Equity distribution · Spin-Out

How to make a successful spin-off ?

David Melchor Global Entrepreneur -- Internet - Mobile - Digital Media

March 9th, 2015

18 months old startup within the mobile advertising space (App install business) is planning its first round of funding. Startup has reach a point where it has: 1) a fully develop product/platform (beyond MVP); 2) 10-12clients willing to tryout beta product and become customers, 3 of them already within the integration process; 3) a management team that includes 3 co-founders with meaningful entrepreneurial experience in the sector; and 4) a big market potential (Startup is initially focus on LatinAmerica and US hispanics audiences - 600M mobile users). The company has no revenues but a clear path to it, including a proven business model.

This startup project was born as part of an Innovation Lab Initiative within Company B. Company B promoted the 3 co-founders to lead this project. Therefore,Company B has been funding the project to date, investing around 800K over the last 18 months. Funds have been mainly used to: 1) develop MVP; 2) build and support a team; and 3) Marketing activities -online presence, Marketing materials, a couple of trade shows to measure demand and capture an initial group of customers.

Company B is not in the position to continue to fund the project and it wants to spin it off to raise outside capital, however Company B wants to retain part of the equity to benefit from a potential upside. Co-funders agree with the idea and want to secure equity before the spin-off. Two outside groups of investors have shown genuine interest in the project and want to invest 250K each, for a total of 500K round. Funds will be used to ramp up marketing efforts, generate some revenue and show traction to have a successful Series A round down the road.

As company B discuss the spin-off with the 3 Co-Founders, the following questions arise:

How should the capital structure look like after the spin-off?How much equity should have Company B? How much for the Co-founders?What is the range of valuation for a startup like this? How much equity should the new investors get for 500K? or should this round be structure as a convertible note?

Eric Wold

March 9th, 2015

Interesting and challenging.  This is going to come down to valuations.  In effect you are dealing with three investors.  Nail each of them down to a reasonable valuation and you'll be off and running.  Bad valuation... and you've just locked up a huge block of equity that you might need down the road to secure more capital.

Pin Company B to a $ amount that their share of the MVP is worth.  If it really is ready for market and you can focus on selling, that is valuable.  Convertible note with a discount against future A round.  Same for the other two if possible.  That delays nailing down the valuation price.  If the product is ready... take that 500k and go build revenue and you will drive that valuation way up before these three investors actually convert to equity.

Of course that's just my opinion based only on the facts available right now.  Need more data points for a more nuanced view.

Lili Balfour Founder of Atelier Advisors + Creator and Host of Finance for Entrepreneurs

March 13th, 2015

Hi David,

I advised a company in this same situation a while ago. You'll want to put together a cap table and look at different scenarios (see cap table example). Make sure you understand the range of outcomes in which Company B is comfortable.

That will help you answer the first three questions -- How should the capital structure look like after the spin-off?How much equity should have Company B? How much for the Co-founders?

Re: What is the range of valuation for a startup like this? How much equity should the new investors get for 500K? or should this round be structure as a convertible note?

Look at comparable companies to get a sense of valuation. Historically, seed stage companies are valued at $2 million. Of course, a company that is in high demand can move beyond this number. 

If your company is valued at $2 million pre money and you accept $500k, you are going to give away 20% of your equity. 

$2 million + $500k = $2.5 million post money valuation. $500k/$2.5mil = 20%

Eric Wold

March 13th, 2015

@Lili
I think you are right on, historically. What do you think about this trend and what it means for valuations, seed deal sizes, etc.

http://firstround.com/review/what-the-seed-funding-boom-means-for-raising-a-series-a/

Lili Balfour Founder of Atelier Advisors + Creator and Host of Finance for Entrepreneurs

March 13th, 2015

I think it means Series A investors are in the driver's seat. The companies that get good valuations are going to have strong metrics. 

I think it also means entrepreneurs need to think about their Series A strategy early on. It's critical to set goals based on comparables and track the right metrics. It's amazing how few entrepreneurs actually do this. 

Nash Ogden Drupal, Magento, and Mobile App Development Development and Consulting

April 29th, 2016

David,

Can you share how the deal structure played out?  I have a similar spinoff situation and want to know how much equity company B founders should retain. Thanks for your advice.

Nash