Many times, we hear success stories where entrepreneurs raise capital and build successful companies and after a great amount of hard work, they find a way to exit the company. But to be considered a real success story, it is necessary to consider what the shareholding structure is at the time of exit. This is something that many entrepreneurs neglect from the early investment stages, which reduces the performance of their effort.
In December 2020 Airbnb began trading on the public markets. At the time of the IPO, the founders had control of 44% of the company’s shares, which translates into a value of more than USD$13bn. On other occasions, there has been the case of companies in Series A where the founder is quite diluted with a shareholding of 10% or less and does not have the ability to convince investors and raise capital.
The capital structure of a company is essential. It all starts when the entrepreneur raises capital and begins to accept contributions from investors. Not all investors are the same, there are some who only contribute capital and there are others who also bring business networks, knowledge and experiences that can be of great value to the startup. For example, it is not the same to accept investment from a VC fund like Sequoia or A16z than from a first-time fund. Now, sometimes the value of Sequoia and A16z could also be significantly lower if they do not have a presence in the startup’s geography or sector of influence, therefore, it is extremely important to choose wisely those who will be part of your cap table.
Not only the relevance of the investor is important but also the terms and conditions of their investment. You can have the investment proposal from Rocket Internet but its proposal may be too expensive so it would not be advisable to accept it.
As an entrepreneur, when raising capital, you have to think about the construction of the cap table according to the stages of your company. In a pre-seed stage, you will probably be raising around USD$100k to USD$500k in exchange for a 10% to 25% equity stake. At this stage, perhaps the most advisable thing is that you have only angel investors and that they have previously been successful startup entrepreneurs. Perhaps to complete the round you could have capital from a VC fund that invests in the Pre-seed stage.
In a seed stage you will be raising from USD$1mm to USD$2mm for a 10% to 20% participation. The capital will come from some VC funds and the rest from angel investors. Series A will have as a leading investor a VC fund that, on average, must contribute a 50% stake in the round of approximately USD$8mm to USD$10mm and a dilution of 10% to 20%. The remainder of the round will come from capital from other institutional funds and from the follow-on investment of current investors.
In subsequent rounds you will be raising between 4 to 5 times the capital that you raised in the previous round with a dilution of 10% to 15% per round. In addition, the main investors in subsequent rounds will be predominantly institutional funds, who are the ones that can contribute the most to the institutionalization of the company and the growth you require to meet your goals.
Some of the most relevant elements to consider are the following:
- Consistency of the cap table according to the stage of the startup: Look for investors according to your stage who will add value and allow you to reach a subsequent stage.
- Consolidation of the cap table: Keep it clean and with a reasonable number of investors so that its management is efficient. As you raise additional capital and have oversubscribed rounds, you could encourage secondary rounds of small investors such as angels in order to consolidate your investor base prior to subsequent rounds of expansion.
- Be mindful of the dilution: If your startup is successful remember that you can have multiple rounds of capitalization, therefore, try not to dilute yourself too much in the first rounds and efficiently manage the resources you are raising.
- Share structure: Raising multiple rounds of capital granting different rights to investors in each one of them leads to having different classes of shares. Try to minimize the classes of shares by trying to favor the fact of having only common shares and a single class of preferred share.
- Know the dynamics of the Cap Table: The Cap Table requires knowledge and expertise to carry out the stock participation calculations of current investors through the exercise of its Pro-rata with respect to new investors. Learn to calculate them and get advice from someone who has the experience, remember to calculate the Pro-rata first and the number of actions last.
- Be careful with convertible instruments: Sometimes entrepreneurs forget that convertible notes and SAFEs also convert at some point in time, perform the necessary calculations so that you do not find yourself in the dilemma of having a higher dilution due to the fact of not having converted the notes and SAFEs in a timely manner.
- Option Pool: Also, remember that every startup needs a pool of shares in order to attract and retain better talent. Consider at least a 10% shareholding for this point that you can constitute before or after the same round that will bring the result of taking the dilution or sharing it with the rest of the investors. You can also resupply it to have 10% available again at the time of constituting a new round.
Most entrepreneurs want to spend time building the product and marketing to clients. However, it is important to recognize that raising capital and building a strong structure is critical to the growth of the business. Likewise, the cap table is an element that new investors will consider in their analysis when making an investment.
“There are few solutions to a messy cap table — you have to do the right thing from the start. If you try to redistribute shares, there will be tax issues, and if you try to rectify with options, this is very costly from a tax point. So, it really makes sense to spend time getting this right from the start.”- Rikke Eckhoff
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Ricardo Latournerie. VC Investor at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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