Now sometimes, entrepreneurs
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and investors are silent about salary,
which means there's a lot of flexibility,
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depending on what the corporate law is;
corporations are gonna have certain sort
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of limitations, I won't get into that the
nuances of that, but let's just assume
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that it gives up an entrepreneur a lot
more flexibility to take out whatever
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salary they can sort of justify. Well
you're setting up another problem there,
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which is at some point the investor
might be upset about the issue they
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didn't cover and they might have an
expectation that you shouldn't
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have any salary or that it shouldn't be
scaling in any meaningful way, because
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the more salary you take out the, less
profit is there for them to participate
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in. So salary can be a little bit
complicated, if you're able to take the
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gloves off and have a really open
conversation, I always encourage that
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then you can really address this thing
and explain like salary needs to have
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expectations about how it would scale
over time. Fourth way, and this is a great
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way to address it especially if the only
check that's in front of you is from
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your uncle and he has told you he needs
half of your business, he doesn't care
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about this video and he won't watch it,
then you could
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negotiate a redemption right. So what you
do is you say that's fine, I'll give you
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half the business, but how about I have a
right to buy back all of it for a
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million bucks in the next two years; or
all of it for two million bucks any time;
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or ten percent of what you own for a
half a million bucks; you get all your
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money back and you're still holding on
to a lot of your investment. This comes
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in all sorts of different flavors, but
you get the idea, which is after I've
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returned to you investor a lot of your
investment, let me get some of that back.
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Even if you're able to buy it back at
fair market value,
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it's just an automatic call right on
investors interest in its fair market
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value. At some point that's going to
start to feel better than just always
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slugging it away, you know and only
getting 50% of the profit, when the
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investors passive. So you're building in
options to start to get some of your
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equity back; and fair market value, you
know isn't ideal from your perspective,
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generally you would want a right to
buy it back at a certain fixed price,
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because in five years that might look
like an absolute deal. And
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investors, upfront are often in the
mindset of oh hey, I have 50% of this
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company, sure I'll let you buy back 10%
of it for the amount of my
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investment, right. That looks like a huge,
what is that, five times their investment
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on that portion. That looks great, you
know they're thinking, I would take that
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in a heartbeat, but when you're killing
it when that business is going like
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gangbusters; they won't think of it like
that
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once they've earned it. So this is
kind of like what we described before
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with the capital/calories problem in a way,
which is the investor is valuing that
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return, that they don't have today, over
valuing it kind of and they might give
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you a very good they might give you a
very good deal;
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they're under valuing the likelihood
you're gonna be able to hit that, because
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they would love to get that kind of a
return. So you could strike a deal
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upfront to give them a great return, but
lock it in; and that's a way to overcome
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the capital/calories problem; that's a
way to overcome sellers remorse,
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you know issuers remorse, where you as a
company issue some stock in return for
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just too high of a percentage. So the
thing to keep in mind is as much as
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possible, understand that this is a
long-term game, that the deal you strike
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today--even though you want it more than
anything--you got to live with for a long
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time; know that universally deals get
done with angels, friends and family,
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venture capitals I see them all the time,
typically around you know any given
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round the company is going to give up,
the founders gonna give up ten to twenty
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five percent of the business; I mean it
just seems to hold true so often. So if
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you're giving up fifty percent, you gotta
backup and think, 'why am I doing this?'
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You're setting yourself up for a
situation that's going to be challenging;
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you're setting yourself up for
renegotiation or some problems, unless
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you bake in some other solutions; you
also, by the way, are not going to
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raise another round because venture
capitalists or even angel investors, who
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are pretty savvy are gonna realize, 'look
there's hardly anything to give to me';
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and at some point
you're not going to have the incentive
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to keep growing the business. So that's
the capital and calories problem;
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recognize it, deal with it. If you have any
questions about it, drop me a line. If you
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need some help thinking through a
capital/calories problem; how to
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structure some of that stuff, give me a
call. Thanks for stopping by today.
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