by Matthew Cushen
Updated: Sep 12, 2017 Published: Sep 12, 2017
Whenever an entrepreneur raises equity funding they should be thinking about the equity they give away.
But most think about holding on to equity in the funding round that is straight in front of them, when it is just as important to think about at least the next and, ideally, a couple of rounds later.
Take these two scenarios…
|Scenario A||Scenario B|
|Round 1||round 2||Round 3||Round 1||Round 2||Round 3|
|Investors’ equity (diluted)
Round 1 investors
Round 2 investors
Round 3 investors
|Founders’ equity (diluted)1||85.7%||68.6%||53.3%||75%||67.6%||56.3%|
|Value of founders’ equity||£450,000||£857,143||£1,200,000||£450,000||£1,200,000||£1,690,141|
1: this assumes no investment from the founders at either round
2: see my column in February – The Black Art of Start-up Valuation – for an explanation of the investment terms
3: if you would like to look at the workings of the example above or your own scenarios with a spreadsheet then please e-mail firstname.lastname@example.org.
In both scenarios the same overall level of funding is received across three rounds, but in scenario A a smaller amount in round 1 and a larger amount in round 2 than in scenario B.
In scenario B the additional funding has given the team extra ‘runway’ – the amount of time they have before they need to raise again. With this additional runway they have achieved more, so they have been able to justify a higher valuation in the second round and have maintained that momentum again in the third round.
See if you can get a Start Up Loan to help you start a business idea
(external site, opens in new tab)
Overall, they have ended up after three rounds giving away a smaller share of their business. Furthermore, when the post-money valuation of the business is taken into account, their equity is worth much more after scenario B than in scenario A.
The way to bump up the valuation is to have some good ‘proof points’ some evidence of what the business has achieved and evidence that the assumptions in the business plan might actually not be too wide of the mark. Gaining good proof points usually comes down to 3 things:
- Runway – as explained above, having enough initial funding, sensible investment plans and a firm hand on cash flow so that there is a decent period in which to achieve things.
- Priorities – knowing at the outset what you are trying to achieve and how it will impact investor sentiment, and then being ruthless at going after it. For example, if the main debate is whether the cost of acquiring customers will or will not be less than the long-term value of a customer, then put the majority of your effort into experimenting with marketing and reducing and proving the cost of acquisition. If your plans rely on the grocers listing your product then spend most of your time hounding the supermarket buyers. There are likely to be a few proof points that are needed to put a compelling case together for investors. The more there are, the more robust they are and the most relevant they are the better they can drive up the valuation of the next round.
- Hard work – the more effort that is put in during the early days to get those early proof points the more it pays back in valuation and therefore retained equity for the long run.
The flip side is when a business has either not raised enough, has invested unwisely or has not driven the business hard enough and run out of cash before its proven much. An investor can smell two things very easily – a business that is desperate for cash, and a business that has achieved little since the last raise.
Neither of which will help the pre-money valuation an investor will be prepared to invest at. This can even result in the dreaded ‘down round’, when a valuation of a round is lower than the post money valuation of the last round. There are few businesses that have recovered momentum following a down round, and if they do it is at a high cost of diluted equity for the founders and early investors.
So whilst the figures above are conveniently made up to illustrate the point, the concepts of ‘runway’ and ‘proof points’ and the impact on subsequent rounds should be as front of mind for founders as the equity that they are giving away in the current round.
Are you seeking investment? Startups.co.uk, with Worth Capital, has launched the Start-Up Series, a year-long competition giving one company the chance to win equity investment of £150,000 every month from a £1.8m SEIS fund. To find out more visit: www.startups.co.uk/thestartupseries