Entrepreneurship is defined as the pursuit of success, regardless of resources. For the majority of entrepreneurs out there, one resource they don’t have is cash. If your idea is good enough to pursue and you are the right person to do it, you can most likely find an investor who has available cash in exchange for interest payments or partial ownership of your company.
The more money you raise and the more investors you take on, the more equity you must give away. But adding more ownership stakes to the equity pool can dilute original value for early investors, employees, advisors and founders. Most investors know this, so you must be prepared to show them how their investment will fare after each new round of fundraising. Cap tables are the perfect tools for understanding equity dilution under different scenarios. Read on to learn about key elements that go into building a cap table.
Bringing on a co-founder is a quick way to dilute your ownership, but two heads often function exponentially better than one, and the expense can be worth it. Before you even think about third parties, decide how you will split the original 100% equity between the founders. Will it be 50/50? 75/25? 90/10? Consider different factors, such as how early in the project you are, how much time each is committing, how much money each puts in, which skills they contribute, etc. Any equity you issue after that, to employees, advisors or investors, will dilute the founders’ equity proportionately.
Advisors and employees often get some equity so they feel like they have skin in the game. It is up to you whether or not to give them outright stock ownership, or the option to buy stock in the future. There are slight differences between stocks and options, but we will discuss that another time. How much equity will you dedicate to advisors? To early employees? To future employees? These people can be pivotal to your success, but will dilute your ownership, so be very selective in giving away pieces of your company.
Nothing gives you more authority to negotiate your company ownership than determining the value of your business. Consult industry standards and the common rules of thumb for your market. For example, it’s common practice that if you have a retail company, it is worth 0.8X annual revenues; a software company is worth 3.01X annual revenues; and a beverage company is worth 2.17X annual revenues (Q2 2015 Valuation Multiples Update). If you haven’t launched and do not yet have revenue to show, estimate what you think your revenues will be. Because an estimate is just an educated guess, fully expect an investor to negotiate a lower value for your business based on the uncertainty of early stage earnings.
Once you have a value for your company, it’s easier to decide how much to give away for any specific investment. If you need to borrow $150,000 to build a $1 million company, be prepared to give away 15% ($150,000/$1,000,000) or more. Additionally, you could take a $150,000 loan, pay interest, and give the lender the option at a later date to trade that loan in for stock. This type of lending agreement usually takes the form of a convertible loan.
Investing in an early stage start-up is risky, but you still need people to bet on you. To incentivize investors to give money despite the risk, early stage startups often offer a “discount,” in other words more equity for their money. For example, a $150,000 loan can buy the investor $180,000 worth of stock at a later date. Instead of $180k, they only paid $150k for the full amount of stock, which represents a 20% discount (($180,000-150,000)/150,000).
The ultimate safeguard against an investor being diluted is by holding a convertible note with a cap. If an investor gives you 100k, and his note has a $1 million cap, he will never convert to equity at anything less than 10% of the company (100,000/1,000,000). Even if your next investor gives you money at a $5 million valuation, which is much higher than the $1 million cap, instead of getting 2% of equity share during conversion (100,000/5,000,000), the cap will still allow the investor to get the 10% ownership that his cap implies.
When you raise money, you are infusing cash into your business. Cash has a very defined value that, when added to a business, increases the value of the business by exactly the value of the cash. If you raise $1 million for a business valued at $4 million, pre-money, then the business is worth $5 million ($4million pre-money + $1 million cash), post-money. Make sure you and your investors are discussing the same type of valuation during the negotiation.