Let’s have a look at the structure of equity participation in a company and its changes in time.
In this podcast, Bolek Drapella is talking about seeking external investment at the early stage of business growth, founding teams often have to decide what share of their business should be sold to investors.
Today, let’s have a look at the structure of equity participation in a company and its changes in time. When seeking external investment at the early stage of business growth, founding teams often have to decide what share of their business should be sold to investors.
To help you answer this question, I can offer my experience from both sides of such contracts. I have been involved both in acquiring funds and investing. For companies such as Morizon, AirHelp or Saunowy Staw, the total amount I acquired in all investment rounds was several tens of millions of Polish Złoty.
a side note: Even though this podcast is in English, I’ll be using Polish Zloty as a currency, as most of these transactions were made in Poland. If you want to convert it into EURos, simply divide all Zloty’s amounts by 4 and a half.
In the recent years, I’ve also been active “on the other side”, as an individual investor or jointly with Black Pearls VC fund, I have invested in a number of companies, at various stages of their growth. Throughout a period of 12 months, we have completed over a dozen investment projects worth about 20mln Złoty. In a single year, Black Pearls VC analysed almost a thousand investment applications.
The ownership structure analysis is one of the key elements in the evaluation of a potential investment in a startup. It often happens to be the reason why a project is rejected and the company is labelled uninvestable.
In this episode, I‘d like to explain various phases of financing an organization. Also, I’m going to discuss some do’s and don’ts of how to maintain a healthy ownership structure at subsequent stages of its growth.
The general rule of financing is to take it as late as possible and only as much as it’s needed to take the company to the next level. That helps keeping the equity healthy throughout the time. But in this podcast let’s begin with the founding stage, often called the “pre-seed stage”, and focus on the case where the founders are trying to obtain external funding for the first time in the very early stage of the company. There are two things they shouldn’t cling on to. One – building a business single-handed and two – keeping 100% of its equity, even at this early stage. It’s obvious to me now but, looking back, when I was starting my first business over 20 years ago, I was not so sure. During my SaunaGrow sessions I keep finding out that it isn’t so evident to business founders today either.
In this episode, I am going to leave out the very early stage when its founder owns 100% of the business and manages a team of employees, with no or little intention to expand. Also, for the sake of clarity, I’m not going to discuss the situation in which the owner of 95% of the young company shares it with a few people he calls co-founders, who each own 1% of the rest.
This type of participation gives better results at later growth stages
when it is offered to key employees in the form of ESOP – being Employee Share Option Plan. But in the early stage the split 95 to 5 usually simply does not work.
Later on, when companies are much larger, even a fraction of a percent of equity is of a huge value to the top management but, at the start, it is best if the co-founders own approximately equal or at least equally substantial shares.
The decision to seek external funding must be sober and timely.
If investors are invited at the stage of verifying the idea and product testing, there usually is no reason to entrust large sums for a small share of something that doesn’t exist.
Having refused once, they might not accept an invitation to invest later. Of course there are exceptions, for instance projects with very high R&D costs and massive potential (like cancer or vaccine research), but here we have to consider the risk vs future gains even more precisely.
In places like the Silicon Valley, or in the American market in general, where a lot more investment funding is available, the businesses quite often receive money at the idea stage. This is more likely to happen for one more reason. The inventors who present their projects mostly have solid experience in building companies from scratch to success. They are the so-called “serial entrepreneurs”, who can have a rich track record that helps in the investment decision equally to the presented idea.
in the markets where investment funds and entrepreneurs laying ideas like golden eggs are more limited, more caution is advisable.
External funding at the idea stage results in having to share too much equity too early. If the early funding comes from the so-called “business angels” – and, luckily, these days most of them live up to the name – be sure that the one that offers several hundred thousand Złoty in exchange for 50, 60 or 70% of equity is more probably a business devil. The fair offers rarely exceed 20%. Be careful. The founders’ minority in the ownership structure renders a company uninvestable at later stages of early growth. The founding team, left with a minority share, without enough decision-making power, is no longer eager to build up the business.
Let’s recap the principles for the pre-seed stage: One – the angels’ participation should not exceed 20% of total equity; Two – at least 60-70% share should remain in the founders’ hands; Three – don’t go below 51% too early, but be mentally ready for it when the right time comes. In practice, these proportions may vary, depending on where a company precisely is on its way from the preseed to the seed stage.
Let’s move on to the next phase of development – the seed stage. This is when other forms of financing open up, such as accelerators, incubators and grants. Most of them are a non-equity type, which means that no shares are sold off to accelerators or incubators.
Grants, being non-returnable subsidies, do not involve any participation transfers. I can recommend grants as a good way to finance such processes as the continuation of product testing and verification of current policies. They can be used to secure the development of the company, until more financing can be obtained, on better conditions.
Regarding public incubation and acceleration offers, one must be careful. Some of them do involve a participation transfer and charge about 5% of equity. 5% may not seem a lot, but again, this may later stand in the way and make the entity uninvestable. This is because such incubators, if run by public institutions, may involve restrictions on the beneficiaries’ decisions that must comply with the ownership structure defined in the incubator’s regulations. These limitations may hinder future investment acquisition plans as the investment funds may find the public shareholders’ restrictions too rigid.
The seed stage is also when the first ESOP appears (the earlier mentioned: Employee Share Option Plan). In ESOP, owners or founders allocate part of equity that can be acquired/bought by the key employees. The founders also plan their own participation in ESOP, usually on a separate basis. A typical ESOP is directed to new employees who join in at the stage when a firm begins to develop a new, mid- management level between the founders and the line employees. Because of their valuable experience in building companies from scratch to success, ESOPs are meant to keep key employees highly committed by offering them shares and future profits. To do that, the owners agree to issue the so-called vested shares, usually worth 10% of total equity at the stage of issuing.
For instance, let’s assume an ESOP programme involves 10 key employees who each receive a share worth 1% of the company. They will own it under certain conditions, such as budget realization or meeting some other goals. This is often referred to as milestone vesting. An alternative to milestone vesting is time-based vesting. Here, the employees are promised that after an agreed time – 4 years, for instance – they will ‘earn’ the right to buy shares at very preferential conditions.
From my experience, time vesting works a lot better. Why?
Firstly, it allows the owners to keep their promises while meeting their long-term objectives. In a fast-growing business, the goals agreed in the milestone vesting contract may become less important than some more urgent goals. For the sake of keeping his word, the owner would either have to modify the contract or stick to the agreed goal, risking his long-term objectives. Time vesting, not linked to achieving any goals, gives the freedom to modify them so that the long-term objectives remain achievable.
Another advantage of time vesting lies in the fact that the shares transfer is deferred until the future owner has actually delivered their value. This mechanism is mutually beneficial. On one hand, the employers will care more about keeping their profit-generating workforce in the company. On the other, the employee will do his best to deliver the pledged value. If he does not, he will simply have to go, without any benefits. Harsh, but fair.
Time-based vesting is also advantageous because Venture Capital Funds often assign the ESOP-allocated shares to founders’ participation. The high participation of founders, key employees and people operationally involved in the firm is an important decision factor for VC Fund investors.
The next phase of company development is the post-seed or bridge stage, just before entering the A-round. It is not a necessary stage of growth for every young business. It is the time that organizations sometimes have to deal with delays in carrying out plans. The reasons why delays happen vary and may literally come out of the blue, like the COVID 19 pandemic and its economic impact.
Generally, during the early stages, planning financing rounds is an art of striking the balance between the more daring approach that may tangibly increase the company value at a higher risk and the tactic of cautious capital build-up. Whatever the strategy, the point is to acquire more funding for lesser participation.
We already know how fragile the balance is in the conditions of fast-growth and the necessity to convert
equity to external investment. Too much equity sold at the pre-seed and seed stage may scare off future investors.
Admitting outside participants gives a much-needed cash contribution and much less-needed lower personal engagement in company affairs. It reduces the share and weakens the decision power of those personally dedicated to the company growth – the founders and key employees. Their situation is far from balanced. With less influence in the company, feeling less committed, defocused by too much “red tape” related to investment issues that distracts them from operational duties they still have to perform.
To restore the balance, at least partially, there is a good practice that relieves the CEOs and lets them focus on the vital issues. The operational issues can be handed over to the COO – Chief Operating Officer. This will allow CEOs to pay due attention to sustainable growth and keeping the full competency range of the crew.
Moving on, after the post-seed or bridge stage, the A-round takes place. Though not always, it is mostly linked with entering the stock exchange. In Poland, joining a market alternative to the the main market of Warsaw Stock Exchange, called NewConnect, is already treated as the start of the A-round. In the Western countries, the alternative market period is seen as a separate round, before the proper stock exchange entrance. At this stage,
after initial VC funding, it may happen that
the original founders no longer own the control packet of the 51% in the company.
Although, by then, their total participation may be 20-30% or even below 20%, it is not necessarily a disadvantage. It’s true that some investors may be unhappy with under-participation of the founders and key staff. The optimal investment decision, however, should be preceded by an analysis of where the company really is in its process of development. The analysis should indicate what really needs to be done at this stage.
It may even show that the original founders, however high their share and their will to pull the strings,
may no longer qualify to run the company they once started. I have talked about it in the previous podcasts – founders must be able to reflect and sometimes accept the fact that, eventually, they may cease to be
the company’s “salt of the earth”.
For the „veteran founding fathers”, the aforementioned ESOPs offer a fair solution. As we know, ESOPs are mostly directed to the new key employees, recruited because their competencies better meet the needs of the company. At the A-round stage, the second ESOP round can also offer the original founders additional share in company profits. That is done to reinstate the power and the motivation of the founding team, if they are still of a great value to the company.
Before I finish, a reminder for the founders and fund-seekers. Take only as much money as necessary to boost your company’s valuation and try to sell as little shares as possible to receive the funding for its future growth.
To illustrate this, let me give the example of Morizon. I joined it at its critical moment, right after the 2009 financial crisis. It had 4 passive co-owners and a negative equity value, on the verge of bankruptcy. I was invited to be the chairman with a task to put it back on its feet. To do this, I left Gratka, the second-largest real property portal in the Polish market. Nearly at the same time, the founders managed to find an investor who contributed 600 thousand Złoty for 17% participation. After less than a year, the company was successfully introduced to NewConnect of the Warsaw Stock Exchange, where 14% participation was sold for 3 mln Złoty investment – a definitely better money-to-share proportion. It was a massive task to drive a company out of bankruptcy and convince 30 NewConnect investors to join in. In following less than 2 years, we managed to nearly double the proportion – by selling 20% of our equity for 6mln Złoty. This opened the door for a merge of Morizon with the Melog Group.
Fina successful equity transaction for Morizon and the whole group, this time without my operational involvement, was the ultimate exit to Axel Springer worth 85mln Złoty, which at the time I only supported as a shareholder. These three investment rounds illustrate how, with each round, larger amounts could be acquired for smaller equity participation.
Don’t forget about this rule when you plan your company development.
All along, keep your equity participation adequate to your company growth, take only as much money as it’s needed to take the company to the next level and do keep your founders and key employees motivated by a healthy portion of company shares.