Getting Off The Ground; Early Formation Economics

After speaking on a panel to a group of entrepreneurs recently, I had a classic follow-up exchange with an entrepreneur trying to get a company off the ground. I thought the exchange was worth sharing:

He wrote:  “Thanks for your talk today – it was very helpful. Here are the details of my question. We’ve raised $15,000 of seed funding from two private investors, in exchange for 0.6% of our company’s equity (which equates to a $2.5M valuation). In order to have an enterprise-ready product, we will need $62,000 more. We were just recently approached by [XYZ] Ventures and they would typically invest $250,000 to $1 million. We will discuss terms next week, but I know that VCs are typically expensive money and that I could lose a quarter of my company from such a round. Our thoughts are to approach some angels to get the remaining capital, but I would like to set a strong valuation for my company that would prevent us from losing too much of the company at such an early stage. Do you think a $250,000 investment for 10% equity is a realistic goal? What should I look out for in our meeting? Is it fair to assume that my seed funding terms will set the valuation for the company moving forward?

“I am bringing on an excellent developer who’s charging $130 per hour for his services. We’re a three person startup and we could really use the extra talent, but our cash position won’t be able to support him for a full project. I want to figure out a good way to incentivize him to play a greater role. Only problem is that he has a wife and two kids. The two of us were connected through a mutual friend and he has extensive experience in the software industry (14+ years). We would be prepared to give him 5% of equity, but how else can I structure our business relationship to hold his interest in the company?

“I have already decided to quit my job to pursue this company full time and we have had some great wins. One of our founders is preparing to leave his job in a month, while the other is only starting his job. To be fair, the latter hasn’t been in the job force for very long and wants a decent savings to live off of. He maintains that we will be able to meet our current development goals, but I have heard him mention that he would only go full-time if we were able to raise 120K, or if we were accepted to Y-Combinator. He is an excellent resource to our team, but it seems that he may not ready to be a ‘founder’. I have considered taking away some of his equity stake, but I fear he would only retaliate by performing less work. We currently have a vesting schedule in place, but I want a better way to clearly define his commitment (not just on a completion of the project) so that we can prepare our next steps. How can I encourage more commitment from him or create a vesting structure that incentivizes him to work more?”

To which I responded:

“Thanks for your note. Here’s a few quick thoughts:

“With experienced professional investors, you don’t set the valuation, they do (or rather the market does, and they make the market). Angels are price-savvy, so they will have a good idea of what your company is worth and will walk away if they valuation doesn’t seem fair. For what you have so far at this early stage, you would probably be doing very well to raise money at a valuation of $2.5M. A good benchmark is that the first professional money into a company is generally looking to give you enough capital to reach the next significant de-risking milestone, and they generally set the valuation in a manner that gets them somewhere between 15-40% of your company – they are willing to be at the low end with companies that are very capital efficient and won’t be raising a ton of additional dilutive financing, and at the high end if you have a long way to go and need to raise a lot of additional money. When you take the amount they feel you need and divide by the rough percentage, you have your valuation.
“One key point in terms of valuation: entrepreneurs obsess way too much about it. You know what the biggest source of dilution is?  Deadweight co-founders you gave too much stock to. Focus on bringing in the best and most helpful investors you can with the best skills and contacts to help you – great investors at a slightly lower valuation are much preferable to mediocre investors at a great price. Remember, 100% of zero is zero.
“VCs can be great, but they also can be expensive money as you say, but not just because they are greedy about gobbling up a big percentage of your company. The bigger issue is their investing model – because of their large fund model, they tend to want to put a lot of money in and push the strategy in directions focused on justifying that. And they need a fair amount of control over you to protect that money on behalf of their LPs. The result is that they can really take you down one-way streets you may not want to go down.
“You raise a hard issue on the engineering talent. Best you can do is pay him what you can afford, give him stock (make sure it is options or restricted stock that vests over time to keep him engaged), and offer him tons of flexibility so he can bring in income with projects on the side. But at the end of the day, if he isn’t interested in the technical challenges and the thrill of helping you build the company, there isn’t much you can do to retain him (so make sure he doesn’t walk away with 5% of your company in a fade-out scenario.)
“Regarding the co-founder, that is an important issue. Markets are efficient and they reward risk. If you and the other co-founder are working more on the company and taking on much more of the risk than your third co-founder (we’ll call him the cubicle cowboy), then you deserve more of the equity, plain and simple. You need to go out for beers and have a heart to heart. For what it is worth, I never invest in start-ups who have part time co-founders who are heding their bets by keeping the day job. If they don’t believe in the opportunity enough to go all in, then why should I? It is hard enough to succeed when your heart is passionately in it; it is nearly impossible if it isn’t.
Hope this helps.”

Comments, questions or reactions to this post? Leave a note below and I will respond to your questions.

If you enjoyed this, you might enjoy: What I Look For In An Entrepreneur, Why Angels Chase ElectronsAre Entrepreneurs Wild Risk-Takers?Pick Your Founder/Co-Investors Carefully & Reflections on the Nature of Entrepreneurs, Top 20 Dos & Don’ts with Angel Groups & Early Stage FinancingDelusional Economics, The OvertureThat Vision ThingThe Power of An Advisory BoardLoch Ness, Unicorns & The First-Mover AdvantageShould I Wait For A Technical Co-Founder.

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