Startup CEOs and/or founders face some very difficult decisions when they opt for VC or Angel funding. Apart from deciding how much money needs to be raised, some decision on how much ownership should go to investors, co-founders and perhaps a select group of early employees needs to be made.
Regrettably, there is no single formula to guide the CEO/founder through this extremely critical phase—only guidelines, because each situation is unique.
What to Expect
Equity crowd funding aside, there are three primary sources for startup funding and each source has its own expectations.
1. Family and Friends
If you receive funding from this source, expect to raise between $25,000 and $300,000, at the upper end. The investment is typically secured by a convertible note that can be swapped for stock at some future date or event.
2. Angel Investors
Investors of this stripe will usually fund in the $300,000 to $2 million range. They will secure with a convertible not but will likely seek warrants for additional shares or discounts on Series A shares.
3. Venture Capitalists
VCs are good for $2 million to $10 million and usually want thirty to fifty percent of your company.
Is There a Right Number
The short answer is yes. However, the right number will be unique to your enterprise and hinges entirely on the pre-money valuation. CEOs and founders should not lose sight of the fact that investors are looking for gains and have no interest in simply being paid back with interest. VCs want to ride your coattails to hefty gains and if you do not act prudently, they will have the controlling interest in your, scratch that, the business.
Paul Graham, co-founder of Y-Combinator, wrote an excellent blog post, The Equity Equation, in which he discusses a formula (of sorts). In the post, he suggests that it is acceptable equity trade-off if what you have left is worth more than the company was before. So, it may be acceptable to receive a $2 million investment from a VC in exchange for up to 33 percent of your enterprise. In short, if you owned 100 percent of a $2 million company before the transaction, post transaction, you will own 66% of a $4 million business, which puts you, $640,000 on plus side of the transaction. In other words, your 66 percent is now worth $640,000 more than the original value of the company when you owned 100 percent.
Ideally, you will have multiple venture capital firms vying for the opportunity to invest in your startup. This competition will be of great value in arriving at a reasonable valuation for your business.
Ultimately, your business is only worth what someone is willing to pay for it. Having VCs in competition with one another is in your best financial interests as it is likely to drive up the value.
Entrepreneurs have an emotional component to contend with when it comes valuing the business. As a result, they tend to overvalue the business and are resistant to surrendering little if any control. This tendency is something that you must acknowledge and factor in.
Another thing you need to understand is that VCs tend to make offers that allow their firms to wind up with a 50 percent share of your company. In other words if your company is valued at $1 million they will want to put in $1 million with the net effect being a 50 percent share to the VC. Consider this; if they are willing to offer you $1million, your company is worth at least that amount. You must also recognize that your equity will be further diluted in subsequent funding rounds and you could end up with a final equity position of 10 percent to 20 percent and the VCs will be at 60 percent to 75 percent.
How Much Should You Take
Your goal should be to raise the amount of capital to reach your next goal plus a bit more, as a cushion. Companies fail because they burn through their cash. The cushion is a necessary evil. No startup should try to raise all the capital it will eventually need in one round. The risk of extreme dilution is just too high.
Apart from the inherent value of your product or service, the greatest single driver for determining the value of your startup is the scope of the potential market after accounting for competition. Nothing excites a VC more than a huge market. The larger the potential market, the more valuable your enterprise becomes.
Consequently, much of your due diligence should be focused on establishing the potential size of your market and, of course, having concrete data to back up your estimates. Additional consideration must be given to current market conditions, interest rates, and the length of time involved in reaching projected milestones.
There is little etched in stone regarding the funding process but hopefully these insights will prove helpful.
(Writing by Andrew Cravenho; Editing by Todd Aitken and Megan Batchelor) – Andrew Cravenho is the CEO of CBAC LLC and Factor Auction. As a serial entrepreneur, Andrew focuses on helping both small and medium sized businesses take control of their cash flow. Prior to CBAC, Andrew founded an annuity financing company relieving tort victims of financial hardship.