Financing Startup Equity: should you give up equity in your company?
There are times in the life of your software startup where you will have to think about giving up some equity. It might be when you first consider getting funding or it could be taking money off the table, selling part of your company and getting a strategic partner.
Why sell part of your company?
There could be several reasons that resonate with your situation:
- You want necessary capital to take your startup to the next level.
- You want to take some money off the table. Your startup may be your biggest asset and that is very scary since it could fail. If you can take a few million out of the company and put it in your personal investment portfolio, that could be a life changing event and would be financially prudent (having all your wealth in your startup is NOT a diversified position!).
- You want the right strategic partner who can help you take your startup to the next level through their expertise, experience, Rolodex for hiring seasoned executives and industry connections. They will have a significant stake in your business and therefore will work to make it succeed.
When you begin your startup journey you probably own 100% of the company, or maybe around 50% if you have a co-founder (see how to find a co-founder for your startup). If you’re able to bootstrap your startup then you may be able to keep most of the equity and continue growing. If you need funding early on, then you’re going to have to give up some equity in exchange for money to build the business.
The first step in giving up equity, once you have a good suitor, is usually figuring out a valuation.
Once you have a good idea on your valuation you have to figure out how to make the deal worth it for you. This can be hard—you’ve been putting blood, sweat and tears into your startup for years. It may feel like you’re giving up your baby in some way. It can be especially challenging if you’re giving up control (> 50% equity stake in your company). But sometimes that is necessary.
So, just give up 5 or 10% equity, right?
Unfortunately, the minimalist approach may present several problems:
- 5 or 10% of your projected valuation may not be enough capital to make anything worthwhile.
- Your investor may not be interested in such a small stake.
- Even if the investor is interested, this stake is so small that they aren’t going to give your company much attention out of their entire portfolio of investments. This could be good or bad for you depending on the goals of your investment round.
- Experienced talent from the investor’s Rolodex is not going to pay much attention to a startup where the investor only holds 5-10% equity since they don’t have much at stake and also don’t have a controlling interest.
Ok, so more. But less than 50%
Let’s say you decide to give up more equity but less than 50%. This means you retain a controlling interest in the company so you’re still in charge. This still has a few significant disadvantages:
- In the software space, it is very likely that you will have to do some acquisitions (typically called “tuck-ins”) to expand your product portfolio in response to customer needs or market changes. These tuck-ins could cost $5M or maybe $50M. If you want to retain your controlling interest then you’ll be required to put 51% or more of that cost back into the company. This will completely invalidate your goals if you were trying to take money off the table. You could avoid tuck-ins but then you aren’t serving the best interests of the company and will be stifling growth.
- If you’re looking to hire industry veterans from the investor’s Rolodex who will take your startup to the next level, then you may have some challenges. Those veterans are in very short supply and they don’t know you at all. However, they do know and trust the investor. If the investor doesn’t have a controlling interest in your startup then these veterans may be reluctant to join your startup. There is a very real fear of the out-of-touch founder who wants to retain control and sabotages their own startup because they disagree with the changes needed to get to the next level. If you can’t take your startup to the next level yourself then you need to acknowledge that and support those that can—so don’t stand in their way!
Here is a surprising true story…
At the end of a year a company had around 50 employees and had done $10M in revenue that year, achieving around 50% year on year growth. They were also generating about $1-2M in EBITDA which was being reinvested into the business to drive growth. However, they were not sure that they could sustain the 50% growth going into the next year (achieving 50% growth meant that they needed to get around $12M in new business in the next year—there was only around $3M recurring revenue).
Thinking about valuation, the startup was probably worth more than $50M if they could sustain the current growth rate. If their growth in the next year dropped to 20% then the startup might only be worth $20M or $25M. So there was $25M or more at stake! They needed strategic help and the owner also wanted to take some money off the table.
They decided to sell 2/3 of the company to a growth equity firm (smart money with expertise, experience and connections). Let’s say the company was worth $1. The owner received 0.67 for the 2/3 and kept 0.33 worth in shares. The company has grown tremendously over the last few years with the new strategic partner and is now at $100M per year in revenue. The .33 is now worth around 10x more. So they got 0.67 initially and in the next 1-3 years they will get $3.30 back on their 0.33 worth of shares when the company goes IPO or is acquired.
They sold 2/3 of company because they didn’t have the resources, experience, expertise or connections to grow it to $100M. Sometimes it is smart to sell a piece of the pie if it means that the pie will get much bigger.
Should you consider a smaller piece of a bigger pie?
How you go about giving up a stake in your business is a personal choice with long-term consequences. There is no one-size-fits-all here. You have to decide what works best for your situation, making sure you take all the relevant factors into account.