< Browse > Home / Financial Literacy, Management, Private Equity, Product Management, Venture Capital / Blog article: How Much Equity Do VCs Really Get?

| Mobile | RSS

How Much Equity Do VCs Really Get?

A common question new entrepreneurs who are interested in raising venture capital is “how much equity do I have to give away to the VCs?”  Entrepreneurs who are experts in market problems and technology probably do not have a ton of experience in the intricacies of venture capital financing.  Before starting down the path of venture capital it would be helpful to be able to envision what the end results of a venture capital financing could be in terms of ownership and the actual dollar payoffs at the end of the rainbow.

OwnYourVenture.com has put together a pretty cool simulator that lets you model basic VC investments over multiple rounds to determine the relative equity shares of founders, investors, and an option pool for executives and employees.  You simply enter in a few variables and it spits out pro forma ownership stakes for all parties.  The tool provides an excellent way to visualize how founders’ shares get diluted over multiple rounds of financing.

Venture capital math is not that hard – but the results always tend to be the same.  VCs tend to end up with 70%+ of the company’s equity while the founders and option holders split the rest.  When it comes to the pot of gold at the end of the rainbow, investors get their original investment back first and anything that is left after that gets split amongst all shareholders on a pro-rata basis – unless the VCs have negotiated even higher liquation preferences (i.e. until they get all the money up to 3x their initial investment before the proceeds are split with all shareholders on a pro rata basis.)

It is important to note that Venture Capital is a high risk business – most investments never payoff and for those that do, they need a very high rate of return.  Conversely most entrepreneurs cannot fund the development of their startup on their own – they lack the personal wealth or bank credit.  It is certainly better to own a very small piece of a valuable company than to own 100% of something that has no value.  One fact of Venture Capital investment you cannot escape is that for a very successful company, the VCs will make 3 to 5 times as much money as the founders in any successful liquidity event.  If your company has better than average success you might be lucky to return the investors’ original investment which means that as founders you end up with practically nothing.  If you are not comfortable with this reality then funding a startup with venture capital is not for you.

Let’s consider a hypothetical example, MyReallyCoolIdea.com.  This is a company that you have been dreaming about for years and you are finally ready to take the plunge.  In addition to yourself, you have two co-founders, Jim & Sue.  In the beginning, you spit the equity up three ways – you get 40% and Jim & Sue each get 30%.  Once you have built your proof of concept and gotten a few early adopter customers you are ready to go chase some venture capital.  For the sake of simplicity let’s assume that MyReallyCoolIdea.com is an absolute killer in the marketplace and that you are able to raise $1 million in a seed round, $5 million in a Series B round the following year, and finally $20 million in another two years to blow the doors off of sales and marketing on a global basis.  The following table summarizes what this fundraising cycle could look like:

 

There are lot variables in these types of calculations – pre-money valuations, whether the option pool comes out of the pre or post-money valuation, liquidation preferences, etc.  The basic math, however, tends to be the same.  The following chart puts the founders’ dilution into a bit more perspective:

While this math might be a little grim for the aspiring entrepreneur, it is important to look at how valuable a successful exit could be.  Taking this example a bit further, we can see how a founding team could achieve the dream of ‘walk-away money’.  The following table illustrates the hypothetical growth of MyReallyCoolIdea.com and some exit valuation and payoff assumptions.  The funding assumptions are the same as in the prior example, except that the VCs have a 2x liquidation preference.  Valuation assumptions are based on the typical valuations for public SaaS companies as of early 2010.  There is a big difference between VC funding valuations and actual market valuations.  Technology companies are typically valued based on multiples of their revenue or profitability.  In the case of SaaS companies, average valuations for slightly profitable SaaS companies generating >$40 million in annual revenues is between 2.3x to 3.7x trailing twelve months revenues.

As you can see, in Year 5 the founders’ payoff finally exceeds the magic $5 million ‘walk-away money’ number.

A more humbling approach is to consider that MyReallyCoolIdea.com stalls out in the fifth year and drops to flat or no revenue growth.  Relative valuations can drop and in that case the payoff to the founders is practically nothing:

The moral of this story is that budding entrepreneurs need to spend some time understanding the true dynamics of Venture Capital financing before they plunge deeply into its waters.  While you can argue with the assumptions used in these models, at the end of the day, the results tend to be about the same.

Leave a Reply 35736 views, 28 so far today |
Follow Discussion

3 Responses to “How Much Equity Do VCs Really Get?”

Trackbacks

  1. DevelopmentCorporate » Blog Archive » How Much Equity Do VCs … | Drakz Free Online Service  
  2. Tweets that mention DevelopmentCorporate » Blog Archive » How Much Equity Do VCs Really Get? -- Topsy.com  
  3. uberVU - social comments  

Leave a Reply


Warning: fopen(/4255305384_8e90aec34c_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
carriedint3
Warning: fopen(/4255305348_5022eca28d_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
carriedint2
Warning: fopen(/4254540579_b296f43c7b_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
carriedint1
Warning: fopen(/4255305256_2b68d522d5_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
Money machine
Warning: fopen(/4254540331_8836e369cc_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
manrev2
Warning: fopen(/4255305016_138cd3d3eb_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
ManRev1
Warning: fopen(/4255304954_48dd4292dd_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
idea2
Warning: fopen(/4255304438_ed7edfa4a2_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
chain-links2
Warning: fopen(/4254539541_30a19becda_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
ipasplash
Warning: fopen(/4254539317_1e015d3629_s.jpg) [function.fopen]: failed to open stream: Read-only file system in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 187

Warning: fwrite() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 189

Warning: fclose() expects parameter 1 to be resource, boolean given in /nfs/c02/h05/mnt/20615/domains/developmentcorporate.com/html/wp-content/plugins/flickr-rss/flickrrss.php on line 190
ipasplash