This key difference between a startup and an established company has strong implications for how to invest in each. When you’re investing in an established company, you’re better off arguing for the lowest valuation possible because the size of the pie is unlikely to change much and you want to capture as much of it as you can. In private markets this involves a negotiation and in public markets you simply have to wait until there’s unjustified selling which lowers the price.
Investing in a startup is very different. You’re faced with a donut hole, not the actual donut. There’s the potential of a donut, but you have to work together with the entrepreneur to create it. Ideally this would mean that you add strategic value as an investor while the entrepreneur is responsible for the operational execution. Even if you’re simply a financial investor, you need to make sure that the entrepreneur has the proper incentives to grow the startup. This includes a sufficient equity stake to produce a personal gain in the event that the business succeeds. This means that it’s not in an investor’s interest to minimize the startup’s valuation because this will leave too little on the table for the entrepreneur. The valuation needs to reasonably balance the investor’s potential financial return with the entrepeneur’s motivation to build a successful business.
So it was to my big surprise when an entrepeneur recently offered me a 40% stake in his startup’s first funding round. Let’s ignore the fact that this was his initial offer, which means that he would have likely accepted a counteroffer of 50-60%. At the rate of 40% dilution per round, he’d be left with 20% of the company after 3 rounds of funding which is at the lower end of the number of funding rounds most successful startups experience. Since he can’t build the business alone, let’s say he shares 15% with his other team members including any co-founders and employees. That leaves the entrepeneur, the most important predictor of a startup’s success, with 5% of the business by the time the company matures.
If this example doesn’t get you off your feet, consider my conversation with another entrepreneur who recently told me that he gave away 75% of his company in the first funding round.
Based on my experiences with successful startups, you shouldn’t give away more than 30% of your business in any funding round. If you’re doing well this figure will likely be 10-15%. You should only need to give away 25-30% if things aren’t going well and you need outside funding fast to stay afloat. The great VC’s who you want to be your partners won’t request more, and you don’t want to be working with the others.