Over the last couple of months, I’ve spoken to a number of early-stage investors — both angels and VCs — who seem to be proud that they’ve been able to take 25% to 30% of a startup’s equity in an early-stage funding round. In one case, an angel investor patted themselves on the back for ‘managing to convince the founder to give them a 41% stake.’ I was reminded of that several times as I was in Oslo this week, speaking with a number of players across the startup ecosystem.
The Short-Sighted Investor
If you are reading the above and wish that you, too, could command that level of ownership in a startup, I’ve got some advice for you: You are being short-sighted and are hindering the startup, the founders, and your own chances of finding success.
Running a startup is hard. That means investors should help, not set up a situation in which the founders of a startup are disincentivized and demoralized, and won’t be appropriately compensated for their hard work in the case of an exit. That’s precisely what will happen if investors take too much of a startup, too early.
The Poison Pill Effect
To explain why investors patting themselves on the back in early rounds are slipping a poison pill into the startups’ cap tables, let’s take a look at what would happen to a company that dilutes by 30% in every funding round.
As you can see from the diagram below, founder ownership can dwindle rapidly:
Founders: 100%
Investors: 0%
Round 1:
Founders: 70%
Investors: 30%
Round 2:
Founders: 49%
Investors: 51%
Round 3:
Founders: 35%
Investors: 65%
The Opportunity Cost
If their ownership dwindles too far, it’s only a matter of time before the founders wake up one day and think, ‘You know, the opportunity cost for continuing this project is too high. I may as well wrap it up, start a new company, and get it right this time.’
The Long-Term Viability
Early-stage investors can do a lot of damage to the long-term viability of a company. Folks, you’re not in the get-rich-quick game, so act accordingly and set yourself up for long-term success.
Conclusion
Investors should prioritize building a strong relationship with founders, rather than trying to maximize their ownership stake early on. By doing so, they can help create a more sustainable and successful company that benefits both parties in the long run.
Recommendations
- Invest in companies where you have a genuine interest in seeing them succeed.
- Be mindful of your own biases and avoid making decisions based solely on potential returns.
- Foster open communication with founders to ensure everyone is working towards common goals.
- Consider investing in later rounds when the company has more traction and a clearer path forward.
By following these guidelines, you can help create a healthier and more sustainable startup ecosystem that benefits both investors and founders alike.
