Understanding Startup Investments
Chapter 1
A panel of investors lean back in large leather chairs. Enter: the startup founder, dressed in Silicon Valley chic-casual (jeans, t-shirt, hoodie, flip-flops).
The startup founder delivers an enthusiastic, if somewhat shaky pitch, ending with the figure he needs to keep his company afloat: $500,000 for 10% of his startup. The investors nod approvingly at the bags under the founder’s eyes and his or her rumpled attire, noting the signs of sleep deprivation and lack of self-care as devotion to the business.
They ask a few questions, confer with one another, and make a counteroffer: 55% of the business for a $500,000 investment. The founder tries to negotiate to no avail, paces back and forth a little, steps outside to phone a trusted friend for advice. Eventually, the founder decides that he or she needs to take the deal, even if it means giving up majority control of the company. If the founder doesn’t take it, the business will go under.
This stereotypical display of the hopeless founder and money-hungry, rich investors is highly dramatic and an example of poorly negotiated equity investing.
A few people get together and come up with an innovative solution to a common problem. They test out their new solution, iterate a little, and find something that works and that a sizable group of people actually want to use.
Inspired, this band of innovative thinkers decide to turn that early idea into a company. But to fulfill that dream, they’ll need advice from seasoned entrepreneurs who have built successful companies before. And money.
This is where startup investors come in.
In Silicon Valley and beyond, early-stage startups can raise venture capital from VC firms and angel investors in various ways (and, in reality, they happen very differently than in the theatrical scene above).
We’re going to explore the different types of early-stage investments that give promising startups the cash flow they need to start chugging toward that IPO, and when investors are likely to encounter each investment type.
Equity investments and convertible investments are both securities, or non-tangible assets; for example, shares of stock in Apple or a government bond. (Tangible assets refer to physical investments, like diamonds or real-estate.)
There are two main ways to invest in early-stage startups:
Seed and early-stage investors often invest in startups via convertible securities, such as convertible notes and Y Combinator’s SAFE documents. Investors in later-stage startups (Series A or later) will more commonly invest in priced equity rounds.
Venture capital is an ideal financing structure for startups that need capital to scale and will likely spend a significant amount of time in the red to build their business into an extraordinarily profitable company. Big name companies like Amazon, Facebook, and Google were once venture-backed startups.
Unlike car dealerships and airlines – companies with valuable physical assets and more predictable cash flows – startups typically have little collateral to offer against a traditional loan. Therefore, if an investor were to issue a loan to a startup, there’s no way to guarantee that the investors could recoup the amount they’ve lent out if the startup were to fail.
By raising venture capital rather than taking out a loan, startups can raise money that they are under no obligation to repay. However, the potential cost of accepting that money is higher – while traditional loans have fixed interest rates, startup equity investors are buying a percentage of the company from the founders. This means that the founders are giving investors rights to a percentage of the company profits in perpetuity, which could amount to a lot of money.
Early-stage startup investing offers potential for astronomical growth and outsized returns (relative to larger, more mature companies). This potential makes acquiring startup equity an attractive investment opportunity to prospective investors, despite the additional risk.
For the Founders, taking VC money can also come with huge benefits – startup investors can offer valuable support, guidance, and resources to new founders that can help to shape their company and increase its chances of success.
Venture Capital financing is also ideal for startups that can’t get very far by bootstrapping. Although many founders self-fund their startups while operating out of a cramped apartment until they’ve reached profitability, bootstrapping doesn’t work for companies that require a lot of capital up-front just to build and test their MVP (minimum viable product).
Equity essentially means ownership.
Equity represents one’s percentage of ownership interest in a given company. For startup investors, this means the percentage of the company’s shares that a startup is willing to sell to investors for a specific amount of money. As a company makes business progress, new investors are typically willing to pay a larger price per share in subsequent rounds of funding, as the startup has already demonstrated its potential for success.
When venture capital investors invest in a startup, they are putting down capital in exchange for a portion of ownership in the company and rights to its potential future profits. By doing so, investors are forming a partnership with the startups they choose to invest in – if the company turns a profit, investors make returns proportionate to their amount of equity in the startup; if the startup fails, the investors lose the money they’ve invested.
The terms stock and equity are often used interchangeably. Stock is a general term that refers to an unspecified amount of ownership interest in a company. Shares represent the way that a company’s stock is divided. A company’s stock can be divided into a potentially limitless number of shares, each worth exactly the same value.
In a priced equity round, shares in the startup have a fixed price, and investors can purchase equity in the company by buying shares at the price during that round.
EXAMPLE
When Ashton Kutcher and Guy Oseary made a joint $500,000 investment in Airbnb’s Series C Round, for an estimated .25% equity stake, they effectively purchased .25% of Airbnb’s shares. This means that, assuming there were 400 total shares, Kutcher and Oseary’s .25% stake would represent 1 share, or .25% of the company
The amount of shares that an investor owns, divided by the total number of existing shares, is the percentage of equity that particular investor owns in the company.
The total number of outstanding shares in the equation above refers to all shares that exist today, including all shares purchased by investors, in addition to all shares likely to exist if a liquidity event were to occur.
How can a share be “likely to exist”?
When calculating an investor’s equity stake in a company, beyond existing shares issued, it’s important to account for both investments made via convertible securities, which haven’t converted to equity yet, and any stock options issued to founders and employees or authorized for future issuance.
Founders and employees generally are granted stock options, which give them the right to purchase a fixed amount of stock in the company, at a pre-agreed upon price, commonly referred to as the strike price.
While the investors/founders and employees in the above situations may not technically own those shares yet, the shares have already been, in effect, spoken for. Therefore, they cannot be issued to any other investor, and must be accounted for in the total number of company shares.
The total number of outstanding shares in a company increases every time a startup issues additional shares.
New shares are commonly issued when:
Pop Quiz: If the denominator (total outstanding shares) is constantly increasing, and the numerator (your # of shares) remains the same, does your percentage of equity increase or decrease?
If you answered decrease, you’re right. Every time a company issues more shares, a shareholder’s percentage of equity is subject to change. When an previous shareholder’s percentage of equity decreases due to additional shares issued during a later round, this is called dilution.
Some shares of stock are issued along with special rights, designed to help investors maintain their percentage of ownership interest in the company. We dive further into preferred stock rights and terms in Chapter 2 of this guide.
Often, startup founders, employees, and investors will own equity in a startup.
Initially, founders own 100% their startup’s equity, though they eventually give away the majority of their equity over time to co-founders, investors, and employees.
Venture investors choose to invest in startup companies (private companies) because they stand to make outsized gains if the company goes public, or if another liquidity event occurs, such as an acquisition by another company.
Employees are often offered equity in the startup where they work as part of their compensation package; employees may elect to receive lower monetary compensation in exchange for a greater amount of equity in the company. In turn, equity serves as incentive for employees to stick with the startup as it grows, as their shares typically vest over a period time.