How to keep bigger slice of equity pie

Inside Entrepreneurship: How to keep bigger slice of equity pie

Friday, February 23, 2007


Q: What are the different strategies a founder can use to retain the highest ownership stake possible during a venture capital funding?

— G.A., San Jose, Calif.

A: I like your question! It's what every self-assured, smart entrepreneur should ask before approaching investors for business funding.

A helpful way to think about your percentage stake in your business is in the form of an "equity pie." Today, you probably own 100 percent of your business, or the entire equity pie. Each time you accept a check from investors or issue stock options to employees, your ownership slice of the equity pie becomes a little smaller. In venture circles, this equity shrinking process is called "dilution."

As a starting point for developing equity-saving strategies, it's important to make a realistic assessment of your company's life-cycle funding needs. A startup bakery may reach positive cash flow with only one round of angel funding. A big- concept technology company will probably need several rounds of funding before it is financially stable or positioned for a lucrative company sale.

Realistically, most startup entrepreneurs are rewarded for taking a long-term view as they negotiate with investors. Here are some strategies to consider:

  • Hire the best: One of the most damaging decisions startup entrepreneurs make is hiring clearly unqualified staff members to fill management team positions. They naively believe that "everything will work out," especially when they hire friends and family members for key jobs. Actually, every time startup entrepreneurs hire so-so employees for demanding positions, the founder's slice of the equity pie is vulnerable to the investor's knife.

    Here's why. The most expensive, call them "big-slice fundraisings," take place during a company's early days. Young companies need investors' help to pay monthly bills until the business reaches positive cash flow. The longer it takes a company to meet product development schedules or bring in first sales, the more money founders have to raise to cover operating costs. Clearly it's in the founder's interest to hire talented employees who can meet or exceed all performance targets.

  • Rational first-round valuations: I encourage founding entrepreneurs to accept reasonable, rather than premium, first round valuations. OK, I admit this recommendation is not a popular one. Still, it is prudent. If a young company fails to reach the higher expectations that go along with premium first-round valuations, the second financing round is likely to fall below the company's first- round valuation. "Down rounds," as they are called, are brutal to a founder's equity stake.
  • "Earn-backs": This is an unusual strategy that doesn't get enough play in term sheet negotiations. To the extent that entrepreneurs accept a very low valuation to secure first- round funding, founders can ask investors to escrow or set aside a certain number of shares to reward truly exceptional performance. If management doesn't meet agreed targets, then the low valuation holds. If management beats projections, the founder earns back a greater slice of the company's equity pie.
  • Stock options: With board of directors' approval, companies can set aside a certain number of treasury shares for an employee stock option plan. Because founders can receive annual stock option awards for good performance, stock options can help founders buy back a greater piece of the equity pie long after the company no longer needs investment capital.

    Most entrepreneurs fret about the potential of losing control of their business to venture capitalists. Here, I always like to remind entrepreneurs that the best way to protect their equity stake is simply to hire exceptional employees and do everything possible to meet cash flow goals in a smart, efficient way.

    Local fundraising event: The application deadline for the Early Stage Investment Forum — where startups can pitch their business to investors — is March 6. For more details, visit

    Susan Schreter writes about startup planning and small-business financing for the Seattle P-I. She has an investment banking and buyout background and serves as a coach to entrepreneurs and consultant to corporations. Find more Inside Entrepreneurship columns at Send questions about small-business management or raising money for your business to or by mail to Inside Entrepreneurship, c/o Seattle Post-Intelligencer Business Section, 101 Elliott Ave. W., Seattle, WA 98119.

  • Leave a Reply