What the heck is valuation and dilution? How much equity should you give up? What are the different kinds of equity? How does all this affect the pie? Watch out! This is where budding entrepreneurs often trip up.
The company pie
A company has shareholders, and those shareholders collectively own 100 percent of the pie. Each shareholder has a slice of the pie. These slices may be the same size or they may be very different. When you start your company, you start it with several partners who each take a certain number of shares. This is what’s called common stock. Here’s an example of how it works:
Let’s assume you’re ready to get started. Your attorney helps you file the paperwork to incorporate your company. In this process, maybe you authorize 200,000 shares. This means that the company has the authority to issue up to 200,000 shares (you can always go back and re-authorize additional shares). But you don’t issue all of those shares. Instead, you issue, say, 50,000, dividing them up equally among the four founders. The founders all get stock certificates saying they each hold 12,500 shares in the company. At the beginning therefore, these founders own 100% of the company, as defined by the 50,000 shares issued. Got it so far?
Now, you want to raise some money. You find an investor who wants a third of your company and is willing to pay you $250,000 for that stake—seed money. You issue that investor a stock certificate for 25,000 shares. Now your total pool of issued shares is 75,000. Your company is valued at $750,000, since $250,000 will buy one-third of the company. This is what’s called a post-money valuation, meaning that it’s calculated after the investment. Your pre-money valuation would be $500,000. So far so good.
You slog along, building your company. You don’t sleep for weeks, months. You make progress. Oops—you need more money. You’ve done well with the first investor’s money. You’ve reached critical milestones. You have a working demo of your product. Now you want some big money to really take this to the moon.
You do the circuit with the venture capitalists. After some heart-wrenching meetings, you’ve found one willing to put in first round money. You’ve hit the big time. You celebrate. And then they fax you a term sheet. Can you believe it? They want fifty percent of your company! Damn. But you need the $3 million they’re offering. So, after some quick consultation with your seed investors and the four founders you decide to take the deal.
Let’s assume that they’re talking common stock (they’re not, but we’ll get to that in a minute). If they’re buying fifty percent of your company for $3 million, that means that you’ll give them a stock certificate for 75,000 shares. Now you’ve issued 150,000 shares. The founders have 50,000 shares, so their stake, in the seed round, got diluted from 100% to 66% and in the first round, from 66% to 33%. Ah, but now (at least on paper) the company is worth $6 million, since $3 million bought 50%. Therefore, the founders’ share, which at 100% wasn’t worth much of anything, is now (at 33%) worth $2 million. In this case, a smaller piece of a bigger pie is better than a bigger piece of nothing.
But, and here’s the rub, sophisticated investors, venture capitalists, never invest by purchasing common stock. No, they want what’s called preferred stock. This means they have a preference upon liquidation. In other words, if the company has to be sold at fire sale prices, the investors will get the first money out. So, let’s say your product bombs—you and your investors decide that you can’t continue to run the company, and you need to sell it quickly. You get an offer, which you accept, to sell the company for $3.1 million.
If your first round investors have preferred stock, they’ll take $3 million (what they originally paid) of that $3.1 million, even though they only own 50% of the company. The remaining $100,000 will be split among the common stockholders. In this case, your seed round investor, who put in $250,000, will only get back $33,000, as represented by that investor’s 33% of common stock.
On the other hand, if your company does well, common and preferred stock investors will benefit on an equal basis…assuming you didn’t accept participating preferred stock. But that’s enough for now.
Reserving stock for stock options
For example, if you got options to buy 1,000 shares of stock at $1 per share, and after a few years the stock was worth $10 per share, you'd then be able to pocket $9,000—you'd exercise your options for $1,000 total and immediately turn around and sell the stock at $10,000. You're issued stock options (and not stock) for tax reasons. If you were just issued $1,000 in stock, from the IRS' perspective that would be as good as getting $1,000 in cash, and you would be taxed accordingly, even though you didn't have the actual money. A stock option is not taxable as income until you exercise it.
Suppose Bill Gates said he'd serve on your Board or give you some help. What share of the company should he get? Just think about the value that his name would bring to your company! If a venture capitalist thought your company was worth $1 million without Gates, that value would increase several-fold with Gates' involvement. Yet, what has he "done" for you?
Often, company founders give little thought to this question. In many cases, the numbers are determined by what "feels good," i.e., gut feeling. For example, in the case of a brand-new venture started from scratch by four engineers, the tendency might be to share equally in the new deal at 25% each. In the case of a single founder, that person may choose to keep 100% of the shares and build by bootstrapping in order to maintain total ownership and control. It may be possible to defer dealing in new partners until later, at which point the business has some inherent value, thus allowing the founder to maintain a substantial ownership position.
So in general, the answer to the question "Who should get what?" is this: it depends on the relative contributions and commitments made to the company by the partners at that moment in time. Take your time in your decision.