Mechanics of Capitalization — How to Capitalize Your Startup
Venture Capitalists are professional deal structurers. Building pro-forma cap tables and evaluating various investment structures is part of our daily activities. For founders and CEOs, it is not. Serial entrepreneurs or founders with a finance background may have some experience with cap tables from previous fundraises, but even that is limited to a handful of financings compared to the hundreds under a VC’s belt. First-time founders may have zero experience with this as they go through their first fundraise.
The truth is, building pro-forma cap tables and structuring an investment is not the core responsibility of a founder. However, the ramifications of how you capitalize your business directly impacts your ownership and, consequently, your own net worth. Though you don’t need to know how to do it, it is imperative you understand how it works. This two-part blog series is meant to help founders better understand the Mechanics of Capitalization.
With the “free-money era” seemingly in the rearview mirror, valuations have come down and negotiating leverage has shifted. It is more important than ever to understand the long-term effect of the capital you bring in to finance your business. Note: I acknowledge every deal is different due to the many levers and investment terms that can be negotiated.
To kick things off, let’s discuss a few common misconceptions. I’ve discussed these three things at length with dozens of founders and yet they keep coming up.
· Dilution in later rounds is higher than that in early rounds >> NOT TRUE.
As a founder it is important to be dilution sensitive; however, as the business matures, founders’ negotiating leverage increases and the company becomes less risky, resulting in less dilution in later rounds compared to that in early rounds.
· SAFEs are always the best option early on >> NOT TRUE.
SAFE rounds are cheaper (thanks to less legal fees) and faster, however stacking SAFEs is more dilutive to founders; it depends on the amount raised and stage but it reaches a point that continuously raising on SAFEs is a poor strategy. More to come on this…
· You need enough capital to last you 24+ months >> NOT TRUE.
Founding a business is a high-risk venture and the reality is, especially early on, you are not going to be on stable ground. In entrepreneurship, a mere 6 months is an eternity and your company can look drastically different in that timeframe. When thinking about fundraising, define target goals for the next stage of your business and aim to raise enough to clear those. Fundraising is a huge distraction from building your business and a prolonged fundraise to bring in a few extra bucks is actually slowing you down. Not to mention the misconceived stability that comes with a plush bank balance that often leads to overspending and resource allocation on non-priority initiatives. You are going to have to raise again, just focus on what you need right now instead of what you want.
Now, with the above in mind, let’s explore how a founder’s ownership gets diluted over time across financing events. I will use a hypothetical example scenario that is derived from our experience investing in early-stage businesses over 20+ years.
In Scenario 1, I lay out the traditional venture-backed capitalization path using actual historical numbers. The Funding Amounts and Valuations in Scenario 1 are the average from the last 10 years (2013–2023) for that respective financing stage per Pitchbook. In Scenario 2, I take a “Less is More” approach in which the founder raises less capital early on but accelerates the fundraising cycle (i.e. shorter time between raises). This additional tweener round allows the founder to get the business to higher revenue milestones before bringing in significant capital. The estimated valuations in Scenario 2 are derived by applying the same revenue multiples as Scenario 1 to the higher achieved revenue in Scenario 2.
Comparing the two scenarios above, it is easy to see that raising what you need (i.e. less early on) can be more valuable to a founder’s own net worth in the long term, a whopping +9% as modeled above. If you sell your company for $500M, that equates to +$45M to the founder simply by taking a different capitalization approach!
Of course, as previously stated, every situation is different. There may or may not be additional conditions that allow this financing structure and path. Further, there are many business models that don’t even require this amount of capital to grow and succeed. Regardless, as a founder it is important to look multiple stages ahead and understand how capitalizing your business today may impact you and your stakeholders in the future.
In the next blog post, I will dive into the differences between SAFE Financing rounds and Equity Financing rounds and again how they impact a founder’s ownership position.
If you have any questions on the Mechanics of Capitalization and would like to discuss further, please reach out!
Authored by Idan Levy (Watertower Ventures)
