Questions on Ownership and Returns

1) What is the relationship between investment, valuation, and ownership? What fundamental economic exchange is at play?

Relationship is that investment = ownership * valuation. Supply and demand is at play, and the market determines valuations. The investors want a low valuation, but entrepreneurs want a high valuation. More supply of ventures needed funding will mean a lower valuation whereas more demand from investors will mean more competition for them leading to higher valuations. Entrepreneurs and investors fight for ownership as for a given investment amount, ownership and valuation are inversely proportional meaning that an increase in valuation will mean less ownership for investors and more ownership for entrepreneurs. Incentives need to be balanced as noted by Holmstrom, Noble prize winner in Economics, so that both investors and entrepreneurs have enough motivation to contribute meaningfully to the venture.

2) What is the difference between pre-money and post-money valuation. How do stock options affect this?

Pre-money valuation is the post-money valuation which equal to the investment/ownership — investment amount. It corresponds to the valuation the investor gives to the company minus the amount they have invested and is the value given to the founders and existing shareholders. Post-money valuation is defined above as the investment/ownership which is the valuation of the company with the new investors. Stock options changes the interpretation of the pre-money valuation to include existing shareholders in addition to the founders. Entrepreneurs should make sure it is clear if investment includes the stock option pool or not as it will either have to eat in to the share of the founders or the investors, more commonly the former.

3) Why do founder stakes get diluted over time? What factor predict dilution?

Founders shares get diluted over time due to additional rounds of financing. This is due to the issuing of new shares. More shares means that the shares the founders own will constitute a smaller portion of the venture after a financing round. This is not necessarily a bad thing as the diluted ownership can be worth more as the company grows and increases its financial resources. It is analogous to having a smaller but more valuable slice of a larger pie.

4) What are the strengths and limitations of the following three return measures: net present value (NPV), cash-on-cash multiple (CCM), and internal rate of return (IRR).

Net present value is a powerful measure which is based on discounting to the present all future cash flows. It considers the time value of money however require subjective choice of discount rate which may make it difficult to compare and adjust for different cash flow needs of investors. It is scale dependent so it may be difficult to compare different sizes.

CCM benefits from simplicity but fails to account for the timing of cash flows and risks entailed. A four year investment with the same return is seen as equal to a two year investment.

IRR is widely used and defines as the discount rate which sets the NPV to zero. No assumptions are required but it favours high returns over short time horizons. E.g. one would rather 4x returns for 4 years then 2x returns for two years.

5) Both the entrepreneur and investor prefer higher exit values. The entrepreneur also prefers higher valuations, but the investor prefers lower valuations. Why?

High exit values will mean for both the investor and the entrepreneur shares are worth more giving them higher returns. Investors favour low valuations so that they can have more ownership of the company and thus a higher proportion of the exit value returns. It is from a common principle of buying low and selling high. On the contrast, entrepreneurs want a high valuation as this directly corresponds to their ownership, a high valuation means they will receive a greater proportion of a given exit value.

6) What economic forces affect valuations?

The opportunity itself — certainly a more attractive opportunity will mean higher returns are expected in the future and therefore investors will be willing to provide a higher valuation as they expect more returns.

The market context — Relates to the opportunity, but market conditions will mean that start-ups are expecting higher exit values and thus higher valuation as investors can justify a smaller ownership share as it will be worth more.

The deal competition — More investors competing for the same deal will mean they lose bargaining power and gives the entrepreneur choice resulting in lower valuations.

Investor quality — higher quality investors bring more experience, networks and resources to the company and therefore they can offer lower valuations, and entrepreneurs often accept them as they can see themselves having a large exit value in the future. A smaller and more valuable piece of a larger pie.

7) Why would an entrepreneur accept a lower valuation from a higher quality investor?

As above the high quality investor can reduce uncertainty and risk in the business. They can leverage special relationships in the industry, expert knowledge and experience to give the business a much larger chance of having higher exit values in the future. Entrepreneurs hope for a smaller slice of a much more valuable pie.

8) What are the pros and cons for splitting equity equally among all founders?

Splitting equally saves having to make difficult decisions and assumptions on who has contributed more to the business to the current date, in terms of time, achievements and finance, how important the initial idea was to the business, and future expected contributions. It also avoids looking at who is sacrificing the most and who needs the largest incentive to stay. These can be difficult negotiations and leave founders resentful of their partners if the decision is not in their outcome. Albeit, these are all valid considerations and it will be unfair to not include them. Just because they are difficult to make does not mean they should not be made at all. Why should a founder who has spent almost all their time be given equal equity to their partner who has taken little interest?

9) What factors determine the allocation of shares within a founder team?

Factors affecting shares include founders roles and time-input (past, present and future), achievements and financial contributions to date, salaries and outside options. An important team member may have an attractive outside option they must be given incentive to stay if they are invaluable to the team. Holmstrom, Noble prize winner in Economics, made important contributions to contract theory, and suggest that ownership stakes should be thought of as a team incentive problem. The objective is to find a share allocation that balances relative incentives. More incentives should be given to those that can contribute productively and have the biggest impact on performance of the firm, such as the CEO. Unfortunately, it would not always be fair, for instance, a finance expert who was working a high salary role may reveal that it is their dream to work in a start-up. This may lead to other founders to exploiting them and giving them a lower share as they do not need much more incentives to stay. This can result in manipulation and exploitation in negotiations bringing the worst out of team members as they seek personal benefit. Negotiations require trust, understanding and honesty. Sometimes objective external input may be helpful.

10) When is the best time to negotiate a founder agreement

The best time to negotiate a founder agreement is not to early or late. Too early and it is impossible to determine contributions and roles, however too late and there is the danger that a subgroup starts the venture on their own. It needs to be made clear at an early enough stage who is in an who is out. There is the ethical question that does a founder have a claim to the company if there is no founder agreement?