editione1.1.3
Updated September 13, 2022You’re reading an excerpt of The Holloway Guide to Raising Venture Capital, a book by Andy Sparks and over 55 other contributors. A current and comprehensive resource for entrepreneurs, with technical detail, practical knowledge, real-world scenarios, and pitfalls to avoid. Purchase the book to support the author and the ad-free Holloway reading experience. You get instant digital access, over 770 links and references, commentary and future updates, and a high-quality PDF download.
“Raising money” does not mean getting money for nothing. Raising venture capital really means selling part of your company in exchange for money you plan to use to grow your business. To determine how much money to raise, founders need to understand how that amount is related to the ownership they already have and expect to have in the future. We’ll start with how ownership is measured, move on to the relationship between price, valuation, and dilution, and then discuss how to use that information to come up with an amount to raise from investors that you can live with.
Keep in mind that understanding how partial ownership is transferred is also essential to learning how to offer equity-based compensation to employees, sell your company, and more. You can visit our Holloway Guide to Equity Compensation for a lot more detail on this topic; we’ll cover the basics here.
What does it mean when people say they own part of a company? Most companies, even when they are founded, are owned by more than one person. Ownership in a company is divided up between multiple people through stock.
Definition Stock is a legal invention that represents ownership in a company. Shares are portions of stock that allow a company to grant ownership to a variety of people or other companies in flexible ways. Each shareholder (or stockholder), as these owners are called, holds a specific number of shares. Founders, investors, employees, board members, contractors, advisors, and other companies, like law firms, can all be shareholders.
Stock and equity are often used interchangeably, but they are not the same thing.
Definition In the context of compensation and investment, equity broadly refers to any kind of ownership in a company that can be held by individuals (like employees or board members) and by other businesses (like venture capital firms).
One common kind of equity is stock, but equity can take other forms, such as stock options or warrants, that give ownership rights. Commonly, equity also comes with certain conditions, such as vesting or repurchase rights. Note the term equity also has several other technical meanings in accounting and real estate.*
Employees often acquire equity that has been set aside in a company’s option pool.
Definition An option pool (or employee pool) is a portion of a private company’s shares that the company reserves for future employees. Companies create option pools by setting up an equity incentive plan, generally before the first employees are hired. The size of option pools varies, but typical sizes are 20% of the company’s stock for more established companies and 10% or 15% for earlier-stage companies.*
The size of the option pool may be negotiated in seed round term sheets, if the founders have not yet set one. Individuals don’t automatically own part of the company when they join; they vest into their ownership over time. The details of vesting, particularly for founders, may also be negotiated in a seed round term sheet.
Definition Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.
Definition In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it.
Definition Vesting schedules can have a cliff designating a length of time that a person—including founders—must work before they vest at all.
For example, if your equity award had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you haven’t vested in any part of your award. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company. This can be true for founders as well as employees. Investors will often negotiate the details of founder vesting in the term sheet, to ensure that the founders are committed to the company for the long haul.
A very common vesting schedule is vesting over four years, with a one-year cliff. This means you vest 0% for the first 12 months, 25% at the 12th month, and 1/48th (2.08%) each month until the 48th month. If you leave just before a year is up, you get nothing, but if you leave after three years, you get 75%.
Definition Common stock and preferred stock are two classes of stock with different rights, preferences, and privileges.* Holders of common stock are able to vote on issues like board composition and stock splits. The value of common stock rises and falls with the company’s fortunes. Common stock (or the option to purchase common stock) is typically held by founders and employees. Preferred stock generally does not carry voting rights but has a liquidation preference over common stock, meaning preferred stockholders get paid before holders of common stock in a liquidity event or bankruptcy. Preferred stock pays predetermined dividends, which are more predictable and often larger than common stock dividends. Preferred stock may be privileged in other ways, such as through protective provisions that give preferred stockholders veto power over certain decisions. Preferred stock is typically held by investors.*
Common stockholders—founders, employees, and advisors—typically earn their equity in exchange for labor (sometimes called “sweat equity”). Preferred stockholders don’t earn their equity; they buy it. Except for some edge cases, investors will almost always hold preferred stock, which exists to protect investors.
important The differences in stock classes affect how VCs can control your company. When it comes to determining an amount to raise from investors, the important distinction is that preferred stock gets a preference, or preferential treatment, in a liquidity event: founders and employees don’t get paid until investors do. (If conversion rights were negotiated as part of the term sheet, preferred stock may also convert to common stock during that liquidity event. We’ll come back to this in more detail in Choosing A Financing Structure.)
Preferred stock has downstream consequences—often very confusing and obtuse ones—on your company’s valuation and your ownership stake. You can make choices to mitigate or even avoid these negative consequences. We’ll first explain the relationship between the price an investor pays for stock, the dilution of ownership that occurs when new stock is issued, and the company’s overall worth, or valuation.
In order to understand how partial ownership in a company is transferred—to investors, founders, employees, or others—we begin with price and dilution. Whether you raise venture dollars or not, these concepts are relevant to startup founders. But most people struggle a lot when it comes to understanding how they all fit together—and, along with valuation, how they affect the amount of money you will raise. If you can’t explain all this to your friends, keep reading (and re-reading) until you can.
Most founders encounter price and dilution for the first time when incorporating and choosing to create the employee stock option pool.
For a person to legally own shares, they have to buy them at a set price. At the beginning, the company is often basically worthless. It’s two people with an idea, and their lawyer deems $0.0001 per share an acceptable price. If the founders agree to split the company 50/50, each founder will buy 50% of the shares at $0.0001 per share. They are the first investors.
Definition When an investor agrees to exchange a fixed amount of money for a fixed amount of ownership in a company, the investor is setting a price. Price is often expressed in one of three ways: price per share (e.g. $1 per share); price of financing (e.g. $2M for a 10% ownership stake); and the colloquial price, formulaically expressed as amount raised on pre-money valuation (e.g. $2M on a $10M pre).
Over the lifetime of a company, there are many cases where the company will choose to issue new stock in addition to the stock founders buy upon incorporation. The two most common cases are offering stock to employees and selling stock (raising money) to outside investors. In either case, founders don’t personally sell their stock to employees or investors. If they did, those checks would be written to the founders, not the company. When new stock is created, it increases the total number of outstanding shares, thereby decreasing the percentage ownership of existing stockholders.
Definition Dilution is the reduction in ownership, on a percentage basis, that occurs when a company issues new shares of stock, such as when creating an option pool, or creating additional stock to sell to investors.
To ensure the company doesn’t have to create and issue new stock to founders later down the road, most companies incorporate with millions of shares. Practically, here’s how this plays out. Two founders agree to split ownership in a new company 50/50. Their lawyer advises they incorporate with 10M shares of stock. To own their half of the company, they will have to buy their shares for $500 each at a price per share of $0.0001.
In the case of offering stock to employees, some companies set aside an employee option pool of 5–20% at the time of incorporation. For example, if the total outstanding shares at incorporation is 10M, 2M may be set aside for issuance to future employees, and the founders will split the remaining 8M.
But many companies don’t issue an employee stock option pool immediately, opting instead to do so down the road. If each founder owns 5M shares out of a total of 10M outstanding, the company must issue new shares to create an option pool. When companies issue new shares of stock, existing holders’ ownership percentage gets diluted to a lower number.
danger Dilution is frequently overlooked by founders who are fundraising. There is a lot of variability around how much each company sells at each stage of financing,* but founders should be aware that the path of venture capital can involve selling as much as 15% at the pre-seed, 25% at the seed, 25% at the Series A, and 20% at the Series B. That’s 85% of the company by the Series B. Think that sounds nuts? Aaron Levie, co-founder and CEO of Box, owned 5.7% of his company at IPO.*
Any conversation about dilution without also talking about valuation won’t show you the whole picture. Publicly announced valuations are usually celebratory, and this can be misleading. You have to unpack that number to understand its implications.
Definition Valuation in the context of early-stage venture capital deals is the projected worth of a company based on its potential to grow in size, revenue, and influence. Founders and investors must agree on a valuation, which is negotiated as part of the investment term sheet. Valuation is used to determine the price per share venture capitalists pay for their equity: the higher the valuation, the less ownership founders have to sell to raise the same funds.
Founders seeking venture capital must arrive at a valuation for their company based on how much money they need to raise from investors, and how much of their company they are willing to sell in order to get it. When venture capitalists are preparing to invest in the company, they will do their own analysis to arrive at a valuation as well. Investors base a company’s valuation on the market, whether a founder has a proven track record of success, if the company has traction with customers or any revenue, and whether there is interest from other investors in the company’s industry.
Definition A company’s valuation can be expressed in two ways: pre-money is the anticipated valuation at the beginning of an equity fundraising process (i.e. before the investment is received); post-money is the anticipated valuation at the close of fundraising (i.e. after the investment is received).
Pre-money and post-money valuations can each be calculated with the following formulas:
The pre-money valuation can be found by subtracting the amount of money invested from the post-money valuation.
The post-money valuation can be found by dividing the amount of money invested by the percentage sold.
Continuing with our example where two co-founders each bought 5M shares at $0.0001 per share, the company’s valuation at incorporation was $1K post-money, that is, after the first investment, which was made by the founders. This transaction proved that someone was willing to pay $0.0001 per share in the company. The product of that price per share and the total outstanding shares (10M) sets the valuation at $1K.
It’s common to hear a valuation in terms of a deal expressed like this: “They raised $1M on a $6M post-money valuation.” Let’s break that down. The founders most likely determined they needed to raise $1M and they were willing to sell 15% of their company in their pre-seed. So they divided $1M by .15, giving them a post-money valuation of $6,666,666.67. The combination of their superstition and a desire for neat, round numbers led them to do the deal for $1M in exchange for 16.67%, leading to a post-money valuation of $6M.
All the way down at the stock level, the company created 2M new shares and sold them to investors at a price per share of $0.50 (2M multiplied by $0.50 = $1M). This increased the total number of outstanding shares to 12M, and when you multiply 12M by $0.50, you get a $6M post-money valuation.
To summarize, in order to raise $1M on a post-money valuation of $6M, the company had to be willing to dilute existing shareholders by 16.67% (each of the founders’ ownership went from 50% (5M divided by 10M) to 41.67% (5M divided by 12M)). In order to actually do the deal—sell the shares and get the money in return—the company had to create 2M new shares and sell them at a price per share of $0.50.
confusion When companies raise money, they sell preferred stock to investors, not common stock. At the time of the transaction, the preferred stock is valued at the price per share of the transaction. Immediately following a large investment, the company must hire an independent firm to perform a 409A valuation and assign common stock a new price per share. 409A valuations typically value common stock at 20–40% less than the preferred stock price of an investment transaction. (For more on 409A valuations, visit the Holloway Guide to Equity Compensation.)
At the end of this, each of the founders’ 5M shares will increase in value. After hiring a firm to do a 409A valuation, they may find the price per share of their common stock went from $0.0001 per share to $0.15 per share (30% of $0.50), increasing the value of their stock (on paper) from $500 to $750K each.
Now that we understand the relationship between price, dilution, and valuation, let’s apply it to the example of Aaron Levie’s “small” ownership share at IPO of 5.7%. Levie’s 5.7% ownership translated to 6,378,126 shares.* The IPO price per share was $14,* valuing his stock at $89,293,764.
Of course, there are plenty of other examples of founders raising several rounds of venture capital only to walk away with nothing.* It’s true that if you build a huge company, even a small percentage will be worth a lot. But not all founders can or want to build a huge company, and not all want to grow by selling stock to many different investors. Founders hoping to maintain a significant ownership percentage of their company need to consider how valuations and investment dollars will dilute their percentage stake. While this tool may look a bit outdated, we recommend founders use the toolOwn Your Venture Equity Simulator (which calculates impact on percent ownership by size of round, size of the option pool, et cetera) to model out dilution across rounds.
contribute If you’ve come across other helpful benchmarks or frameworks for modeling dilution, please let us know so we can include them there.
Every founder needs a capitalization table (or cap table) to keep track of who holds ownership in the company and in what form (stock options, warrants, shares, et cetera), and anything else you need to know about that ownership. In the simplest form, it is a list of securities.
If you’re raising your first round, you don’t want to wait until even more investors come along before building a cap table. Start building your cap table now, recording any founder or employee equity or stock options you have granted. Everything you negotiate in your term sheet related to how ownership in your company is held by various investors, including things like who has protective provisions or pro rata rights, can be recorded in your cap table so that you have only one place to look when making financing or sales decisions. Keeping track of your company’s ownership will keep you from making big mistakes when it comes to dilution.
There are many ways to build and maintain a cap table, and depending on your financing, at different stages you might have a simple spreadsheet or a sophisticated management tool. Simple cap tables might just be a list of investors and employees and the number and kind of shares or stock options they hold. More complex cap tables would be current on the value of shares held by all shareholders, dilution percentages, vesting schedules for employees, and more.
Read up on the purpose of cap tables and how to build one from former founder and current startup attorney Noah Pittard at Cooley.
No one knows exactly how much money they need to build their company, but once you’ve gotten your head wrapped around the interplay between dilution, price, and valuation, there are several best practices for backing into a target amount of money to raise.
First, you’re raising money because there’s something you want to accomplish. If you’re going to raise money, investors will want to see how accomplishing that goal will translate to increasing the value of your company.
Second, you need to estimate what it will cost to accomplish that goal.