Deciding How Much Equity to Give - How Much is Less Important Than What It's Worth!
Equity and percentage ownership has always been a lightning rod for discussion and controversy with startups and entrepreneurs. It is also less understood than it should be, with dilution and control issues being major points of concern.
One of the first blog posts I ever wrote was entitled "100% of Zero is Still Zero." The point of it was that with any kind of equity distribution, dilution will always occur. The % of equity you own is far less important than the value of that equity. And for value to increase, obviously, value has to be created. Often you use that very equity to do that. And when you do that you are, hopefully, trading value for value.
Bringing on a Key Individual or Contractor
Bringing on a key individual or a contractor, paying them with "paper," of course, you are conserving cash, but you are also placing a bet that the work they are doing for that equity will increase the value of your startup.
That is, if you pay out 5% of your equity (being diluted by 5% in the process), you're looking for a corresponding 5% (or better) increase in the value of that equity in the work they are doing. For example, if they are helping you complete a product, the revenue and associated profit generated from that product helps increase the value of your business. The key individual or contractor is betting that the equity they receive will be worth more than the cash they didn't.
Same thing with investors and investment capital.
Bringing on an Investor
Raising (and investing) capital is always a gamble, always involves risk. The entrepreneur is betting that the capital being raising will enable faster growth and increased value so that their diluted equity will be worth more.
The investor is hoping to apply their capital to a situation where it can be best leveraged to increase its value multi-fold.
Real world example of valuation
When an investor provides "X" amount of capital (and let's use $1 million for illustration purposes) for "Y" % of equity, (and let's use 20% for illustration purposes) you immediately get diluted by 20% (that is, if owned 100%, you now own 80%). They have valued your enterprise at $4 million pre-money and with their investment it is now valued at $5 million. Your 100%, which was worth $4 million is now 80%, but still worth $4 million.
What you are both betting on is that you can put that $1 million to work to create more value so that each of your respective positions (%s) is worth more than at the initial investment. So, if, theoretically, you were able to hire staff to bring out more product and increase sales and distribution of that product so that the value of your enterprise is $7 million (increase of 40%) at the end of three years, both sides have won. Your 80% is now worth $5.6 million and their 20% is worth $1.4 million.
...But I'll Lose Control
There are two kinds of control when it comes to your equity. Actual voting control, which is, usually dictated by the corporate bylaws - sometimes, simple majority, sometimes, specific majority - all determined by you when you set up the company or by bylaw amendment, later. Then there's operating control.
"Who's in charge of running your day-to-day business operations"
That is, who's "driving the bus" on day-to-day and major decisions in your company. When it's just you and your team, you guys figure it out. When you introduce an outside investor, that better be a question you ask PRIOR to any investment. How much will they be involved and how? Understand, there is no such thing as "silent money." Investors will be in your underwear. You may have control, but they will exert "influence," often. But it's their money and they want to be sure their investment is being managed properly. It is price of capital that you must take into consideration before you accept their investment...and the increase in potential value it represents.
The main objective of equity ownership should be value creation. Whether that be an entrepreneur, a key employee or contractor, or an investor. With each comes risk. And each risk (dilution, underpricing services, misreading the company's potential) comes with expected returns (value creation) and tradeoffs (control, paper instead of cash, a less leverageable investment) that have to be weighed in light of that risk/return model. Create enough value and it's all moot.
"The Entrepreneur's Yoda" knows these things. He's been there. May success be with you!
Have you worried about or even turned away investment because of fear of dilution? Please share your thoughts in your comments. It can help another entrepreneur.
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This article was originally published on LinkedIn January 14, 2016.