Startup Funding - How Does Equity Splitting Work

Nate
Equitydistribution

If you’re thinking about funding for your startup, chances are you’re knee deep in fleshing out the execution of your idea. Your progress is similar to people saying they are going to start training for a marathon. A lot of people say that, but when you get to the starting line, you look around, and none of those people showed up. From this point, it’s about keeping your energy, focus, and staying hydrated. My goal is to help you understand that funding is the water that will keep you going. Not having enough is scary, and having too much will weigh you down or tempt you to use it wastefully

Recently, I’ve been approached by entrepreneurs seeking guidance as to how they should organize their young companies. The biggest grey area for them was how equity gets reallocated at each stage in a startup’s development. These startups need funding, but don’t want to give away the farm. The question is, “What is the right balance that keeps everyone motivated, and makes the startup attractive to investors?”. This is a tough question because every startup is different. The only thing that is constant across the board is that you start out with 100% of the company, and when others are brought into the equation to help make the startup profitable, you have less. I’m going to show you how quickly equity splits up, and how important it is to keep momentum. If you keep momentum, your founder percentage shrinks, but your net worth increases because of the progress you’ve made.

Different startups require different methods of funding. Some startups decide to bootstrap and self fund their businesses. If you can do this, awesome. It keeps you in control of your destiny and owning more of your company. Problems arise if you want to do things like grow quickly and bring on more people to increase capacity

If you decide to go the funding route, remember that there isn’t that much to pass around. Giving too many 5% share allocations early on could end up biting you pretty hard. VC’s like to see that you’re able to achieve a lot while giving out as little equity as possible.

You can decide to split equity a few different ways, depending on your preference. I’m going to show you an example that takes funding from day one all the way to an IPO. In this scenario, there are three cofounders. The numbers we’ll assume is that the startup will get $25,000 from friends and family, $250,000 from Angel Investors and $5,000,000 from Venture Capitalists.

At the beginning, the founders own all of the equity in a very small company. If all goes well, they’ll own a much smaller portion of a really big company. It sounds a bit scary, but the numbers are eye popping.

Let’s get started:

I’ve got it!

Over the years, you’ve had quite a few ideas, but this one is the first that without a doubt is worth chasing after. At this point, you’re creating value in equity that doesn’t yet exist, all of which you own. Ideas of what things might look like in the future may start creeping in at this point, like whether you want to organize yourself as an LLC or CCorp (In my mind, this is an easy answer… Go LLC if you’re going to bootstrap, and CCorp if you’re going to go for funding. VC firms will probably make you convert to a CCorp, so you may as well get it out of the way)

I could use some help!

As you get into the nitty gritty of building your idea out, you start to see your scope creeping bigger. Right now, I’d say this is normal, but don’t try to boil the ocean. You need to stay focused and build a product that can be tested. Features can be added later, and right now, you should probably spend your time on more important things. With a wider scope, you could use some help, and decide to bring on two cofounders. As you build out the entire product scope, you recognize that these two cofounders are integral to your success, and decide to make them equal equity owners. Who cares that it was your original idea. You need these two people to make it happen, and making it happen means showing appreciation for the mad skills these two individuals possess!

At this point, the wrong thing to do is to go to a VC and pitch your idea. You hear it all the time, “ideas are a dime a dozen. It’s all about execution”. VC’s come into the picture later on to help you scale your idea. They want to see that you can plan, build, and get confirmation from potential customers. Then they’ll come in. But don’t you need their financing and expertise now? Why would you need a VC once you already have the thing built out with all of it’s shiny features? That’s why it’s imperative that you build an MVP that is testable. It shouldn’t have all the bells and whistles you desire. Show VC’s the data points that will make investing in your product a ‘shut up and take my money’ situation.

Hey Aunt Jane!

Getting money early on so you can survive is tough. Soliciting money from people you don’t know before you register your company is a big time nono. Thankfully, there are a couple things you can do.

There is no limit on asking for money from friends and family no matter how much money they have in the bank. This is a great avenue as long as you’re honest about the risk involved in your startup. Many people refuse to do business with family, and for them, that’s probably smart. Other people can handle the ups and downs. If these individuals believe in the product and your work ethic, go for it.

The other avenue is from ‘Accredited Investors’. These are people you know who either have $1,000,000 cash in the bank that is investible, or make a minimum of $200,000 a year. The government looks at these people as being smart enough to understand what a risky investment is.

All together, this group of investors gives you $25,000 and you give them a collective share of 5%. You decide at this point to make things legal and form your CCorp. Here’s where the fun starts.

At this point, things look a bit different. You and your cofounders own 75%, your friends and family own 5% and we’re introducing this thing called an option pool. Most of the time, your option pool will be about 20% of total equity, which may sound like a lot, but here’s the logic. Most VC firms will want you to have an option pool that you can use to attract talent. Anymore, a lot of startups will issue ‘restricted stock’ rather than options. They both work for the sake of the example. Even though the option pool is set aside out of the founder’s equity, it’s still technically owned by the founders if the stock is not allocated to other people. What does that mean? Let’s say Google looks at your company and decides to buy you. If you have only given out half of your available options, the remaining option equity would be split between the founders at the time of sale since the founders technically own it.

The Seed Round

The ‘Seed’ or ‘Angel’ round is a good place to assess your progress. Are you close to getting to your MVP? If so, the higher your ‘PreMoney Valuation’. A PreMoney Valuation is what your company is worth before the next round of financing comes in. It’s a true assessment of the progress you’ve made. Let’s say your budget for the next 6 months means you need to get $250,000 in seed funding and you only want to give up 14.3%. This means, your premoney valuation must come in at $1,500,000.

Now wait a minute. Wouldn’t that work out to 16.7%? The answer is no because the $250,000 is on top of the current valuation of $1,500,000. The investor is going to own a portion of the ‘PostMoney Valuation’.

The math is: $250,000/($1,500,000+$250,000) = 14.3% Seed Funder’s Equity

At this point, the equity breakdown is:

Founders: 64.275% (worth $1,124,812.5)
Friends and Family: 4.285% (Worth $74,987.5)
Seed Investor: 14.4% (Worth $250,000)
Option Pool: 17.14% (Worth $299,950)

The Venture Capital Round

Even though there can be multiple VC rounds of financing, we are only going to go through one round. This first round is your ‘SeriesA’. The math works much like the Seed Investor Round. At the time you want to get more funding, we’ll take a snapshot of what the company looks like to come up with your ‘PreMoney Valuation’. At this point, let’s assume you were able to increase your company’s value to $10,000,000 over the last 6 months.

The VC is going to want a large percentage of your company if they are going to invest. For this example, let’s say the VC Firm wants a third of your company after they make their investment. The investment the VC firm would have to make in your company is $5,000,000.

The math is: $5,000,000/($10,000,000+$5,000,000) = 33.33% VC Equity

Now, your Post Money Valuation is $15,000,000.

Founders: 62.85% (worth $6,427,500)
Friends and Family: 2.86% (Worth $428,500)
Option Pool: 9.53% (Worth $1,430,000)
Venture Capital Company: 33.33% (Worth $5,000,000)
Seed Investor: 11.427% (Worth $1,714,000)

IPO

There are a couple reasons a company would want to go IPO. The most obvious reasons are to get a very large amount of working capital to continue expansion, buy out competitors, and cash out on stock holdings. It’s also the time when all of the restricted stock or options can be traded in for actual shares. For a founder, transitioning a company to become publicly owned and traded sounds glamorous, but comes with another set of rules and obstacles.

Summary

While the numbers in this example are simply a shot in the dark, I hope that seeing the math play out helps you understand your obligation to the startup. It’s no longer just ‘your baby’ any more.

Read your operating agreements, founders. If you don’t understand something, ask questions until you do, even if that lawyer stuff isn’t your thing. It will be the moment you get hosed.

Things to Remember

  1. Choose your cofounders wisely.
  2. Only take friend’s and family’s money if everyone understands the risk.
  3. Bring on advisors who can actually help you get the job done.
  4. Choose ‘FounderCentric’ VC firms.