Questions

Is a 23,5% share for an early angel-investor, who is not contributing in the future, too much "dead equity" for raising a VC-backed seed round?

Hey entrepreneurs, I have a question regarding a seed investment round and would like to hear your opinion. I am the owner of a design/development agency and 1,5 years ago I cofounded a startup with two friends. The deal was, that my company designs, develops and maintains a webplatform for a fixes time horizon (1,5 years), while the other guys are working on the business side and that I take a 23,5% share in the company for that. Myself took the role of a product-manager on an almost-fulltime basis and was also involved in every strategic decision. The product is already live for more then a year and has a lot of traction as well as revenues. According to the agreement, I (and my company) want to quit now and minimize my commitment completely, while maintaing the 23,5% stake in the company. On the other hand, after having bootstrapped for 1,5 years, my cofounders want to raise a seed round now. However, they say that it will be impossible (or difficult) for them to find an investor if I (or my company) have a 23,5% share in their company without being a (committed) team member in the future. They claim, that a too large stake is "dead equity", which is not contributing anything to the company. Every investor will now refrain from investing in the company. I claim, that my role in the beginning was more the one of an " angel investor". Instead of investing money I agreed to bring in a service with the value of XXXXX€ as we have built the product for free and only took a share for that. What is your opinion about that? Is it true that we took a too large share in the company early-on and that every seed investor will now refrain from investing in the company because 23,5% is in the hand of an investor (my company) without contributing future money/value? With that logic no company should get a business-angel on board early on because it will deny every future seed round. Could some guys with experience in Venture Capital give their view on that topic? If any further details are from interest, feel free to ask me. All the best Jack

5answers

Mark is wrong. I personally know of a handful of companies in that exact same situation and most importantly that have good traction and the cap table NEVER came up once, and each of these companies have raised in excess of $1m in seed funding from great investors this year.

Especially if your shares are common shares and/or have no particular unique traits about a share class, and especially if you can document the time and resources your firm expended to build and maintain the service that now has traction, this will not be a problem.

Investors give many excuses when they don't want to do a deal but those excuses are rarely the reason for not pulling the trigger.

The issue is more likely to be that there are two business folks running a company without a technical founder, which is almost always a deal-killer but that has nothing to do with your equity share.

Happy to talk to you in a call if you'd like.


Answered 7 years ago

I agree with Tom. You and your share will be diluted with added rounds of capital. New investors will likely require convertible preferred shares with additional voting and conversion rights. If you hold common this should not affect them at all.

If you hold preferred (which is not likely), they will simply require that you modify some of your rights so that they can get the deal they need. This can easily be accomplished by a good attorney.

Bottom line is that if the company is attractive to potential investors they will work current equity holders to get a deal done. All of the founders will be diluted with successive rounds of capital.


Answered 7 years ago

If the company looks like an attractive investment, professional investors (i.e.: VC partners) will not let the drag on the cap table stop a deal from being done. Having said that, there are going to be three voices at the table when discussing this issue: yours, your co-founders, and the investor's. A big question is: do your co-founders feel the same way about your contribution as you do, or do they instead feel that "you got too much equity for the contribution you made". Note I'm not speculating about who is right and who is wrong, but if they feel that way, there are many ways they can cram your equity position down.

For example, they could arrange for a new company, newco, to be created and financed, and then to buy out the assets of the old company. All shareholders (including you) in the old company would receive some shares in newco, but it would be a much smaller percentage than any of you currently hold in the old company. But they will have arranged it so that they already hold a percentage of newco before the acquisition, as does the new investor. The result is that they end up with a larger percentage of newco than they used to have, and you end up with a smaller percentage. It turns out to be very hard to show that this kind of transaction is unfair, since newco brings a lot of new financing money to the table. Indeed, the other founders may feel that this is the fairest solution if they don't believe your contribution merited your current equity stake.

But if they feel really great about your contribution so far, the dominating question will be: Does the new investor feel that the ongoing management team is sufficiently compensated, and will they remain sufficiently compensated once future rounds of equity are incorporated into the cap table. If they feel that the answer to this question is "no", they will worry about having to dilute themselves later in order to properly compensate the ongoing management team. This is where the cap table drag concern comes in.

Sorry this is a bit complex, but hopefully I'm explaining it in a way that makes sense. In a nutshell, I'm saying that if your co-founders disagree with your assessment of the value of your contribution, there is a lot they can do to squeeze you out (or down) at the time of the financing. But if they agree with you, and if the company is really compelling, an investor will probably cope with the cap table, maybe by incorporating the future expected necessary dilution right now, by lowering the company's valuation.

Good luck with it. Too many unknowns to be definitive.

Dan


Answered 7 years ago

What I am hearing (and how I feel) is that the question as asked can be interpreted differently. Lets try to answer each interpretation.

1) Will it prevent the company from moving forward?
It is unlikely to be the cause of the companies demise and more likely the company's own shortcomings would cause the issues. That said, your ability to pivot is sometimes more limited with more substantial shareholders.

2) Will it affect me?
This it may. You could end up with less control than you would think and your co-founders and investor could push you aside.

3) Is it too much?
This is the true question you are asking. This also depends. Why 23.5% and what are you getting for this. This is the overall issue here. So if you are giving too much away, why are you doing this. In essence, if I give away 50% of my company in return for the first 25M in revenue, I won't get faulted for this as it is a lot of revenue. You need to balance growth at this moment with monetary needs to ensure that you don't end up giving away a lot now only to end up with several cram down rounds around the corner.

So, if it is about the company, it won't be a big problem (unless the investor is difficult or has too much control), if it is about you, it may be a problem, and if you are asking, then are you already feeling like it is too much to give away.


Answered 7 years ago

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