One day in the shower, a eureka moment inspires you with a novel idea that can solve a real problem for real people. You build a prototype, test it with potential customers, and your cursory one-page business plan looks bullet proof. You’re all set to start the new venture!
One problem: you’re don’t have cash to set up shop.
Sweat equity is often the best form of start-up capital. But selling ephemeral riches to your first hire seldom works. And for some ventures, getting the simplest minimum viable product working costs millions.
Time to find investors for seed capital.
This is usually the one problem every entrepreneur hits when starting out. Fortunately, finding investors is not the hardest problem to solve. There’s a lot of capital looking for places to invest, despite a global pandemic and locked down economies. (In fact, especially due to a pandemic, investors are struggling to find viable investments.)
The real problem is negotiating how much equity to exchange for capital. If your start-up is pre-revenue or there’s no market traction, your first investor will want a big chunk of equity. Makes sense, right? After all, they’d be putting a big chunk of capital at risk.
Practically and logically, giving away a 100% equity stake for 100% of the capital is not unreasonable. But then you’d no longer be the entrepreneur, merely an employee. That leaves little reason for you to drive growth – you know the sacrifices needed to make a new venture work!
That’s why most savvy early-stage investors and venture capitalists will want the founders to retain a controlling stake. In exchange for investors “giving up” equity, they might negotiate other terms, like guaranteed chairman or director positions to influence decisions at board level, or a convertible loan portion instead of pure equity.
So giving away 30%, or 40% or even 49% for seed capital sounds OK, eh? As founder, you would still be running the show, right?
Yes. In the short term.
We recently helped a client in their negotiations with a prospective investor. In exchange for several million in seed money, the investor asked for a 40% stake, leaving the founders with 60%. On the surface, it wasn’t an unreasonable offer. But we advised our client to leave the money on the table.
Given the growth plans we co-developed with our client, we knew that seed funding was not the only funding we’d need. Even with pessimistic growth projections, we’d forecast needing a series A funding round for market expansion within 3 years. With the forecast value of the business at that stage, combined with the growth capital needed, the equity dilution would have easily pushed the founding owners to be jointly minority shareholders.
Of course, the next funding round didn’t have to be through selling equity; debt- and asset financing could have worked. But why limit future options before you’ve left the starting gates?
While the best investments are where everyone gets along, we can’t count on relations not getting fractious and parties relying on their legal rights to enforce their interests. Maybe the best example of a founder getting voted out was when Apple fired Steve Jobs. It happens.
So you want to leave room to “sell” a little more equity later.
You also want to leave room for employee share options.
That being said, after a few funding rounds and rewarding employee equity, it’s normal for the founders to be minority shareholders in a growth-oriented business. (This is different for founders building a legacy business or family-run business.)
Either way, a rough rule of thumb is for founding entrepreneurs to exit a growth business with at least 25%. Two factors inform the exit equity proportion: 1. to make the sweat, family and emotional sacrifices worthwhile, and 2. to assure retirement funding and financial freedom.
Regardless of your reasons and timelines for being in business, plan your end-game scenarios before your first investment negotiations.
Regardless of whether you’re building a growth business to exit soon or a family legacy, you don’t want to give away too much equity too early.