An uninvestable startup

I meet uninvestable startups more often than I would like. These companies, despite having good technology and good team, are not able to attract new investors due to their ownership structure. An obstacle is the fact that the founders have a relatively small stake in the company, which discourages potential investors who fear that the founders may be poorly motivated. While there are no rigid rules, ideally after series A round the founders still should have at least 50% of shares in the company, and employees another 10% (in the form of already acquired shares or ESOP program).

From my experience, I can identify three main reasons for the excessive dilution of founders in the ownership structure of a startup:?first investors received too many shares, spin-off companies, and the departure of some or all of the founders from the company. In each of these cases, I have met with startups in which the active founders already owned less than 30% of shares after the seed round (and in extreme cases even only a few percent).

First investors received too many shares

Not all founders have the option of bootstrapping their startup until at least the moment they build an MVP and achieve the first revenues. Therefore, they often face the dilemma of acquiring the first, relatively low financing (amounting to several dozen - few hundred thousand usd) for a relatively large share in a startup (I have even encountered cases of an investor taking a majority stake at this stage). Obviously, it is difficult to value a startup at such an early stage, as most valuation models are based on revenue multiples; however, by engaging capital at such an early stage, an investor invests in the team and product potential.

For the above reason, a good mechanism in the absence of a compromise with a potential investor in terms of company valuation are 'safe notes'. It is an alternative to convertable notes made by YCombinator and the main difference is no interest. Safe notes provide investors the possibility to take shares in the next round of financing without determining the startup’s valuation at the moment of transferring the funds by investors (but at a discount to the valuation at the next financial round -?usually 20%). An alternative to safe notes may be vesting for the founders, under which?investor takes a larger stake in the company (i.e. at a lower valuation), but at the same time undertakes to reduce his share after reaching agreed KPIs (by reselling a part of his shares to founders at a nominal price or by startup issuing new shares at nominal price to founders, thus diluting the investor). Vesting is usually triggered by achieving established revenue/MRR level or next round of financing?above a certain valuation.

If, as a founder, you have no other choice and need to give investors a lot of shares in your startup, at least make sure that a written policy is set under which investors?will reduce their stake in your startup in the future based on set KPIs. If you do not do it immediately, there is a good chance that you will not be able to straighten it in the future (not every investor is ready to voluntarily give up some of their shares in startup without prior arrangements, even if it is a deal breaker for potential investors in next round).

Companies established as spin-offs

In Poland, we have a relatively small number of spin-off projects created at universities / scientific institutions, but more and more of these types of projects come from software houses. Unfortunately, in many of these, the software house has more than 50% of shares in the company, and sometimes even close to 100%. This means that a relatively small amount of shares in the company are owned by the founder and a key team involved in the development of spin-offs. These types of projects rarely get financing, at least as long as the spin-off entity does not reduce their exposure to 10-15%.

Unfortunately, there is no awareness that allowing a spin-off company to enter the path of obtaining venture capital financing makes the scenario in which a minority stake of 10-20% may be worth much more than the current 50% or 100% of shares. For the above reason, the more likely scenario of obtaining financing by a software house from financial investors is its transformation from a service company into a product company. I have personally seen such cases - it is usually spread over time, and during the transition period, the software house provides its services and simultaneously develops its own product.

Departure of founder from the company

Even the best founding teams may not stand the test of time and fall apart, whether because of differences in the vision for the startup, or whether for personal, health or financial reasons. Regardless of the reason, the departure of one of the founders, who is also a significant shareholder in the company, has serious consequences and can also make the startup non-investable - investors pay special attention to the amount of shares held in the company by founders who are active in the development of the startup and devote 100% of their professional time to its development.

While a solution addressing this problem has already been developed, i.e. the founder agreement, under which the reverse vesting mechanism is introduced - the founders agree that if one of them leaves the company within a specified period of time (usually 4 years) he or she is obliged to resell some or all of his shares to the other founders. Unfortunately, such agreements are rare, especially in Poland, which is why some venture capital funds use reverse vesting provisions in their investment agreements. If you want to learn more about reverse vesting, I recommend my article on this subject, which you can find HERE.

Summary, or how to avoid mistakes in the ownership structure

From the first day of establishing a startup, founders should think about the ownership structure and next rounds of financing. Postponing it in time and acting without a previously prepared plan only increases the risk of not being able to attract new investors. First of all, founders should sign a founder agreement between themselves, introducing reverse vesting provisions. And if there is no possibility of bootstrapping and you need to attract the first investors at the pre-revenue stage, you should offer them safe notes or establish a vesting program under which, after reaching certain KPIs, founders will increase their share in the company (whether in the form of a share buyback).

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a few words about myself:

• i'm currently a member of the Warsaw Equity Group fund ($150M AUM)
• i co-managed three VC funds: Skyline Venture, bValue Bridge and bValue Starter (as managing partner and senior partner) with a total AUM $35M
• i was a board member of the Skyline Investment S.A. - investment boutique listed on the Warsaw Stock Exchange (during that time company invesated over $20M and completed consulting projects worth +$200M)
• so far i have invested in +50 projects and completed +20 exits
• i was a member of the management board and a member of the supervisory board in +30 companies (including two listed on the Warsaw Stock Exchange)
• for many years i have been a mentor and lecturer in acceleration programs and incubators located in Poland and the CEE region
• i'm the winner of the PSIK 2020 award in the SBA Mentor category
• in the period Q2 2021 - Q2 2022 i supported startups in fundraising, closing on average one round per month (during this time I participated in +200 meetings with VC funds)
• during 2021-2022 i invested in startups as an angel investor