This is one question that most StartUps’ need to deal with sooner than they expect. Capital is the fuel that propels any idea and turns it into a working business. Most StartUps’ are the brainchild of young entrepreneurs who are in their early 20s and 30s and who require initial capital to get their business up and running. Unfortunately, the math of sharing equity with investors while getting initial capital isn’t a sacred formula written on a rock that can easily be relied upon. To understand it better we need to take a look at one example.
Let’s look at this example. Jatin and Ramesh, who have started with their app-based medical services StartUp and have found a potential investor who is willing to pump in ₹6,00,000 but the investor is demanding 60% equity in return. Should they take it? The answer is a big ‘NO’ and there are two obvious reasons for it. First the math, of course, they would own only 40% of the company (rather 20% each) while raising seed investment for their business. Even if their idea works and they reach the Angel and VC rounds where their share would see further dilution they would become mere employees in their own company, owning a small fraction when it actually comes to earning their millions. Secondly and what’s even more appalling is that they are taking money from a naïve investor who doesn’t quite understand the StartUp ecosystem where investors don’t merely look at a percentage of their stakes but the overall value of the idea and the potential of growth.
This brings us to the question that we started with – how much equity should a StartUp share with its investors? Given that every StartUp is different and how they raise capital in their early days is dissimilar, it isn’t possible to state a formula for breaking up ownership. However, there is a trend that is going in the industry which would give you a decent path that you can follow and for the sake of better understanding, we shall stick to our above example.
In The Idea & Early Business Stage
So Ramesh and Jatin have been working on an idea for a few months and now they think the time is ripe for them to create a business out of this idea. So they quit their 9 to 5 daily job, start giving formal shape to their business and launch their website. Technically being co-founders they own 100% of the business or 50% each though the business is yet to be incorporated. Their saved funds won’t last long and hence they need to raise the initial working capital which would take them to the incorporation stage.
Company Registration Stage
Incorporating a start-up is much more than registering the company and complying with the corporate laws in the country. It is also an opportune time to raise the necessary capital for the company. Let’s say Ramesh and Jatin go to one of their rich relatives or friends and ask a for a fund in return of a certain amount of equity in the company. How much equity should they part with? Nothing more than 20% at this stage (the lesser the better as it will increase valuation in the company). Let’s assume Jatin’s uncle gives them ₹5,00,000 in lieu of 20% equity the company immediately gets a valuation of ₹25,00,000. Recall how they were offered ₹6,00,000 for 60% of their equity.
Attracting Angel Investors & Venture Capitalists
After the initial seed funding, Jatin and Ramesh have been steering their ship well. Their product has been appreciated by the users and they are fast making deep inroads into the market. However, they are soon reaching a stage where they would need to get aggressive with their branding and marketing to break ahead of other similar StartUps’. What they need is big sums of investment which won’t come from individuals they know. They are entering a stage which is often termed as Series Funding. They would need to look for Angel Investors or people who have tasted success with their own StartUps’ or other businesses and often bring in more than just money but ideas, contacts and also other investors. Also, they would need to look for Venture Capitalists or VCs who can fund by the millions. So how do they share equity for these much-needed investments? Let’s find out.
Their business is already valued at ₹25,00,000 termed as Pre-Money Valuation and it would act as a benchmark for this round of investment. Let’s assume they find an Angel in Series A Round who is willing to pump in ₹15,00,000 into the company. So their Post Money Valuation would stand at ₹25,00,000 + ₹15,00,000 which equals to ₹40,00,000. The new shareholding pattern would be decided by a simple formula – Shareholding = Investment / Post-money Valuation or 15,00,000/40,00,000 or the Angel would own 35% of the company and now Jatin and Ramesh would own roughly 26% of the company each while their seed investor would own 13% of the company. They won’t take a cut in the total number of shares held but new shares would be issued to the Angel in what is known as dilution. While their shareholding has dipped they own more thanks to increased valuation.
Similarly, they can go for a Series B Round and raise money from Venture Capitalist where similar formula would be applied to calculate the shareholding pattern. Technically in subsequent rounds, there would be an exponential jump in a valuation of the company and all investors would need to part with some percentage of their holding to accommodate new investors. If Jatin and Ramesh can successfully scale their business they would be able to attract multiple rounds of investments till they reach an IPO or an Initial Public Offering stage where their company would be traded in the equity market among ordinary investors and they would get the right platform to convert their holding into the company into money if they choose to exit.
If you are an entrepreneur looking to raise investments you need to play the ball carefully. Don’t part with too much of equity during seed funding and don’t stop from parting with equity at a later stage when the valuations are right.