Financing a startup - whether bootstrapped or cash-endowed - is always a challenge for early-stage companies. Sometimes a founder will rely on their own funds (thus, bootstrapped), but more often founders will consider future rounds of financing like raising "seed capital"or "seed fundraising". This is especially true for high tech or larger companies.
Founders usually have strong emotions about sharing ownership with outside investors. On the one hand, they ordinarily require seed capital; on the other hand, they are apprehensive about surrendering control.
When a company agrees to accept seed capital or later stage funding, it will often receive much needed capital injections that can significantly grow a company’s value and market share. The tradeoff is dilution. Dilution occurs when equity (the percentage of a company’s ownership) is exchanged for cash infusions and the opportunity to become a more prosperous company.
How Much of Your Company Should You Give To An Investor in Exchange For Seed Capital?
The numerous variables in play for each entity create circumstances as unique as fingerprints. So, there is no-one-size-fits-all answer. Perhaps it would be useful to imagine the metaphorical pie, and to think about how you define “investor.” Placing your investors in different groups will also help you to determine how to share your growing pie when you raise seed capital.
The usual cast of investors consists of family and friends, angel investors, and venture capitalists (VCs).
Family and friends (F&F) typically do not expect to own a percentage of your company. Rather, their cash infusion tends to be a simple note: a loan plus interest to be repaid by a certain date.
Angel investors are high net worth individuals who provide a company with a loan with the expectation that their loan will convert to equity ownership (shares) at a later date when a company’s valuation can be determined.
VCs are private investors who offer funding to promising new companies. Since their investments are characterized as securities, they usually enter the funding rounds at the Series A stage. They typically demand 50% ownership at the Series A round, where the company’s first valuation is first ascertained.
The Big Pie Picture
When you start your company, you might own 100 percent of a small entity with little to no assets (thus, no value). As you grow, you will own a smaller percentage, but it will be part of a much larger pie. In other words, 100 percent of nothing does not have much value, but 50 percent of a $1 million pie starts to look like something. As you continue enlarging the size of your pie with each new round of funding, your equity stake will be reduced, but the value of your holdings should be significantly higher. So, thinking about “value” as opposed to “percentage” is probably a better way to think about when raising seed capital.
Making The Rounds
While each company and its circumstances are unique, there are some guidelines to consider regarding the usual percentage of shares that get sliced off in seed, Series A, and Series B rounds. Certainly, much depends on the valuation and other variables, which we will for put aside for now. (Valuation will be discussed in more depth below under convertible debt notes.)
As you advance to the next funding round, you should realistically expect further dilution. Founders start with 100 percent ownership. Seed rounds - the earliest stage of funding, usually from family and angel investors - typically dilute founders’ ownership by an average of 15%.
By the time you reach the Series A stage, you need to be prepared for further dilution. Series A investors are usually funders who provide venture capital for emerging companies. Since their funding typically exceeds $2 million, their percentage of ownership can be as high as 50%.
If you get to the Series B round, expect a dramatically different mindset from earlier funders. Whereas Series A and seed investors believe in your vision and have bought into the prospects of your company, those in Series B want to see that you’ve successfully progressed and satisfied important milestones. They typically see about 33 percent ownership, which will dilute all previous ownership percentages.
You also need to reserve a percentage for the option pool - usually, about 10 percent to 15 percent. Since a startup’s valuation is usually an unknown, you need to make sure that you’re protected by the terms in your note. While a valuation cap is one device, there are other moving parts.
Seed capital rounds: (founders, F&F, employees and angel investors): expect anywhere from 10 percent to 25 percent as a normal range, with a median 15 percent dilution to be realistically expected.
Series A round: 25 percent to 50 percent dilution is the typical range.
Series B round: an estimated 33 percent is the norm.
Here’s a Chart That Could Offer You Some Additional Guidance:
Seed Capital Investors
Series A Investors
Series B Investors
A Special Notice About Advisors
Let’s say you start with a co-founder. You might carve the pie 50/50 at first, but later decide you could use someone with experience to help you make a larger pie. So you hire an advisor with knowledge, experience and a network in your industry. The appropriate percentage of equity that you should offer an advisor will depend on their depth and breadth of experience. It will also depend on which round of financing you’re in.
There are no hard and fast rules about assigning advisor equity, but there are some guidelines that show an average range of 0.2 percent to 1 percent is the customary average.
Founders often assume that the best way to initially divide equity is to do so equally or in fixed splits before raising seed capital. What that means is that a percentage of ownership is allocated among founders (or founders and employees) without changing. So whether you divide the pie 50/50, in thirds or however you allocate percentages, that share will remain the same (except, of course, that they’ll be proportionately diluted at each funding round).
Fixed equity is a pretty inflexible model and often leads to conflict and sometimes even a company’s extinction. That’s why innovative equity sharing models are becoming increasingly popular. The dynamic-split model is one variation that enables company owners to be more flexible in adjusting equity allocation according to the weighted contributions of each owner.
Since many founders often lean toward equal and fixed splits, we are going to break down these two model to show you how they work.
This should be carefully considered since each founder/partner usually offers a different value to a startup - some provide more cash, others more experience or broader networks, while still others might contribute inventory and equipment. Accordingly, each founder’s contribution should probably be weighted differently to reflect as accurately as possible the value of their contribution, which will usually result in unequal percentages.
Next, equity splits tend to be fixed, meaning that the assigned percentage of ownership remains firm. This, too, should be carefully evaluated since founders’ contributions are typically more fluid, changing over time. A founder who initially contributes substantial sweat equity may later inject significant seed capital. Since cash is usually awarded a higher weighted value, it would be more appropriate to adjust that person’s equity share upwards to reflect their larger contribution.
In response to the minefield of challenges that fixed equity models have presented to startups, new equity sharing arrangements have been developed. The dynamic-split model is one alternative that’s finding increasing popularity. This system allows founders more flexibility in assessing equity percentages as contributions shift over time. Since it allows for a more fair and accurate apportionment of founders’ contributions, it reduces conflict among founders, which helps to ensure a startup’s longevity.
The way it works essentially is that relative values are assigned to each person’s contributions. For example, one founder might have greater access to financial resources, while another founder has more product knowledge and the ability to enhance the company’s intellectual property. Each type of contribution would be given an hourly value to reflect the premium value of the contribution.
For instance, capital injections might be assigned a factor of four times the actual value, intellectual property might be equal to or greater than cash contributions, equipment might be given a value at twice cash value, and so on.
You will also want to ensure that your advisors, employees and co-founders do not unfairly benefit in the event of an early exit. Vesting and cliff periods are critical to preventing this from occurring.
Vesting periods are usually four years, with rights accruing only after one year. If someone who is assigned an equity share in your company departs within the first year and your agreement doesn’t specify a vesting cliff, they will reap the financial benefits without providing the promised value to facilitate your company’s growth.
Therefore, all early equity owners should have a minimum vesting period, requiring them to contribute to the organization’s growth for at least one year before they can access the value of their ownership percentage. If they leave before the end of the first year, they forfeit their ownership. If they continue with the company beyond the initial year, they can start to accrue a percentage of their ownership (for example, an additional 25 percent each year for four years, with full vesting after the vesting period has been satisfied).
Protecting Your Equity Stake
It is strongly recommended that you engage a startup attorney to review all your funding documents so that you understand what you actually own and what you are sharing. While each round of investment presents a new valuation, you’ll need to ensure that there are minimal - if any - restrictions on your equity, such as vesting periods that give you less than what you might think you own.
These simple guidelines are offered to you in order to give you some idea of what the range of possibilities looks like to many startups. It’s not recommended that you rely on any of these general parameters as a substitute for sound legal advice. You are going to encounter questions that are very specific to the unique circumstances of your company especially during your seed capital raise, and therefore require competent legal advice. This includes everything from vesting cliffs to intellectual property and other issues beyond the horizon.
The most important thing for you to do before anything else is to ensure full disclosure and adequate understanding of any terms and conditions with the proper documentation. This means having a business plan to share with your family and friend investors, as well as adequate legal protection - whether you’re using an investment vehicle or a simple unsecured loan.
In order to best protect your company and interests, as well as personal relationships, it’s highly recommended that you obtain legal guidance, which can save you substantial money and hard feelings down the road.
The necessity to clarify the expectations of your F&F investors prior to accepting seed capital cannot be overemphasized. Since F&F investors usually do not demand sophisticated deal structures, you might be expected only to repay the loan. Typically, smaller investments from friends and family are unsecured loans (i.e., there’s no collateral to secure the loan’s repayment).
On the other hand, some early stage investors might expect higher returns, so considerable thought should be devoted to developing some common key elements. Critical terms might include defining the equity type (e.g., common stock), board seats (e.g., offering seats to leading angels), price (ownership percentage), mechanisms for minimizing dilution, and dissolution preference.
A sophisticated investment structure is going to look dramatically different from a simple loan. Convertible debt notes would generally be inappropriate for smaller investments. Instead, convertible equity could be an appealing alternative to traditional convertible debt notes when closing your seed capital. Convertible equity vehicles - such as Ressi instruments, Y Combinator’s SAFE agreements, or KISS securities - also help simplify these transactions, reduce legal costs and enhance the opportunity for the company’s success.
Financing Mechanisms For Seed Capital
A convertible debt instrument is a loan from an early round private investor (angels or VCs). VCs and angel investors are high net worth individuals who offer startups private loans with the expectation that at some point later down the road (e.g., 1-2 years), the debt changes into equity ownership (stock) in the company.
They were pioneered to allow founders to get a quick loan from private investors, in exchange for promising to repay those investors with equity (stock) at a later time when equity could be determined - normally, after a Series A funding round. In other words, company founders get fairly quick, inexpensive (low interest) cash, which they repay with ownership equity at maturity.
First, it’s important to understand that the general purpose of convertible notes is to reward early investors for taking an extra risk, and to provide some protection for them when valuation is ascertainable at a later time - that later time normally being the Series A round.
Your share price at the Series A stage is determined by dividing the valuation cap by the A valuation. This means that if you invested with a $2 million cap, and A investors set the price at $4 million, paying $1 per share, you would divide $4 million by $2 million and arrive at $.50 per share - effectively giving you twice as many shares as the A investors at the same price. While a valuation cap can give you some protection by setting the maximum price that the note will convert into equity, there are other variables in play.
The discount rate is one factor that should not be overlooked. Like the valuation cap, it determines how much you’ll receive for taking an early risk. Average discount rates fall at around 20 percent. What this means for you in that if your convertible note provides for a 20 percent discount, and Series A investors land at a price of $1 per share, your equity translates to $0.80 per share, giving you more shares for the same price.
You need to ensure that your note provides you with the option to use either the valuation cap or the discount rate. These are fairly standard terms since the idea is to allow the early investor to obtain the best price for their early risk.
Typically, when you reach the A round, either the discount rate or the valuation cap will provide you with a lower share price, which is the one you want to opt for since it will give you more shares. The general rule of thumb is to aim for a high valuation cap and low discount rate.
Finally, you need to consider other factors such as the note’s maturity date and interest rate. Obtaining sound advice from a professional is the best route to ensure you’re both protected and rewarded for taking on an early risk.
Convertible Equity: SAFEs, Ressis and KISS
Simply because convertible notes are used by the majority of early-stage investors does not mean that they actually “prefer” them to equity.
The reason why convertible instruments have been overwhelmingly used during seed capital raises in lieu of obtaining a straight equity position is principally for two reasons: (1) they expedite the early-stage funding round by reducing legal expense and simplifying the overall process, and (2) they kick the valuation can down the road to later funding rounds when the company’s valuation can more accurately be determined.
For example, a convertible debt note can be written in just a few pages; however, drafting a straight equity agreement is more time intensive and therefore most costly. Drafting an equity agreement requires due diligence, valuation assessment, SEC compliance, and negotiation. Consequently, longer and more numerous documents are needed in order to represent as thoroughly as possible all of the investors’ rights, obligations, terms and conditions.
Put simply, it’s a more painstaking and expensive process at a time when early investors don’t want unnecessary delays and companies don’t want the disruptions; they’re anxious to pull the trigger to close seed capital and get operations moving with minimal distractions.
However, there’s a hybrid option that’s been available for the past three years. Convertible equity was unheard of until just a few short years ago. After Adeo Ressi pioneered the new instrument in 2012, Y Combinator caught on a year later in 2013, with 500 Startups following suit in 2014.
These descriptions basically sketch only the contours of these more recent financing mechanisms. The crux is that they offer early investors the opportunity to convert their loans to equity quickly and inexpensively in the same way that convertible debt does, but without the maturity date and interest accumulations - or the threat of near extinction.
The largest challenge with traditional convertible notes is that if the maturity date is reached without securing the next round of funding, the note can be called for repayment. Without financing to repay the loans, investors holding convertible debt notes can force a company into bankruptcy.
Convertible equity solves this problem by eliminating interest and maturity dates, while still providing for automatic equity conversion upon successfully completing the Series A round of funding. Moreover, some tax advantages could be available to convertible equity holders since it appears that they’ll be characterized as qualified small business stock, resulting in a lower capital gains tax.
SAFE, Ressi’s Convertible Equity and KISS agreements are fundamentally the same types of instruments with just a few minor differences.
Identifying the need to reduce the potential financial stress that convertible debt can inflict on startups at maturity, Ressi developed convertible equity as an alternative financing mechanism that operates similar to convertible debt notes, with two critical differences: (1) no interest and (2) no maturity date.
Ressi’s innovation debuted just over three years ago, with Y Combinator’s SAFE (Simple Agreement for Future Equity) following about one year later. YC took its inspiration from Ressi and pretty much followed the Ressi model, with some relatively inconsequential variations - e.g., Ressi separates the note from the purchase agreement, whereas YC combines them in a single document.
There are also some minor differences on round limitations, conversion triggers and preemptive rights, but they both function with the same purpose: eliminate maturity dates and interest, sidestep debt, and ease the process by reducing legal burdens.
Other than that, both instruments provide for equity conversion when triggered by events such as financing or dissolution. Of course, the agreement can be terminated if no triggering event occurs.
Although Mr. Ressi predicted in early 2014 that 60 percent of all early startup financings would use convertible equity structuring by the end of that year, estimates of mid-2015 placed it more at around 25 percent, leaving them still relatively untested. Their rising popularity has, however, hit a nerve for early stage investors, reflecting more long term commitment.
The ultimate takeaway of Ressis, KISS and SAFEs is essentially that they aim for long term stabilization by eliminating those features that make convertible debt risky. Again, both securities remove interest and maturity provisions characteristic of convertible debt notes in order to reduce the risk of a run on investor calls that could trigger a domino effect, ultimately leading to a total collapse.
Finally, each agreement - whether a SAFE, KISS or Ressi - can be amended to include milestones that are tailored to the unique needs of the company when raising seed capital. The considerations that guide those amendments will largely be the same as with convertible debt: minimizing legal fees, adapting to the sophistication of the investors, deciding what is the appropriate amount of time needed to raise financing, and how much and what kind of financing is desirable.
Recent Developments: The Right to Pro-Rata Participation In Seed Capital and Series A Rounds
Among the most important rights that investors have is pro-rata participation. This is especially true for investors in tech companies since they give the investor the right to participate in future financing rounds and to maintain their ownership percentage.
The Changing Pro-Rata Landscape
Up until several years ago, pro-rata rights were given to larger investors in later rounds, less so to angel investors. However, it is now becoming increasingly common to find angel investors demanding pro-rata participation.
The reason is a purely economic one: there’s simply a whole lot more angel investors with a whole lot more cash. The result is that tech startups have access to far more capital than ever before. What you’re seeing now is the mushrooming of larger tech startups with pretty beefy capitalization. Combine that with unprecedented speed in their growth and that means more companies that are giants by the time of an IPO.
Let’s look at a simple example: Angel puts $500k into your company for a 10 percent ownership interest. If the company raises $20 million on the next round, angel might not be able to inject the $2 million that would be required to preserve their 10 percent ownership stake.
As you can see, even if this angel were given pro-rata rights, it doesn’t mean they would be able to execute them, since in this example we’re assuming that the investor doesn’t have the cash to keep their 10% stake. You can see how easy it is for an angel to feel like they’re being pushed out by the more weighty investors in the room.
What is happening now, however, is that there is a fairly abundant number of extremely high net worth angels who are ready, willing and able to put significantly higher sums into later financing rounds. Since they have the means to participate in those later rounds, they want to maintain their percentage of ownership, and pro-rata rights allow them to do this.
Cutting The Seedlings
Investors are wealthier and more sophisticated than ever before. They rely on their due diligence when making the decision to invest seed capital, so signaling does not necessarily carry the weight it once did. Consequently, the heat is being turned up in these later funding rounds as seed investors are fighting more for their pro rata rights, while later investors want to maximize their gains.
Some later stage investors take an all-or-nothing approach by threatening to pull out of the deal if seed investors don’t surrender their pro-rata rights. But this is not true for all later investors. Later stage investors who are opting to find a more balanced way forward tend to promote not just better deals, but also a stronger organization.
Ultimately, the later stage investor’s decision is philosophically-based. The primary take-away here is that later stage investors don’t come in just one color: there are many shades along a broad spectrum of advanced investors.
Caveat: Engage in some due diligence as early as possible - and certainly before a Letter of Intent and Term Sheet - to make sure this is an investor you will be comfortable with.
Entrepreneurial Advantage: It’s a ‘Seller’s’ Market
Entrepreneurs have the opportunity to leverage the growing competition between seed and later stage investors. Since VCs have growing appetites to own as much stock as possible in a promising tech startup, they are more willing to allow founders to take money off the table pre-launch.
While many founders usually hold their shares until IPO or sale, some are opting instead to cash out early. The reason gets back to the changing landscape: more investors - seed and VCs - with extraordinary cash reserves.
If a VC wants to have at least a 20 percent stake in your hot tech startup, they are going to be willing to secure their position by paying founders to take an early exit in exchange for a larger portion of the pie - and potentially far greater gains down the road.
Some founders are incentivized by these lucrative early exit offers. Take for instance two 30-something year old founders of Secret, a messaging app, who made $6 million from selling some of their shares in an early round of financing.
Like with most things, there are tradeoffs and moderation is the operative word. Ideally, the interests of founders and investors should be aligned. If a founder’s early liquidity feeds off the intensity of investor competition and their exit payoff is too high, it could be damaging to both parties’ interests: Founders’ creativity and drive could become flat and VCs won’t get the value of founder expertise to create a winning product.
Look for Win-Win Strategies
As a founder, one of the best things you can do is to understand who your investors are and what drives them. While it’s common to find VCs who disfavor an angel’s pro-rata rights, there are others who are finding innovative ways to accommodate everyone’s interests for seed capital.
For instance, some VCs adopt an approach that’s inclusive of angel and micro-VCs. This type of strategy incorporates a guarantee of angels’ pro-rata rights, subject to a clause that gives the majority of their class of preferred shares the right to waive pro-rata participation in whole or in part. If the majority votes to waive their rights, then everyone in the round is required to waive their rights.
An additional clause provides that if the majority does exercise its pro-rata rights, then they are required to offer the same deal to early investors proportionate to the majority. For example, if a VC is 80 percent of a round, but decides that it’s more sensible to take only 40 percent, then all investors in the round must adjust their percentages proportionately. This approach assures a more equitable accommodation of the rights of angels and later stage investors.
Final Thoughts for Frothy Times
Anything can change on a dime, so founders - especially of tech startups - are well-advised to consider how the competition between angels and later investors over pro-rata rights can best work to their advantage.
Each company has its own unique set of circumstances when closing seed capital. Your angels might have pro-rata rights, but this doesn’t mean they can enforce them. For example, if their investment is a relatively small one, even with pro-rata rights, they might not be able to participate because they don’t have the means. If they do have the means, VCs might insist those rights be surrendered or they (the VC) will walk. Or, the VC might find a way to appease everybody’s interests.
This is no substitute for legal advice, so enlisting the assistance of an experienced attorney to help guide you through this process is a solid investment.
Best practices is something that is going to encompass much more than just seed capital legal documents and financing. The following list offers some general guidelines that will help you understand the larger picture, and therefore steer you in the ‘right’ direction. Generally, the right direction is one where you have more clarity, better focus, and an enhanced vision that builds a more robust company.
Join Forces With Knowledgeable Investors
Founders need to be prepared to tackle complex questions, often spontaneously. Having an experienced investor by your side can help a founder respond more effectively to important decisions and inevitable challenges. While you do not want your investor to necessarily be overly involved in the minutia of daily operations, having access to a knowledgeable investor can be a valuable resource for dealing with strategic issues. Let them know you’d like to use them as a resource moving forward.
Start With Good Communication
This includes providing your investor with a realistic assessment of all the pertinent information. You want to build trust and a strong foundation, so make sure that you are prompt in submitting important data and honest with both the positives and negatives. Be proactive and diligent in your communications.
Be Compliance Conscious
This includes providing your investor with a realistic assessment of all the pertinent information. You want to build trust and a strong foundation, so make sure that you are prompt in submitting important data and honest with both the positives and negatives. Be proactive and diligent in your communications.
Make sure you divulge all strategic information, while not compromising confidential information. Distinguishing between the two can be tricky and require some legal guidance.
Investors will often have a fairly well developed network. They can help founders create value by introducing you to potential customers or future investors beyond the initial seed capital. Don’t be shy about asking your investor for introductions to important stakeholders such as those who could be valuable strategic partners, advisors, customers - and additional investors. Let them know you’ll be relying on their expertise and connections.
Be prudent about your expenditures: founders with a lot of accessible capital at their fingertips can make some imprudent spending decisions “in the best interest of business.” Those pricey dinners, memberships (even professional ones), and marketing costs add up quickly, so look for value and distinguish between ‘needs’ and ‘wants.’ Be cautious with your time: time management is more crucial than you realize. You don’t need to attend every event, accept every lunch invitation, or even look at every invitation as an opportunity. Again, let your investor know that you’ll be counting on them as a resource.
A Solid Term Sheet
Along with your letter of intent, the term sheet facilitates an understanding between founders and investors as to what’s expected regarding debt vs. equity considerations, BOD participation, liquidation preference, future financing and valuation, and what the parties can anticipate in the event that the company is acquired prior to a loan’s maturity. While a term sheet is more than just a handshake, it is still not a financing commitment. It - along with your negotiation - sets a tone, so make it a positive one.
A Sensible Business Structure
Delaware isn’t always the best option for incorporating, whether as a C-corp or some other type of business entity. Also, it can be tempting to incorporate yourself since many states now offer immediate, online incorporation for less than $100. If you haven’t yet incorporated or are changing structures, do not DIY this vital aspect of your business. Engage a knowledgeable attorney to help you decide on where and how to incorporate. Another important consideration is to avoid being top heavy with too many co-founders.
Build A Strong Team
Hire key recruits who can offer your company not only product and process expertise, but a different way of thinking. You aren’t committing to adopting their views as much as incorporating their ability to push your team’s thinking in new directions. What I’m aiming at here is essentially incorporating design thinking into your corporate culture. Design thinking is a problem-solving technique that’s fundamentally dissimilar to traditional, linear approaches. Instead, you start with a goal in mind rather than the notion of solving a particular problem. Traditional analytical thinking limits creativity and the explosion of ideas that can result from a nonjudgmental brainstorming session. Design thinking allows for unlocking a solution or inviting a critical ‘but-for’ tweak that takes the company or a product in a direction that couldn’t otherwise occur if your team was constrained by self-imposed restraints. Educate your investor about your team-building and problem solving approaches. It can distinguish you from your competition.
Tying Together the Loose Ends
As is often the case, many of these practices do not have neat borders. You will find that nurturing these practices prior to closing and continuing to promote them as values after closing will serve you throughout the company’s lifecycle.