The 0% Founders Club

Unlike articles about other aspirational groups you may want to join, the 0% Founders Club is not a Club anyone wants to be a member of. Yet it seems to be inching nearer to handing out membership packs.

To join the Club, you need to have founded a start-up, then worked hard to grow it, gaining traction from clients and investors. However, for reasons I’ll go into below, you will be getting a nice salary but have been diluted to the extent that you own little to none (0%) of your own business.

0% equity stakes are bad, regardless of what part of the VC market you are in. Though smaller founder stakes are more normal at late stages. I work at the early stage — Ufi Ventures make EdTech investments into companies with about 1 to 3 years of revenue. At pre-seed and seed stage we shouldn’t be seeing anything close to 0% founder stakes.

Yet in the past few months I’ve seen full-time, C-Suite founders owning less than 15% of their company raising their first or second institutional round. And I am not the only investor worried about it.

Why is this a worrying sign for VCs?

Because we want founders to be aligned for growth — growing the traction, valuation and exit potential of their company. This growth comes from the founders’ passion, IP, connections, know-how etc. — whatever fundamental components/’secret sauce’ made the business in the first place. But to execute on this takes a few years, and if a founder leaves, that can really jeopardise a company’s potential for growth. If the founder isn’t incentivised by the long-haul (ie their equity stake), but rather than the short-haul (ie their salary), the founder isn’t likely to stick around. As a consquence VCs are very worried by founders who aren’t aligned, via their equity stakes, to drive the growth and valuation of their company.

If VCs want equity incentivised founders, why are we seeing 0% founders?

It’s partly due to the big market changes over the past few years. In 2021 we had high valuations. In 2022 these came down. In 2023 funds are focussing on traction, rather than potential (see more about this in my last blog post here). So there are more down rounds and flat rounds. These dilute the founder(s) stake in the business, without giving them a larger chunk of the pie. More than one flat or down round can hit hard.

There have been record numbers of new businesses set-up in the past 3 years[1], which is great. However not all know what is ‘normal market practice’ for how much they should own of their business… nor who to turn to get advice on this. In that environment, we’ve seen some very generous angel investors, looking for significant stakes in businesses. But if a business has relied on an angel for a while, and this angel has put in money at low valuations, then they can “out-own” the founders… and have the controlling stake in the company. VCs get scared off if an angel investor, who isn’t going to run the business longer term, owns more than a founder. The only exceptions are: if there is a strong management share option pool in place, often linked to KPIs, or if the angel is an ‘executive director’, working in the business several days a week. Because if the founders leave, that angel will not be doing sales calls or running the next sprint…and VCs will have lost their investment, as the company isn’t likely to raise new funds, or scale, or exist for much longer.

What can founders do about it?

Try and reach out to as many funds and other angels as possible. The more investors that founders have looking at their deal, the more options they have, and the greater their ability to drive terms. Founders are often worried investors will “gang up against them” to force a term or valuation …but this is much less likely than in situations where founders are only talking to one investor. As the company will really need that one investor, so that investor will be in a stronger position to dictate terms.

We hear a lot about failing fast, especially around product, but with equity it’s a bit of a different gamble. It’s a lot more difficult to claw back equity when its lost. So founders should speak to as many other founders as they can about fundraising — is this normal ? What would you do? Thinking through different scenarios for funding routes, round structure, and valuation is a good thing for founders get mentorship on, prior to looking for investment.

Option pools can come to the rescue — if companies can create a big enough option pool, and perhaps link it to revenue milestones, founders and key hires have a ring-fenced pool of shares to draw from, as the company grows.

What can funds do about it?

Remember that founder incentivisation, and morale, is key… as much as a good deal is a good deal. Funds should look to their own comparable ‘long-haul’ incentives, like liquidation preferences. They should get clear ‘leaver provisions’ and a strong option pool /management share option scheme in place. If funds are asking founders to take a risk on long-term growth, funds need to ensure they don’t de-risk their side of the deal, to the detriment of the company and its founders. However, it’s a balancing act at early-stage, because of the dearth of data available to funds, when trying to see if an investment is worth the risk.

Whatever the methods used, founders and funders need to ensure we aren’t opening the doors to the 0% founders club too early… and killing high-potential companies in the process.

If any of this resonates with you, do get in touch with me (ellasaid.woodhouse@ufi.co.uk) or the team at Ufi Ventures.

[1] https://centreforentrepreneurs.org/wp-content/uploads/2023/04/CFE-2022-Business-Startup-Index-Report.pdf