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Startup Equity Capital – a Balancing Act
Properly balancing the equity capital in a startup or high growth venture can be complex and challenging.
What is Equity Capital?
The Equity Capital (also called Shareholder’s Equity or Owners Equity) of a company can be broadly defined as the funds contributed by shareholders through the purchase of shares plus (or minus) the accumulated retained earnings of the company.
The management of equity capital ensures ownership interests are properly reflected and protected and that new stakeholders (like a new investor for example) can be effectively accommodated.
This is particularly relevant to startups where equity capital is usually the primary source of funding (before the business starts generating significant revenue). As a result, equity capital can change quickly and significantly.
What is a share?
A share (or equity) in a company represents a unit of ownership. For example, if a Company has 100 shares on issue, then each share represents a 1% ownership interest in the company.
Classes of Shares
Companies may issue various “classes” of shares to satisfy differing company and investor requirements. Each “class” of share is usually distinguished by its voting rights, rights to dividends, and rights in the event that the company is liquidated or wound up.
The most common class of share is an “ordinary” share which entitles the holder to vote, and to receive dividends.
These are also common in ESOP arrangements seeking the Startup Concessions.
Startups at times will issue Preference Shares. Preference Shares are entitled to dividends in preference to Ordinary shares (i.e. Preference shareholders receive dividends before any dividends are paid to Ordinary shareholders.)
Preference shares usually have a fixed dividend, which may be expressed either as a percentage (e.g. the face value of the share + 5%) or as a fixed amount (e.g. a fixed payment of 25c per share).
The advantage of Preference shares is that they are more likely to provide a return than Ordinary shares – it is possible that dividends are paid to Preference shareholders, but not to Ordinary shareholders if there is a shortage of funds.
Startups will often issue Preference Shares as an incentive to prospective investors because of their comparative advantages to other share classes.
Convertible Notes are also often used by startups as a source of funding. A Convertible Note is a debt obligation which converts to shares if and when certain conversion criteria are met – usually when the next round of fundraising occurs. When a conversion event takes place, the notes convert to shares at a discount to the ruling share price.
See our article on Convertible Notes for more information.
Dilution and Founder Shares
A common problem in startups is that the founders may risk losing control of the company as a result of ongoing equity capital raising. As more funding is raised through share issues, the founder’s percentage of ownership successively decreases (the reduction in ownership is known as dilution).
Dilution – an example
A founder holds 100 shares representing 100% of the shares in a company.
The company issues 15 shares to a new investor.
After the issue of new shares, the founder has a % ownership of 100/115 shares = 87%.
The founders’ ownership interest has therefore been diluted by 13%.
To address this problem, a separate class of shares may be issued to the founders which carry special ownership, control and vesting rights.
See our article on Founder Shares for more information.
The “Cap Table”
- A Cap Table is a summary of all the ownership interests in a startup. The Cap Table will show for each round of investment;
- Date of investment
- Name of the shareholder / investor
- # of shares / options held for each class of share
- $ price paid per share
- % ownership interest in the company
The Cap Table helps to manage the structure and composition of shareholders in a company. This is particularly important for startups where investors and ownership interests are frequently changing.
Balancing the financial and non-financial interests of existing shareholders, new investors and potential investors (e.g. option holders) in a startup or high growth business can be complex and challenging.