Now that you have finally received funding, it seems you have reached the finish line, but getting funding is not the end of your startup journey. It’s time to go to the drawing board again. The journey may still be tough, but at least, you now have some desperately needed resources.
When you are raising money for your startup, it helps to also understand how the investors you are pitching will make money for themselves. The formula for paying investors is often not as simple as taking their return on investment and allocating it equally among the key players.
For angel funds, venture capital funds and other investment partnerships, there are often complex formulas for how the individuals involved in managing investments make money. Ultimately, you should remember that all the investors want in return for their money is pretty simple: more money.
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What is the implication of raising funding?
By seeking funding rather than taking out a loan, startups can raise money that they are under no obligation to repay. However, the potential cost of accepting that money is higher – while traditional loans have fixed interest rates, startup equity investors are buying a percentage of the company from the founders.
This means that the founders are giving investors rights to a percentage of the company profits in perpetuity, which could amount to a lot of money. Big-name companies like Amazon, Facebook, and Google were once venture-backed startups.
4 ways startup investors can make money from their investment
- The startup is acquired by another company: For an investor in a startup, this is frequently the quickest way to make money on your original investment. When a startup is acquired, an investor may receive cash or new stock (or a combination of the two) from the acquiring company. So, how much an investor would see back on a merger or acquisition of this kind depends on his share of the startup and the valuation the company was being acquired at (Example here is Instagram).
- The startup goes public (IPO): If you had invested just $10,000 in Amazon, Dell, Apple, or Microsoft, when they went IPO, you’d be a million dollars richer just from that investment according to the IPO Playbook. Apple kicked that 100x ‘Franklin Multiple’ to the curb with a 4,581.7% rise in stock value between 2002 and 2012 alone.
- The company begins paying dividends: Some companies decide not to get bought or IPO. Their founders have a vision of running large, standalone businesses. To repay investors, they can pay out part of their cash flow in the form of ongoing dividends or if the cash buildup on their balance sheet is large enough, they may decide to dividend out a chunk of that cash in a one-time, special dividend.
- Investors sell their shares to other investors: Investors in startups typically have the ability to sell their shares to another buyer for a profit if they can find one.
What is Equity?
Equity essentially means ownership. Equity represents one’s percentage of ownership interest in a given company. For startup investors, this means the percentage of the company’s shares that a startup is willing to sell to investors for a specific amount of money.
As a company makes business progress, new investors are typically willing to pay a larger price per share in subsequent rounds of funding, as the startup has already demonstrated its potential for success. If the company turns a profit, investors make returns proportionate to their amount of equity in the startup. If the startup fails, the investors lose the money they have invested.
Returning Money to Investors: How to calculate their actual return
Often you know how much you want investors to invest, and they are demanding a certain rate of return. What cash flows do you need to provide to give them that rate of return?
If they provide $100,000 and demand a 40% rate of return per year, that means you’ll have to pay them $40,000 each year. If you agree that they get their money in a lump sum when the company goes public, then the 40% compounds.
The calculation is easy — the total due each year is the previous year’s total plus the interest (40%). If you estimate the company will be worth $5,000,000 at the end of the fifth year, then the investors will need to own 10.8% of the company ($537,824 / $5,000,000) in order for them to get their 40% return.
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Splitting the Pie
Every time you get funding, you give up a piece of your company. The more funding you get, the more company you give up. That ‘piece of company’ is ‘equity.’ Everyone you give it to becomes a co-owner of your company.
The basic idea behind equity is the splitting of a pie. When you start something, your pie is really small. You have 100% of a really small pie. When you take outside investment and your company grows, your pie becomes bigger. Your slice of the bigger pie will be bigger than your initial bite-size pie. When Google went public, Larry and Sergey had about 15% of the pie, each. That 15% was, however, a small slice of a really big pie.
Let’s look at how a hypothetical startup splits its equity from idea stage till it gets external investment:
Idea stage: At first, it is just you. You own 100% of it now and you are the only person in your company, you are not even thinking about equity yet.
Co-Founder Stage: As you start to transform your idea into a physical prototype, you realise that you could really use another person’s skills. So you look for a co-founder. You also realise that since she will do half of the work, so you give your co-founder 50%.
Soon you realise that you need funding. You would prefer to go straight to a VC, but so far you don’t think you have enough of a working product to show, so you start looking at other options. The Family and Friends Round, then The Angel Round. And then more options:
Incubators and accelerators: These places often provide cash, working space, and advisors. The cash is tight – about $25,000 (for 5 to 10% of the company.)
Angels: Let’s say it is still early days for you, and your working prototype is not that far along. You find an angel who looks at what you have and thinks that it is worth $1 million. He agrees to invest $200,000.
Now let’s calculate what percentage of the company you will give to the angel. We have to add the ‘pre-money valuation’ (how much the company is worth before new money comes in) and the investment:
$1,000,000 + $200,000 = $1,200,000 post-money valuation
Now divide the investment by the post-money valuation $200,000/$1,200,000 = 1/6 = 16.7%
The angel gets 16.7% of the company, or 1/6.
What about you, your co-founder and the family member that invested? How much do you have left? All of your stakes will be diluted by 1/6. Is dilution bad? No, because your pie is getting bigger with each investment. But, yes, dilution is bad, because you are losing control of your company. So what should you do? Take investment only when it is necessary.
Venture Capital Round
Finally, you have built your first version and you have traction with users. You approach VCs. How much can VCs give you? Let’s say the VC values what you have now at $4 million. Again, that is your pre-money valuation. He says he wants to invest $2 Million. The math is the same as in the angel round. The VC gets 33.3% of your company. Now it’s his company, too, though.
Your first VC round is your series A. Now you can go on to have series B, C – at some points either of the three things will happen to you. Either you will run out of funding and no one will want to invest, so you die. Or, you get enough funding to build something a bigger company wants to buy, and they acquire you. Or, you do so well that, after many rounds of funding, you decide to go public.
Why Companies Go Public?
There are two basic reasons. Technically an IPO is just another way to raise money, but this time from millions of regular people. Through an IPO, a company can sell stocks on the stock market and anyone can buy them. Since anyone can buy, you can likely sell a lot of stock right away rather than go to individual investors and ask them to invest. So it sounds like an easier way to get money.
There is another reason to IPO. All those people who have invested in your company so far, including you, are holding the so-called ‘restricted stock’. The people who have invested so far want to finally convert or sell their restricted stock and get cash or unrestricted stock, which is almost as good as cash. This is a liquidity event – when what you have becomes easily convertible into cash.
A prime example is Google, which launched as a startup in 1997 with $1 million in seed money. In 1999, the company was growing rapidly and attracted $25 million in venture capital funding, with two VC firms acquiring around 10% each of the company. In August 2004, Google went public, raising over $1.2 billion for the company and almost half a billion dollars for those original investors, a return of almost 1,700%.
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The term sheet
In the context of startups, a term sheet is the first formal document between a startup founder and an investor. A term sheet lays out the terms and conditions for investment. It is used to negotiate the final terms, which are then written up in a contract.
The downside of receiving funding
- After the investment, it’s not entirely yours anymore. That dream you had of building your own business ends when you take on outside startup investors. You have partners now. You have people who have a claim to ownership, shares, and having a voice in key decisions. You no longer set your own goals, strategy, milestones, and pace.
- Investors aren’t generic. Some become collaborative partners and even mentors, some are nagging insensitive critics. Some help, some don’t.
- Investors can be bosses. You are not your own person when you have investors; you’re part of a team. You can’t decide everything by yourself.
- Investors don’t make money until there’s a liquidity event. That’s why we always talk about exit strategies. You can be the world’s happiest, healthiest, most cash-independent company, but your investors won’t be happy until you get them cash back. The win is getting money back out of the company.
Founders should raise money when they have figured out what the market opportunity is and who the customer is, and when they have delivered a product that matches their needs and is being adopted at an interestingly rapid rate.
Look for ways to keep the amount of equity or percentages as low as possible when negotiating with an investor. For instance, ask for a smaller amount of money initially, rather than a sum you feel you’ll need over a few years. This allows you to give away a smaller slice of your business in exchange for the capital, leaving you with more as the owner of the company.
What are the Alternatives?
If it’s the advice you need more than the financing, another option is to take on a partner willing to offer working capital and expertise to your company. Your partner gets a cut of all profits, depending on your operating agreement, but you may have more options for terminating this arrangement.
Your partner can agree to sell his portion of the partnership to you, for example. Then you own his share and do not have to pay a percentage of the profits to him anymore.
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