The start-up dream is simple; develop a game-changing product that grants the founders maximum investment funding with minimum division of the shareholder pie. Unfortunately, the reality is quite different.
Founders of game-changing start-ups such as Aaron Levie of Box and Mikkel Svane from ZenDesk have found themselves approaching IPO holding less than 10 per cent of the companies they founded.
While having 10 per cent of a multi million-dollar company isn’t a bad thing, having more is always better. So why do start-up founders find themselves holding on to too little of the pie? The answer begins with the first round of investment funding.
When start-ups are in the foundation stages, they often make the most critical mistake concerning future distribution of equity. Technology based start-ups often split the initial pie between the founders, the technical developers (engineers, software developers etc) and investors.
While the founders dream it and the developers build it, the investors are the ones that have the potential to make the dream come true – but at what cost?
No matter how big or small the start-up is, there is only 100 per cent of a pie to give away. In the early days, start-ups will choose to allocate the pie between the founders and the technology developers; however they must remember that as they grow, their stake will be diluted to make room for investors, employment equity, etc. Dilution is not a bad thing for a start-up despite what founders may think. When a company secures investment at each step of the way, the percentage of the founders may decrease but the value of the pie is getting bigger due to the increased funding that now comprises the pie.
That being said, investors funding start-ups rarely do so out of altruistic reasons; they want one thing and one thing only - maximum return on their investment. To get maximum return for minimum funding, investors often seek to gain control of a large stake of the pie, leaving little for the founding team.
How much can the investor take? Well that all depends on how close your dream is to becoming a reality.
The stages of a start-up and what it means for investors
Like in every competitive sport, start-ups have stages depending on what stage of development your start-up is in.
The brilliant idea - All great start-ups start from great ideas. Whether an individual founder or co-founders with a dream, this stage has little value and no place in the equity game. While this is the most critical stage for founders, it means nothing to investors who will rarely consider ‘a really great idea’ unless you are a veteran entrepreneur with several successful start-ups under your belt.
The bootstrappers (Self-funding) - Start-ups in their early days are often bootstrapped, depending heavily on friends and family and self-funding. Start-ups in the bootstrap days still get to split the entire pie among the founders and friends and family members who contributed in the early days. This often results in funds given having little ties to valuation and percentage of equity allocated is arbitrary at best.
The beta builders (Pre-seed/seed) - This is where investors’ interest may be piqued for the first time. The investors that consider funding a start-up that is still working on a Proof of Concept (PoC) or Beta version of their idea often do so knowing there is a high risk that may yield a high reward. Simply put, this means less funding for more equity. Start-ups at the beta stage are still working on their PoC and seek external funding often rely on incubators, angels or early stage VC’s for investment. Working on a proof of concept that has the potential to fail means that a company will be valued conservatively.
Accelerators and incubators often demand five to 10 per cent of a company for between $15K-$25K (meaning a simple across the board valuation of $150-$250K) and angel and VC investors have been known to take as much as 50 per cent of the pie during the beta stage.
Proof of concept veterans (Series A/B funding) - Start-ups that were able to pass the beta stage and have successfully proven their concept have the highest leverage as they approach future funding stages. When a company has a successful proof of concept behind them, it is assumed that funding will go into scaling the product and obtaining a true market fit. This stage of investment is dedicated to examining the potential user base and the capital needed to market to and convert those users.
Since investor capital is used to grow customer or user base, monetize the product and/or recruit new employees, start-ups are able to maintain larger pieces of the equity pie.
Not all PoC’s are created equal
It seems as though the key to securing investment, particularly large ones, lies in the ability of a company to successfully complete a proof of concept. Does this mean that any proof of concept will do?
Not at all.
Some start-ups have a PoC that is more of a MVP that does not connect them to consumers or show any scalability, but rather proves the bare-boned idea and its ability to work in a controlled environment.
Start-ups that are able to execute a successful PoC with a large enterprise level company are the ones that truly shine in investment rounds.
When a start-up is able to integrate with an enterprise level company and creates a PoC that is proven on the infrastructure of an enterprise, their PoC gains even more value in the eyes of investors due to the proven ability to work in a controlled environment that can instantly be scaled to mass audiences.
The question lies in the ability of start-ups to actually go through the PoC with an enterprise level company – a process that is usually riddled with red-tape, gate keepers and other hardships.
Due to the fact that enterprise CTO’s and CIO’s are inundated with proposals for PoC’s that are often complicated to integrate and require a great deal of effort on the enterprises part, many companies forgo potential PoC’s with start-ups to avoid the hassle of integration.
Life before and after your PoC
While a poorly executed PoC can have end-all results for a start-up, a successful PoC can transform a start-up and open them to new investors that may not have previously considered them.
A successful PoC doesn’t just provide start-up founders with leverage for retaining more equity while securing more funding; a successful PoC increases the company valuation and heightens its appeal to the traditionally conservative or risk averse investors. Start-ups that have successfully passed the PoC stage have proven their technological abilities as well as product potential.
Since valuation for start-ups is primarily based on qualitative sources rather than quantitative, start-ups with quantifiable numbers behind them post PoC can increase their valuation which can help start-ups secure more funds during investment rounds.