A hypothetical startup will get about $15,000 from
family and friends, about $200,000 from an angel investor three months
later, and about $2 Million from a VC another six months later. If all
goes well. See how funding works in this infographic:
First, let’s figure out why we are talking about funding as something
you need to do. This is not a given. The opposite of funding is
“bootstrapping,” the process of funding a startup through your own
savings. There are a few companies that bootstrapped for a while until
taking investment, like MailChimp and AirBnB.
If you know the basics of how funding works, skim to the end. In this
article I am giving the easiest to understand explanation of the
process. Let’s start with the basics.
Every time you get funding, you give up a piece of your company. The
more funding you get, the more company you give up. That ‘piece of
company’ is ‘equity.’ Everyone you give it to becomes a co-owner of your
company.
Splitting the Pie
The basic idea behind equity is the splitting of a pie. When you
start something, your pie is really small. You have a 100% of a really
small, bite-size pie. When you take outside investment and your company
grows, your pie becomes bigger. Your slice of the bigger pie will be
bigger than your initial bite-size pie.
When Google went public, Larry and Sergey had about 15% of the pie, each. But that 15% was a small slice of a really big pie.
Funding Stages
Let’s look at how a hypothetical startup would get funding.
Idea stage
At first it is just you. You are pretty brilliant, and out of the
many ideas you have had, you finally decide that this is the one. You
start working on it. The moment you started working, you started
creating value. That value will translate into equity later, but since
you own 100% of it now, and you are the only person in your still
unregistered company, you are not even thinking about equity yet.
Co-Founder Stage
As you start to transform your idea into a physical
prototype you realize that it is taking you longer (it almost always
does.) You know you could really use another person’s skills. So you
look for a co-founder. You find someone who is both enthusiastic and
smart. You work together for a couple of days on your idea, and you see
that she is adding a lot of value. So you offer them to become a
co-founder. But you can’t pay her any money (and if you could, she would
become an employee, not a co-founder), so you offer equity in exchange
for work (sweat equity.) But how much should you give? 20% – too little?
40%? After all it is YOUR idea that even made this startup happen. But
then you realize that your startup is worth practically nothing at this
point, and your co-founder is taking a huge risk on it. You also realize
that since she will do half of the work, she should get the same as you
– 50%. Otherwise, she might be less motivated than you. A true
partnership is based on respect. Respect is based on fairness. Anything
less than fairness will fall apart eventually. And you want this thing
to last. So you give your co-founder 50%.
Soon you realize that the two of you have been eating Ramen noodles
three times a day. You need funding. You would prefer to go straight to a
VC, but so far you don’t think you have enough of a working product to
show, so you start looking at other options.
The Family and Friends Round: You think of putting
an ad in the newspaper saying, “Startup investment opportunity.” But
your lawyer friend tells you that would violate securities laws. Now you
are a “private company,” and asking for money from “the public,” that
is people you don’t know would be a “public solicitation,” which is
illegal for private companies. So who can you take money from?
- Accredited investors – People who either have $1 Million in the bank
or make $200,000 annually. They are the “sophisticated investors” –
that is people who the government thinks are smart enough to decide
whether to invest in an ultra-risky company, like yours. What if you
don’t know anyone with $1 Million? You are in luck, because there is an
exception – friends and family.
- Family and Friends – Even if your family and friends are not as rich
as an investor, you can still accept their cash. That is what you
decide to do, since your co-founder has a rich uncle. You give him 5% of
the company in exchange for $15,000 cash. Now you can afford room and
ramen for another 6 months while building your prototype.
Registering the Company
To give uncle the 5%, you registered the company, either though an
online service like LegalZoom ($400), or through a lawyer friend
(0$-$2,000). You issued some common stock, gave 5% to uncle and set
aside 20% for your future employees – that is the ‘option pool.’ (You
did this because 1. Future investors will want an option pool;, 2. That
stock is safe from you and your co-founders doing anything with it.)
The Angel Round
With uncle’s cash in pocket and 6 months before it
runs out, you realize that you need to start looking for your next
funding source right now. If you run out of money, your startup dies. So
you look at the options:
- Incubators, accelerators, and “excubators” – these places often
provide cash, working space, and advisors. The cash is tight – about
$25,000 (for 5 to 10% of the company.) Some advisors are better than
cash, like Paul Graham at Y Combinator.
- Angels – in 2013 (Q1) the average angel round was $600,000 (from the HALO report).
That’s the good news. The bad news is that angels were giving that
money to companies that they valued at $2.5 million. So, now you have to
ask if you are worth $2.5 million. How do you know? Make your best
case. Let’s say it is still early days for you, and your working
prototype is not that far along. You find an angel who looks at what you
have and thinks that it is worth $1 million. He agrees to invest
$200,000.
Now let’s count what percentage of the company you will give to the
angel. Not 20%. We have to add the ‘pre-money valuation’ (how much the
company is worth before new money comes in) and the investment
$1,000,000 + $200,000= $1,200,000 post-money valuation
(Think of it like this, first you take the money, then you give the
shares. If you gave the shares before you added the angel’s investment,
you would be dividing what was there before the angel joined. )
Now divide the investment by the post-money valuation $200,000/$1,200,000=1/6= 16.7%
The angel gets 16.7% of the company, or 1/6.
How Funding Works - Cutting the Pie
What about you, your co-founder and uncle? How much do you have left?
All of your stakes will be diluted by 1/6. (See the infographic.)
Is dilution bad? No, because your pie is getting bigger with each
investment. But, yes, dilution is bad, because you are losing control of
your company. So what should you do? Take investment only when it is
necessary. Only take money from people you respect. (There are other
ways, like buying shares back from employees or the public, but that is
further down the road.)
Venture Capital Round
Finally, you have built your first version and you
have traction with users. You approach VCs. How much can VCs give you?
They invest north of $500,000. Let’s say the VC values what you have
now at $4 million. Again, that is your pre-money valuation. He says he
wants to invest $2 Million. The math is the same as in the angel round.
The VC gets 33.3% of your company. Now it’s his company, too, though.
Your first VC round is your series A. Now you can go on to have
series B,C – at some point either of the three things will happen to
you. Either you will run out of funding and no one will want to invest,
so you die. Or, you get enough funding to build something a bigger
company wants to buy, and they acquire you. Or, you do so well that,
after many rounds of funding, you decide to go public.
Why Companies Go Public?
There are two basic reasons. Technically an IPO is just another way
to raise money, but this time from millions of regular people. Through
an IPO a company can sell stocks on the stock market and anyone can buy
them. Since anyone can buy you can likely sell a lot of stock right away
rather than go to individual investors and ask them to invest. So it
sounds like an easier way to get money.
There is another reason to IPO. All those people who have invested in
your company so far, including you, are holding the so-called
‘restricted stock’ – basically this is stock that you can’t simply go
and sell for cash. Why? Because this is stock of a company that has not
been so-to-say “verified by the government,” which is what the IPO
process does. Unless the government sees your IPO paperwork, you might
as well be selling snake oil, for all people know. So, the government
thinks it is not safe to let regular people to invest in such companies.
(Of course, that automatically precludes the poor from making
high-return investments. But that is another story.) The people who have
invested so far want to finally convert or sell their restricted stock
and get cash or unrestricted stock, which is almost as good as cash.
This is a liquidity event – when what you have becomes easily
convertible into cash.
There is another group of people that really want you to IPO. The
investment bankers, like Goldman Sachs and Morgan Stanley, to name the
most famous ones. They will give you a call and ask to be your lead
underwriter – the bank that prepares your IPO paperwork and calls up
wealthy clients to sell them your stock. Why are the bankers so eager?
Because they get 7% of all the money you raise in the IPO. In this
infographic your startup raised $235,000,000 in the IPO – 7% of that is
about $16.5 million (for two or three weeks of work for a team of 12
bankers). As you see, it is a win-win for all.
Being an Early Employee at a Startup
Last but not least, some of your “sweat equity” investors were the
early employees who took stock in exchange for working at low salaries
and living with the risk that your startup might fold. At the IPO it is
their cash-out day.
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