The startup ecosystem is currently evolving at a higher pace than ever. Investors’ expectations have changed, and fundraising is a huge challenge for startups. Crunchbase data shows that seed and angel investment to U.S. startups fell 50% year over year in the second quarter of 2023.
Seed and angel investments in the U.S. are facing their lowest quarterly level since the fourth quarter of 2020. While there has been a decline in seed and angel investment, the drop in Series A investment for U.S.-based startups has been even more significant.
Due to the current economic conditions, investors may ask for more startup equity to cover the increased risk. Founders, therefore, must carefully evaluate the trade-offs and decide whether venture capital is the right path for their startup’s growth and long-term vision.
Here are five things you should consider before negotiating startup equity with investors.
Are you ready to give up equity to venture capitalists?
First, you must ask yourself whether you are okay with losing equity and control in your startup. Acquiring venture capital is not for everyone. Giving up equity in your business can be emotionally challenging, especially when you have invested significant time, effort, and money into building your business.
The loss of ownership and decision-making power can impact key business decisions. It also can cause a misalignment of interests regarding the company’s future.
This is the reason why some startups choose to bootstrap. Bootstrapping allows founders to maintain control over the company without giving equity to investors. However, they will have to operate the company with a tight budget, rely on personal funds, and take on multiple job roles versus hiring employees.
The question is, when should you consider obtaining venture capital from investors?
Lack of money
Founders raise money from investors for various reasons, but probably the main reason is a lack of capital. Founders who start with self-funding generally run out of their personal, friends, and family funds early. So, they require additional money to support their startup growth and cover the incurring costs.
To hire employees
One of the other most common uses for funding is hiring ahead of revenue. Hiring employees contributes to the scale of a company’s operations and increases production capacity. It also helps the founder to delegate responsibilities to employees so the founder can spend more time on critical tasks.
Accelerate sales and marketing
Startups often need venture capital for marketing campaigns, customer acquisition strategies, and user acquisition. Such costs include advertising, content creation, social media marketing, and other promotional activities. Due to limited resources, low brand recognition, and evolving product-market fit, acquiring first clients can be a massive cost for early-stage startups.
The development of a product or service requires financial resources. In many scenarios, predicting the exact product development costs is tricky. The product development process can be more effective with the help of angel investors and venture capitalists. As a result, a startup can launch products earlier and achieve important milestones sooner.
Mentorship and guidance
There are cases when a startup has sufficient funds but lacks crucial relationships, networks, and mentors. The main driving factor in getting financing is the investor’s expertise and experience instead of money. Many angel investors and venture capitalists will take an active role in a startup’s life and provide guidance to the founders.
In addition, having reputable investors on your board can improve your startup’s credibility. This factor is crucial when approaching potential customers, partners, and venture capital firms.
Have a valuation to know how much your company is worth
A valuation provides the basis for determining the fair market value of your business. It serves as a strong reference point to how much equity you should give for the venture capital. If your startup already has revenue, the preparation of the valuation should be easy. However, most seed round companies have not started making sales yet.
Having a proper valuation for companies with no revenue can be tricky. Figuring out how much equity you should give to an investor at the seed round is tough. There are some methodologies that you can use to value a business that has no revenue:
It compares a startup at the seed stage to other startups which have similar sizes and products. Preferably, startups should be at the same stage of the startup journey. The method uses several categories with weighted values to estimate the fair market value of the startup business.
Risk summation method
This methodology does not estimate the chance of success but instead evaluates the startup company’s risk factors. These factors can be management risk, exit risk, legislation risk, and others that can result in startup failure.
Market approach method
This method relies on the startup’s potential market value in the future. Market approach methods consider factors like market demand and level of competition to establish the company’s valuation.
Determining a proper value, however, is more art than science. It is also a common approach that investors postpone valuations until the startup achieves revenue and milestones.
Let the investors say the price first in startup funding
In the case of startup funding, the investors are the buyer and the founders are the sellers. Trying to set a price for startup equity without understanding the buyer’s perspective will likely fail. As investors tend to know the market better than you, it is easy to leave money on the table by setting prices too low for startup equity. And the opposite can be true as well. You risk pricing yourself out of the market by setting a too-high price.
Allowing investors to lead the discussion is the best way to start a negotiation. If investors say a price much lower than what you have in mind, you can always react. In cases when investors are pushing you to give a price, try to provide a range instead of an exact number based on the valuations.
Try to reach milestones before acquiring venture capital
Depending on the industry and the startup stage, venture capitalists typically ask for 15 to 25% of startup equity in the course of seed funding. The higher the level of risk, the more significant equity they ask for. Reducing risk by reaching milestones can decrease the equity you should give an investor.
Such a milestone can be revenue, for example. Even if your startup does not generate revenue before the seed round, other milestones may exist during the way to reach revenue. These milestones influence the volume of venture capital funding, the equity investors may ask, and the types of investors who are more likely to jump on board.
These could be having a mockup, MVP or receiving a patent on your idea, a letter of intent to buy from a customer, or the users you have on your platform. Achieving revenue or non-revenue-based milestones reduces investors’ risk and should be part of the startup equity discussion.
Be aware of unfriendly terms
Some investors use unfriendly terms to ensure they profit most from a startup’s success. You should pay extra attention to clauses like liquidation preference.
Such a clause prioritizes the investor to receive profit from the business’s sale before others, up to a specified multiple of their original investment. If the liquidation preference is set at 3x and the investor gives $1 million to your startup, the investor should receive at least $3 million when selling the company. If you were to sell the startup for less than you expected, it could happen that the investor would take the whole amount of the sales price.
There can be terms giving the right to the investors to expand their initial equity under specific circumstances. Ultimately, there might be uncommon terms that can harm your equity and even your business. Don’t hesitate to hire a lawyer to review the investment contract. A lawyer will recognize clauses that may look good on paper but can damage your chance of profiting from your startup’s success.
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Dealing with startup funding challenges
Finding the right investors can be a major challenge. But it is even more challenging to get things done in a way that you do not give too much equity to investors.
By using suitable funding options, you should be able to secure your future profits in a potential exit. The key is understanding the potential risks and asking for professional advice to help navigate your negotiations.
Should I give up equity in my startup?
The decision to give up equity depends on various factors. It is essential to understand your startup’s current and future financial needs. Exploring alternative financing options before deciding on equity funding is crucial. It will help you find a suitable financing option that aligns with your startup’s long-term vision.
What are the cons of giving up equity?
When you give investors equity, you also give them decision-making power and control over your startup. Investors may have different priorities and goals than you do. It can also impact key decisions like future fundraising or exit.
How much equity should I give up in a startup?
There is no one-size-fits-all answer. In general, investors ask for 15 to 25% of startup equity in the course of seed funding. The exact percentage depends on the startup stage, valuation, milestones reached, and funding requirements.