In the beginning, a startup’s founders own 100 percent of the company. If the founders can raise their own funding and grow the company from its initial profits, the founders can retain complete control over the company. Most likely, the founders will need seed capital to help them get started.
Outside funding usually works either by charging you interest (and expecting you to pay the debt off within a fixed period of time), or by taking a financial stake in your company. Banks typically loan money to companies while venture capital firms take an equity stake in your company.
The key is to accept only the funding that you need to retain as much control over your company as possible. A simple formula for calculating the percentage of ownership the founders retain is as follows:
F = F0 * (1 – L)
Where F = Founders’ latest % ownership
F0 = Founders’ previous % ownership
L = Outside investor’s % ownership
In a new startup, the value of F0 = 1.0 and L = 0, so the formula is as follows:
F = 1.0 * (1 – 0)
= 1.0 * 1
= 1.0 (or 100%)
In exchange for providing seed capital, outside investors want a percentage of the company. Suppose that outside investors provide seed capital in exchange for 25 percent of the company. The remainder of the company’s ownership is now calculated as follows:
F = 1.0 * (1 – 0.25)
= 1.0 * 0.75
= 0.75 (or 75%)
When outside investors take 25 percent ownership of the company, the remaining 75 percent is left in the hands of the founders. Now each round of additional funding requires exchanging capital for a percentage of the company. So if a company goes through a second round of funding where these additional investors accept a 10 percent stake in the company, the formula calculates the diluted ownership for the founders using these values:
F = Founders’ latest % ownership
F0 = 0.75 (Founders’ previous % ownership)
L = 0.10 (Outside investor’s % ownership) Inserting these new values into the formula calculates the following result:
F = 0.75 * (1 – 0.10)
= 0.75 * 0.90
= 0.675 (or 67.5%)
With each additional round of funding, the ownership percentage of the founders gets less and less, which is called dilution. The more funding your company requires, the less ownership of the company is left for you.
If a company goes through too many rounds of financing, their percentage of company ownership can sink below the ownership percentage of any outside investors. When this happens, it’s possible for the outside investors to take over the company, fire the founding team, and put their own people in charge of the company instead. This creates zero value for the founders and rewards them with a trivial payoff for all their hard work.
To retain control over your company, you have several options:
- Start up your company as inexpensively as possible, relying on high technology to leverage your company’s reach and strength
- Only accept as much outside funding as necessary
- Grow organically; let your company’s profits fund your growth
Exchanging partial ownership of your company for funding is inevitable. How much funding you accept and how much ownership you’re willing to give away is negotiable – so choose wisely.
Jon B. Fisher served as Bharosa, Inc.’s CEO until its successful acquisition by Oracle Corporation in July 2007. Jon became Oracle’s Vice President Product Management assisting with the release of Oracle Adaptive Access Manager 10g. Jon now serves as an adjunct faculty member at the University of San Francisco’s school of business. Jon’s unconventional 15-year software career, described in detail in Strategic Entrepreneurism. The book, which centers on the idea of designing a company specifically to be acquired by a larger one (rather than to become the next big IPO), offers a guide for ambitious entrepreneurs to help them complete their own successful acquisitions.