Don't Let Your Equity Slip Away

Equity ratios matter enormously to the management of every stock corporation, not just startups.

Even an elementary school student knows that much, but the important thing is

“how you should behave when you receive an investment”

Naturally it depends on the stage. Let me offer simple definitions of stage here (I’ll leave the academic version to specialist textbooks), roughly:

• Seed (nobody really understands the market yet, but this concept of mine is amazing!)
• Series A (market launch achieved, or right on the verge of it)
• Series B (launch is done, now you want to scale. In business terms this might mean overseas expansion or a new business challenge)
• Series C and beyond (from here it’s just for convenience — there’s no particular meaning attached to C or D or E) From Series B onward there’s an element of just going with the flow, but you don’t need to be too wary, because the investors who led your seed or Series A round (the investors or VCs who took charge of each stage) will support you. (I’ll leave it at that here. There is danger from Series B onward too, but that’s a topic for another time.) In other words, let’s set the target here at seed and, at most, Series A. Most of the people who come to me for advice are at this stage, so I trust this also aligns with the needs of readers of this blog. First, one important point.

“Consult someone who has no stake in the outcome”

This means: seek an objective opinion. To put it bluntly, most startup founders hand over their early-stage shares at an “unfavorable ratio” far too readily. This is exactly where the gap shows most starkly between those with experience and those without. When someone asks me for advice and I say, “Hmm, given where your prototype is right now, if the investment is $-amount, something like -% seems fine,” I often get, “Huh? Is that really enough?” Sometimes I even get an angry reaction thrown back at me. Something along the lines of: “There’s absolutely no way that works! If we say that, we’ll scare off the investor we finally managed to land! What are you talking about!”

This is a textbook case of sunk cost fal— (I won’t spell it all out).

A startup founded by friends from student days, each of whom was thriving as a promising young talent at a major company, an environment full of future prospects that they threw away to leap into the startup world. The business model is solid, they’ve secured engineers they trust, and the prototype is on track — but money is the one thing they desperately want to secure right now. A familiar story.

I understand, I really do. But that’s exactly the moment for patience.

Investors are financiers, professionals of a certain market in their own right. Their business hinges on buying cheap and in bulk, then selling high at the right moment, and that itself is an extremely symbolic act of capitalism. Ever since the East India Company, the accelerating technological innovation after the Industrial Revolution would never have happened without the power of the aristocrats and industrialists who invested in the risk-sharing system called the “stock corporation,” and without the development of investment banking, capitalism might well have suffered an unexpected setback during the era when socialist thinking ran rampant. Those things deserve enormous respect, and they are wonderful historical facts. But here, they are your business counterparts, so you must stay shrewd. Being told to “stay shrewd” probably doesn’t help much, though. So ask. Ask people. Ask those with experience. It’s simple. If you’re a startup manager, there’s surely someone close to you who has recently succeeded in raising funds. There may even be a senior colleague who has already gone through Series A and B rounds. Just ask them. Ask about their failures and successes, in their own words. Doing so will give you a sense of market norms and reveal what you do and don’t actually want. I don’t want to spell out the answer here, so please find it yourself. Next, one important point.

“Don’t think equity funding is everything”

Naturally this means, in its plain sense, that you should keep debt (borrowing) in view too, not just fundraising through handing over equity, and it also means you should make use of grants and various forms of subsidy. On top of that, the importance of support from angel investors in the early stage can’t be ignored either. Some angels call themselves that outright (though apparently there are few of them in Japan), while others are, in essence, simply wealthy individuals. The reason they’re called angels is that they take almost no equity. (This is purely my personal view, but if someone calling themselves an angel wanted 30% or 40% of the company in exchange for a seed investment of a few million yen, that is without question a devil wearing an angel’s skin. I’d bet on it.) By the time you look at Series A or B, once dilution has occurred to some degree, they usually hold only around 1%, or at most a few percent of the equity. And yet they may have invested several million dollars, sometimes tens of millions. Truly, nothing but angels. (Well, some care is needed not to inflate the valuation too much.) So, in short, the important thing is this:

The money you need right in front of you right now is, in the end, mere “pocket change,” and it isn’t worth selling your soul — your equity — in exchange for it. Even if that doesn’t immediately click for you, at least stop and think it over after reading this.

That’s the point. There are other options too, like equity loans (if you repay the money, your shares aren’t taken, and the repayment terms and interest rates are heavily favorable) or taking on outsourced work for a while as an alternative. Founding a company while remaining a salaried employee is a perfectly legitimate option too. Be careful not to narrow your options so much that you undersell yourself. Let me close by responding to the follow-up question (complaint): “Why do I have to worry about all this? (What a pain.)” First, from a general standpoint:

Nobody knows exactly when or how they’ll run into the 33% wall, so be as cautious as you possibly can in the early stage.

33% is veto power. Falling below a majority is one thing you can live with, but once you lose veto power, it means that if the other shareholders ever band together, they can not only fire you at any time but flip the entire direction of the business. That’s an extremely frightening prospect. Naturally, many company executives hold well under 33%. But that’s only true for “companies generating stable profits.” If you’re thinking “I might get fired this year” while fighting a make-or-break battle every year, you can’t take bold risks. That’s out of the question. Now, next, from a personal standpoint:

Forget about the VCs and the individual investor guys — just become millionaires and billionaires yourselves.

When a company IPOs, the shareholder registry and ratios become public. Anyone who wants to look can see it end to end (that’s precisely what “public” means). It’s not exactly something I enjoy, so I only glance at it occasionally when I happen to be interested. And, well, with a fair degree of probability it leaves me feeling gloomy, which is why I don’t really want to look. In short, it’s questions like “Why does this person hold such a ratio?” and “Why does this person hold such a low ratio?” Very simple. Naturally I know nothing about the internal circumstances of the company, nor its history, at most what I’ve picked up from industry rumor. But it happens that a VC clearly holds an absurdly large block of shares (the investment amount and timing are usually already public, so you naturally form some impression), while a “brilliant young engineer!” who founded the company as a student holds an unbelievably tiny sliver.

It’s deeply regrettable.

Of course, “whoever held more” played it well in business terms and deserves to be recognized for that (having made it all the way to an IPO, that evaluation isn’t going to waver). But since I’m rarely asked for advice by people on that side, I’ll basically speak from the standpoint of the management side here. And from that standpoint, I have to say it’s deeply regrettable. The startup world, taken as a whole, has something of a mutual aid society to it. Someone once said “there’s no such thing as a startup industry,” but I think Silicon Valley had exactly that. The flow of talent, the flow of capital, the sharing of information, a framework for building trends together as a kind of community. In other words, a robust “ecosystem” existed. In that respect too, support especially in terms of capital is a form of risk diversification, and the mechanism by which those who have money take on that role is precisely the philosophy of the stock corporation itself. So why can’t “investment in the future” be built into that philosophy as well?

Forget about the VCs and the individual investor guys — just become millionaires and billionaires yourselves.

Americans (or at least people in Silicon Valley) loved the concept of risk and reward. So who is taking on the greatest risk when a startup is founded? Naturally this differs depending on which axis you compare along, so in general it’s not that simple a question. But here I’d like to deliberately simplify it as follows:

How much did you put in, out of what you had to give?

Founders, in most cases, have neither money nor status. What they have is only time and possibility. We must never forget respect for people who wager 100% of that. Now consider the opposite case: what if some guy with tens of billions of yen in total assets puts in $280,000? $280,000 is a large sum of money for an ordinary person, and for a startup that just launched, it’s precious cash to keep it running for a while. But for that wealthy guy, there’s no question it’s pocket change. That’s putting it harshly — there’s no question it’s “a tiny fraction of his investment capital.” For instance, if at that very moment the equity split ended up at 6:4, how would that look to everyone watching? It’s the equivalent of slapping someone’s cheek with a stack of cash. It’s hard to greet that with much respect.

I’m well aware this is a view that sits awkwardly with the basic principles of capitalism. But for the “startup industry,” whose whole focus is “how to succeed” and “how to build the future,” I believe people should think seriously, day to day, about how to accumulate success stories and plant the seeds for what comes next. That’s what develops the ecosystem and builds competitiveness. Apparently, most of Google’s early members became angel investors using the large sums of money they got from the IPO. That’s the kind of depth that makes the difference.

Author Profile

Yuichiro “kuz” Kuzuryu Engineer / Executive Has fallen into every manner of deep valley, from launching new businesses at major Japanese corporations to startups in Silicon Valley. CEO, Founder, ClayTech Inc. Director, EYS-STYLE Inc. Director, 144Lab Inc. Visiting Professor, Tohoku University Also serves as technical advisor/advisor for several other companies https://twitter.com/qzuryu https://www.facebook.com/qzuryu https://www.linkedin.com/in/yuichiro-kuzuryu-kuz-27b92838/

Originally published in Japanese at https://clazytech.com/2019/09/195/. Translated with LLM assistance and reviewed before publication.