How does equity influence a company’s ability to raise capital?

Just as stock market investors assess shareholding patterns and corporate actions, private equity investors must assess a startup’s equity management practices. In both these assessments, the goal is to understand what exactly you are buying into. A startup’s equity management practices can significantly impact the value of investment opportunities.

Poor equity management may lead to excessive dilution whereas effective equity management may manifest as simplified cap tables and clarity in corporate governance.

In this article, we will dive deeper into how equity management-related issues impact investor decision-making and how you can optimize your startup’s equity to ensure fundraising success. Read on to know more!

How do equity management-related issues impact investor decision-making?

Some of the equity-management concerns that prospective investors may want to be addressed are:

Dilution concerns

Dilution occurs when a company issues new shares and the ownership percentages of existing shareholders drop. It typically happens when companies issue equity compensation and in events like funding rounds, mergers and acquisitions (M&As), and initial public offerings (IPOs). In each of these events, the incoming shareholders are bringing something of value in exchange for the equity they get.

Dilution, by itself, is not bad and is even needed for a company to grow. Startups need to raise funds periodically to make the right investments, develop a good product, and attract the right talent.

However, dilution is a problem when the equity recipient has not added enough value to the startup. This can occur when early investors are given extensive anti-dilution rights and when equity compensation is offered at a low price.

Suppose early investors are issued non-dilutable shares instead of the right of first refusal (ROFR) as anti-dilution rights. Then, they essentially do not need to offer additional funds to buy the shares they need to maintain their ownership percentage.

If equity compensation is offered with short vesting periods, low exercise prices, and/or lenient performance conditions, the employee may not add enough value to earn the equity they receive.

In such cases, the existing shareholders will face excessive dilution. Thus, extensive anti-dilution rights and cheap equity compensation can discourage investors because of dilution concerns.

Governance concerns

A common issue with many startups is the concentration of voting power among founders. As a result, investors cannot influence company decisions and it is difficult to hold the founders accountable for their actions. This can manifest in the form of unreasonably high valuations and lead to decreased transparency in decision-making.

On the flip side, governance issues can also arise when early investors are given perpetual rights to board membership. This can leave larger shareholders with more skin in the game underrepresented.

In funding rounds, investors may also want to verify if the company’s shareholders have any conflicts of interest. Such situations can arise not just from institutional investors holding a portfolio of similar companies but also from high-ranking ex-employees who switched to competitors after their stock options were vested and exercised but not bought back by the company.

Data privacy breaches can also threaten corporate governance efficiency. If your cap table gets leaked, interested parties could approach your shareholders behind your back and make offers. This would enable external agents to stage coups.

Thus, equity structures can create corporate governance issues. These issues create a lack of accountability and transparency in decision-making and affect the company’s prospects.

Attracting and retaining talent

Startups rely on equity compensation to attract and retain talent because of cash shortages and the lucrative nature of equity. When an employee holds equity in your company, they have greater incentive to contribute to its growth.

However, in funding rounds, investors would want to see how much equity you need to offer to have the talent you require. They will want to compare your equity compensation policy with that of similar companies to see if the amount and exercise price of your equity compensation are close to the market standard.

If you offer too much equity or have low exercise prices and easy vesting conditions, the investors will be exposed to dilution risk. However, if the exercise price is high, there are unreasonable vesting conditions, and you are offering too little equity, you might struggle to attract the talent you need. This could hinder your startup’s growth.

To help your existing shareholders and potential investors perform dilution analysis, you must maintain an employee equity option pool that reflects your hiring plans. Again, an inadequate employee equity option pool will affect your ability to attract talent and stunt your startup’s growth, and an oversized one will cause excessive dilution down the line.

Flexibility for future rounds

To incentivize early believers while not giving away too much equity, startups may need to use complex securities such as preferred shares and warrants. In the early stages, startups commonly raise funds through Simple Agreements for Future Equity (SAFE) notes when it is difficult to value the business.

If a startup’s sector is perceived as risky by the market, the founders might need to offer shares with liquidation preferences and anti-dilution clauses to raise funds. Thus, complex securities can be a creative way for startups to raise funds in challenging situations.

However, if a startup’s cap table contains excessive amounts of complex securities, future fundraising efforts will become challenging. Prospective investors may struggle to understand the dilution risk. Not only that, liquidation preferences provided to existing shareholders can obscure the incoming investors’ exit potential through events like IPOs and acquisitions.

Complex cap tables also require ongoing management and periodic legal review which can increase equity management costs.

Another issue that arises from complex cap tables is inefficient corporate governance. At any given point, it will be difficult to judge which stakeholder has the most influence, if the startup has granted anti-dilution rights, convertible debt, warrants, stock options, and other convertible securities.

How to manage equity for fundraising success?

Now that you understand the dangers of inefficient equity management, let’s explore strategies to optimize your approach and ensure successful fundraising.

Buy Back shares from employees

Once your employees have exercised their stock options, you may offer them an opportunity to liquidate their holdings. Most employees will want to hold the stocks until they qualify for long-term capital gains tax treatment to lower their tax liability. In view of such cases, you must structure periodic buyback plans to target employees who have qualified for long-term capital gains tax treatment.

You may also want to buy back shares from existing employees. This will help you mitigate any future conflicts of interest.

Periodically convert the convertible securities

A straightforward way to simplify cap tables is to encourage stakeholders to convert their convertible security holdings. A better solution would be to issue convertible securities that automatically get converted after a certain amount of time or a certain event.

For instance, at the pre-seed stage, you may issue SAFE notes that automatically get converted in the Series A stage. Similarly, at the Series A stage, you could issue convertible debt with a time-based conversion clause.

Sometimes, companies also issue securities whose conversion gets triggered by liquidity events, qualified financing rounds, or changes in control.

Periodic conversion simplifies corporate governance and lends agility to your decision-making.

Invest in equity management software

A good equity management software can help you spot issues like potential over-dilution, compliance issues, vesting schedule discrepancies, and unbalanced ownership structures. It can help you visualize the dilution impact of funding rounds and stock options being exercised by employees.

When you leverage Eqvista’s waterfall analysis, you need not mull over the liquidation preferences of various investors. The software will automatically chart how proceeds from liquidity events will be distributed among shareholders.

Thus, various equity management tasks are simplified by equity management software.

Optimize vesting schedules and conditions

When you are offering equity to an employee, you must estimate how much equity their work will earn in the vesting schedule you are offering. You must also identify performance benchmarks that the employee is likely to meet if they actually earn the estimated equity. This will help you craft vesting schedules and conditions that protect against excessive dilution.

Once an employee reaches the end of their original stock option plan, you must repeat the analysis and re-optimize the vesting schedule and conditions.

Eqvista – Equity made easy!

In funding rounds, prospective investors will examine your cap table and equity management practices because of dilution and governance concerns. At this stage, they will also want to verify that you are offering enough equity to attract the necessary talent but also not over-compensating.

Investors will also assess flexibility in raising funds from future rounds based on the complexity of your cap table.

You could devise employee share buyback plans, periodically convert the convertible securities, invest in equity management software, and align vesting schedules and conditions with employee contributions to optimize your equity management approach. This should help you alleviate any equity management-related investor concerns.

If you require advice related to equity management or are simply looking for cap table management software, consider choosing Eqvista. We have provided equity management solutions for 15,000 companies in just 6 years. Contact us to know more!