Carolyn Deng, CFA
A Wharton MBA and CFA, Carolyn has executed 20+ VC/PE deals, managed a $700M portfolio and is a fundraising, growth and M&A specialist.
Attention on the financial aspects of startups tends to focus on the external measure of fundraising. Yet before this, there are many aspects for an entrepreneur to consider regarding setting their business up for financial success.
In this article, we address eight vital considerations to take around the equity, budget, and valuation components of a startup.
Attention on the financial aspects of startups tends to focus on the external measure of fundraising. Yet before this, there are many aspects for an entrepreneur to consider regarding setting their business up for financial success.
In this article, we address eight vital considerations to take around the equity, budget, and valuation components of a startup.
A Wharton MBA and CFA, Carolyn has executed 20+ VC/PE deals, managed a $700M portfolio and is a fundraising, growth and M&A specialist.
As a startup founder of an early-stage technology company called VitiVision, I recently went through the challenging process of setting up a business, raising funding, refining my business model, interviewing customers, and recruiting a team. Even as a CFA charterholder, former investment banker, and VC, I realized during the process that there were many financial considerations that I wasn’t aware of or ready to make. Startup advice that I gathered from internet research was also fragmented, legally oriented, or biased towards a VC perspective.
In light of these experiences, I will now share with you my learnings in the form of a checklist of the eight important financial considerations that you will encounter as a founder. These are categorized under the themes of equity ownership, budgeting, and valuation considerations.
Why is it important to get “Founder Finances” right?
How much equity you and other stakeholders will have, and when, is one of the most important financial decisions you will have to make as a startup founder. It’s important because equity provides financial rewards and motivation for co-founders, employees, advisors, and service providers. It also determines decision rights and control of the company.
Getting this wrong could not only risk underperformance and resentment among stakeholders but also result in your own termination from the company or dilution to an insignificant level.
Most likely you will begin your journey with a co-founder, or recruit one shortly thereafter. You will need to decide on the equity split as soon as possible.
Regarding the equity split, there are many articles written on this topic and various online calculators (e.g., here and here) to help you determine the exact amount. The broad factors determining the split should be:
Whatever model you use, remember that the split should be forward-looking, in that it should reflect the “future value” of the company.
I made an initial mistake by basing my startup’s entire split calculation on a backward-looking, “How much work has been done to date?” method. In my case, that model gave the co-founder who invented the IP, but was only working as a CTO part-time, a disproportionately larger equity stake (>60% vs. typical IP licensing deal of only 5-10% equity) than my own. I was the one who created the entire business plan, pitched successfully for funding, and was working as the CEO full-time. The missing part of this decision was that it didn’t reflect the forward-looking elements of risks and potential contribution.
Instead of deciding the equity split up front, another approach is to just wait and see. In reality, startups and personal situations evolve quickly. Leave 15% or so of founders’ equity un-allocated for the future, and decide only when you reach the first significant milestone (e.g., MVP or first investment).
In summary, my practical advice from experiences with equity:
Over time, as you grow the team, you will need to give shares to employees, to incentivize their performance. Most VCs will also ask you to establish an employee share options pool (ESOP) and to top it up over time. Typically, at Series A, VCs will ask you to put in ~10% to the employee share options pool. Over the next rounds, investors might ask you top it up to 15-20%.
How much to give, and when, depending on the stage of the company and the seniority of the employee. Common practices are:
Position | Suggested % | Comments |
---|---|---|
Senior Hires | 5% | For C-suite or important hires with salaries > $100k |
Engineers | ~0.5% | Assume a minimum salary of ~$100k. Or if you are in Silicon Valley, all-in expense for a good engineer is ~$15k per month. The lower the salary, the higher the equity needs to be. This tool is useful for determining employee equity compensation. |
Service Providers | 0.1% ($10k of services at a $10m post money valuation) | Some lawyers might provide services for equity consideration via convertible notes. |
Advisors | 0.5 - 2% | Depending on their value and commitment |
Vesting schedules are put in place to protect other shareholders against early leavers and free riders. As co-founder, unless you have a milestone-based vesting schedule among the founding team, the usual vesting schedule is four years, with one-year vesting cliffs for 25%, and 1/36 of total eligible shares earned each month for the next 3 years. There are variations to this term, such as accelerated vesting, vesting cliffs, and percentage founder vesting earned before outside investors.
You want to retain control throughout and have a healthy financial windfall when your company exits, right? Sadly, statistically, four out of five entrepreneurs are forced to step down as CEO during their tenures. The HBR article The Founder’s Dilemma argues that the control vs. wealth dynamic is usually a rich vs. king tradeoff. According to the article:
The ‘rich’ options enable the company to become more valuable but sideline the founder by taking away the CEO position and control over major decisions. The ‘king’ choices allow the founder to retain control of decision making by staying CEO and maintaining control over the board—but often only by building a less valuable company.
This article highlights how important it is for you, as the founder, to understand dilution and its impact for you as early as possible. After multiple rounds, you could end up with less than 30% of equity at exit; however, the value of your stake could increase significantly at each round.
You can do a dilution analysis by developing a pro-forma capitalization table (called a “cap table” by VCs) and continually updating it. The important input assumptions are:
The output of this analysis should be the founder percentage ownership at each round and the dollar value of the equity. What should you assume? Here are some typical assumptions you can make, followed by a demonstrative example (Table 2 and Chart 1):
Pre-seed (incubator/accelerator) | Seed/Angels | Series A | Series B | Series C/Pre-exit | |
---|---|---|---|---|---|
Post-money Valuation | $1.0 | $2.5 | $12.5 | $62.5 | $312.5 |
Money Raised | $0.1 | $0.5 | $2.5 | $12.5 | $62.5 |
New Investor % | 10% | 20% | 20% | 20% | 20% |
New ESOP % | 0% | 0% | 10% | 6% | 5% |
Founder's Equity Value | $0.9 | $1.8 | $6.3 | $23.3 | $87.4 |
Budgeting sounds boring, but doing it right ensures that you make rational decisions from day one and don’t let your biases cloud your execution.
It’s important to have a clear estimate for the first-year budget so that you know how much you can self-fund or if you need to raise investment. The cost items on an initial budget should include:
Timeline | Activity description | |
---|---|---|
Q1 | First 3 months | Company registration, pre-seed fundraising, business plan, pitch book, co-founder negotiation. |
Q2 | 3-6 months | MVP development, customer validation, marketing, first hire |
Q3 | 6-9 months | Seed fundraising, second hire, product launch |
Q4 | 9-12 months | Traction building, trying to survive |
In summary, a realistic first-year budget for a startup of non-paid co-founder(s) and one FTE (contractor or employee) is in the range of $160k to $300k. You should have the confidence to raise this or be prepared to fund it yourself. There are some alternative funding sources out there, such as incubators or accelerators, where they either invest an initial amount or provide FTE resources, such as technical engineers, to help you develop an MVP and kick-start the venture.
This should be done in conjunction with a desired exit valuation (discussed in the next section) so that you can realistically project the next three years of P&L in lieu of an end goal.
I suggest that you focus on major items: milestones, key metrics (e.g., number of users), revenues, and expenses, as your business can pivot drastically during its life. Make assumptions and document them in detail so that you can continually iterate.
As ex-VC and banker, I love building valuation models. It gives me a range of returns that I can expect as a professional investor. And It’s fun—I can build a model valuing a company by playing with assumptions such as market size (TAM/SAM/SOM), growth rates, and exit valuation multiples. Usually, I would project out three potential scenarios:
Now as an entrepreneur, I find it even more necessary to build valuation models, as it allows me to estimate the expectations placed on myself. Most importantly, as an early-stage entrepreneur, I can use the exit valuation analysis to steer my business towards:
I don’t want to discuss here on how to value at each round because valuation at earlier rounds is usually out of the founder’s control and driven by supply and demand of capital. You can find many good articles written online on different valuation approaches for early rounds, such as this one.
Instead, I want to talk about exit valuation and founder’s return projections, which are usually overlooked but important to analyze.
Exit valuations, if considered in advance and done properly, can help you to carefully plan the business’s path. Below are a few critical assumptions that will drive your valuation, exit value, and commercial strategy:
What metrics do you have to hit to achieve an exit? For example, if you are a new drug development company, you need to get FDA Phase II approval to be acquired by a major drug company, or IPO.
When can you hit the target metrics? This puts a ballpark number on the timing of exit. Typically, it takes at least five years to build a viable company.
How would you exit, IPO or M&A? This might sound too premature to think about, but it’s not. If you are targeting M&A, you need to build a company to be a valuable potential asset to the acquirers. For example, if you are building an electric vehicle startup targeting to be acquired by Tesla, you should get familiar with Tesla’s business strategy and technology pipeline. On the other hand, an IPO candidate needs to appeal to a wide range of institutional investors who don’t have specific needs but require an exciting story.
What’s the typical industry valuation approach applicable to your business? The main valuation approach for any financial models is discounted cash flow (DCF), public comparables, and precedent transactions. You can obtain a detailed approach from various finance textbooks and online tutorials.
Even though money is not the most important driver for starting a business, you will want to be properly rewarded for your blood, sweat, and tears. Now that you have projected out your expected equity ownership at exit and you know what your target valuation is at exit, you can calculate your return:
Your return = the expected equity % at exit x the target valuation x (1-capital gains tax rate).
For example, if you expect to own 20% of equity at exit, at a $100 million valuation, and your capital gains tax rate is 25%, you will earn $15 million from the transaction.
If you’re debating whether to start this business or not or try to convince someone else to join you can use this analysis to show the potential reward.
It is vital before starting a business that you compare this projected figure versus your own opportunity cost of earnings potential staying in the corporate world. Having this foresight will ensure that you start your business without any regrets and a clear understanding of what you are aiming to achieve.
You should be aiming to do this analysis as soon as you are confident about your startup idea and co-founder selections, or at the very latest, before raising external financing.
Many startup founders prefer to focus on building a great business first and then figure out the housekeeping over time. However, it could be even more time and money wasted later if you don’t get it right at the start. For example, we all know about Facebook’s co-founders’ nasty fight, and Zipcar’s co-founders’ not being properly rewarded for their hard work (of the $500 million acquisition of Zipcar, one co-founder only had 1.3% equity after multiple rounds of dilution, and the other had less than 4%).
Looking at some examples from founders of famous companies, there is a wide disparity of ownership percentages held at the time of IPO. This shows that there is no set course to take and that personal fortunes are not entirely correlated to the company’s.
In conclusion, like tax and death, these financial considerations don’t go away. It’s better to learn how to deal with them up front or get professionals to help you do this. This will empower you to focus on actually building a great business, from “lean startup” product development to acquiring customers.
Founder equity is the ownership that is held by the team that started the company. The original capital to start the company will come from founders’ own funds or ‘sweat equity’ that they put into getting the idea off the ground.
Vesting represents time milestones used to release equity to stakeholders over a set time period. Often, metric targets or timing are used as the rule for releasing shares in this manner. Vesting is applied as a means to ensure that interest and effort from stakeholders is maintained as a reward for equity.
The dilution of shares refers to the percentage ownership of the holder falling, it does not refer to a reduction in the number of shares held. As companies grow and raise financing, they issue new share capital, the effect of which dilutes older shareholders through the increased pool of stock available.
The exit value is the financial consideration given to a startup, or private business, in the event of a transaction that materially alters its ownership structure. This can come from an IPO, M&A, or ultimately a winding up of the business’ affairs
A Wharton MBA and CFA, Carolyn has executed 20+ VC/PE deals, managed a $700M portfolio and is a fundraising, growth and M&A specialist.
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