Category Archives: Capitalization

Do Founder Investments Dilute Earlier Investors?

ScalesAs president of Offtoa, a company committed to assisting entrepreneurs succeed, I am often asked by first-time entrepreneurs if their “investments” after founding dilute the ownership stakes of their earlier investors. The answer is always “it depends.”

Specifically, it depends on the type of legal entity that the company is; it depends on the terms laid out in the articles for the company; and it depends on what the founder means by an “investment.”

I’d like to explain the various implications of a founder “investing” money in a company subsequent to its creation and acceptance of earlier investments.

First of all, let me explain how the question is usually posed:

The Starting Conditions

“When I started the company a few years ago, I invested $20,000 and owned 100% of the company. Later, two outside investors made cash investments and purchased 10% and 20% of the company, respectively. Now I want to make another investment of $20,000. Will that dilute the ownership positions of the two outside investors?”

The Answer if your Startup is a Corporation:

If your startup is a corporation, then the outside investors did not purchase a percentage ownership stake; instead they purchased a number of shares.

Investment. If you are purchasing additional shares with your new $20,000 investment, these shares always come from the company’s treasury. Thus, the total number of outstanding shares will increase, and the percentage ownership represented by the outside investors’ fixed number of shares will indeed decrease. So, yes, they will be diluted.

Loan. If you are just lending the company $20,000, then this has no effect on the number of outstanding shares, and outside investors will not be diluted. You become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before shareholders.

Convertible Loan. It is common practice for insiders who lend the company money to convert those notes into equity if a major investment round occurs in the future. That is, the note is retired, and the outstanding principal including accumulated interest becomes part of the next investment round.

The Answer if your Startup is a Partnership:

Capital Account. Typically, if you invest cash in a partnership, it has no effect on ownership distribution; instead, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the partnership to the partners, you would be eligible to receive that amount from your capital account.

However, because partnerships allow for “special allocations,” both allocation of profit and loss to a capital account and subsequent distributions is negotiable. So, no, the “outside investors” (i.e., partners) will not be diluted.

Increasing Your Stake. Notice that if you did want your investment to dilute the partners, you would pay the other partners to acquire their positions. This would not provide cash to the company to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before partners.

The Answer if your Startup is an LLC:

Because most LLCs are treated as partnerships for tax purposes, the manner of priority, allocations, and distributions are negotiable. However, here is how they typically work.

When you as a founding member invest additional capital in the LLC, it could be treated in either of two ways, based on the LLC’s articles of organization:

  1. Capital Account. Like in the case of a partnership, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the LLC to the members, you would be eligible to receive that amount from your capital account. So, no, the “outside investors” (i.e., members) will not be diluted.
  2. Like in the case of a corporation, the cash could be used to add to your ownership interest, diluting other members (in this case, the “outside investors”), with their approval.

Increasing Your Stake. As in the case of a partnership, most LLCs also allow you to pay other members to acquire their positions. This would not provide cash to the LLC to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the LLC. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before members.

Summary:

It is extremely common for founders to want to make additional infusions of capital into companies after starting. But notice that the implications of making such an investment are non-trivial. This is one of the many reasons why almost all startup mentors recommend that first-time entrepreneurs consult with an attorney experienced with entrepreneurial matters prior to creating their companies.

The type of legal entity that you decide upon and the terms you include in your incorporation/organization/partnership agreement will have significant effects on many aspects of your business. The above example of re-investing in the company is just one small example.

Please note that I am neither a CPA not an attorney. If you want to understand how investing in your company will affect your earlier investors, please consult with your CPA or attorney.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
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If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com,.

When should you ask for investments?

1024px-Wonderland_Walker_2A successful startup company needs to create a sustainable growth model using paid, viral, and sticky strategies. However, before it gets there, a startup usually needs some cash investments to get things going.

Let’s say you have performed a financial analysis of your startup company and have determined that you will need $1M to keep it afloat until it can sustain itself.

When should you raise the $1M? No simple answer exists. In general, the longer you wait to raise any round of investments,

  1. The higher your valuation is likely to be because you have likely reached more milestones, like generating more revenue, obtaining more partners, producing more product, and so on. The higher the valuation, the less of the company you will have to “give away” to investors for a given amount of money.
  2. The higher risk you have of running of cash, so unscrupulous investors could take advantage of you by delaying their investment decision until you are desperate, thus forcing you to accept a lower valuation.

Some advisors will tell you to ask for all the money you need at one time because the investment-seeking process is so time-consuming that you want to do it as infrequently as possible. Get it over with at one time so you don’t have to do it again.

Some advisors will tell you to always raise more than you need because you have probably been overly optimistic in many of your predictions, and you want the cash cushion.

Some advisors will tell you to always raise less than you need (i.e., be as lean as you possibly can be) because your company’s valuation will always be higher later and you can raise less expensive money later.

Only you can make this decision. It is a delicate balance act.

What does cash flow look like?

Every startup’s cash flow looks like the following graph:

Cash Flow Figure

Notice that in the ideal world a successful company would burn cash at a slower rate of speed after each successive investment round; note that the slopes of subgraphs A, B, and C increase with each round. Eventually, the company sustains itself (at point C in this case) from operations without additional infusions of cash from external sources.

If the entrepreneur waits too long to raise investment round 2, line A will continue its downward trend below the horizontal zero line and the company will be out of business. If the entrepreneur doesn’t wait that long, but long enough so investors can see the company running out of cash soon, investors could just delay their decision.

In Summary

Entrepreneurs have to make their own decisions.

Some prefer to bootstrap using revenues to grow their businesses; this approach maintains ownership among founders and employees, but usually means slower growth because they can be cash-strapped.

Others prefer to raise as much as possible . . . and then spend it as fast as possible, reducing the risk that a competitor will beat them to the market.

Others take a middle of the road position of raising just enough capital, and spending is judiciously.

All a matter of style.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

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If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

Photo of Nik Wallenda (Wonderland Walker) courtesy of Kevint3141 (Creative Commons).

Should you sell investors common or preferred shares?

Photo PreferredPhoto CommonIn most start-ups, founders’ shares are common.  Subsequent investment rounds tend to sell preferred shares to investors, but some start-ups sell common shares to investors.

Why offer preferred shares to investors?

The reason for offering preferred shares to investors is that insiders (like founders and officers) have a huge amount of control over the success or failure of the company whereas outside investors have so little control.

The preferences that come with preferred shares lessen that almost intolerable level of risk.  These preferences reduce risk for their owners, and generally fall into two categories. The categories are downside insurance and upside insurance.

What are “downside insurance” preferences?

Downside insurance preferences provide owners with protections in case the company does not do particularly well. Two examples are liquidation rights and anti-dilution rights.

  1. Liquidation rights give the preferred shareholders a multiple of their initial investment back before a general distribution of the proceeds of a liquidity event. Say the investors purchase their shares for $600,000 and they negotiate 2x liquidation rights.

    A few years later, the company is acquired for $4,000,000.The preferred shareholders would receive 2x their initial investment, i.e., $1,200,000, and then the remaining $2,800,000 would be divided pro rata among all shareholders (including these same preferred shareholders).

  2. Anti-dilution rights give the preferred shareholders a “guaranteed best price” on their share purchase. The preference kicks in only if the company ever sells shares at a future date at a price lower than the current offering.

    Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate anti-dilution rights.

    A year later, the company has run into difficulties and is forced to sell shares at $1 per share in order to attract investors.

    If they succeed in raising this follow-on round, they will have to issue 300,000 additional shares at no cost to the original preferred shareholders (the ones who had the anti-dilution rights); this has the effect of retroactively selling them 600,000 shares at $600,000, so they actually ended up paying the better price of $1 per share.

What are “upside insurance” preferences?

Upside insurance preferences provide owners with some additional benefits in case the company does extremely well. Two examples are registration rights and warrants.

  1. Registration rights allow preferred shareholders to sell their shares at the time of the initial public offering.
  2. Warrants allow preferred shareholders to purchase additional shares at the current price. Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate a warrant to purchase an additional 100,000 shares at $2 per share.

    A year later, the company is doing poorly; the preferred shareholders will not choose to exercise their warrant.

    However, if a year later, the company is doing very well, and the shares are now worth $5, the preferred shareholders may choose to exercise their warrant and purchase the additional shares

In Summary

Some first time entrepreneurs avoid selling preferred shares to investors out of fear that they should not sell something “more valuable” than what they, the founders, own. However, most founders become officers and thus have almost complete control over the company’s success or demise, while outside investors have very little power to influence the success of the company.

Outside investors deserve some ability to reduce their risk and share in the upside. And the only way for them to do that is to negotiate the preferences that go with preferred shares.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

WYNSUMM CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

 

 

Why do I need a founders round?

No FoundationA founders round is an investment round that generates the initial cash needed to get the company started, but more importantly, it distributes equity to the founders of the company. In effect, it creates a foundation for the company’s ownership.

Do not start your company by simply giving stock to the founders. Doing this creates a taxable event for the founders because they have received something of value, a security, which is taxable. Rather, let the founders purchase a security, which establishes a basis for the purchase of the stock and which is not taxable.

What price do founders usually pay?

Since the company has just started, it isn’t worth very much. Usually, the founders pay a nominal amount, just enough so the company has enough runway to reach the first real investment round.

How many shares should founders purchase during the founders round?

No hard and fast rule exists. However, one million shares would give you good flexibility for the future. It would enable you to sell reasonable pools of shares to future investors and grant reasonable packages of options to employees, without having to do splits to create additional shares.

The only reason not to issue a million shares to the founders would be if your state of incorporation charges your company annual corporate tax based on the number of shares outstanding.

When should you conduct the founders round?

Ideally, you should conduct the founders’ round soon after you execute the paperwork that legally creates the company.

That way, the articles of incorporation and bylaws (if a corporation), the partnership agreement (if a partnership), or the operating agreement or articles of organization (if an LLC) can reflect the distribution of ownership.

Can you have a second “founders round” after the founding of the company?

Legally, founders’ shares are only available at company inception.

Founders can of course sell their shares to somebody. In this case, the new shareholder would pay the founders (not the company) for the shares.

And of course a company can always sell its treasury shares to a new shareholder. In this case, the new shareholder would pay the company. However, be careful! The investor must purchase them at a price using the current market value of the company, likely not the extremely low price the original founders paid for their shares,

When the original founder share price is paid for shares later in the company’s life, the new investor may be subject to a taxable event by the IRS.  Only in the case where nothing happened in the company between its founding and the time of the new investment would the potential exist for this to not be a taxable event.

So, the answer to the question Can you have a second “founders round” after the founding of the company? is  “Yes, sort of.” The new investor would purchase his/her shares in an “investment round”, which you can call whatever you want.

In summary

When you start a company – whether it is a corporation, a partnership, or an LLC – make sure that the founders/partners purchase their shares of the company. That establishes a basis for the security and will make tax filing a lot easier in the future. When shares are sold later on, make sure they are sold at the fair market price at that time.

 

Alan DavisAl Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books. He is not a CPA or an attorney, so the above is just his opinion!

 

Startup: Loan or Investment?

Wordle Loan or InvestmentYou have a great idea for a company.

You’ve validated that the market wants the product and is large enough. You’ve determined that their pain is significant and you’ve found the right messaging that hits their pain point.

Your product is unique and early tests indicate that customers want your product much more than they want competing products.

You’ve found ways to protect your intellectual property so competitors cannot copy you.

You’ve created financial models that show you can be profitable by the end of the second year, and cash flow positive by the third year.

You have just one problem left: You need $350,000 to get the company started. The big question is: should you try to obtain a loan? Or should you try to obtain an investment?

For experienced entrepreneurs, it is an easy answer based on experience. For the new entrepreneur, the choice can be gut-wrenching. Let’s explore what the choices of loan or investment and their pros and cons.

What’s an Investment?

An investment occurs when investors (usually angels or venture capitalists, but it could also be friends or family members) provide the company with $350,000 and you sell them a part of your company.

For example, if you and the investors were to agree that your company was worth $1,050,000, then you could sell one third of the company to them for $350,000. If you and your co-founders owned, for example, 1,000,000 founders’ shares and the company needed $350,000, the company would need to sell 500,000 shares to the investors and they would then own 500,000/1,500,000, or 1/3, of the company.

Notice that it would not be sufficient for you and your co-founders to sell them a third of your 1,000,000 founders’ shares. If you did that, the investors would need to pay you $350,000, and the company would get nothing!

Some variations exist:

  • As managers of the company, you have complete control over the success of your company. The investors have almost no control; yet all their investment is at risk.

    For that reason, and to make the playing field just a wee bit more level, most investors demand 
    preferred shares. Many possible preferences could be requested by investors, but the most common is called a liquidation preference, which means that investors get back their original investment (or a multiple of it) prior to a general distribution of the proceeds of the sale of the company.

What’s a Loan?

A loan occurs when a creditor (usually a bank, but it could also be a friend or family member) provides you with $350,000 and you promise to pay it back in even installments over a period of time, with interest.

For example, if you were to obtain a 7-year, $350,000 loan from a local commercial bank with an 8% interest rate, you would need to pay $5,500 each month for 7 years to repay the loan.

In general, lenders expect personal guarantees; if your company cannot make payments on the loan, you will be personally responsible to make the payments, and that means you could lose your house or your car.

Whether or not you are willing to put these items up for collateral is a good indication to the lender as to whether or not you believe in your own company. If you wouldn’t risk your house, why would you expect them to take the risk? At the end of the seven years, you would be free of any obligation to the bank.

Some variations exist:

  • A balloon loan lowers the monthly payments during the term of the loan, but then includes a much larger one-time payment at the end of the term. In the above example, monthly payments could be $4,000/month, and then a balloon payment of $166,000 would be due at the end of seven years.
  • An interest-only loan allows the company to pay just the interest on the loan each month, but then must repay the entire loan at the end of the term. In the above example, monthly payments could be $2,333/month, and then the company would pay the bank $350,000 at the end of seven years.
  • A convertible loan allows the creditor to convert the outstanding balance of the loan into equity. In the above example, interest would accrue but not be paid, so if the loan converted to equity at the end of one year, the creditor would become a shareholder with $379,000 worth of stock.

Advantages of getting an investment

The advantages of obtaining investments rather than loans include:

  • No monthly payments required.
  • Investors can generally provide much larger sums than lenders can.
  • Owning a smaller piece of a huge pie rather than a larger piece of a tiny pie.
  • You might not be able to find a lender interested in your company.
  • Generally no collateral is required.

Advantages of getting a loan

The advantages of obtaining loans rather than investments include:

  • No loss of “control”.
  • You might not be able to find an investor interested in your deal.
  • You might be in an industry that produces returns insufficiently high to attract investors.
  • You might be in an industry without any possibility for liquidity.
  • You and your co-founders may want to manage a life-style company and never sell the company (no liquidity event -> no investor interest).
  • Interest rates are much lower than investors’ expected internal rates of return (IRR).

Summary

If you need cash for your new company, many options exist, but don’t expect anybody to take the risk without you taking at least an equal risk.

If that risk is a loan, you will need to risk your personal assets. If it is an investment, you will have to offer preferences, which puts your personal piece of the pie at risk. However, as long as do well, there will be plenty of returns for everybody. Neither lenders nor investors want more than they deserve; what they want is shared risk.

Al Davis is a serial entrepreneur currently in his fifth startup.  He is also an angel investor and the author of six books.

Planning Investment Round Pricing for Startups

High WireSuppose you are just starting to plan your startup company.  It’s a balancing act, to put it mildly.

You’ve researched your market and industry.

You think you understand what products you’ll sell at what price to what target markets.

You and your co-founders already purchased, say, 1,000,000 (common) founders shares at $.001 per share.

You have built pro forma income statements for five years and see that you expect to achieve revenue ($19,000,000) and profitability ($7,500,000) compatible with your goals. Here is what your pro forma income statements might look like:

IS1

You have also built pro forma cash flow statements and have learned that you need two infusions of cash: $400,000 during the first year of operations and an additional $800,000 during the second year.

After that, the company will grow without infusions of cash. Here is what your pro forma cash flow statements might look like (Note that the cash balance at the end of the first year is negative $337K, which is why we concluded you need $400,000 in cash. Note that the cash balance at the end of the second year is negative $1.17K, which is why we concluded you need $800,000 more in cash.):

CFS1

The next big questions you must answer concern the two investment rounds:

  • What class of shares should you sell the investors?
  • At what price should the shares be sold?

What Class?

Most outside investors in startup companies want preferred, not common, stock. The reason is simple. Unlike company founders, outside investors typically have little or no influence over decisions and outcomes because they are not part of the management team.

With so little control, they take on much more risk, and thus deserve a higher return. Preferences (specifically Liquidation Preferences, but often others as well) provide that higher return.

At What Price per Share?

Determining price per share is an iterative process.  In the scenario being discussed, let’s start by guessing that a price per share of $5.00 might work. See figure below.

Investment Round 1

Next, take a look at the Internal Rates of Return (IRR) in the last column of the following table.

IRR1

 

In this case notice that two problems exist:

  1. The IRRs (21.9% and 28%) for both rounds are below external investor expectations.
  2. The IRR received by the second set of investors (Series B) is higher than by the first set of investors (Series A). That is inappropriate since earlier investors always take higher risk and therefore deserve a higher return.

With that in mind, let’s adjust the prices per share for the two rounds to $1.25 and $4.00, respectively.

Investment Round 2

This time the relative returns of the two rounds are appropriate, but the Series B investors are still receiving a return too low for outside investors; in fact they’d be better off making a safer investment in the public markets (they would receive a lower return but with a much lower risk).

IRR2

In this specific case, iteratively adjusting the prices per share will eventually demonstrate that prices of $1.25 and $2.75 result in IRRs of 44.1% and 35.5% for the two classes of investors.

Personally, I tend to plan for larger returns for my investors, so I would likely plan my rounds at around $.75 and $1.50 per share to at least plan for returns of 51% and 45%, respectively.

Of course, this exercise is a planning exercise only. When you get around to actually raising capital, many other factors are going to come into play including whether or not you have met key milestones, the general availability of capital, the negotiation strengths of both parties, competition, and so on.

Now you have determined the right prices per share to use during the planning stage of your company so that your shareholders receive fair returns. There is just one more step left. It is to look at the cap table for your company to verify that you have not sold too much of the company in the process of attracting investors. If necessary, read How to Read a Cap Table: Advice for Entrepreneurs.

Cap Table

As you can see above, Series A sold 19% of the company, and Series B sold 18% of the company, leaving 63% for the founders and optionholders.

If you are comfortable selling more of the company and offering a larger return (and thus making it more likely to receive investments), lower the price per share for each round.

The price per share is your “lever,” which is equivalent to manipulating the valuation of the company or the “pre-money valuation”.

Planning your investment rounds at company inception enables you to understand the impacts of seemingly small changes to deal terms at a time when you are not under duress. Then when the time comes to deal with investors you can apply the knowledge you learned previously to remain calm.

Dealing with investors requires precision, patience, and a keen understanding of your company’s present and forecasted finances. Operating with the finances as your fulcrum allows you to balance everyone’s interests and give your company the best possible chance of success.

Alan DavisDavis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

 

 

High Wire Photo courtesy of orangebrompton (Creative Commons)

How Investors Value Your Startup

Let’s start by discarding two myths:ダイヤモンド査定

  • Investors do not want control of your company! That is the last thing they want. What they do want are (a) handsome returns, and (b) for you to responsibly manage your own company so they don’t have headaches.
  • Investors do not care what past valuations were. On previous rounds, you may have received poor advice and valued your company at, say, $5M, and you found some unfortunate investors to purchase stock at that ridiculous valuation. Oh well, that’s too bad. It has zero effect on what the company is worth today.

What do investors want?

So, what do investors want? And how will they decide what your company is worth? Five main factors influence them:

  1. Is the opportunity exciting? If it isn’t exciting, they won’t bother valuing the company at all.
  2. Is the team qualified to execute on the plan? If not, you just aren’t worth the risk.
  3. Valuation based on current performance. Based on current trailing financials (i.e., what you have already done regarding revenues and profits), and multiples applicable to your specific industry, what is your company worth today?
  4. Valuation at desired time of liquidity. Based on expected performance (i.e., what you say about expected revenues and profits in your plan), and multiples applicable to your specific industry, what will your company be worth in the future? See below and blog on Determining Future Valuation.
  5. At what stage is the company? The biggest hurdles a startup has are:
    • building a product
    • getting the first revenue
    • demonstrating a repeatable sales model
    • demonstrating sustainable growth without continuing to invest external cash.

As you jump each of these hurdles successfully, the risk of total failure decreases significantly. Investors have their own rules of thumb about how that “risk of total failure” affects valuation. Here are my rules of thumb:

  • If you have not yet built your product, assume valuations will be no more than 25% of the valuations calculated using the techniques shown below.
  • If you have built your product but have not yet received revenue, assume valuations will be no more than 50% of the valuations calculated using the techniques shown below.
  • If you have built your product, started receiving revenue, but have not yet demonstrated a repeatable sales model, assume valuations will be no more than 75% of the valuations calculated using the techniques shown below.
  • If you have demonstrated a repeatable sales model and are looking for investments to “ramp up,” then the following techniques for valuation are applicable.

What To Do With Future Valuation?

Let’s talk a bit more about item 4 above. What will investors do with that future valuation once it is computed? They certainly won’t use it for today’s valuation. What they will do is use it to determine what value the company needs to have today so they can receive an acceptable return on their investment. Assuming that FV is the computed future valuation of the company at the time of liquidity, IRR is the investor’s desired rate of return and n is the number of years between now and the liquidity event, the calculation goes as follows:

Current Value of Company = FV / (1 + IRR)n

So, for example, let’s say the FV is determined to be $15M (using the techniques of the blog, Determining Future Valuation), and the investors desire a 50% IRR (not unreasonable considering the degree of risk) over 5 years. Plugging those numbers into the above formula, we get:

Current Value of Company = 15M / (1 + .5)5 = $1.98M

So, if you are looking for those investors to invest $500K now, expect them to ask for 25% of the company (because $500K is 25% of $1.98M); if you are looking for those investors to invest $250K now, expect them to ask for 12.5% of the company. And so on. But this applies only after you have demonstrated a repeatable sales model.

Now you need to factor in the risks described above. If your company is:

  • Pre-product, valuations decrease by around 75%. So continuing with the above example, the company now has a current valuation of around $500K. So, if you are looking for those investors to invest $500K now, expect them to ask for 100% of the company (obviously not a good idea); if you are looking for those investors to invest $250K now, expect them to ask for 50% of the company.
  • Pre-revenue, valuations decrease by around 50%. Continuing with the above example, the company now has a current valuation of around $1M. So, if you are looking for those investors to invest $500K now, expect them to ask for 50% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 25% of the company. And so on.
  • Pre-repeatable sales, valuations decrease by around 25%. Continuing with the above example, the company now has a current valuation of around $1.5M. So, if you are looking for those investors to invest $500K now, expect them to ask for 33% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 16.6% of the company. And so on.

None of the above is motivated by greed or a desire for control; it is pure economics. Investors want (and deserve) a fair return for their investment.

Of course many other factors come into play including experience, negotiation skills, degree of desperation to obtain cash, and availability of competition for deals (for the investor) and investors (for the entrepreneur).

Alan DavisDavis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

Accounting for Kickstarter in Startups

You want to start a company and heard it’s easy to get money from Kickstarter. But where do you record the $20,000 in your accounting system?

It’s Not Shareholder Equity

First of all, Kickstarter funds cannot be used as investment dollars, so the $20,000 cannot be recorded as equity.

It’s Not Long-Term Debt

Businessman attracts money with a large magnetTypically, when you apply for Kickstarter funding, you state you are promising to give something back in return for the investment.. So, in some ways, when you accept funding, you are creating liability, i.e., the obligation to “pay back” the backers with whatever you have promised them. But it is not quite a loan because there is no interest and no legal instrument that you must repay. So, the $20,000 cannot be recorded as a typical long-term debt.

Is it Revenue?

According to http://outright.com/blog/accounting-for-crowd-funding-what-you-need-to-know-before-starting-a-kickstarter-campaign/, the IRS might consider funding from Kickstarter to be taxable income! After all, these people are paying money to the company with the expectation that they will receive a product in return.

Could be Deferred Revenue

That sounds like revenue! Actually, it is more like unearned income (aka deferred revenue, which is a liability) because you have not yet delivered the product. The unearned income only becomes revenue when you deliver the product to the customer.

If I were considering Kickstarter funding, I’d start by asking my accountant how to record the events. If you were penny wise and pound foolish and wanted to avoid paying an accountant, I’d play it safe and record the transaction as a credit to your Unearned Income (liability) account and a debit (i.e., a deposit) to your Checking/Bank (cash) account.

Then when you deliver product to your Kickstarter supporters, I’d record each transaction as a debit to your Unearned Income (liability) account and a credit to your Revenue account. But I’m not an accountant!

I don’t know how most recipients of Kickstarter funds are accounting for the funds on their books, but I suspect that most are so happy to receive the funds that they haven’t thought about it much, and most haven’t asked their accountants. I recommend that you do! You really don’t want to spend all that money and then receive a surprise letter from the IRS.

Al Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books. He is not a CPA or an attorney, so the above is just his personal opinion!

 

How to Read a Cap Table: Advice for Entrepreneurs

A capitalization table (cap table for short) shows how ownership of the company is distributed among all shareholders. It is the de facto standard entrepreneurs use to show investors what they are buying.

sharks When you are seeking investor money, you are essentially selling something, specifically equity in your company. Providing a cap table when you sell equity in your company is similar to providing a CarFax report to buyers when you sell a used car.

In both cases, you are fully disclosing to the buyers exactly what they are buying. It shows you are honest and reveals (in both cases) material facts that buyers cannot otherwise discern.

Although the cap table is a standard tool among entrepreneurs and investors in private companies, it is not a standard financial statement in a larger corporation.  Learn to read one to be credible to investors.

What Does a Cap Table Show?

A cap table shows in a single table a complete breakdown of the ownership of equity of a company. It displays exactly what classes of stock exist, who owns shares, and how many (and what percentages) of each.

Let’s look at an example where the cap table is being used to show “before” and “after” situations as part of a stock offering. In this case, the stock offering is for 200,000 preferred shares of the company.

Capitalization Table for NewCo, Inc.

 

Before

After

Common

Shares

Undi-luted

Fully Diluted

Shares

Undi-
luted

Fully
Diluted

    George

   250,000

25%

17%

 

   250,000

21%

15%

    Harry

   250,000

25%

17%

 

   250,000

21%

15%

    Sally

   500,000

50%

33%

 

   500,000

42%

29%

Total Common

1,000,000

100%

67%

 

1,000,000

83%

59%

Preferred

 

 

 

 

 

 

 

   Series A Shareholders

        –  

0%

0%

 

   200,000

17%

12%

Total Preferred

        –                               

0%

0%

 

   200,000

17%

12%

Total Common + Preferred

1,000,000

100%

67%

 

1,200,000

100%

71%

Options

 

 

 

 

 

 

 

   Granted

   300,000

 

20%

 

   300,000

 

18%

   Authorized, Not Granted

   200,000

 

13%

 

   200,000

 

12%

Total Options

   500,000

 

33%

 

   500,000

 

29%

Total Fully Diluted Shares

  1,500,000

 

100%

 

 1,700,000

 

100%

Here is a description of the various parts of the cap table shown in the above example:

  • Down the left side, a list of all (classes of) shareholders. In some cases, actual names of shareholders are shown (in the case of the figure, common shareholders’ names are shown). In some cases, they are grouped together as a class (in the case of the figure, preferred shareholders’ names are not shown).
  • Along the top, two groupings of columns are shown; they are labeled Before and After, corresponding to how the company’s ownership looks like before and after the investors make their expected purchase of the 200,000 preferred shares.
  • Along the top, within both Before or After, three columns are displayed:
    • Shares. Number of shares that this shareholder has been issued.
    • Percent undiluted. Percent of total outstanding shares that this shareholder’s shares represent. Thus, if this shareholder owns 250K shares (as is the case of George), and 1M shares are currently outstanding, the percent undiluted is shown as 25% (250,000/1,000,000).
    • Percent (fully) diluted. At this time, a certain number of options have been authorized to be granted to individuals. If all these options were to be granted, and all option holders were to exercise their right to convert those options into shares, additional shares will exist. When we include these shares in the overall count of shares, we call the new count (fully) diluted.

Thus, continuing with the above example, if a pool of 1,000,000 shares have been authorized for options, then George owns 250,000 shares out of a total diluted pool of 1,500,000 shares (i.e., 1,000,000 shares sold plus 500,000 options authorized), then his percent diluted will be 17% (250,000/1,500,000).

Number of Shares

Let’s now compare the Before and After sections. The example above shows the following numbers of shares (see the two columns labeled Shares):

  • The number of founders’ shares is unchanged at 1,000,000. We will almost always see the same number of founders’ shares in every round (unless something unusual happens like a founder sells shares).
  • The number of preferred (Series A) shares increases from zero to 200,000 as we move from before to after. These are the shares that are being sold.
  • The total number of outstanding shares (i.e., total common plus preferred) reflects the same increase, i.e., from 1,000,000 to 1,200,000.
  • The number of options granted and the number of options remaining in the option pool are unchanged at 300,000 and 200,000, respectively.

Undiluted Ownership

It shows the following about undiluted percent ownership (see the two columns labeled Undiluted):

  • Although the number of shares owned by founders (total common) is unchanged, their undiluted percent ownership decreases from 100% to 83% because the total pool of issued shares increased from 1,000,000 to 1,200,000.We will almost always see the percentage ownership of founders decrease with each successive round because the total number of outstanding shares increases. This is because investors generally purchase new shares from the company’s treasury as opposed to purchasing existing shares from current owners.Note that if a founder happens to participate as an investor in a round, those shares are shown on the cap table as owned by the investors in that round, not by the founder.
  • The 200,000 new shares purchased by Series A investors represent 17% of the 1,200,000 total shares.

Fully Diluted Ownership

The cap table shows the following about fully diluted percent ownership (see the two columns labeled Fully Diluted):

  • Once we add 500,000 authorized options to both the before and after totals, the 1,000,000 shares owned by founders represent 67% and 59%, respectively, of the total. Said another way, by selling 200,000 shares to investors, the founders’ ownership stake is diluted by 8%.
  • Once we add 500,000 options to the totals, the 200,000 new shares purchased by Series A represent 12% of the 1,700,000 total fully diluted pool of shares.

A cap table enables investors to understand what they are buying. It enables entrepreneurs to make it clear that they have nothing to hide. In summary, a cap table is an essential tool for communication between entrepreneurs and investors.

Alan DavisThis article is an edited excerpt from the book Will Your New Startup Make Money? by Al Davis. Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.