For you as a startup founder, negotiating equity with investors can be the most hair-raising part of fundraising.
The question on every founder's mind is:
"How much equity should I give to investors?"
The answer lies in understanding the factors that influence investors' equity expectations.
In this article, we’ll delve into the 8 key factors that determine the amount of equity investors typically expect
What’s more:
I’ll give you practical tips for negotiating a fair equity deal.
1. Initial capital requirement: How much money does your startup need?
Before you start talking about equity, you need to be well-prepared. Know your facts.
Define the sum of money you need to sustain your startup throughout the stage you’re at, whether that’s pre-seed, seed, or further growth stages.
Analyze the costs involved:
- salaries, wages, consulting fees
- product development,
- marketing, advertising,
- operational expenses,
- office space, equipment, etc.
Don’t cut corners, but don’t be wasteful either.
Don’t expect to be paying yourself a top salary from day one.
Because the higher your initial capital requirement, the more equity investors expect in return.
So, if you want to give away as little equity as possible, keep your costs low and your runway long.
2. Runway: How long will your startup be able to function with that capital until it needs more?
This is a simple calculation:
If your costs are $500.000 and you’ll spend $25.000 per month (your “burn rate”), then the money will last you 20 months.
That’s your runway. 20 months.
The higher your burn rate, the shorter your runway.
Potential investors will ask you about your runway.
To them, a longer runway indicates a lower risk because it gives you more time to reach key milestones and secure the next round of funding.
So, show that you’ve got a solid business plan, that the deadlines you’ve set for reaching milestones are realistic, and that you’ve maximized your runway.
That will help you negotiate a more favorable equity deal.
3. Ticket size: How much money are you asking this investor for?
You’ll probably be talking to more than one investor.
Maybe a lead investor and some co-investors.
If you need $500.000 to make it work, your lead investor’s ticket might be $250.000 or $300.000.
The bigger the chunk this investor takes, the greater their sense of risk.
That will usually affect the amount of equity they request.
Now here’s where it can get strange, and be careful not to make this mistake:
Don’t ever start talking about equity for the ticket before you’ve defined a fair equity stake for the whole sum.
Don’t mention ticket sizes; if the investor does, move to another topic.
Why?
Because any conversation about “leading” the investment with a large ticket allows the investor to emphasize their critical role in “making it happen” for you
And that can distort the amount of equity they expect.
They might not even do it with ill intent, but subconsciously, there’s a tendency to think:
- You should be so very grateful to them.
- They’re really like a kind of savior for you.
- They are taking the biggest risk of all: the first-mover risk.
So how can you avoid this mess?
Discuss and define an appropriate equity stake for the whole sum ($500.000) before you start talking about ticket sizes.
Talking about the whole sum keeps the focus on the more rational aspects of the equity negotiation.
When you clearly define the equity that way, it sets a baseline.
An anchor.
And once that anchor is set, the more emotional (and possibly irrational) aspects of the “first mover risk” felt by your lead investor hold less sway over the negotiation.
4. Valuation: What is the projected value of your startup?
Valuation plays a pivotal role in equity negotiations.
Your valuation represents the estimated worth of your startup.
It directly impacts the equity stake investors expect.
If your post-money valuation is $5 million and you need $500.000, you’re giving away 10%.
(Post-money means your pre-money valuation plus the money invested so that the pre-money valuation would be $4.5 million plus $500.000 investment = $5 million.)
You see how that works:
The higher your valuation, the lower the amount of equity per capital.
If your post-money valuation was twice as high ($10 million), the equity for a $500.000 investment would be halved: 5%.
You want to keep it high but realistic:
Assess the market, your competition and growth potential, and try to arrive at a realistic and justifiable valuation.
Presenting a well-researched valuation analysis can help you build trust and negotiate a favorable equity arrangement.
5. Returns: How soon can the investor expect a return on their investment?
No matter how idealistic or impact-driven an investor may be, your startup is a business opportunity for them.
Meaning:
They are motivated by returns on their investments.
So, a valuable skill for founders is: Learn to communicate
- your growth strategy,
- the potential for substantial returns, and
- a timeframe
with confidence and great clarity.
As you do, pay attention to these two factors, and you’ll do well:
1. Most investors expect returns within 5 to 7 years.
In some cases, they accept longer timeframes but don’t push it.
Best case scenario:
Show clearly that you can deliver great returns within 5 years.
2. Keep it concise.
Know what’s important and what’s not.
In this part of the conversation, don’t drag your investor into idealistic detours, saying, “But our positive social and ecological impact will be so great!”
That’s a different part of the negotiation.
Stick to the one thing: ROI.
These two factors will strengthen your hand in the equity negotiation.
6. Long-term Capital Requirement: How much money will your startup need until it reaches maturity?
If there’s one word that all investors hate, it’s “dilution.”
As any early-stage investor knows:
5% ownership of a pre-seed startup does not mean 5% ownership after series A funding.
As startups raise additional funds in future rounds, the initial equity granted to an early investor gets diluted
Like the amount of milk in coffee if you pour more coffee into a half-full cup.
In a coffee cup, you can see the color change as the percentage of milk gets diluted:
The coffee gets darker again.
And when you talk about dilution of an early-stage investor’s equity by future funding rounds, this is precisely what happens to their mood:
It gets darker.
That’s where concepts like maturity and “the exit” come in.
Maturity is when your startup needs no more funding because it’s reached all its growth and market share targets and has become profitable.
Alternatively, an “exit” is an initial public offering (IPO) or when your startup gets bought up by a large multinational corporation.
This kind of event usually makes anyone holding equity very rich very fast.
This means that investors will want to know:
- how much money you need to complete the stage you’re at (pre-seed, seed, etc.)
- how much you need until you achieve maturity or an exit.
There are two factors here that will help you negotiate a fair equity while considering dilution:
- Show your funding needs until maturity/exit and that they won’t be astronomical.
- Discuss how your investor will be involved in future funding rounds and what conditions may make that involvement favorable for them.
7. Added Benefits: What non-monetary benefits are both parties bringing to the table?
Equity negotiations should not only revolve around financial aspects.
Non-monetary benefits, such as industry expertise, mentorship, networks, and strategic partnerships, can be valuable assets that both parties bring to the table.
Highlighting what benefits you bring to the table can help you negotiate giving away less equity.
This means:
Increased visibility in the market, additional networks of partners and potential clients, or industry expertise you’ve already built up before your funding round can affect your equity negotiations.
So you’ll benefit from strategically considering the timing of your investor negotiations:
- after you’ve signed an MoU with a potential new client, or
- after you’ve brought on that super-skilled CTO you’d been searching for, meaning you’ll be less dependent on the investor’s networks.
Then highlight these added benefits during your equity negotiations, enhance your overall value proposition, and get a better deal.
8. Non-equity Monies: What alternative financial benefits can your startup offer the investor?
Is it all just about equity? Ownership?
No.
You can offer alternative financial benefits to investors.
This may include dividends, compensation for serving on the board, or future profits from an initial public offering (IPO).
Learn to diversify the financial benefits.
That way, you can create a more attractive package for investors, giving yourself more room to negotiate freely and flexibly about equity stakes.