Many entrepreneurs’ burning question when considering investment for growth is how much equity to give away.
This decision is critical and often complex, requiring a delicate balance between securing the necessary capital while retaining future financial benefits and operational control.
While there’s no one-size-fits-all approach, several key factors can help you determine the proper equity-to-investment ratio for your business.
The type of business and equity raise
The key distinction to start with is the type of your business and, therefore, the style of investors you will be talking to. Suppose your business is a fast-growth technology startup, and you’re speaking to tech-focused angel investors or venture capitalists. In that case, your approach and expectations will differ significantly from someone raising a growth investment round for a more traditional and established, cash-generative company.
Understanding your company’s value
The first step is understanding the value of your business as a whole and, therefore, the equity stake you will need to give away. The stake will depend directly on the amount you want to raise compared to your business’s total valuation.
In my experience, with eight years as a mid-market M&A advisor, SMEs traditionally trade for between four and seven times their profitability. Here, I’m considering SMEs as businesses with around £1 to £3 million in annual profits, and I’m excluding software businesses and other recurring revenue businesses, which can be valued differently based on their recurring revenue profile.
To determine the value of the shares specifically, you need to adjust for the debt and cash in the business. Where you end up in the range (or if you are on outlier outside that) depends on the nuances of your business and the investment process you are running. Generally, the larger the company, the higher the multiple and valuation an investor would pay for an equity stake.
A significant minority
A technology startup can generally be expected to offer between 10 per cent and 20 per cent equity in a seed round, but the amount raised and equity sacrificed by founders can vary enormously. This is then often followed up by various equity raises in subsequent rounds.
For a growth investment in a larger established business, we still see significant variations, but it is more likely for investors to take between 15 per cent and 30 per cent — a ‘significant minority’. Fundamentally, investors will invest for less than 50 per cent, allowing control to remain with the founders, but they need a large enough stake to make it worth their time and allow them to make a good absolute return on their capital.
Factors to consider
There are lots of factors that will influence the equity you will end up needing to sacrifice. The key ones are:
- Company valuation: Your current valuation will impact how much equity a given investment represents. Be prepared to justify your valuation to investors
- Amount of capital raised: Companies must balance their capital needs with dilution concerns
- Minority stakes discount: Founders should appreciate that investors will often pay a ‘control premium’ when buying over 50 per cent, so it is not perfectly proportional between the value of the entire equity value and the equity stake in a minority growth investment
- Company stage: More mature companies with proven business models can often negotiate better terms
- Additional investor value: It is worth considering what strategic value beyond capital each investor brings, such as M&A expertise, industry knowledge or connections. This can increase the equity stake sellers are willing to offer
- Competitive dynamics of the deal: In a competitive environment, companies can often offer less equity
Striking the right balance
Ultimately, deciding on the investment needed and equity stake to offer is about striking a balance, and it’s personal to each seller. You need to carefully weigh up how much capital you really need to accelerate the company’s growth and what you’re willing to part with.
The key is to be sure you will get long-term value for the equity stake. Five or 10 years down the road, will the value they’ve provided, funding or otherwise, have been worth the equity they now hold?
If you need assistance, I’d always recommend speaking to experienced legal and financial advisors whose knowledge you can leverage to ensure you’re getting a deal that you are happy with and that balances your short-term needs with long-term objectives.
By carefully considering these factors, you can make an informed decision that sets your business on the path to success.
Michael Goodwin is the co-founder at boutique recruitment firm investor, Jigsaw Equity
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