Startup funding methods: equity financing explained

Instead of taking debt, entrepreneurs can give equity. Noam Wasserman, author of The Foundere’s Dilema, argues that equity splits should rarely be equal, and more experienced entrepreneurs craft more intricate equity splits that involve vesting periods, milestones, and premiums based on ideas and/or experience. Much of that however applies to founding teams or taking money from FFFs. For equity splits, two important areas come to mind: angel investors and venture capital.

Unfortunately, there isn’t a whole lot of data surrounding angel investors. Angel investors are high net worth individuals, typically very familiar with starting businesses and pitching VC firms. It is believed that angels cumulatively invest more than VC firms (Wasserman, 2012). However, angels do so in smaller doses typically between $20000 and $100000. Angel investors typically invest in the early stages of a company before VC rounds of funding.

Venture Capital is a much larger way to fund a business. In order to advantages, it is important to understand what VC firms are. VC firms are institutional investors who invest for limited partners such as pension funds with the expectation of extraordinarily high returns (Thacker, 2017). Like Aaron Judge, there are a lot of strikeouts in the quest for homeruns.

These investors (angels and VCs) both have expectations of a return on their investment. This means some form of liquidity event either being an acquisition or IPO (Fernandes, 2017). However, in order to reach their goals, these investors will guide the company. Equity funding can often open up doors for companies. This is also the way to get the most funding. Companies that need a lot of experience and expertise should seek the equity financing route. From there, how they negotiate with their investors should reflect their motivations. Keeping 51% is hardly control when the VC stack the Board of Directors. Ultimately this option favors wealth focused entrepreneurs and less talented (in terms of craft not business) ones also. Yet this option can cause trouble down the road. The influence that VCs can have on the company can pressure the entrepreneur to sell their business, perhaps short. VCs also take a lot of equity for their money. By the D round of funding, the founders and team average 20% equity (Wasserman, 2012). This minority ownership is troubling for control motivated entrepreneurs while wealth motivated entrepreneurs can live with 20% of $100 million.

VC deals are by far the most complicated of the funding. The complexities can include caveats like liquidation preferences (disproportionate share of liquidation), board seats, vesting periods, milestones, and more. There really is no template for these deals. Customization is an advantage if you know what you’re doing and disadvantage if you’re clueless.


Raymond Fava is the founder of Startup Christ and the founder of EcoEats, Inc. EcoEats crafts exotic jerkies using unique flavors. To see their selection, click here.


References

Thacker, S. (2017, October 12). The Pros and Cons of Venture Capital Funding. Retrieved from All Business: https://www.allbusiness.com/the-pros-and-cons-of-venture-capital-funding-11382154-1.html

Wasserman, N. (2012). The Founder’s Dilemma. Princeton: Princeton University Publisher.

 

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