Once the fundraising need is established, the next goal is determining how big a stake in the company to give early investors. This is tricky in a company’s first days. No one knows how valuable the company will be and what percentage of ownership the founders, initial funders and later investors will receive until the second or subsequent group of investors buys in.
Hence the usefulness of convertible debt, Gillespie said. Much of the initial uncertainty can be relieved by setting a few parameters on how much equity the “first money in” will receive.
Determine the fundraising need. This is what the previous steps established. Once again, it’s better to ask for what is needed rather than trying to soften the blow by asking for a smaller, rounder number and hope for the best – as many failing startups do, Gillespie cautioned.
Determine the number of shares, and set some aside. This is an arbitrary exercise, but there should be a sufficiently large number of shares to be divided among investors. At the same time, Gillespie suggests setting aside a “pool” of shares, say a 20% stake in the company, to offer in compensation to early employees.
Set an interest rate. The company’s first investors deserve interest on their money comparable to what they would receive elsewhere in the market – usually between 6% and 8% a year.
Set a discount rate. Once a valuation is established, early financiers should get the chance to buy shares in the startup at a discounted rate. Agree on that discount ahead of time. Generally, it’s about 15% to 25% less than the price at which later investors buy in.
Cap the conversion valuation. This guarantees early financiers a reasonable stake in the company once new money comes in. The fear for early money is that future investors will dilute their stake. In general, the lower the conversion cap is set relative to the eventual valuation of the company, the bigger the stake in the company the first investors will have. If the company becomes a blockbuster, the early investors with the vision to fund it will be substantially rewarded.
