How much equity should you give up?
As a financial leader of various early stage businesses, I often get asked certain questions repeatedly, like “How much is my company worth?”, or “Do we have enough cash to get through this year?” or “Can I wear white pants after Labor Day?” However the question I hear most often is “How much equity should we sell to investors for our seed or series A round?”
“How much is my company worth?”
Well, folks, just like the timeless post-Labor Day fashion question, the answer is often, “It depends”. Founders typically give up 20-40% of their company’s equity in a seed or series A financing. But this number could be much higher (or lower) depending on a number of factors that we will discuss shortly.
“How much equity should we sell to investors for our seed or series A round?”
Before that, however, let’s take a brief side-bar to discuss fundraising math. You will hear investors speak about pre-money valuation, which is the value of your company before their investment, and post-money valuation, which is the value of your company after their investment. Pre-money valuation + Cash raised = Post-money valuation.
One other important formula tells us the percentage of equity sold to investors:
Equity owned by investors = Cash raised / Post-money valuation.
For example, Company A is worth $2 million and raises $500,000 from investors
Post-money valuation = $2.5 million ($2m pre-money valuation + $500k)
Investor’s ownership stake = 20% ($500k / $2.5m post-money valuation)
Given the above math, the amount of equity you will give up in a financing is ultimately a function of 1) the value of your company and 2) how much money you raise. So let’s now discuss the key factors that determine these two elements and some ways to influence them in your favor such that you retain more equity in your company.
Size of the round: simply put, the more money you raise, the more equity you will have to give up. In the above example, if the founder raises $1 million instead, he will end up with a post-money valuation of $3 million and his investors will own 33% of his company ($1m raised / $3m post-money valuation). So, in order to retain more of your company, seek out ways to reduce the amount of money you need to raise. Be as thrifty as possible – find cheaper office space or work from home, delay any non-critical hires and go easy on the company-funded happy hours.
Strength of the team: the stronger your team, the higher your company’s valuation, and therefore the less equity you will give up in a financing round. Fill your team with proven rock-stars or ninjas, or better yet, rock-star ninjas. Ideally these will be people who you know well, have worked together before and have a verifiable track record of success in your industry. If you don’t know or can’t find people like this, you probably shouldn’t be starting a company, but that’s a whole separate blog post. Now I recognize that this advice seems to contradict the earlier point about hiring a stellar team, however great entrepreneurs usually find ways to hire awesome people without paying huge salaries. These include giving early employees a greater slice of equity, deferring salaries, reducing base salaries in exchange for higher variable compensation, and so on.
Attractiveness of the opportunity: If you are running a company in an industry that’s attractive to investors, you will receive a higher valuation and will be able to retain more equity in the company. In the current environment, cyber-security software start-ups are hot. E-commerce companies with sock-puppets as their spokesperson, not so much.
Fundraising environment: the broader economic environment plays a huge role in determining whether you will successfully raise money and how much equity you will retain. For example, during the 2008-09 financial crisis, it was very difficult to raise any money, much less receive a decent valuation. As a founder, you may not be able to change the economic environment, but you can certainly recognize its impact on your fundraising prospects and adjust your expectations and tactics accordingly. In tough environments be prepared for the process to take longer and be more difficult, so be willing to consider giving up more equity to achieve your goals.
So, enough talking – get yourself out there and start raising money! And as always, please reach out with any questions regarding fundraising or other financial management issues.
P.S. – As my lovely wife just informed me, apparently the answer is yes, you can wear white pants after Labor Day! So rock on with your white pants, people!
Written By: Peter Kihara – CFO Advisor
During his 20 year career, Peter has provided financial and entrepreneurial leadership to numerous companies seeking growth through acquisitions, raising capital, improving operations and/or turning around failing businesses. At DecisionCFO he has served as CFO Advisor to such thriving technology companies as Thuzio and Mediapredict.