From the February 2011 issue of Investment Advisor • Subscribe!

February 1, 2011

A Great (and Surprising) Venture Investment Source

Recently, a wealth manager wrote that he was approached by one of his high-net-worth clients and asked to consider investing in the client’s new Web-based technology startup. The client, according to the advisor, is a “successful serial entrepreneur” and held in high regard. The advisor contemplated making the investment in his client’s venture, and considered introducing some of his other clients to the opportunity, as well. He asked me what the usual range of founder’s equity should be at the seed stage of funding a startup, relative to the outside investors bringing cash to the table. Additionally, he asked what the ownership balance between founders and outside capital may look like down the road, after a larger financing and at a liquidity event such as an IPO or acquisition.

The scenario described above is an ideal way for an advisor to venture into … well, venture. My first venture investment came to me by way of a client of my RIA practice. Firsthand familiarity and knowledge of the career, reputation and integrity of a venture’s founding partner is invaluable.

Moreover, as an investor, the advisor has the benefit of an intimate understanding of his client’s personal balance sheet and attitudes toward risk and return. In private equity investing, this is referred to as positive informational asymmetry—actionable information that is not available to all of the parties in a transaction. I have often posited that above all, the people responsible for executing the business plan are the most important ingredient to a successful startup and invaluable in due diligence.

Most venture-funded startups issue two classes of stock: common and preferred. Common stock is issued to the founders and set aside to be subsequently granted to employees through a stock option pool. Common stock can be considered a vehicle to provide currency in exchange for founder’s and other early-stage employee’s “sweat equity.”

Preferred stock, on the other hand, is typically issued to investors and has considerably more rights and privileges than the common stock issued to employees. Preferred will generally have preferential rights in matters of liquidation that predicates investors will get paid back first, before the common stockholders if the company is acquired or liquidated.

So, what is a worthy founder worth in terms of equity interest in his startup? There are many factors in play that are necessary to address. Founders receive equity in the form of common shares based upon the value of what they are bringing to the table. Is the business the brainchild of the founder? Does he bring critical intellectual properties and relationships to the venture? Will this be his sole focus? Is he “all in?” Generally speaking, the larger the contribution, the more equity a founder should receive.

At the initial seed (or, perhaps, “friends and family”) financing stage of a startup, angel investors are likely receiving in the area of 25% preferred equity for their cash investments. If the company is fortunate enough to obtain additional financing in what would commonly be referred to as the larger (and often institutional) “Series A” round, the ownership capital structure will typically look something like this:

Founders:    20%-35%
Angels:    20%-30%
Option Pool:    15%-20%
Series A:    30%-40%

Contrary to an investor’s instinct, passive investors, as a class, should not own the majority equity interest of an early-stage company. Incentives must be properly aligned to keep the founding partners and executive team motivated through the inevitable challenges that lie ahead.

Also contrary to the entrepreneurs’ instincts, maintaining a controlling (majority) ownership interest in the venture should not be their goal. Management must be motivated to maintain their stake by performing in a manner that warrants increasing the valuation of the company during subsequent financing rounds. If the company is fortunate enough to have an IPO, the founders should be pleased to have retained approximately 20% of the company, with another 20% in the hands of management and key employees, and 60% owned by the outside investors.

Next month, we’ll take a closer look at how early stage companies are valued.

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