In the start-up universe one of the most valuable (if not the most valuable) finite resources you have at your disposal as a founder is equity. This is because start-ups generally don’t have the capital to scale, in market or products developed, significantly enough to leverage and fund ongoing enterprise growth.
This makes your start-up’s capitalisation table (cap table) an integral representation of how your venture is funded from an equity perspective (including convertible notes, warrants and equity ownership grants). The cap table represents how much of a claim each party has on the value created by the business, and what they paid for their ownership stake. Managing the cap table well is therefore a strategic imperative for any start-up founder. As a start-up scales, the evolution of its cap table has serious implications on how easily the venture can attract and raise new investment.
At the beginning of a start-up’s journey, the founding team owns 100% of the company. Depending on the resources they have available, founders tend to self-fund the venture as much as possible (called bootstrapping), up to and including the pre-seed stage, to protect their equity value. At some point, though, the resources they have can only take them so far, and they need to raise external capital.
At the pre-seed stage, a start-up hasn’t necessarily found a product-market fit, and its revenue is often not the best measure of its potential because founders are honing their minimum viable product. At best, the venture has indications of potential product-market fit, such as user growth, engagement and active usage and retention. A lack of product-market fit and bankable recurring revenue is typically a deterrent for investment by later-stage investors due to their inherently lower risk tolerance. This is where angel investors and early-stage venture capital (VC) firms step in. Angel investors are wealthy individuals who are highly risk-tolerant and have the financial means to invest in start-ups and their potential future returns — at the right price.
That “right price” is usually an ownership stake in the business, ranging anywhere between 5% and 15%, with that percentage being a symbol of the risk angel investors accept in return for their capital and operational expertise. Early-stage VC firms, on their end, typically provide additional institutional capital, operational and governance support as well as credibility to ventures. Angels and other types of early-stage investors, such as Founders Factory Africa, play a vital role in the VC ecosystem. Without the high-risk tolerance, these investors bring to the table, most early-stage start-ups would not break out of the pre-seed stage due to a lack of funding.
Given the importance of a start-up’s cap table in its future trajectory, it’s worth highlighting the vital role a VC term sheet performs at the point of investment. A VC term sheet is a document that outlines the terms and conditions of a VC investment. It includes details on the amount of money to be invested, the equity being granted to investors, the timing of investor liquidity, and investors’ rights in the venture.
Some of the key terms founders and investors must be familiar with when reviewing this document include:
As both an investor and a venture builder that helps start-ups improve their product and find product-market fit, Founders Factory Africa often advises founders to be extremely careful when exchanging equity for capital. When an investor decides to invest in a startup they are looking for an alignment of interests where the founders can make a meaningful return for starting and scaling the venture, thereby providing a higher chance of a successful exit for the investor.
Some of the errors we typically see include founders raising their initial funding at too high a valuation. This creates unrealistic expectations for future funding rounds. At times, founders ask for too much capital without deep thought into what metrics and milestones they would like to achieve with the capital, leading them to give up too much equity early on, without considering the need for future funding rounds. These scenarios, in turn, stunt the venture’s ability to raise funding and scale, due to the lack of alignment of financial interests with investors.
As a start-up matures and goes through its different funding rounds, the equity allocated to founders is diluted as larger sums of investment are raised at series A, B or C. If the cap table is not thoughtfully constructed, the start-up may find it increasingly difficult to raise capital as questions around incentives for later-stage investors increase.
This article was originally published on BusinessLive. Original source here.