How much equity to give away is one of the main concerns of entrepreneurs raising capital and rightfully so – as a startup founder, you don’t want to be fired from your own company by investors who get on board after a round of funding.
And cases like this are not a rarity.
Control is more important than equity share
One of the mistakes first-time entrepreneurs make is believing equity share and control over the company are synonymous.
They believe that in order to stay in charge of their startup they need to own at least 51% of the equity. That’s a false belief.
Mark Zuckerberg owns 24% of Facebook, yet he’s in full control over the company. How is that possible? It’s all in the different classes of shares.
Class A versus Class B shares
Among other things, a share represents a right to cast a vote for board members.
Facebook shares are divided into two classes – the class A shares are those you get if you buy shares in the market have one vote per share, and class B shares get 10 votes per share. Almost all of the class B shares are owned by Zuckerberg.
The charter also provides that “any transaction that would result in a change in control of our company will require the approval of a majority of our outstanding Class B common stock voting as a separate class”.
As a result, even after the IPO, he retained almost 60% of voting rights, despite being diluted to less than 30% ownership.
Mark was lucky to meet Sean Parker early in his journey. Parker, who was previously ousted by investors from his own company, designed this class of shares to prevent others from the same fate. If Mark didn’t take the control over the board, Facebook would certainly not become the $200 billion plus company it is today- it would have been sold by early investors wanted for a mere $1 billion to Yahoo.
So ensuring you have control over the board is what matters the most.
Equity matters too
The size of your equity share is also important. With every round of financing you get diluted and the more investors get on board, the lower your stake in the company.
Always bear in mind you also have to keep some 10-20% aside for employee options.
Obviously it’s better to own 10% of a billion dollar company than 100% of a company that’s worth peanuts. So if you want to take investors on board and attract top talent you want to avoid dilution to the point when your stake is so low that you’ll lose motivation to keep working on your company.
Model your dilution and be careful about what you sign
When you start fundraising make sure you create a cap table. A cap table explains who owns what in the company and it can help you model your dilution and option pool. You want to be diligent about it and try different scenarios.
When striking a deal with an investor make sure you understand the potential implications of everything you agree to. There are other ways to lose control that aren’t so obvious, like a super pro rata clause that allows your investors to increase their share in subsequent rounds.
So do your due diligence or find a great and experienced lawyer to do it for you.
Mark McDonald is the co-founder and co-CEO of Appster, a leading mobile app and product development company with offices in Melbourne and San Francisco.
You can download a free whitepaper on how to raise $50k in 50 days here.