Starting a business from scratch and driving it forward is more than just having an idea. Other factors that influence the success of startups are timing, funding, a strong team, and a business model. You’ll surely agree with me that every startup company needs capital to drive their business to success.
Bootstrapping is one of the many ways to raise early-stage capital for a startup. However, bootstrapping might not be an effective solution for startups that need a lot of capital upfront to build and test their minimum viable product or MVP. Instead, such companies need to attract private investors, such as angel investors and venture capitalists, to their business.
Investors often invest in early startups in a couple of ways; one of them is through convertible securities. This method involves converting the investment amount into equity. Here’s where “equity,” a term that means the percent of ownership interest a person has in a startup, comes into the scene.
How do startup founders raise capital for their business? What exactly does equity mean in startups? Is there any difference between “equity,” “stocks,” and “shares?” What is the best way to calculate the percentage of equity ownership? As you read through the rest of this post, you’ll find answers to these questions and more.
How Do Startup Founders Raise Capital For Their Business?
As earlier mentioned, “capital or funding” is one of the critical factors influencing every startup’s success. That’s the fact, and according to experts, funding contributes about 14% of the overall success of a startup business. With that, it’s only standard for all startup founders to source funds to drive their businesses forward.
There are many reasons why startup founders need to raise venture capital for their businesses. Today, Amazon and Google are big-name companies across the world. But do you know that these companies started up by raising venture capital to drive their businesses forward?
One of the benefits of raising capital as a startup founder is that it allows you to be free from obligations to repay your debt or risk losing your collateral. The only issue, however, is that the investment amount is usually converted into equity. With that, it means the private investor will own a certain percentage of your company’s earnings depending on the amount invested.
Furthermore, raising capital for your business also comes with additional benefits, such as getting advice from investors to drive your business to success. Here’s the thing; private investors have been in the game for a long time. As such, they understand what companies need to become successful. So, when they invest in your business, they also provide you with business advice that can make the business thrive.
Here’s How Startup Founders Source Capital For Their Business
Startup founders can always raise capital for their business in several different ways. Some of them include getting funds from venture capitalists, angel investors, or family and friends.
Angel investors are private investors that provide early-stage capital to startups. These investors have certain factors they look for before deciding whether or not to invest in startups.
After looking into your business, they find out the company can grow; angel investors will provide you with capital. Since they are taking a risk by investing in your business, the investors will demand a certain percentage of the company’s earnings in exchange for their investments.
Furthermore, an angel investor will most likely ask for your business plan before investing in your startup. In addition to that, you’ll also need to provide your company’s financial projections, specifics regarding your target market, as well as your startup’s detailed marketing plans.
Venture capitalists are private investors that primarily focus on providing capital to startups and large businesses; as a startup founder, if you aim to shoot pretty far and need a lot of money, you certainly need venture capitalists. However, it would help if you were convincing enough to attract these investors to your business.
Here’s the thing; venture capitalists want you to be able to generate sales and profits. They want a high return on their investment, at least before competitors come in and reduce the profitability.
Unlike angel investors, venture capitalists often invest more money in businesses that have the potential to grow. However, it can be pretty hard to attract them to startups because of what they look for.
A venture capitalist often looks for startups with excellent leadership ability, a strong team, an innovative product, traction, and a reasonable cash burn rate. In addition to that, you also need to be convincing enough when talking about how to use the funds to drive your business to success.
Ways To Invest In Early Startups
As earlier mentioned, private investors, such as angel investors and venture capitalists, invest in early startups using two approaches. The methods are; investments in priced equity rounds and investments in convertible securities.
When investors invest in priced equity rounds, they buy shares in startups at a fixed rate. As for investment in convertible securities, the investor will provide the startup company with capital and get equity in exchange for the investment amount. That said, here’s a burning question; what exactly is equity in startups?
What Does Equity Mean In Startups?
As earlier mentioned, equity means ownership interest, and it’s the percent of ownership interest a person has in a startup company. Let me make it simple for you; equity is the value of shares issued by a company to its investors and members.
For instance, startup companies often give equity or a percentage of ownership interests to their investors in exchange for capital, which they use to develop their businesses. Interestingly, as the companies grow and become well established, the value of the shares also goes up. This means, in subsequent funding rounds, new investors will have to pay a higher price to get the shares.
The bottom line is, equity in startups is the value of shares that your company is willing to give the venture capitalist and angel investors. You should see it as an exchange for the investment amount provided by the private investors.
Equities vs Stocks vs Shares: What Is The Difference Between These Terms?
Equities, stocks, and shares are business terminologies that people use interchangeably. However, it’s worth noting that the three terms are slightly different.
As you already know, Equity is the percentage of ownership interest that an individual possesses in a company. On the other hand, stocks can be defined as the amount of ownership interest in a company that’s not specified. As for shares, it’s simply the way a startup’s stock is divided among the general public.
Furthermore, you can say that a startup’s equity, whether tradable or not, is simply a stake in the company. However, stocks are a startup’s tradable equity that the company can roll out to the general public.
Here’s the bottom line; since stocks are tradable, you can always call them equities. However, not all equities are stocks, as some are tradable while some are not.
What Is The Best Approach To Calculate The Percentage Of Equity Ownership?
As a startup founder, if you’re looking to raise venture capital for your business, you need to understand how to calculate the percentage of equity ownership. Doing that will make things pretty easy for you, especially when negotiating how much percentage of your company’s earnings should go to new investors.
The percentage of equity ownership can be defined as the number of shares owned by an investor, divided by the total number of your company’s existing shares. This is the exact way to calculate the percentage of equity that your shareholders own in your startup.
Furthermore, when calculating the percentage of equity ownership in your startup, you’ll need to consider certain factors. One of them is the stock options issued to employees and founders, and this provides them with the ability to buy a fixed amount of stock in the company. Another factor to put into consideration is the convertible securities coming directly from the investors.
Who Can Get Equity In Your Startup Company?
So far, I have talked about what equity means and how to calculate the percentage of equity ownership. But here’s a quick question, who can get equity in a startup company?
To answer the question, I’ll start by saying that many individuals can always get equity in your company. To make things easier, here are the four groups of people that can own equity in your startup; co-founders, investors, employees, and advisors. Let’s take them one at a time, and see how possible it’s to own equity at your startup.
- Startup founders and co-founders
Sharing of equity is one of the many challenges that startups often encounter. According to Matthew M. Rossetti, as cited by startups.com, equity distribution issues come up about 60% of startup founders end up in court.
If you’re a sole founder, it’s always pretty easy to determine your equity. However, when you have a startup with co-founders, here’s where the issue lies. How do you fairly distribute equity between the founders?
When distributing a company’s equity among its founders, you should consider these three factors; risk, level of commitment, and innovation.
- Are all the founders facing the same level of risk at the company?
- Do the founders contribute the same level of commitment to help the business grow?
- Is the startup established from a joint idea?
These and more are the factors that influence how equity can be distributed relatively between co-founders. Furthermore, if a startup is co-founded, it’s essential to distribute equity between all the founders at the early stage of the business.
- Startup investors
Startup investors are another group of individuals that can own equity in a startup company. Startup investors can be venture capitalists, angel investors, family members, or friends. These are the people that throw money into your business; they take most of the risk by investing capital into the business.
A couple of factors influence how much equity is given to startup investors. The first one is the valuation of the company at the time of investment. Another factor that influences equity distribution among investors is the size of the investment.
Every time an investor is looking to invest in your startup, “equity” should always be negotiated. Of course, when doing that, ensure to correctly calculate the value of your business so you don’t end up giving out more than the company can afford.
- Startup employees
Employees can also own equity shares in a startup company. You’ll surely agree that having a solid team is essential for every startup as a business owner.
It’s normal; most startups often experience tight budgets to fully pay employees’ salaries at the beginning of their projects. In this case, startups can always incentivize their professional employees or talents with equity. The advantage of doing that is simple – it’ll motivate the employees to work harder and drive the business forward.
- Startup advisors
Startup advisors occupy the last category of individuals that can own equity in a startup company. At the early stage, startups need an advisory board of industry experts to advise the companies on moving and driving their businesses forward. Offering the advisors a certain percentage of equity can help motivate them to work more with founders to make the business successful.
There are no standards when it comes to rolling out equity for startup advisors. However, most startups believe equity between 0.2% and 1% is a fair cut for these individuals.
Conclusion
Many startups receive funding from investors in the form of convertible securities. This method involves converting investment into equity when you gain an ownership interest in a startup company.
Equity is how much of the company you own. Your equity stake in a startup will depend on what type of founder and your level of involvement with the business. The more work you do, the higher your equity share should be – but it’s best to get things in writing before signing anything or taking any money from an investor.
It’s also intelligent to know that if there isn’t a written agreement between founders, then they can argue about ownership later as time goes by because information could change as people forget who did what when. This uncertainty means that investors may not want to invest without clarity around this issue ahead of time so consider getting legal help for these types of agreements early on!
Quick Answers To Frequently Asked Questions
What’s the difference between startup equity financing and equity funding?
Startup equity financing is when one person or corporation invests their money into a startup to get equity. Equity funding is more of an investment mechanism, and the investor doesn’t own any part of the company but instead owns shares of that company on paper that can be done very quickly.
What is private equity dilution?
Private equity dilution is the increase in the total outstanding shares of its stock to which each shareholder (and their pro-rata share) has access. The company will issue second-stage shares, called “private equity,” to investors for them to ultimately own or control more than 50% of that company’s shares.
What is a restricted stock option?
A restricted stock option (RSO) is an employee benefit that companies offer to employees. Unlike other types of stock, you can’t just buy them on the open market. If you leave your company before they vest, the options are considered fully vested and must be exercised within 90 days.
Can you use venture debt financing to pay off an equity investor?
Yes. The VC debt will be repaid using the proceeds of the sale, which, in most cases, have already been allocated to repay the equity investors.
What’s the difference between a convertible note and convertible debt?
Convertible debt is a loan which the lender converts to equity in the company. A lender makes a loan to a startup and converts it into shares if they have an “up round” event, such as being acquired, going public, or achieving certain milestones. The company pays back the debt plus interest until conversion occurs. If not converted, usually, these loans remain as debt owed by the issuer indefinitely, with interest accumulating over time.
Conversely, a convertible note enables investors to convert their notes into equity at any point during those convertible notes hold periods via anti-dilution provisions included within those specific documents. In other words, both can provide equity but with different methods of conversion.
Is equity investment better than equity crowdfunding?
Yes. Crowdfunding is a newer investment scheme, and equity investment has been around longer.
In contrast with crowdfunding activities, an investor in an equity scheme typically incurs a time horizon of five to ten years. They are entitled to the principal and the income from their shares. A crowdfunding participant will only get back their principal after a campaign ends or reaches its cap with no guaranteed return of income on that money.
What’s the difference between preferred stock and common stock?
Preferred stock pays a fixed dividend, while familiar stock owners only get the dividends if enough money is available. This means that select owners who own less than 10% of outstanding shares are not entitled to vote on any corporate issues.
However, for standard stock owner rights, people must hold more than 10% of their company’s outstanding shares to have voting power at corporate meetings. They also get dividends on their investments, but the investors only get the dividends if adequate cash flow is available after paying all other costs.
Can you equity split shareholder equity?
Yes. If you own a stake in a company and that stake will be split between two parties, such as when one partner exits the company, you can divide it equally between those who remain. You would need to hire an attorney or accountant with experience in this type of situation to do so. Equity splitting benefits those remaining after one person leaves because they share the risk and responsibility more directly than having only one holder (because if one person feels the too great financial strain and leaves, then there’s still another remaining owner).
Can you have a liquidation preference with a private company?
Liquidation preferences are typically reserved for venture-capital deals, where the choice is designed to protect investors against dilution.
Is a term sheet and balance sheet the same?
The term sheet must be agreed upon to find the value of an asset or business; then, a balance sheet can be drawn up.
Do crowdfunding platforms offer equity compensation insurance?
No, but if you need this type of insurance, please get in touch with a finance or insurance professional to discuss your options for obtaining it.
Does the venture capital firm offer the potential investor common shares?
The venture capital firm offers the potential investor “common shares.” A Venture Capitalist decides to invest in a small business, provide money for assets and management, guide how it should grow, and aid an exit strategy. They are not looking for profit, and their goal is to generate long-term stockholder value that will exceed their initial investment. This means that they usually prefer common stocks instead of preferred stocks.
Is there a valuation cap on preferred shares?
Share preferences are determined by the company issuing them. This means that there is no set valuation cap for preferred shares, but they are typically given a lower limit found in the company’s documentation.
What ownership percentage should startup investing look for?
It’s hard to say what percentage you should pursue, but if you’re investing for retirement, your best bet is probably around 20-25%.
Can you get an equity offer from a capital structure?
Yes. Any company could have a capital structure made up of only debt and equity.
An equity fund is an investment vehicle that uses either debt or equity to acquire ownership in companies. Equity funds may take the form of publicly-traded mutual funds, unit trusts, ETFs, closed-end trusts, or private funds offered directly to qualified investors.
