How often do we read about companies Filing for IPO with large valuations and wonder at the wealth of the founders of such a business? How many of us realise the original entrepreneurs probably only own 5-20% of the business between them.
How can this happen? The simple answer is funding rounds. New start-ups need capital, more often than not they must raise more and more capital as the business grows. Often family, friends and “fools” , the three f’s invest early stage for a small share of the business, but as the business develops and the need for further capital is identified, this usually leads to a series of funding rounds to the market; seed funding, followed by angel funding, venture funding (this may be several rounds) and then possibly a mezzanine round close to an IPO or exit.
The one thing all these funding rounds have in common is they dilute existing shareholders. In addition, without careful forward planning, founding shareholders can lose control of the decision making process. One further exacerbating factor is often that in order to retain key employees a share incentive scheme needs to be established. This will require a meaningful portion of shares to be set aside for this purpose.
In the recent $8 billion US floatation of Zynga (the creators of Farmville - one of the most played games on Facebook) Mark Pincus, the founder, created two new classes of shares in order to protect himself and early investors. These share classes provided early investors with 10 voting rights per share and Mark with 70 votes per share, while new investors have just one vote per share. This allows Mark to remain in control of the company he founded just 4 years ago.
Mark Pincus was fortunate, in that Zynga was sufficiently attractive to the market that he was able to impose these conditions and still sell his stock. Many companies will not be in a position to impose such conditions and often the founders lose control of some or all executive decisions at an early stage.
Mark has sold shares worth just over $100 million dollars (in an $8 bn+ company) and retains less than16% of the company; the remaining shares were all diluted through funding rounds or provided as rewards for key employees. In this case the founder is still extremely wealthy and in control of his company.
How do start ups protect their shareholding, when they need capital to establish and grow their businesses? Unfortunately, if you need the money you are going to have to dilute your shareholding. To what degree is the key; there are some simple things entrepreneurs can do in order to retain the maximum shareholding:
Be frugal, don’t spend anything unless it is necessary. This may sound simple but when your business is not generating sufficient revenue to cover your costs you are potentially spending your shareholding with every pound you spend. Avoiding needless expenditure can help founders retain more of their companies. By deferring expenditure (without effecting growth) you may be able to use conventional funding methods at a later date.
Take good advice, retaining control is as much about understanding governance procedures and shareholder agreements as it is about understanding your marketplace. Don’t sign away control of your business because you did not understand the long term implications of any shareholder agreements. Quite often it is the unintended consequence of an early shareholder agreement that causes problems with future rounds.
Consider other forms of capital, once the business is established it may be possible to use more conventional methods of funding, such as bank loans or asset backed funding.
Raising capital is a difficult and frustrating process, consider what you want from your future business partners. Understand their motives for investing and make sure your expectations are aligned. An investor who is aligned to your goals for growth and ultimately exit will provide for a much smoother journey than one who is looking for the first opportunity for an exit to realise a quick profit. Not all investors are the same so choose carefully.
It is not possible to raise equity investment without diluting your shareholding, however by understanding how much you need in order to realise your start ups full potential then you can take steps to retain the maximum possible. Also understanding the number of rounds you will have to undertake may help you retain control of your business to IPO.
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