For an aspiring entrepreneur, there are many ways to learn about how to start a company, how to pitch to a VC, how to get funding. We used to survive without good books about the startup process itself, but now we have Steve Blank. And many entrepreneurs that were not at ease when dealing with VCs, from term sheets to Boards of Directors, have now access to the excellent series from Brad Feld and colleagues.
With all this info easily available, I still find myself explain many times the “why”, the fundamentals of funding a startup and the implicit choices founders make when they decide to take OPM (aka “other people’s money”) instead of “bootstrapping” (aka fund from their own wallet).
To be clear, I don’t think there is anything wrong about OPM, most of us have a mortgage or have taken a loan, as long as you don’t overdo it and end in personal bankruptcy.
However, when founders take external money, they put the company on a different trajectory. Founders will usually sell equity, i.e. founders “issue” new shares, create them out of thin air, and give to people in exchange for their money. So let’s say the founders incorporated with 1000 shares, a capital of $1000, and now each share is worth $1 and each founder has 500 shares and therefore owns 50% of the company. Now uncle Joe offers $21,000 to help the fledgling startup (seed investment), and founders issue another 300 shares to uncle Joe, at a price of $70/share. The situation after the seed new money is as follows:
- Total shares 1300, valued at most recent price of $70/share, company value is $91,000
- Each founder owns 500/1300 = 38.5% of the company
- Uncle Joe owns 23% of the company
To summarize, founders experienced “dilution”, since now they own 38.5%, down from 50%. And uncle Joe owns 23% of something that actually has almost no value.
If the founders use the money wisely, they can build a demo, maybe even an MVP, and seek more OPM, usually venture capital funds that fund (very) early stage startups. Assuming founders find such a VC, they can get, for example, an offer of $1mill for 25% of the company, essentially valuing their early work at $3mill. The deal is described as $3mill “pre-money” and $4mill “post-money”. But what happens to dilution?
For the extra $1mill, the founders will have to issue new shares, and the math says it has to be 433 shares, for a total of 1733 shares. The new investor will pay $1mill/433 = $2309/share. The share ownership is as follows:
- New investor owns 433/1733 = 25%
- Uncle Joe owns 300/1733 = 17.3%
- Each founder owns 500/1733 = 28.85%
Pretty clear by now that percentage ownership goes down significantly each time there is new money coming in, however the value of those shares goes up dramatically (at least in my example, otherwise you have a “down round” – the subject of a future post). What is the value of those shares?
- New investor 433 * $2309 = $1mill (as expected)
- Uncle Joe 300 * $2309 = $690,000
- Each founder 500 * $2309 = $1,155,000
Now, what can go wrong? First, founders can issue more shares to themselves, let’s say another 1000 each, diluting both outside investors. That’s why, while uncle Joe just trusted the founders, the venture capital firm will insist on a clause in the funding document that will not allow the company to issue more shares without the approval of the VC. This clause is still subject of arguments between founders and VC firms – I was once told that I should just invest $5mill in a startup without such protection, because the (very) early investors in Microsoft did not ask for it and they got very rich later. Just because Bill Gates did not do it, doesn’t mean others will not try, given the opportunity. I know of at least one case when the founder tried to issue 100,000,000 shares to wipe out his external investors and “retake control” of his company – he was caught at the last moment. The VC that would not invest without such a protective clause would be foolish, and out of business soon.
Second thing that can go wrong (from the investor’s perspective) is that founders think “we have built a $4mill company, let’s sell it for $4mill and we get $1,155,000 each for our genius and effort”. The VC in this case is used to validate the business and its valuation, and gets its $1mill back. Not exactly the business of a VC to give a company money to have it returned in 3 months with no gain. To prevent this scenario, the VC will ask for a “liquidation preference”, a way to get more money from a potential sale at low exit price – a way to get the “sell early” thought out of founders mind and gently nudge them towards continuing to grow the company. Some founders try to frame liquidation as another way for VCs to “take control”, when it is nothing more that a protective measure.
To recap, when founders take other people’s money, they will be diluted, they cannot wipe out external investors, and they cannot sell when they want. If they are willing to pay this price to get significant capital to grow their company, they should take the money. If the most appealing part of founding a startup is the sense of freedom, they should bootstrap, use their own money to start, and revenue to grow. The narrative may be different, the growth scenario may be different, and the ownership will definitely be different. So it’s either OPM, or bootstrap if you can.