Dilution · Fundraising

How should share dilution be viewed, when building a global enterprise that needs major funding?

Anonymous

February 25th, 2016

I am CEO of a start-up business based in the UK, but which has aspirations to grow globally based on the identification of an unmet consumer need. It's in the social media space, but with a search engine at its core.

I have worked in several businesses in the past but I am now really struggling with the idea of offering up equity for investment when i have no real sense of the final cash investment required before the business monetises and therefore becomes cash generative. I hear all these cliches about owning !% of a $1BN business is preferable to owning 100% of zero, but where is the magic formula to help me understand at what point I should be releasing further equity in order to pursue some smarter (i.e. more valuable) endgame.

Am I supposed to learn the hard way and expect to get flleeced at some stage?; or is there any truth in the idea that Investors (angels/VCs) are genuinely interested in keeping the founder(s) and key personnel financially motivated at all times? I'd love to be able to navigate this terrain with more confidence.
A-level teams with B-level ideas succeed. B-level teams with A-level ideas fail. This course provides a comprehensive roadmap for building a standout team, teaching everything from hiring to structure, compensation, and culture.

Mike Dierken Chief Troublemaker

February 25th, 2016

What stage of investment are you - angel, series A, series B?
In the very early stages you may be able to take 'debt financing' also called a 'convertible note' which is a loan that converts into shares of equity in the future when the company has an official valuation. 
If you go the route of shares, you will have to put a value to the company. If you have no revenue then the value may be low & asking for lots of money at a low company value means selling a large percentage. Its just math.

Here's a tool to run simulations - http://ownyourventure.com/equitySim.html
  

Martin Omansky Independent Venture Capital & Private Equity Professional

February 25th, 2016

Speaking as the front guy for angel investors, I can understand your dilemma. I would suggest the following: (1) estimate your need for cash by doing a cash flow analysis (perhaps an accountant would help you) and determine how much cash you would need before the project pays its own way; (2) sell a big chunk of equity to an investor who will commit to furnishing the entire amount over the deficit period; (3) assume this is not the only bright idea you will have, take whatever $ you get from the first deal, and use the profits to finance the next deal. If you do this right, nobody can second-guess you and you will get full value for your idea and hard work, because you are using your own money. Said another way, think experimentally. Don't assume that everything is going to work the first time out. Sent from my iPhone

Chris Copple Chief Operating Officer & Executive Vice President at ETX Pharma, Inc.

February 25th, 2016

First round of financing should be Convertible Debt. That way you do not have to grasp the nettle of early pre-revenue valuation. Debt should preferably convert at a pre-determined discount with Warrant coverage. Best round to convert into is an A round of equity financing following a distinct value infection point event. Warrants are fine as they bring in capital later and only ever get exercised if you are into serious multiples. Hope that helps. C2 Sent from my iPhone

Lonnie Sciambi

February 25th, 2016

Here's a more high level view point that can help you better understand and rationalize equity that you exchange for either capital or resources or both -http://bit.ly/1ogUObY.  At the end of the day your dilution has to be worth your increase in valuation.  If it's not, you shouldn't do it, no matter how it's structured. Hope this helps.

Deepak Natraj Investor

February 25th, 2016

may i request you to consider the following:

- estimate the fund requirements for the next year, two years after that and where the company will be in terms of its key indicators of success (key metrics), which need not entirely be financial metrics only at each stage

- to determine the fund requirements - assume all costs add a contingency of 5%
 and take it that this will be the cash burned, do not assume any revenue unless you have signed contracts and clear visibility on inflows

- once you know  the cash requirement you may want to seek funding for the amount you need for one year and a bit more - the next funding can be had at a better valuation assuming you have met or exceeded your metrics

please do your homework on how much dilution occurs on each round for your category of startups.  a good source of dilution by round is available at crunchable and elsewhere on the internet

this will give you enough knowledge on how to manage valuation expectations and how much to dilute

my experience shows that it is imperative that both in terms of %equity and absolute $ terms you have a sufficient stake in the business - investors get nervous if the founder stake is too low - the psychological issue is that the Founder begins to feel like an employee and that is typically not a good place to be for both parties

hope this helps

best wishes

Anonymous

February 26th, 2016

A big thank you for your prompt responses. All high quality advice, certainly more useful than the inputs I have been seeking/receiving in the past month or so. Much appreciated.

Kamen Zahariev Experienced international finance and investment professional

February 26th, 2016

The advice is indeed good. agree with everything. Just to underscore the same point from another perspective: last year I was invited to participate in an internet start-up. the founders had put up several 100K own equity. Then 1 year later needed more capital and got it at 2x the original cost. then, having spent not more than 800K on upgrading the site, they needed more capital and "valued" themselves at 4x, all the same while not breaking even and not having a full overview of the additional capex needed. I felt that they were far from having de-risked my investment 4x compared to their own investment and declined to invest.   

Mike Dierken Chief Troublemaker

February 26th, 2016

I agree with Chris Copple regarding debt financing (convertible note, converting at a premium), but Mark Suster (a startup advisor) tries to wave people away from convertible notes - see his post here (kind of long) : http://www.bothsidesofthetable.com/2014/09/17/bad-notes-on-venture-capital/ 

Richard Alcott Marketing and Communications

February 26th, 2016

Mark - always a challenging question. There are solid reasons why you do partner with VCs or other sources for dilutive funding. And, there is nothing inherently wrong with share dilution for funding that builds share value. The trick is delivering on their expectation. Below are some initial thoughts on if and when. - R 1. Do you have cash flow that can be leveraged? If so there are ways to finance w/o yielding equity. Equity funding is the last money you take. 2. Your local experience is the best way to understand requirements for global execution. Every financial model reflects a conservative to best case scenario that needs calibration against milestones. Actual vs Plan becomes the starting point for understanding the cost of scaling/expansion. Without an Actual, you are working in a predicate or hypothetical model. The lack of Actual data represents higher investor risk and more expensive funding. 3. A solid start-up execution validates a model which reduces risk which in turn attracts smart money. Lower investor risk generally translates into better terms. You have credibility that buys you the time and resources to execute. There is a collective buy-in and belief in your leadership and business/revenue model. However, if you take the money and fail to course correct or deliver milestones over a reasonable period of time, you generally won't survive a vote of confidence. 4. No matter the funding source, chemistry is more important than the money. You and your funding partner need to be fully in sync. You need to be able to live with them, and like working side by side at midnight on a Saturday night eating cold pizza, drinking warm beer. Any funder will influence the business and your culture either positively or negatively.

Sriraman Chakravarthy Founder & Director at Metamorphic Networks P Ltd

February 26th, 2016

I would suggest the following
a. assess your need of the finance required for minimum salable product. this is some thing which you got to get to complete the product.

based on the need either you can go for debt financing or convertible notes with fixed time of maturity. You got to prepare your sales pitch even for getting the loan - interms of projected sales and revenue flow statements

If your minimum viable product ( MVP) can generate income go for it as it will help you for further investment needed eg: enhancements etc

Approach a Angel if first two does not take you to the level you want to reach with out much dilution of your stakes

Even in Agel funding have hard negotiation on how much you are willing to dilute and what phases? usually we need different group of people we approach for different stages of funding.

Final answer is Yes you need to dilute your stake if you want money. Do it more carefully