WHY IS FOUNDER OWNERSHIP IMPORTANT?
- Early signs of trouble. Excessive founder dilution is a sign of trouble. Either the business has gone through some pivots and some bumpy roads requiring further funding. Or the founder wasn’t fully up to speed with how fundraising economics work before embarking on the VC fund raising journey (i.e. simply put, the founders sold too much too early). Neither are good signs. Founders need to be good at 2 things — raising money, and attracting great talent. Substantial dilution equates to failure.
- Founder incentives. Having founders well incentivised early on will mean the business won’t require to issue further founder incentive plans in the near term (e.g. founder options / equity), diminishing the risk of investor dilution shortly after joining the company’s cap table.
- Passing the baton — later-stage investor criteria. The business of an early-stage VC is to find early signs of strong teams and strong business models, and then pass on great investment opportunities to later stage (growth to mid-market) investors. Late-stage investors tend to be strict when it comes to founder ownership for the investments they make. Such preferences cascade down the food-chain, causing earlier investors to be wary of founder ownership red flags as the company matures.
- Public perception — reputation. There is reputational risk when investors identify a “broken” cap table. Investors often reside in small circles of hearsay, where herd-like perception makes reality. No investor wants to be seen potentially as the cause for a broken cap table, nor do they want to fix it, unless they really have to.
- A first error that portends future error. Excessive dilution is often the first mistake most start ups make in the excitement of getting started and taking in cash, and can become a measure of decision making ability when faced with significant ‘firsts’. A start up journey is punctuated by ‘firsts’, and as such, this first error, is arguably predictive of future error.
Remember Mailchimp’s $12bn exit? Probably the most successful bootstrapped tech company of all times. This monkey knows something.
WHAT FOUNDER OWNERSHIP TO TARGET?
- VCs’ perspective: We asked 9 VCs in our network and it came across consistently that the benchmark when raising a Series A (i.e. pre- Series A) is that founders need to own +50%. Some added that lower ownerships won’t be a deal breaker if founder ownership would be addressed through a re-cap at that round.
- Our perspective: We agree, and would add an 8–10% team option pool before the Series A. We typically see the following founder ownership when raising the following financing rounds:
Pre-Seed: usually 100%, but with outstanding convertibles (ASAs, CLNs) and a promised option pool. Subtracting the unconverted convertibles and the option pool we expect a founder ownership between 75 and 85%.
Seed: hopefully 70%, but more frequently around 60–70%. Sticking to these figures, will typically allow founders to get to a Series A fundraise above or very near the 50% target.
Seed extension: if there is an extension, it typically means the founders are already diluted beyond the ideal scenario — we see founders at this stage owning about 50% of their business, which means they’ll get to the Series A sub 50%. Not ideal.
Note, these are metrics when raising a round. That means, the pre-seed metrics refer to the ownership figures before the pre-seed is completed and when the founders are speaking to investors whilst raising their pre-seed.
- Industry studies:
2021 State of European Tech (Option Impact source) — 31% pre- Series A
Index’s Rewarding Talent (2018) — 65% pre- Series A
IMPORTANT CAVEATS
- Cash needy businesses are tied to lower founder ownership as the business requires further funding over their lifetime. Longer sales cycles, hardware capex intensive businesses, deep tech moon shots, are good examples of areas where founder ownership benchmarks are likely different to those above.
- The number of founders matter. To state the obvious, the more founders involved, the greater the collective ownership benchmark to ensure enough individual incentive.
- Long fundraising journeys — being at the earlier stages (e.g. going through multiple equity accelerators), or at later stages (e.g. multiple extension rounds) — will typically imply lower ownership. Founders need to choose accelerators wisely, they can prove exceptionally expensive longer term.
- Founders with a stronger background typically manage to own a bit more of their business for longer. There is nothing novel in this, success in venture is widely accepted amongst investors as a predictor of future success.
- Defer pricing rounds before pre-seed institutional funding (i.e. defer issuing equity, and issue instead convertible notes, preferably with an uncapped valuation). [S/EIS rules updates to allow longer longstopswould be MEGA here]
- Set round prices and convertible note prices on pre-money valuation terms, not on post-money ownership terms. By setting the price on a pre-money basis, founders ensure the investor will invest at that price. By setting the price on a post-money basis, the investor will own a % of the business, no matter what else will need to be done prior (e.g. conversion of a convertible note, issuance of options, etc.), often resulting in worse outcomes for the founder. Carta, the cap table management software, writes about this neatly here.
- For housekeeping purposes, keep refreshing your option pool at every funding round to avoid large surprisingly dilutive events.
Know these guys? Martin Eberhard and Marc Tarpenning, founders of Tesla. Founded in 2003, both ousted by 2008, both severely diluted, hostage to opportunistic capital from Elon Musk.
YOU NEED A RE-CAP. WHAT TO DO
- Issue founder equity. The most common way to do this is to issue founder equity, most often through options. By issuing equity, everyone on the cap table gets diluted a tiny bit in favour of the founder. This issuance typically occurs at financing rounds.
- Do secondary sales. If there is a portion of the cap table that is currently inactive, we’ve seen founders, the company, or new investors, buying out those inactive shareholders. Even though new investors buying inactive shareholders might not help increase founder ownership, it balances the cap table.
- Growth shares. Issuing virtual shares to the founders that trigger in an event of a successful exit or sale is another possible way. It aligns founder incentives with the long-term investor incentives, whilst creating low impact on the cap table today.
- Share transfers. Is there someone inactive in your cap table with whom you have a strong relationship (e.g. a good leaver from your founding team)? Would they be willing to give part of their equity to the operating founders? This is often more easily communicated when suggested by an investor. It is even more so when the share class held by the inactive founder is meaningfully lower than the most preferred share class (e.g. in the event of a sale “right now”, the inactive founder wouldn’t get 100% of their share value anyway given their position in the liquidation preference capital stack).
- Share splits. A mechanism we’ve seen, although regressive and needing a lot of shareholder consents, are share split of all shares, but where the new shares are not redistributed evenly. Something like a share split of 1 to 100, but where certain shareholders would only get 49 new shares, instead of 99, and where the remaining 50 would get added to a company option pool, or a founder option pool. This naturally involves the agreement of all affected shareholders and needs typically to be associated to a strong business reason.
I hope this is helpful. Feel free to drop me a line if you have further thoughts here.