Startups need capital to meet their growth aspirations. Too often, the startup founders cannot contribute enough capital, and the company does not produce sufficient revenue at early stages to maximize growth. As such, startups turn to investors who can provide the necessary capital in exchange for a share of equity. In return for a capital investment, the investor will desire a certain percentage of the company ownership. More specifically, the investor will require preferred shares of stock. Let’s review the many steps in the investment process.
The funding process generally does not begin by offering investors a certain percentage of the company. Rather, the investor and company will determine the company valuation while establishing the amount of funds needed (and on what schedule), and calculate the percentage of funding required in the investment process. The company will also consider the ultimate wishes of the existing shareholders when deciding whether to pursue equity financing. In this article, we discuss the factors that determine the percentage of stock that a company should offer to investors and the funding process.
Maintenance of Control
Most startup founders of a company wish to maintain control of the company as long as possible. If the startup is going to go through multiple rounds of equity investment, the founder’s ownership percentage can be diluted very quickly. Each round, investors will receive a share. Further, the investors may require a specific ownership percentage of 10-20% to be set aside to compensate company employees. This pool of stock shares comes from the founder’s share of equity. As such, it is not uncommon for startup founders to be minority shareholders after just a couple rounds of equity financing. While the percentage of stock awarded is determined by the company’s valuation and the amount of money invested, the founder’s preference should be a primary consideration in the percentage of equity to be offered. Further, this decision should anticipate the future rounds of equity financing.
Valuation and Investor Terms
As part of the investment process, how much of a share of equity to grant to an investor is the subject of negotiating the terms of investment between the investor and company. The ownership percentage is generally calculated by determining the amount of investment divided by the value of the company. For this reason, the company valuation is subject to considerable negotiation. Once the company valuation is established, the company and the investor will negotiate the benefits associated with the equity interest. Most investors receive a liquidation preference, conversion rights, and anti-dilution protection. The liquidation preference makes certain that the investor receives a return of her investment (or some multiple thereof) before other company owners receive any proceeds from sale of the company. Conversion rights allow the investor to convert her shares into common shares if the common shares become more valuable than the preferred shares. This happens when the preferred shares are subject to a cap on the amount of distribution from the sale of the company. In such a case, converting the shares to common shares may yield a higher return. Finally, the investor will receive some form of anti-dilution protection. This maintains the investor’s ownership percentage following later rounds of investment by other investors. This fact causes the interests of the existing shareholders to be diluted even faster. As such, the startup founder of a company must consider the terms of investment and valuation when considering the ownership percentage of equity interest to sell to an investor.
So far, we have discussed the preferences of existing shareholders and the valuation and deal terms as affecting the ownership percentage of the company. The final point of discussion is the investor’s disposition. This means the investor’s preference for ownership percentage. As discussed above, an investor can make certain that she receives a preferred payment from a future sale of the company. Further, she can make certain that she receives preference in any dividends. And, she can protect her ownership percentage against dilution from future rounds of equity financing. Further, she can protect her level of company control by establishing voting and approval rights. She can do all of this with deal terms in the equity financing. For this reason, the investor may be willing to accept a smaller percentage of interest in the company. This would normally be done by lowering the company valuation. Of course, if the investor secures all of these rights in the form of deal terms, it may defeat the benefits of maintaining a higher interest in ownership percentage.
LawTrades Knows Equity Investment
The equity financing and funding process for startups is complicated. It requires a thorough understanding of the investment process and the ability to effectively negotiate the terms of investment with the investors. If your company is considering undergoing an investment process, don’t go it alone. The legal professionals at LawTrades are experts in equity financing and deal structures. They can advise you on the investment process and assist you at every stage of the funding process.