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Comments and Insights on the Capital Structure of Startup Companies

capital structure

A company’s capital structure

In the regular corporate world, the capital structure of a company usually means the ratio between the company’s equity (money the company’s owners invested in it) and debt capital (external funding injected into the company by banks and other loans).

For technology companies, however, the term “capital structure” usually refers to the division of the company’s ownership among the entrepreneurs and investors subsequent to the investment rounds in the company.

Thus, holding 50 shares of a “regular” company that has 1,000 issued shares represents ownership of 5% of the company’s shares and entitlement to receive 5% of its distributable profits.

However, if you hold 50 shares of a tech startup company that has 1,000 issued shares, this does not necessarily mean you are entitled to receive 5% of the proceeds in the event of an “exit” and the startup’s sale to a third party. Over the years, investors and entrepreneurs in startup companies have developed ownership structures that bear no resemblance to the ownership formula used in “regular” companies.

Capital distribution among founders

When a group of friends wants to launch a startup, and they start thinking about how to divide the company’s ownership among themselves, they should take into account the following considerations:

-The time each founder invested in the company before its formation.

-What each “sacrificed” in order to devote themselves to the company.

-The time each devoted to the company either in a full-time or part-time capacity.

-The skills each bring to the company.

-The market values of the skills each founder brings to the company.

-The capital, if any, each founder contributed or will contribute to the company.

For the most part, however, founders divide the shares among themselves equally. Thus, in a case of three partners, for example, each will receive one third of the company’s shares. Equal division among founders is the default for most entrepreneurs, mainly due to the desire to proceed swiftly and avoid debates that seem superfluous at the time. However, avoiding in-depth discussions of these issues usually only delays the inevitable haggling.

Timing of the company’s formation

It is advisable to form the company as early as possible. During the initial stages, before the process of creating value has begun, the founders’ shares may be assigned a low or negligible value. At this stage, it is possible to show the income tax authorities that the price at which the company’s shares were acquired is the fair value for these shares.

Impact of a capital recruitment on the capital structure

When a company starts recruiting equity from external investors, the founders’ shares are diluted. Dilution is the loss of a relative holding ratio of the company’s shares when external investors purchase shares.

Although entrepreneurs are inclined to focus on the negative aspects of dilution, it also has positive implications:

-The value of entrepreneurs’ shares of the company rises.

-The company is then capable of growing using the investors’ money.

The seed funding round

Seed funding usually comes from private and angel investors. Venture capital funds have been participating less and less in seed funding rounds in recent years, and “serial” entrepreneurs are practically the only ones who succeed in obtaining funding today from a venture capital fund during a seed funding round.

Technological incubators are another source of funding during the seed funding round. Concessionaires that won a tender published by the Chief Scientist of the Israel Innovation Authority operate these incubators. The incubators support the activities of companies that won state funding, in consideration for between 20% and 40% of the shares of those companies.

The pre-money valuation and the post-money valuation

The main question a company’s founders ask themselves is what company valuation they can agree upon with the investors in order to define the investors’ holding ratio of the company in consideration for their investment. A company’s valuation prior to an investment is called the pre-money valuation, while a company’s valuation subsequent to the investment is called the post-money valuation. The post-money valuation is the company’s pre-money valuation plus the sum of the investment.

For example, if the founders reach an agreement with the investors that the company’s pre-money valuation is ILS 2 million and the external investors invest ILS 1 million in the company, then the company’s post-money valuation is ILS 3 million. The founders’ shareholding subsequent to such an investment round is diluted by 33.33%. Therefore, after this investment round, the founders hold 66.67% of the company’s shares.

The class of shares to be issued to investors

When a company is formed, the founders allot themselves ordinary shares of the company. However, investors usually ask to receive preferred shares in consideration for the money they inject into the company. The “preference” is expressed by rights attached to holders of preferred shares that exceed the rights granted to holders of the company’s ordinary shares, such as priority in receiving their investment money back before the company’s profits are distributed to ordinary shareholders. Additional rights may also be attached to preferred shares, such as the right to block particular courses of action by the company’s management, the right to receive part of every sale of shares of the company, the right to compel an IPO if the investors believe the time is right, etc.

Startup companies usually need several investment rounds until they are self-sufficient. Therefore, startup companies may have ordinary shares, class A preferred shares, class B preferred shares, etc.

The volume of the investment rounds

Since the seed funding round usually entails higher risk than all subsequent investment rounds, it is also usually the most expensive round for the company. This means that, in exchange for receiving a relatively small amount of seed funding, the company’s founders must hand over a significant ratio of their ownership of the company to investors. Consequently, it is advisable not to try to recruit more seed funding than is necessary to enable the company to reach the next investment round, when it will be able to recruit more money in exchange for a smaller ratio of ownership of the company. (This piece of advice also applies to all subsequent rounds.)

Nevertheless, experience has shown that the actual R&D, marketing, and sales costs rarely stay within the realm of the founders’ forecasts. Therefore, as part of our recommendation to recruit only the seed funding that is critically needed, we also strongly advise founders to factor in a scenario whereby progress in the company is less optimistic.

Additional investment rounds subsequent to seed funding

-What should the current company valuation be for the purpose of recruitment before the round, i.e., prior to the investment?

-How do we explain the growth in the company’s valuation since the previous round and to what extent is this rise reasonable compared to the company’s valuation during the previous round?

-What sum of money do we need during this round?

-What holding ratios will be retained by the founders and previous round’s investors?

 

A round at a lower share price or what happens when things don’t go according to plan

Unfortunately, entrepreneurs’ optimism when building a company often bears no resemblance to the reality. Potential issues include problems during product development, delay of the sales launch or sales do not take off as expected, problems staffing the development or sales teams, and, often, unsuccessful management of the company. Problems such as these affect the risk assumed by founders and investors and the chances of receiving a return on their investment.

When this happens, the company must recruit additional money. Sometimes, it must even do so at a lower company valuation than the one in the previous round. Such an event usually triggers an exercise of the preferred right granted to shareholders, which is price protection. Price protection is activated in order to protect investors in previous rounds when shares are sold at a lower price than what they paid for their shares.

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