Getting Started as an Entrepreneur/Money/Pieces of the Pie

Pieces of the Pie
Funding pitfalls

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. The catch

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.