Historically, scientists pretty much owned human advancement, but today we are in an era where entrepreneurs contribute immensely to societal progress via technology. I admire each founder who has decided to take a plunge into this deeply gratifying yet terrifying journey. Emphatically during this roller-coaster of a ride, people are bound to make mistakes.
In my discussions with thousands of founders spanning a decade, one thing that does not seem to have improved is the mistake that a founder(s) makes while giving part of her equity to well-wishers, mentors, early-stage investors & accelerators/incubators. I have utmost respect for the well-wishers and mentors as they are there to help you. Nevertheless, I have seen ensuing capitalization tables (shareholding) post such an investment, making it challenging for the startup in consideration to raise a subsequent Series A/B round and the likes.
During my discussions, I realized what the founders could do to avoid such mistakes and thought of sharing the same. These are simple but vital tips for early-stage founders to get things right from a share allocation perspective. For those, who have already made the folly, I would suggest a few ways to correct these mistakes but believe me, these measures might be one of the mightiest ones to implement
I cover two most common examples—a relative and a friend investing and backing you early during your journey. These are real-world incidents from my interactions but have been modified to protect the identity of the startups.
Did you notice that there are multiple issues with both examples? These capitalization tables can really hamper subsequent Series A/B/C rounds for startups’ fund-raising journey. In my experience, a case in point, out of ~100 odd startups, ~5-6 startups are bound to come across such an issue! Allow me to highlight some of the obvious but overlooked obstacles:
- Valuation is pegged at ~66.67 lakhs. This causes a big issue because when you go in to raise the next round from an angel or a network – their anchor would be at this valuation. You would need to show a substantial growth to claim a valuation even upwards of 10 crores.
- Bigger pain is that you have diluted 30% of your equity during a family & friends’ round! An angel round post this translates to a stunted founder’s ownership in the company at ~60%, which is very low.
- You have two investors on your cap table – who may not be qualified investors and hold a significant chunk of the equity. This will not be appreciated by the next set of investors, particularly the institutional investors.
On the face of it, this capitalization table looks much better but still has issues:
- This time again, valuation is 5 crores. Decent for a start, but risky at such an early stage because the next stage investor will get anchored at this number.
- More importantly, your friend, who in all probability is not a seasoned investor and naturally may not be able to help you with the startup growth, fund-raise & strategy is, in turn, owning ~20% of your company. This is a big no-no for the follow-on investors.
What Could the Founders have Done Better?
Firstly, I am totally in for taking monies from family and friends in the initial part of your journey, but it would have been best not to distribute equity and instead use convertible note as an instrument for investment. This would have solved majority of the issues as described above.
However, I understand that first-time investors can insist on equity and may not appreciate the convertible note as an instrument. In such a case, be realistic about the equity you would want to offer. So, for INR 10 lakhs, is 2% equity good? Tricky question, but we can answer it by analyzing forward looking numbers. For instance, your valuation after three years is INR 100 crores, so INR 10 lakhs would translate into INR 2 crores in 3 years! Not bad, eh.
Again, solutions are akin to the previous example – try a non-priced round (convertible note) or distribute equity proportional to a healthy return over time – say ~5% in this case. Now, if you have already made the mistakes laid out earlier in the post, the most straightforward method for you is to ask the relative in the 1st example and the friend in the 2nd example to return some of their equity to the founders. Founders could buy the equity at a nominal price or other options such as a gift. Be prepared as this can stir some heat in the discussions, so I recommend engaging a qualified finance professional who can offer a balanced perspective.
To Sum It Up
It is commendable to receive early monies from friends and family but using a convertible note as an instrument for these monies, makes much more sense. If equity route is a must, I would suggest that you do not give a number greater than 10% (ideally less than 5%) and make them understand how the returns can grow over three years by simple calculations. Obviously, they know it is a high-risk investment, but they must also understand that if the capitalization table is not conducive, the startup may not be able to raise funds in the future and will be short of breath for growth.
These are some honest thoughts around improving the journey for our superstar founder(s). But in case of doubts, do reach out to a mentor/advisor who has been there & done that. In my next part, I would cover the mentor equity allocation methodology.