How Do Investors Decide – How Much Equity They Need, How Many Shares To Issue, How To Price The Share?

Ignore the first two slides if you’re unaware of the methods.

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Why the team means more than the idea in a start-up?

Ideas are a dime a dozen, at least in the start-up world.

Paul Graham once said that ideas mean something, but execution means far more. He also said that if he provided the entire idea to a team and the team executes the idea, he would still be entitled to less than 10% of the company. 

“What matters is not ideas, but people who have them” – Paul Graham.

In the context of this post, when I say ‘idea’ it is not only the raw idea like lets build a social network for kids, but an idea that also includes answers to questions like – will customers buy/use you and how do you know it?, how will you make money?, how will you go-to-market?, etc.

If one spends little time around start-ups, then one will very soon realize that the idea doesn’t matter much, and it is actually the people behind the idea that matter so much more.

Here are five reasons why the team matters more than the idea?

1. An idea doesn’t have any saleable or usable value. Ideas alone don’t hold any value to the end customer, because the customer has to solve a particular problem by using a product or a service and not by using the idea itself. If you don’t believe this, try selling your start-up ideas.

2. Ideas are relatively easy to arrive at. This is probably the reason why almost everybody has start-up ideas, even including people who think they don’t have one. On the other hand, execution (tech/business) demands a certain depth of know-how and a good amount of motivation for a long period of time.

3. An idea is not the reality, it is a wishful piece of organized thought. A startup is not about the idea, but it is about the  team that actually transforms an idea into a product or a service with their know-how and their motivation. Therefore, if the people behind an idea are good and motivated, then chances are that the idea might translate into a good product or a service eventually.

4. Ideas change with time, but the team might not change. Or I can say that it is much easier to change the idea than to change the team. If you put a good team behind any idea, they would at least bring out the best possibilities out of the idea. So, what happens to the idea is actually dependent on the team that is behind the idea.

For example, I am not saying that Mark Zuckerberg would’ve made a multi-billion dollar company out of any idea during his collegeBut, I am saying that if Mark got interested in an idea, he would’ve seen it through into a product or a service, trying to come up with the best possibilities to do so.

5. In the startup world, there are so many ideas floating around perennially that the startup community is not very excited to listen to only ideas anymore. Having an exciting idea doesn’t really separate you from the crowd. Investors actually almost every time look at the execution (the growth or the product or the people) behind the idea, because it is very difficult to judge an idea in isolation. You either have to have the product (or traction) or you have to be a highly motivated team with a strong reputation for execution and know-how or probably balance out the previous two, in order to have a small chance of success in the start-up world.

We all have ideas; it just doesn’t matter!

How start-up equity dilution works for Founders and Early Investors ?

Startups typically have three broad ways of funding their companies. They are incubators/accelerators, angel investors, and venture capitalists (institutional investor). Generally, Incubators and Accelerators help the start-up team to set-up the company, and shape the start-up’s Go-To-Market strategy. This article is limited only to explain how the equity dilution works and won’t get into the details of valuations of start-ups.

The typical amount of money different investors pump in and the equity they take is as follows.

Startup Fundraising Options

Understanding Equity Dilution with an Example

Let us take a start-up named XYZ Labs, and we shall walk through how the equity of the founders and the early investors gets diluted as the company goes through various rounds of investment. For the sake of simplicity, lets say the company has gone through an Angel round and one VC round (Series-A). Let’s say the angel investor took 20%, and the venture capitalist took 25% of the company for $N and $M post-valuations respectively. Let’s see how the equity gets diluted.

In any round of investment, if an investor is taking x% of equity, then the equity of all the existing equity holders will come down by x%. So, if I say y% goes down by x%, then the calculation is:     y%*(100-x)%     Or      y%*(100-x)/100

Let’s start with Founders of XYZ Labs holding 100% of the company, and having a first angel round of 20% for $N valuation.

Angel Round

Let’s say the angel round is followed up by a Series-A round of 25% and $M valuation.

Series A

So, as mentioned above, at each stage of investment, the equity of the earlier investors or founders (equity holders) will get diluted. But, with higher valuations in every round, the diluted equity will have more value than in the previous round. Also, typically in Series-A there will be an additional 12.5% of Employee Stock Option Pool (ESOP) that is to be allocated. I haven’t considered ESOP in the above example to keep things simple.

The typical equity dilution at various rounds of investment looks as follows.

Equity Dilution

So, how does it happen in practice?

In practice, your earlier investors won’t like their equity to be diluted too much in the further round of investment.So, they would like to put some cap on the dilution.

The other important thing to notice is – the type of equity that the investors and founders hold is different. Lets understand that with an example. Let’s say the company XYZ Labs is being acquired by some other major company ABC Labs. So, will all the equity holders of XYZ Labs be paid at once? The answer is No. Typically, the order of payouts is as follows:

1. You first clear out any debts that XYZ Labs owes to any banks or other investors.

2. You then start paying out the equity holders in the following order:

a. Preferred Stock

b. Common Stock

The stock that the founders hold is called Common Stock. This has the least priority during payouts in case of bankruptcy, mergers & acquisitions, etc. As the investor would want to have an early and safe exit, the investors’ stock comes with certain preferences over the commonly held stock, and it is called Preferred Stock. Preferred Stock could have preferences such as conditions on future dilution, priority during payouts, option of investing in future rounds, etc. Additionally, preferred stock can also be converted into common stock to maximize investors’ returns. Also, since debt is payed before equity during payout, some investors will give you money in the form of debt (debt note) and not in the form of equity. Because investors know that debt has the highest priority during the time of payout, and hence they can have the earliest exit .

Now, you see that not all of us in the company are equal, and not all money is equal. But, remember that investors are putting their money on you at early stages and are taking high risk. So, it is justifiable for them to look for a safe and early exit with maximum return. As an entrepreneur, you will hear many terms such as convertible debt, participating preferred stock, etc. These are various payment preferences for the investors to have maximum return, and a safe and early exit under various situations of bankruptcy, mergers and acquisitions, or dividend payouts.

If you’re interested to know more about the start-up terms, please refer to the below link to a Forbes post.

http://www.forbes.com/sites/jjcolao/2013/10/14/10-terms-you-must-know-before-raising-startup-capital/

Hope you found this post useful. Thank you.

Managing the VC

The following is a nice article from The Economic Times on start-up and fund-raising. I thought it would be a good article for all the start-up buddies here.

To raise risk capital from a private equity or venture capital investor marks a high point for most start-up companies . It sets to rest one of the biggest concerns in the initial months of company formation and while many entrepreneurs are loath to admit it, being funded by a venture capitalist is a prized validation.

However,once the initial euphoria fades away, most entrepreneurs find that raising money was the easy part, managing the intricacies of having an investor on board and minimising conflict while maximising the benefits is the more arduous task.

When to raise funds?

India Emerging spoke to a roster of start-up entrepreneurs who have successfully managed this transition. Taking on investment at the right time is essential. “Do not raise capital to keep it in the bank for mental comfort. Raise it when you need it,” says Manav Garg, whose firm Eka Plus develops risk management software for commodity firms across the world. However, entrepreneurs say the timing of the fund raising depends on the business model and the stage a company is in.

Eka Plus was started with seed funding from Thailand-based GP Group and later took on venture investment from Nexus Venture Partners. Garg says most companies take on investment when they are developing a product, or to invest in sales and marketing and in operations when they are expanding . “We took on funding when we were expanding internationally to the US and the UK and needed to hire international talent,” says Garg. Still, others do not have the luxury of choice.

Sourabh Jain launched JiGrahak Mobility Solutions, which runs mobile-based shopping solutions product ngpay, in 2005. But funds started running out in 2006. “We took on funds for survival . It was as simple as that,” he says. Jain raised funds from Helion Venture Partners in 2006. However, Jain says it is best to raise funds as late as possible .

The earlier the investment , the more time required for returns to come through. “How long can the VC wait without numbers and clear direction ? Life is easier for the entrepreneur and the VC if the investment is done later,” he adds.

Amount and Valuation

Once an entrepreneur decides on when he needs to raise funds, he also needs to decide how much equity he is willing to dilute for the required funds. Typically , VCs look to acquire over a fifth of the company going up to owning almost 40%.

They could stay invested for up to five years and would expect to earn at least a three-fold return on their investment .

“Entrepreneurs must also know that with every subsequent round of funding, promoter’s stake will reduce,” says Manish Sharma, co-founder of Printo, a printing and documentation solutions venture, which received funding from Seed Fund and Sequoia Capital at different business stages. Eka’s Garg says an entrepreneur should build in a buffer while raising funds as sudden expenses can come up. He says the investment should last for around 24 months.

The role of a VC

While money does matter, that should not be the only consideration , as a VC has a say in the running of the business. Most entrepreneurs also expect strategic direction, business contacts and help in hiring talent from the VC. Garg compares an entrepreneur-venture capital relationship to marriage.

“It is one of the most important relationships an entrepreneur can have. The chemistry is important ,” he adds. IT management services venture Appnomic Systems raised funds in two tranches from Norwest Venture Partners in 2009 and 2010. The company’s co-founder D Padmanabhan says they wanted Norwest’s managing director Promod Haque on board.

“Participation from Promod is very high and that was very important for us,” he says. Padmanabhan says the strategic and sometimes practical advice Haque provides is invaluable . He says that in their hurry to expand internationally the team considered acquiring a company. However, Haque told them to first partner with the company as Appnomic was still getting its structure and processes in place. “This was very good advice . We finally expanded organically and did not acquire the company,” says Padmanabhan.

Dealing with conflict

In an early-stage venture, most partners, including VCs, cannot know for certain which decision will lead to results. Entrepreneurs feel the VC must not interfere in operational issues while their counsel is important on strategic matters.

Ngpay’s Jain says there was a time when he wanted to stop a particular segment in the business , but the Venture Capitalists wanted to keep it going for some more time. “I did not want a delay in decision taking and we agreed to stop it immediately,” he adds.

Knowing that such disagreements can happen and handling it maturely will steer the relationship away from break point. “Communication is important. The VC should be kept in the loop, especially if the decision will have an impact on the fund,” says Eka’s Garg.

Tempering Expectations

Managing expectations is also important. “Expectations change as an entrepreneur matures . When I set up my first company, I was literally expecting ‘hand-holding’ ,” says Alok Kejriwal, who straddles both lines of the entrepreneur-investor divide. A serial entrepreneur, Kejriwal also invests in start-ups .

He says now he expects industry contacts. Printo’s Sharma says the Indian VC ecosystem is still in its infancy and so many of them cannot contribute more than funds to a start-up . “Entrepreneurs need to temper expectations and should do extensive homework before opting for a fund,” he adds.

Finally, entrepreneurs say it is still all about the money. The fund can help in getting excellent valuations in further rounds of funding. Kejriwal, whose Mobile2win China was acquired by Walt Disney, says: “VCs help in exits, not because they love you, but because they love themselves.”