How can founders leverage valuation increases to maintain their stake’s value?

Typically, a startup reaches profitability in 3-4 years and takes a few more years to reach self-sufficiency. In this period, you might go through a funding round every 18 to 24 months. As a result, founders experience considerable dilution.

Such dilution can lead to a situation where founders do not receive a satisfactory portion of the fruits of their labor.

How should you negotiate funding rounds to maintain stake value?

The value of your stake will fall only if your stock price falls. So, in the context of this article, your primary objective in a funding round negotiation should be securing a higher share price than the previous funding round.

Additionally, in the funding negotiations, you can also take the following strategic measures for maintaining your stake’s value in the long term.

Leverage IP and brand valuations

Once investors are convinced of your company’s potential, the funding negotiations will center around your valuation. A great way to anchor the negotiations to a favorable valuation would be to leverage the value of your intangible assets.

Unlike mature companies, startups cannot secure funds purely on the basis of financial performance or market position. Instead, they must raise funds on the basis of growth potential. The best way to support your growth potential claims would be to substantiate the value of your technology and brand.

You should request a professional valuation of your intellectual property rights and brand to quantify their benefits, such as the licensing potential, demand stability, higher demand, and premium pricing.

Seek approval to receive stock-based compensation

Startup founders naturally take up leadership positions such as Chief Executive Officer (CEO), Chief Finance Officer (CFO), Chief Technology Officer (CTO), and Chief Information Officer (CIO). At these positions, it is not unusual for stock-based compensation to make up the majority of the total compensation. By following this norm, you can protect yourself from dilution.

Since the compensation for these positions can be extremely high, investors are likely to be in favor of issuing stock-based compensation to founders. A larger stock component means a comparatively smaller cash component, thereby reducing the burn rate and extending the runway.

You can use the following formula to calculate the amount of stock-based compensation you must receive to maintain your stake value until the next funding round:

Stock-based compensation=Existing shares ×Current share price ×Expected total outstanding shares after the next funding round/Expected post-money valuation-Existing shares

Note: The above formula will return a negative value if your future expected share price is greater than your current share price. In such scenarios, you do not need stock-based compensation to maintain your stake value since the stock price growth would increase your stake’s value.

Let us test this formula through an example. Suppose you currently own 100,000 shares, and the current stock price is $40.

So, the value of your stake = $40 × 100,000 = $4,000,000

Now, assume that you expect your startup’s post-money valuation to reach $50 million in the next funding round. You also expect the total outstanding shares to reach 2 million post the funding round.

Let us apply these values in the earlier-mentioned formula.

Necessary stock-based compensation = 100,000×$40×2,000,000/$50,000,000-100,000 = $4,000,000/$25-100,000 = 160,000 – 100,000 = 60,000 shares

If you receive 60,000 shares as compensation, the value of your stake would be:

Value of stake after funding round = (Existing shares + Necessary stock-based compensation) × Future stock price =100,000+60,000×(Future valuation/Future total outstanding shares) = (160,000)×($50,000,000/2,000,000) = 160,000 × $25 = $4,000,000

Establish a multi-class share structure

In a multi-class share structure, shares from different share classes carry varying dividend rights, risk levels, share prices, and most importantly, voting rights.

A multi-class share structure would ensure that you and your co-founders hold the greatest influence on board decisions in comparison to other stakeholders. This would make it easier to implement favorable stock-based compensation policies, buyback offer prices, and secondary share sale policies.

Such a share structure allows you to:

• Protect yourself from dilution using stock-based compensation
• Offer buybacks at a pre-determined and favorable price
• Have the chance to match any third-party offers to increase your shareholding

An example of a multi-class share structure would be Alphabet Inc. (Google’s parent company). The company has three share classes, which are Class A, Class B, and Class C. Class A shares carry 1 vote per share, while Class C shares do not carry any voting rights. Class B shares, held mainly by company insiders, carry 10 votes per share.

Retain investor diversification

When you raise funds from only one investor, you will be gradually ceding control of your company to that investor over funding rounds. On the other hand, when you raise funds from multiple investors, there is a lower likelihood of facing a unified opposition to your equity-related decisions.

Furthermore, when you raise funds from multiple investors, you are more likely to secure a favorable valuation. If you must rely on a single funding source, the investor would have leverage to secure a low valuation to improve their overall investment returns. On the other hand, when you have more than one viable funding source, you are less likely to accept additional funds at an unfavorable valuation.

How should you operate your startup to maintain your stake value?

In addition to funding round strategies, you can also maintain the value of your stake by how you operate your startup. Two ways in which you can do so are as follows.

Consider corporate partnerships

As discussed earlier, a startup must raise funds on the basis of its growth potential rather than its financial performance. A startup’s growth potential claims become more believable when it has the backing of a large corporate player. Such support would help a startup access the know-how of an established player and their network while also ensuring that the product development roadmap aligns with the needs of a large potential customer.

Thus, such partnerships catalyze product development, reduce the time to revenue generation and profitability, and ultimately, help you secure a higher valuation.

Optimize cash flows

When you have a high burn rate, the urgency with which you need additional funds is high. This gives your prospective investors leverage to negotiate a low valuation to improve their investment returns.

Thus, managing your burn rate can be a critical part of maintaining your stake’s value.

In addition to cutting down on non-critical expenses, you can manage your burn rate by negotiating favorable terms with your creditors and debtors. Essentially, you must aim to have a cash conversion cycle shorter than your creditor repayment terms.

You would experience a similar disadvantage when your startup is not generating revenue. Investors can argue that a startup that is not generating substantial revenue has not established product-market fit and hence is a risky investment. On the other hand, a revenue-generating startup feels less urgency to raise funds and hence has more leverage in funding negotiations than other startups.

Why should you NOT facilitate exits through debt?

While debt can help increase your shareholding by facilitating exits to small investors and employees, it involves complex financial risks. Only consider this after exhausting all other strategies and if repayment terms are very favorable. If you have other assets, it’s safer to liquidate them to buy shares rather than take loans. Rising interest rates or startup failure can make repayment difficult, leading to personal liability. Therefore, using debt to increase shareholding is rarely a viable way to preserve stake value.

Eqvista – Accurate valuations for informed negotiations!

A key part of maintaining your stake value is avoiding a decline in share price. However, startups often struggle to drive share price growth due to limited financial history, perceived inexperience, intense competition, and unproven business models.

Eqvista helps overcome this challenge by delivering detailed, research-backed, and defensible valuation reports. Our insights empower you to negotiate valuations with confidence. Contact us to learn more about our services!