As an entrepreneur, you’ll surely agree that funding is an essential factor in all businesses. However, if you don’t know, it’s one of the critical factors that influence the success of every startup company. According to an extensive study performed by the CEO of Idealab Bill Gross, funding makes up about 14% of the entire startup’s success.
Furthermore, as a startup founder, one of the many ways to source funds for your business is by attracting venture capitalists; however, this doesn’t always come easy as you’ll need to meet up the requirements of the investors. For instance, most venture capitalists and angel investors, in a way to fund your business, will require you to pay them a certain percentage of your earnings. That said, here’s a burning question; how much is considered fair enough to pay startup investors?
Several factors can influence how much is good enough to pay your investors. Generally, however, most angel investors could demand about 20% to 25% of your company’s earnings in exchange for funding the company. As for venture capitalists, they typically take between 25 and 50% of your company.
Since they’re the ones taking the financial risk for your startup, it’s only standard for investors to demand a higher percentage of your company’s earnings. They might end up losing parts of their entire investment if the company doesn’t grow as expected. In the rest of this article, I’ll further discuss everything you need to know regarding what percentage is fair enough for startup investors?
How Can Founders Find Investors For Their Startups?
As earlier mentioned, funding plays a pivotal role in the success of every startup. One of the responsibilities of startup founders is to source funds from investors to drive the business forward. But how exactly do they make that happen?
As a startup founder, you need to understand that there are tons of options that you can choose to source funds for your company. While I won’t mention all of them, you can check below to see some of the best options you can consider for your business.
- Incubation programs
In business, incubation programs could be sponsored by several different organizations, including private companies, public institutions, and municipal entities. These programs are usually created to provide financial support and technical services to startups and small businesses.
Incubator programs often last for weeks or months. During this period, the business incubators guide startup companies to compete with the top industry players. That’s not all; they also help with market research and provide startups with access to bank loans and loan funds.
Furthermore, business incubators are highly connected people; they have different business experts and retired executives. This is why it becomes pretty easy for them to help connect startups with established businesses and private investors.
- Private investors
Another great way in which startup founders can source funds for their company is by attracting private investors. If you don’t know, there are two different kinds of private investors; venture capitalists and angel investors.
- Venture Capitalists
Venture capitalists are private investors that provide capital to businesses. Before these investors go ahead and offer money to businesses, they check and understand that the company has high growth potential. Furthermore, in exchange for the capital provided, venture capitalists often demand a certain percentage of the company.
As a startup founder, to attract venture capitalists to fund your business, there are specific requirements that you need to meet. One of the many things your company needs is to have a competitive advantage in their market industry. That’s not all; you also need a strong team in your company.
Here’s the thing; venture capitalists know they are taking significant risks by investing in startups. So, to minimize risks, they try to understand exactly what they are getting themselves into by staking their investments into startups.
- Angel investors
Angel investors are high net worth private investors that provide early-stage capital to startups. Like venture capitalists, angel investors also have certain factors they look for before proceeding to fund businesses. That’s not all; they also demand a certain percentage of the company in exchange for their investments.
So, here’s a quick question; what factors do angel investors look for in startups?
The first thing angel investors look for in businesses is a strong return on investment. As a startup founder, to attract angel investors to your company, you must be willing to offer them a fair percentage of your company’s earnings. Angel investors often ask for a higher return on their money because of the high degree of risks they take to invest in your company.
Why should we invest in your company? Here’s another factor that angel investors look for before investing in businesses. So, as a startup founder looking to attract them, you need to ask yourself: Do I have good reasons to convince and attract the investors to my company?
Another thing that angel investors look for in startups is the management team. Does the company have strong leadership team members who are passionate about driving the business to success?
Your business plan is another thing angel investors would want to see, and they want to be sure your business plan is complete and convincing enough before they start investing in your company. So, as a startup founder, to attract these investors, you need to craft a pretty good business plan, clearly explaining how you intend to drive the company to success.
- Crowdfunding
As a business owner, another effective way of finding investors for your startup is through crowdfunding. This approach will enable you to get funds for your business through online platforms.
There are several different crowdfunding platforms out there. Before you can gain access to funds through them, you’ll be required to upload information regarding your business, such as your business idea, how you intend to make it a success, and many more.
As long as the members of the crowd platforms find your business idea worthwhile, they can raise funds for the business. Apart from getting funds, another advantage of this approach is that it’ll help your marketing campaign as many people have already known what your business is all about.
Value Your Startup And Decide The Fair Percentage For Your Investors
So, you’ve successfully attracted investors to your startup company. While that’s a huge achievement, you need to understand that there are still a couple of things to sort out. One of them is deciding what percentage you need to give the investors coming to your startup.
However, before you can decide what percentage is fair enough for your investors, you need first to understand the value of your startup. For you to do that, you’ll need to start by asking yourself a couple of questions?
- How much money should I raise from investors?
- What is a fair percentage of the company for the investors?
- What is the best way to calculate your returns?
How Much Should You Raise?
As a startup founder, you need to be sure of the amount of money you need to raise at a specific time. According to financial experts, the amount of money you raise for your startup should be enough for the company to execute its projects. It should, at least, last for about 12 to 18 months before you decide to raise more to drive the business forward.
Financial experts often advise startup founders to raise money that’ll be enough to sustain them for at least 12 to 18 months because of a couple of reasons. Here’s one of them; for you to attract new investors to your startup, you’ll need to show them your company’s growth. If you’re targeting less than 12 months runaway, the possibility of completing your milestones and showing them your achievements is slim.
That said, one of the many factors to consider when deciding the optimal amount to raise for your startup is the number of months of operations you’re looking to fund.
So, the best way to answer how much you want to raise for the recommended 12 to 18 months is by saying: you’ll be growing for x months (usually between 12 to 18 months) of operations. And as such, you’ll be needing roughly $y to achieve your milestones.
For example, engineers in Silicon Valley startups usually cost roughly $12,000 monthly. If you’re going for five engineers for 18 months, you’ll need to have a total of 12,000 x 18 x 5, which is 1.08 million dollars. This is just an example of how you can go about calculating how much you need to raise for your startup.
Bottom line: To decide how much you need to raise for your startup, you first need to look at your monthly burn rate, add in the cost of team members you’re looking to hire, marketing costs, and other development costs for a month. After that, multiply the total amount by the number of months’ runway you desire (usually between 12 and 18 months).
What Percentage Of Your Company Is Fair Enough For Your Investors?
Now, let’s talk about how to decide on the percentage of your company that should go to your investors.
As earlier mentioned, the general rule is that most angel investors, in a way to help your company with early-stage capital, will demand about 20 to 25 percent of your company’s earnings. So, if at all you’re going to sell a portion of your business at the early stage of the business, it’s going to be what the investors are looking to get in returns for their investments.
But is 20 to 25 percent of your company worth it for angel investors?
According to a study by SeedLegals, average startup founders only give out about 15% equity in a funding round. That said, if the investor is asking for too much, you can always negotiate to 15% or consider opting for a series of smaller raises. This way, you can always get about 6 percent or lower for every fund you raise in a couple of months.
What Is The Best Way To Calculate Your Returns?
Since you’ll be giving out a certain percentage of your company’s earnings to your investors, it’s essential to understand how to calculate your business returns. It’s critical to understand your returns, as it’ll help you a lot when negotiating with the investors.
For you to calculate your company’s returns, you’ll need to understand and take note of your cash flow. After that, you also need to note down how much money is coming from the investors. With these two factors, you can always decide what’s best for your company. Yes, you’ll be able to determine whether to offer your investors money or provide them with equity.
That’s not all; your company’s cash flow and the funding will also enable you to understand whether or not a certain percentage is fair enough and will not harm the business.
Furthermore, to calculate your returns the right way, you need to be very tough on your calculations. What that means is that you need to make sure you correctly calculate the valuation of your startup. That’s so because what you’ll be offering the investors depends, to a large extent, on the value of the company.
Conclusion
According to experts, 15% equity is the best for your investors. Furthermore, getting an investor that will take that as a return on investment requires you to correctly do the maths of equity and valuation of your startup. However, if the angel investors demand 20 to 25% equity, it’s also fair enough as long as it doesn’t affect your business.
Quick Answers To Frequently Asked Questions
Can venture capital be used as startup equity?
Venture capital is a form of equity. Technically, it’s more like high-risk debt than equity, but venture capitalists have received shares in the company in some cases.
Can an angel investor receive a free stock option?
No. The key to success in investing is diversification and taking advantage of the opportunity, not gaming the system. If an angel investor were to lend money instead, they would pay interest on the loan and be entitled to a profit rate.
Can venture capitalist funds increase a company’s value?
Yes. Venture capitalists invest in most emerging and startup companies that have the potential to grow large and successful. These investors usually take a substantial stake in these companies, providing capital through debt or equity to fuel growth.
Can a VC firm claim percentage ownership over common stock?
It depends on the arrangement terms, but if so, VC firms often might not be capable of selling shares because there is no open market where they can buy and sell shares.
What ownership percentage can an early investor expect?
What ownership percentage an early investor can expect mostly comes down to two things. The amount of capital they invest, and the current deal structure. Most early-stage VC investments are made on a pre-money valuation basis, meaning if your company gets seed investment of $500K at a post-money valuation of $1M, your investors will get 20% equity or equivalent shares in return for their cash contribution. If you’re raising more money from them later on, say at a post-money valuation of $2M with seed round investments accounted for. They’ll get 8% more percentage points worth of equity or stake in response to their additional funding contribution.
How does an early stage investor receive equity compensation?
It’s up to the company. Equity compensation can be in the form of common stock, shares you purchase on the open market or taking out an equity stake in the company.
Does a potential investor usually want to see the startup valuation?
Yes. Investors will generally want to know how much the startup is worth on paper to manage their own risk.
Is there a valuation cap on equity stake?
No, the only cap that exists on this type of instrument is the owner’s investment limit.
What’s the difference between company valuation and pre money valuation?
Company valuation is the present value of all future cash flows, discounted back to the present day. Pre-money valuation is simply current or remaining capital invested in a company.
How is equity split calculated on a company’s valuation?
Equity in a company is split based on the percentage of ownership that each person or entity has. The calculation is quite simple; for example, if there are ten people, and one person owns 20%, they would own 20%/10=2%.
Can a private company be an accredited investor?
Private companies are typically not eligible entities in which an investor’s interest may be publicly traded on the stock market. If the company has over $10 million in assets at this point, they can file to go public when they meet specific SEC requirements for qualifications.
Can angel investment be converted into company equity?
Angel investments are relatively low-risk since the investor pays for any expenses incurred by the business without taking part in how to use them. These investments are classified as high risk with very high potential rewards, so there is no guarantee of equity or who gets what kind of share if you become successful. Equity investors typically contribute cash and equipment, which provides more investment participation than angel investors.
How does a venture capital firm perform equity allocation?
Equity allocation is the process of using a VC’s investment capital (i.e., money and time) to invest in an entrepreneur or start-up company by providing them with equity ownership/claims on the company.
Can an early stage startup receive equity financing?
There are different types of financing, discounts, and loans that early-stage startups could receive. However, these are not good for an increasing number of reasons.
What does it mean to have liquidation preference?
Liquidation preference is a term that broadly refers to the provision in shareholder agreements where one shareholder takes precedence over another in the event of sale or liquidation. For example, suppose two entrepreneurs want to sell all their shares. In that case, he may wish for equity protection that means he gets paid back first before the other individual – this would be an example of a liquidation preference.
Can you buy preferred stock using equity investment?
The two types of preferred stocks are common and convertible, but both can be negotiated differently based on the contract with the equity investment company. Take a look at this article comparing how to buy preferred stock using equity investment for more information.
Does an equity investor receive an equity share?
An equity owner is an individual who shares in the ownership of a business entity by holding some form of equity interest in it. Equity can also be considered to entitle its holder to share in goodwill, which may derive from the company’s operation or other organizational aspects.
What does it mean to have a convertible note term sheet?
A convertible term sheet includes provisions at the bottom that will allow specified investors in a company’s financing round to convert the series interest into common equity. In other words, it’s a paper contract describing different terms for debt and debt instruments.
What is post money valuation?
The post-money valuation refers to the worth of a company after an investor puts money in it. In other words, the company’s value has increased because now there is more money invested into it which can be used for things like expansion and infrastructure.
