How much should an entrepreneur pay for early stage capital?

John C Botdorf, MBA, Author, Inventor, Serial Entrepreneur

Understanding what drives investor demand one of the most important questions founders and entrepreneurs face is how and when to seek startup capital, and by association, what is the proper amount to pay for money? Clearly as a five time Entrepreneur and “Finance Guy,” I have some thoughts on this important topic.

In order to fully address this question, it is important to acknowledge that financing an early- stage company includes many factors. These are best understood by breaking a success rate for a start-up into understanding the importance of two broad categories, those factors that are in control by the Founders, and understanding those factors that are beyond the control of the Founders. While there are many challenges a startup needs to succeed internally, the most important are how relevant is the product, pricing, and value prop for the customer, can you transact with your target customer, and how does your company’s existing and proposed capital plan impact the odds of an Entrepreneur being successful beyond just raising a seed round? It is the intention of this article to address the financial aspect of this equation.

Before doing so, it is relevant to understand what outside factors impact the ability to a􏰁ract capital. Things like the perceived track record of the Founders by investors, the current private equity market, the general perceived direction of interest rates and the outlook for alterna􏰀ve investments like stocks and bonds all play a role in most cases as to how investors may react to a private equity investment. Additional factors include projected exit windows that include the downstream IPO forecast and future private stock demand, and even sector issues where money is chasing emerging markets like today’s Artificial Intelligence, SaaS models, bio-Engineering, and space exploration.

These external factors help shape the perceived risk/demand profiles of a private equity investment as being touted as possibly out of favor for sector reasons or because a deal might be viewed as out of the norm or just plain not understood by investors. These external factors, although not relevant to an Entrepreneur’s direct vision do impact how a routine start up may fare when putting a Pitch Deck and Business Plan together to raise capital. It is important to understand that these external factors may not ma􏰁er to you as an Entrepreneur but may matter to the person you are pitching.

When more money chases hot sectors with proven management teams, the price of capital is more likely to trend down for hot deals and landing be􏰁er terms on key business points may be more controlled by competitive demand to place capital versus an Entrepreneur driving a hard bargain. In contrast, a deal may be well presented but just not have sufficient demand because the sector is not understood, is out of favor and/or the macro-economic backdrop is trending toward investor illiquidity with rates rising and consumer default rates increasing, thereby changing private equity risk profiles. In other words, the 􏰀ming of seeking financing can present a headwind that makes a particular deal more or less difficult due more to external factors that what is in your Deck. Timing your play to the capital market matters. As an example, if you are looking to raise capital in a declining economic environment (increasing unemployment, housing starts slowing, default rates trending up), then addressing this risk directly might be highligh􏰀ng (as an example) one or more large new contacts that may provide your company with 2-3 years of growth regardless of economic headwinds.

The point here is the be􏰁er you understand not only your internal risk factors but those that are external in an investor’s mindset, the be􏰁er chance you have of overcoming a perceived headwind. As noted, it is the combination of addressing investor concerns across the risk profile spectrum that helps drive downstream investor appetite. As noted below in a graph by Pitchbook looking back at four years of data, only 56% of all startups ever succeed in raising capital past the seed round and even fewer, 33% ever raise a third round of capital. Putting yourself in the head of an investor will sharpen your ability to create be􏰁er go to market strategies and help solidify your long-term capital plan.

Why Your Long-Term Capital Plan Matters Since most startups fail and even seasoned Venture Capital Firms may only produce big wins on 2 or 3 investments out of 10, it should be clear that behind a great product and marke􏰀ng plan, the financing plan is what will drive the growth model. This requires a delicate balance between how much equity can be paid out to early investors (rightfully seeking more return for early-stage risk) and what is then paid out to investors in subsequent rounds. There is no such thing as giving away more than 100% of an equation when it comes to equity ownership.

The key is to think ahead. Imagine two great chess players who understand the power of math (since chess is math played behind a series of moving pieces that have different mathema􏰀cal equa􏰀ons). Now as the game goes into three hours, it is likely that more than half of the pieces on the board are now gone. What is le􏰄 to win the game? Do you s􏰀ll have your Queen? When winning for Entrepreneurs means cashing in your Founders stake and you have mortgaged all of your pieces to other investors, then how can you win? It is imperative you compile a long-term capital plan and stick close to it, so when the game ends, you have something left of the priority payouts have occurred.

Equity provisions like preferred returns, conversion premiums, accrued debt, warrant conversions, ESOP liabilities, and participation clauses can play havoc on what is left over for Founders. While every deal is different, the basic concept of managing accruing liabilities is nothing more than a series of mathematical calculations that must be understood by Entrepreneurs.

I recall my fifth start up, with six rounds of capital and over 22,000 calculations on over 55 schedules. That said, there was never a day when I could not recite the exact shareholder count and what each Founder owned to the penny on any projected sale. Ge􏰂ng ahead of the curve using the right tools like Excel or other so􏰄ware programs can help project what happens when mul􏰀ple layers of investment provisions that include many layers of funding rounds all combine for their respec􏰀ve share of the pie when an exit is created.

The Time is Money Obligation The main provisions in an equity capital plan include either a preferred dividend return issued through a Preferred Stock issue or it may include a stated rate of interest in a debt instrument. While technically different, a well drafted preferred stock offering will align close to its cousin the convertible debt offering, albeit the convertible debt will have creditor rights that will rank superior to shareholder equity rights in order of liquidation. You may also have default remedies in a preferred dividend structure that are more tolerant than a default remedy in a debt instrument. The irony here is that 􏰀me is what Entrepreneurs usually need more of in challenging 􏰀times versus an investor preferring a convertible debt structure with a tighter payout noose.

The take away here is you are competing with who gets to use the projected or in place cash flow and hence your pay out rate or stated interest rate plays a more significant role in your capital plan than most Entrepreneurs realize. If you do not make it to the end game, what difference does it make how big your Founder’s Share might have been.

Conversion Rate-Cost of Capital Impact These types of clauses can come in many forms but they are in addition to pay rate obligations (based on the passage of me) and are separate from a traditional back end split. If Investor A is entitled to an 8% preferred return and gets 35% of the back end, that back end could end up being 45% or more when conversion clauses, puni􏰀ve claw back provisions, or investor incentive clauses are factored into the final payout. It is the combination of all three (in whatever form or adjective used) that impacts your total cost of capital.

These clauses must be mathematically imputed into the long-term capital plan to understand if your plan can withstand worst case scenario’s. When the model becomes over stressed, key management members may depart because their op􏰀ons are too far out of the money, thus creating a revolving door of successive op􏰀on grants with the possibility of investor write downs and the need to issue new ESOP op􏰀ons to more key employees. It is in the interest of the both the investors and the Founders to craft a plan that can withstand some level of pain before it may start to cave in under the pressure of too much debt or preferred obligations.

Back End Splits Most Entrepreneurs rationally assume that the back-end split that goes to the Founders is the most crucial element of their capital plan. This makes sense since the back end split usually will represent the largest payout for the Entrepreneur. The problem with this thinking is that this logic assumes that one gets to a back-end split. The one thing that could prevent a successful outcome is incurring too much debt or any combination of accrued payout liabilities.

Eventually earning a higher valuation through increased earnings growth via a lower payrate may create a higher payout for the Founders, even with a reduced back end split. Most Entrepreneurs at the end of the day, would rather own 10-15% in a successful venture than own 25% of a failed company. As I built a few companies, I started looking at ways to increase the odds of success and o􏰄en traded a few basis points on the back-end split for a rate enhanced lower pay rate. Increasing cash flow that can be reinvested back into the business can reduce risk and grow profits faster, driving downstream exit prices to higher levels. Increasingly, Venture Capitalist want to see quicker paths to revenue by start-ups with an increased emphasis on operational performance. We note in a recent Forbes article from Thom vest Ventures.

“A strategy that we are pursuing is one of focusing on operational efficiency (as measured by unit economics) while also investing in areas that can generate positive ROI in the next months, whether that be a new product or expansion into an adjacent market”. (Butler, 2020).

WHY EXTERNAL RATES OF RETURN IMPACT THE COST OF PRIVATE EQUITY.

COST OF CAPITAL AND RETURN MATRIX

We noted earlier in this blog article how External Factors can impact the cost of private equity. The above example is intended to be illustrative and we caution that any of these asset classes can trade higher or lower as the economy changes, however, it is the relationship between alternative asset returns that tends to remain constant that matters. This is why understanding where the cost of private equity is heading may help define your capital plan. We note private equity is the most expensive cost of capital, ranking just ahead of investing in junk bonds. Remember, the total cost of private equity also involves other equity provisions like incentive payouts and backend splits, driving the total cost of private equity past junk bonds. In this analysis, we are just talking about the 􏰀me value of money here or the annual payout for using private equity.

I recall in 1982 when I left college for a year to pursue commercial real estate sales. Commercial mortgage rates actually hit 18%. When the top of the matrix moves to higher rates (CD rates, Prime Rate), then everything below it must also rise to maintain investor parity for increased risk. In “Mastering Your Company”, we refer to the annual pay rate for private equity as the “BAR” rate, or Bond Adjusted Rate over high quality bonds, typically trading at 350-500 basis points above AAA bond rates.

Early-Stage Conclusions for the Cost of Private Equity. We have assumed the Internal Factors under the control of the Founders, like creating a real product with a unique value prop, and understanding how to find and convert your target customer, are understood. We have also covered the impact of External Factors with the goal of concluding what is the right amount to pay for equity capital. We also acknowledged the three general area’s inherent in calculating the total cost of equity capital.

Our assumptive model here further assumes the Business model will produce at least $5M on total revenue within the first five years. Since only 4% of small businesses ever exceed one million in revenue, our observations here exclude 96% of small business. For example, a Seed Round should range between 10-20% of total equity for a company shoo􏰀ng for at least $5M in revenue. By contrast, a small bakery start-up looking to achieve $1M in sales in five years, might give up more equity to a Seed Round because the owner may not intend to need more capital. The operator either opens and sells its products at a profit or it closes. We are not talking here about a corporate chain here, just a small mom and pop operation.

As a larger company begins to scale it will need more capital a􏰄er the seed round. The objec􏰀ve should be to double or triple the valua􏰀on such that giving up another 20%-25% raises two to three 􏰀mes the amount of capital (and in some cases much more) over the seed round. Sector issues, the ability to grab market share, and scalability issues will all play a role in your up round valuation. If you are pricing below this amount, you have left􏰄 too much risk in the deal, and investors are pricing down your valuation to compensate for the risk or passing on your deal for lack of progress. You may be be􏰁er off delaying funding, reducing expenses, and focusing on landing more revenue if you can operate without funding for another six months. This is why I am debt averse with start-ups.

Every company I founded or co-founded was able to run with little or no funding if needed, just to make sure we hit our up-round valuation if we needed more 􏰀me. I was fortunate to sell out most all of our private placements because we were debt free and could focus on hi􏰂ng several milestones along the way to raising more capital.

A start up without a milestone chart is like a boat without a motor. Investors need real data and evidence of progress to make investment decisions. A milestone chart reminds them of your progress and helps confirm you are capable of executing on your business plan. Benchmarks like patent status, enhanced code improvements, prototype acceptance, first sale orders, a detailed marketing plan with real go to market strategies, and key hires can push valuations well beyond these points, particularly if you achieve profitability with your seed round or second round of capital.

The Founding Group should always include stock for key employees. It takes a village to commit to a successful venture and I have always gladly given up stock so many others could par􏰀cipate in the bounty. If a general rule of thumb provides around 20% to the seed round, and the Founders group (including employees) should have at least 30%, you have only 50% to give up in your second, third, and fourth rounds.

If you are able to go public, the entire cap table can sell a large stake for 30% or more because you are running at valuations 20-40 times above your seed round and owning even a 5% stake can be worth tens of millions but this exit is beyond the intent of our example in this blog. The take away here is to remember your annual pay rate obligation should trump your back- end split because any type of successful exit is worth way more to you and your employees than a larger piece of the pie that never makes it to an exit.

References:

Botdorf John (2019) “Mastering Your Company”, BAR rates and their impact on private equity. Outskirts Press. Denver, CO.

Butler, Don, (May 27th, 2020). Forbes. “Start Up Success Rates and Posi􏰀oning for the New Normal”. Thom vest Ventures.