Startup Series: Guide to Understanding Capital Structure


How is ownership decided in a startup? When should we bring on board investors? I'm being diluted! What does that mean? What's a ratchet? What's pre-money and post money valuation? Help! Here's our startup series guide to understanding capital structure:

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In the startup world, the founding of a new company can be carried out for a raft of different reasons and by a myriad of different groups or individuals.

  • A couple of guys may have an idea that's potentially commercially viable and commit to starting a business.
  • A campus company may be formed out of a promising research project by the academics involved.
  • A group or division of a larger business may have the opportunity to spin off creating a new separate company.

There is one common issue that all groups or individuals will have to deal with and that is the ownership of the company and how that ownership is allocated. This manifests itself when the capital structure of the business is being decided - that is the mix of debt and equity financing employed to provide capital needed for the firm and by extension the resultant distribution of ownership in the firm.

The default position for many groups of founders is to allocate ownership and stock on a proportional basis. This may be done to be pragmatic - 'Let's just get on with it and focus on the business'. Or it may be done to avoid in-depth, potentially embarrassing and more importantly potentially contentious arguments about founders' relative value to the company and the amount of time and capital they may or may not have invested in the creation of the concept that motivated the start-up.

It can be argued that a structured in-depth analysis is needed on the new ventures capital structure at formation stage because this

  1. Clears the air among an executive team that are going to be fighting in the trenches together in a place where deficiencies and imbalances in skill, commitment and perseverance cannot be hidden, and
  2. The capital structure of the business will be an issue that raises its head time and time again as the venture grows and investors and new rounds of funding (therefore ownership) comes on board. Dealing with it 'right' from the start means it doesn't necessarily have to be an ugly issue.

Here are some things that should be considered:

  • How much time has each of the founders put into the concept before the formation of the legal entity?
  • Has there been any sacrifice involved or endured by the founders in order to make the formation of the company viable?
  • What is the skill sets brought to the table by each of the founders and how important is his/her skills for the company?
  • Have any of the founders contributed capital to the formation of the company?

These could be contentious issues. However consider the debate if one of the founders was an entity i.e. a college or university that wanted a stake in the campus start up or the large company that wanted a stake in the spin off? Wouldn't the other founders be organised and eager to negotiate the capital structure (ownership) of the business under these circumstances?

Raising capital - the effect of capital structure

Once the company begins to raise equity capital from outside investors, the founders begin to suffer dilution. This is the loss of a proportional percentage of the company's shares when shares are purchased by outside investors. If founders own 100% of the company before outside investment and 80% after, they are deemed to have suffered a 20% dilution in their interest in the company.

The word suffered is interesting because dilution isn't necessarily negative. Founders may have a smaller piece of the pie but should be concentrating on the overall value of the pie and its potential to increase in value now that the company has raised capital to accelerate the growth of the business.

  • Products now have a better chance to getting to market in time and potentially eclipsing competitive offerings.
  • Talent needed for the business can be hired and key individuals to help growth or product development can be brought onboard.
  • Money is now available for marketing, brand building and lead generation - fundamental for growth.
  • In addition, the bringing in of outside investors, if thought through, can bring new talent onto the board - people with particular skills such as industry experience, contacts and credibility that may reassure potential customers.

Notwithstanding the value that outside investors can bring, the primary question in the mind of most entrepreneurs is the valuation they can obtain from investors. There will be a pre money valuation (before the investment comes in) and a post money valuation i.e. the pre money valuation plus the amount of capital invested in the company.

There isn't a scientific formula that will be recognised by all parties to come to an agreed valuation. It will be down to negotiation and like all negotiations; entrepreneurs need to have the research done. By all means do the revenue models and prepare the spreadsheets, but also have examples of other investments that can act as a benchmark.

However fundamentally it will come down to both parties wanting to do business together in the belief that there will be future shareholder value from the partnership. Founders should never lose sight of the value of closing the funding round. Too much focus on pre-money valuations and possible dilution can alienate investors and lead to a failure to obtain the capital.

Series A finance

Series A or the first round of financing can be the most expensive ever raised by the business. As a result, it is wise to take no more money than is necessary. However entrepreneurs tend to underestimate how much money they will need and when they will need it.

Experience has tended to how that development, marketing and sales seldom go as fast as expected - and experienced VCs are aware of this - so taking more investment and coping with a larger dilution is a reasonable precaution.

Type of securities issued to investors

Founders receive shares of common stock when a company is formed. Investors usually receive preferred shares in exchange for the capital they put into the company. Preference shares bestow rights and privileges that the common stock holders are not entitled to.

Key rights of preferred stockholders may be:

  • to get the invested money back before founders begin to share in the proceeds of an exit;
  • to block certain moves by management
  • to share in any sale of the company's stock and
  • to force an exit such as IPO if the investors feel the timing is right.

What happens if things don't go as planned?

Sales don't go according to budget because the sales cycle is taking longer than anticipated.

Problems with product engineering are eating cash as more and more developers are used to deal with unforeseen issues.

The 'banker' deal didn't go through because of an unexpected downturn in the prospects business.

Some of the harsh realities of business life that entrepreneurs have to deal with.

Problems such as these also affect the risk taken on by investors, so the price of obtaining their money will also be affected. And if a business is looking for money against a scenario that is not on plan, it means that founders are facing a down round.

A down round means that the company sells stock to investors at a lower price per share than those shares sold at an earlier round of financing. A ratchet to protect investors usually comes into play under these circumstances. This could mean that the sale of shares at a lower price than previous rounds will revalue all previous share sold to the lower price.

We hope this guide to understanding capital structure has been helpful. 

Over to you now. What's your experience of raising finance? How did this affect your business? Tell us your experience in the comments below. 



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