Startup Equity Explained: What Investors Want.
VC Portfolio Construction, Valuation & Dilution Ranges & Down Rounds
Welcome to Part 2 of the series discussing startup equity dilution decisions.
In Part 1, we discussed some of the basics of equity and shares and dove into some considerations for hiring a co-founder, early employees or advisors.
This was followed with an appendix discussing SAFEs and Convertible Notes.
In this post, we are going to discuss what type of investors you might encounter, how they view the value of your equity and why everybody is afraid of the dreaded down round.
Investors:
There are different types of investors but in the earliest days of a startup, there are 4 main sources:
Friends and Family: These are people you know, that believe in you and are willing to give you the capital to pursue your idea. These are generally not full time investors, and they are likely offering you this capital more out of love/friendship than because they are expecting financial returns. At the same time, because these are people that you know well, you should be very motivated to not waste their money on your idea. Just because you can raise tens or hundreds of thousands of dollars from Friends and Family does not mean that you should. If you do raise from Friends and Family, you should feel confident that these people can afford to lose their investment and not have their lifestyle impaired. If you do raise from friends and family, try to have smaller cheques pool together and invest through a Special Purpose Vehicle (SPV) to avoid the number of different shareholders on your cap table. This will save you headaches down the line. Since most people can’t rely on their friends and family to fund their business, they need to turn to the other sources of capital mentioned below.
Angel Investors: Angel investors are typically High Net Worth Individuals (HNWHs), that contribute small amounts of capital (5 - 6 figures) to companies at the earliest stages. Angel Investors sometimes invest on. their own or part of Syndicates. Angels are willing to tolerate the most amount of risk, because it is their money they are investing, their check sizes are often smaller and unless they are new to angel investing, they understand the risks involved. Many Angel investors were likely once founders or early startup employees themselves, therefore in addition to their capital, they might be able to provide valuable advice, introductions to other investors as well as potential customers or early hires. Angel investors typically don’t invest in startups as their full time occupation and often lack big operations to support them. As such their reporting requirements are low but unless you proactively reach out to them, they will probably stop offering support shortly after their investment closes. Angel Investors are often the best option at the very start, when you are pre-product and need enough capital to build a minimum viable product (MVP) that could be good enough to convince potential customers to explore a proof of concept (POC) or pilot agreement. Since Angel Investors typically write small cheques, they typically can’t make up a meaningful part of the round past the Pre-Seed or Seed stage. If your business has high capital requirements, they might be priced out from the very beginning. If your goal is to raise larger amounts of capital, you likely need to speak to one of the next types of investors.
Corporate/Strategic Investors: These are generally early customers or key players within a specific industry vertical in which you operate. Their investment can come across in several ways but many large companies have established Corporate VCs (CVCs) or added people within their Corporate Development team that look to invest in promising early stage startups. While still motivated by returns, their investment mandate is generally focused on areas of interest for the parent Corporation. Some invest with the idea of later acquiring, others to identify future tech alliances and some simply want to be able to benefit from information rights from innovative young companies. Their willingness to work with early stage companies can vary greatly depending on the Corporate Investor. Many VCs started off as CVCs that eventually raised external capital and gradually reduced ties with the corporate parent. Not all CVCs or Strategic Investors, prefer leading rounds but this does not mean that they cannot be a valuable addition to your cap table. Their willingness to invest can also help attract investors from this next type.
Venture Capitalists: Once a rare breed, Venture capitalists, often spotted in their native Patagonia habitats, migrate seasonally between the lush ecosystems of startup conferences and exclusive networking events. With a diet consisting mainly of pitch decks and artisanal coffee, the venture capitalist thrives on the adrenaline of potential unicorn sightings. In all seriousness, VCs are professional investors who raise pools of capital from Institutional Investors and HNWIs (Limited Partners or LPs), with the intention of investing in early stage companies. LPs invest in VCs (the General Partner or GP) because they expect that they will earn a return equal to or in excess of 2.5-3 times the amount of capital invested (before fees). The reason these LPs expect such a high return is because of the high risk and lack of liquidity, present in the asset class (compared to Public Equities, Bonds etc.). For a VC to return 3 times their LPs capital, if they raise a fund of $100M, they will need the total value of their invested capital to be worth at least $300M before the end of the fund's life (typically 8-12 years). Given the high degree of uncertainty involved with early stage companies, it is very unlikely that each portfolio company will at least triple in value from the time of the investment to exit. Since 30-75% of venture backed startups go bankrupt or fail to return their raised capital, VCs achieve their return targets following the Power Law. Usually only 1 or 2 investments will generate the majority of the funds returns, with the rest making slightly above their initial invested amounts or losing it entirely.
This is why VCs look to invest in companies that they believe have the potential to be one of these top 1 or 2 investments. As a Founder, this is an important point to consider when trying to decide between bootstrapping or raising venture funding. While you might be satisfied with your company one day being worth millions of dollars, your VC investors will not be satisfied unless your business has the potential to be worth hundreds of millions or even billions of dollars. Taking money from VCs can also lead to other conflicts, such as them wanting you to sell sooner, so they can distribute capital back to their LPs or pressure you to pivot, so you won’t compete with another one of their portfolio companies. This is why you need to be careful with who you take money from. A good VC can’t make your company successful but a bad one can definitely make it much more difficult for you. Case in point from one of my favorite Angel Investors. Nonetheless, if you have decided that your business model requires Venture Financing and a VC has determined that your business has the potential to return >10X or better, they might decide to invest.
This decision to invest will be contingent on the negotiation between founders and investors over how much of the company’s ownership are the founders willing to give up in exchange for their capital. Naturally, Founders want to get as much capital as they can raise while giving up the least amount of equity, while VCs will want to get as much ownership for the least amount of capital. There are a few common valuation approaches, based on revenue multiples, comparable companies valuation, exit value etc. but generally there are standard amounts raised and valuations based on funding stage, which are constantly fluctuating because of market conditions. VCs see thousands of deals per year, and will typically specialize either in a few verticals or a funding stage. When a company is pre-revenue or at the very early stages of commercialization, it is common for investors to punt on a valuation for later, with SAFEs or convertible notes 1. As a Founder, it is important to be aware of the valuation ranges that deals are happening at per stage. Investors or Advisors can give you an idea of how much you will be able to raise, at what valuation, based on your current progress.
The temptation to raise as much money as possible is an obvious impulse, but this can create problems down the line. If you raise too much capital, too soon, you will likely give up way too much ownership. Unless this capital can sustain you to an exit, you will need to raise subsequent funding rounds and the founders and early employees will suffer massive dilution. Each time a new investor contributes capital, more shares are created and unless existing shareholders receive more shares, their total ownership will decrease. As such, Founders & employees will gradually own less of the company as time goes on. This can be problematic for everyone, because if people working at the company do not own enough equity to stay motivated, they will not want to stick around, which will make it difficult for the investors to realize the value from their investment. If the Founding team does not own enough of the company, this can scare off potential investors as early as the Series A round.
VCs, like most people, do not want to overly complicate their lives. They see thousands of deals per year and their time comes at a premium (although from Twitter & Linkedin it might not always appear that way). If they come across an interesting company that they would want to own a piece of, then notice that the cap table shows the founders owning very little equity with more financing rounds needed before an exit, they will often pass just on that basis alone. In order to issue a term sheet, they need to get their firm’s Investment Committee to sign off. Since they can only invest in a tiny percentage of all the deals they see each year, you don’t want to give them an easy reason to eliminate you from consideration.
If despite this unfavorable cap table position, they still want to invest, they might insist on a recapitalization (re-cap) of the business. A re-cap basically means, they want to re-distribute the way that equity is allotted to different shareholders. A re-cap can be done a few ways but the goal is that in the end result, the Founders and Employees working at the company have enough of a stake that they can still benefit from the upside if the company does well and that the newer investors own enough of the company that they feel that risk-reward tradeoff is worthwhile.
In general, it is best to avoid putting your company in a situation where a re-cap might be necessary. To ensure this, you want to make sure that you raise appropriate amounts of funding, at reasonable valuations. Wait, Ben didn’t you say that Founders want to raise as much money for as little dilution possible? Why would a founder take less money, or suffer more dilution than is absolutely necessary? Great question, intrepid reader. Any time somebody offers you large sums of money, the natural instinct is to take the money and run, and not ask too many questions.
In the short term that will seem great. You get to issue a nice press release, maybe throw a few parties and everybody in the company is in a good mood. Once the hangover wears off and you show up to your next board meeting, your investors who just gave you all of this money, are suddenly way less chill than before you signed the term sheet and other legal documents. You show up to your next board meeting and instead of the 4X Year over Year growth you promised them during the fundraising process, a few key deals slip and you only finish the year at 3.5X (still very impressive). Suddenly they are less interested in your revenue growth and hype around your product. Now they are asking if you really need 3 baristas on staff, and want to know about your efficiency, cash flow break even, gross margins (when did you sign up for an accounting class?) and start throwing these weird acronyms at you such as CAC & LTV. Evidently, they are ok funding you at 40 times annual recurring revenue (ARR) when you are growing 4X, but at 3.5X, they have a serious problem. They tell you that the tides are shifting, if you can’t achieve the very lofty revenue projections you presented to justify the high valuation before the end of your runway, you won’t be able to raise at a higher valuation, and you will be at risk of the dreaded down round.
A down round, as the name implies, indicates that the valuation of the company decreases between rounds. In most cases, this happens despite the company growing revenues and making enhancements to the products since the last financing. This clip from the TV show Silicon Valley sums it up well.
In the table below, here is a scenario in which your last round’s valuation was $10M, but now you now can only raise $2M on a Pre-Money Valuation of $6M, implying a Post-Money Valuation of $8M (80% of last rounds valuation).
(Calculation Walk Through Below2)
Normally this happens because of some combination of these reasons:
a) Market conditions deteriorate: Sentiment can quickly shift, and Investors suddenly reduce their appetite to pay for future growth. This can be triggered by changes in public equities multiples, difficulty exiting, increases in interest rates, less availability of early stage risk capital etc. I am old enough to remember 2022 when valuation multiples quickly dropped leaving many companies that raised big Series A-C rounds, in a situation where they had no way they could justify their previous rounds valuation before their runway ran out.
b) The company's growth rate slows down: Given that VCs only want to invest in companies that have the potential to score big exits, if a company is no longer growing as quickly, they will need to adjust their expectations to reflect the new trajectory. If you are growing 4X YoY, and your investors just funded you at 40X ARR, if you can maintain your trajectory, that means that 1 year from now, your company will be valued at 10X ARR (based on last round’s valuation). If you only grow 2X, you will be at 20X ARR. The closer your current valuation multiple is compared to the current multiple for your investment stage, the more at risk you are for a down round. If at the time you are trying to raise, companies are funding Series B rounds at 6-12X ARR, at 20X, you are at very high risk of a down round. At 10X, you are still at risk but provided you are not at the end of your runway, you can likely grow out of that range, permitting you to raise your next round at a higher valuation. You just need to hope that multiples don’t drop further.
c) The industry vertical is no longer as desirable as it was when the last investment was made: Investors will often form similar opinions on what types of companies can have Unicorn potential. As such, they can quickly pile into specific types of companies, creating deal competition that will force them to pay much higher multiples compared to what they would pay in other verticals. In recent years we have seen interest in investing in Crypto & Fintech startups quickly rise, fall and rise again. If you try to raise at a time when your vertical is out of favor, you might not be able to avoid a down round.
For a venture backed startup to be able to successfully grow from a small group of people, into a massive category leading company, it requires a very delicate dance between Founders, Employees, Early Investors and Later Investors to ensure that the company can successfully raise enough money to fund the businesses capital requirements while still giving all parties involved a satisfying result. While there are standard valuation ranges for each financing round, each business is unique and as a founder you must decide how much capital is needed, at the right moment to help achieve your company goals. If this means suffering more or less dilution than what is customary, this is up for you to decide.
This concludes today’s post on Startup Equity on investors. In Part 3, we will cover equity considerations for Employees and Liquidation Preferences.
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Prior to the new financing, there were 10 Million shares, at a $10M Valuation, that would imply a price per share of $1. With the new round of financing, you are raising $2M on a $6M Pre-Money valuation. You will be creating 3,333,333 new shares, which you find by dividing the New Pre-Money Valuation by the Number of Existing Shares prior to the new funding round ($6M/10M). This gives you the new price per share ($0.60). You then divide the new money raised ($2M) by this price per share $0.60. A shareholder prior to the round, who owned 1M shares, just saw the value of their holdings drop from $1M, down to $600K and their ownership drop from 10% down to 7.5%.