Optimizing Founder Equity in your Startup Venture.
Growing a startup often means several waves of giving away equity, diluting your hard-earned founder shares. You will want to manage this process carefully to optimize outcomes for yourself and your co-founders.
The standard startup financing process involves selling equity to venture capitalists, thus reducing the percentage of company equity held by the founders. Each round of financing dilutes everyone (founders and previous investors) a little more. Today, Mark Zuckerberg only owns 12.8% of the company he founded (but let’s not cry too much for him).
Any startup founder knows that dilution will happen as you raise money. And then it continues to happen as you create stock option plans for your employees, give stock warrants to key partners, give stock options to advisors, and eventually raise some more money. But any good startup founder also wants to optimize this process as well as possible, and not “give away the store”.
Here are my quick tips and thoughts on this process:
- Make sure everything is carefully documented! One of the most expensive mistakes in my career was giving some extra shares to an early investor and then forgetting to record it properly on the cap table. Don’t be me.
- Don’t raise more money than you need. I was once shopping for a $500K seed round and got talked into $5M. It’s seductive to be offered more than you were looking for, but you give away too much of the company too early, which can limit future fundraising.
- Use SAFE’s cautiously. SAFE’s are a commonly-used lightweight seed-stage investment instrument that isn’t equity today, but turns into equity in the future based on pre-defined terms. I’ve seen founders hand out SAFE’s like tissue paper then be startled three years later when the SAFE’s convert to equity and most of the company is gone.
- Do Cap Table modeling. To the point above, use a good tool like Carta to model different cap table scenarios so that you choose a financing path (through multiple financing rounds) that yields an optimized outcome for you and your co-founders.
- Beware the Full Ratchet. Make sure you have a really good attorney to consult with before you accept any term sheet from an investor. There may well be terms they are asking for (like the dreaded Full Ratchet) that sound reasonably innocuous on a term sheet but have the potential of being painfully dilutive in the future.
- Vesting schedules are your friend. Make sure that any stock you give out is on a vesting schedule, even co-founders. The Silicon Valley standard is 4 years, meaning that they have to stay with the company for at least 4 years in order to get all of their stock. I’ve seen companies whose cap table says the company is 20% owned by a co-founder who quit two weeks into the venture and nobody has heard from him in five years.
These are just a few of the things you can do as a company founder to optimize your founder equity as you grow your company. The are many other considerations, including Right of First Refusal associated with stock agreements, and more. Again, having a good corporate attorney is key.
Also, I’d like to note, many first-time founders think that venture capital equity financing is the only route. There are many other, non-dilutive ways to finance a startup, including revenue share notes, debt capital, non-dilutive marketing capital, bootstrapping, and more. Do your shopping, and make sure you choose financing that makes sense for you and your venture.
If you choose equity financing, then managing that process well will ensure that you will end up still having a nice chunk of a very successful venture.
I’ll be hosting a livestream discussion on this topic on April 5th, with a panel of experts. Register here.