Recently, a wealth manager wrote that he was approached by one of his high-net-worth clients and asked to consider investing in the client's new Web-based technology startup. The client, according to the advisor, is a "successful serial entrepreneur" and held in high regard. The advisor contemplated making the investment in his client's venture, and considered introducing some of his other clients to the opportunity, as well. He asked me what the usual range of founder's equity should be at the seed stage of funding a startup, relative to the outside investors bringing cash to the table. Additionally, he asked what the ownership balance between founders and outside capital may look like down the road, after a larger financing and at a liquidity event such as an IPO or acquisition.
The scenario described above is an ideal way for an advisor to venture into … well, venture. My first venture investment came to me by way of a client of my RIA practice. Firsthand familiarity and knowledge of the career, reputation and integrity of a venture's founding partner is invaluable.
Moreover, as an investor, the advisor has the benefit of an intimate understanding of his client's personal balance sheet and attitudes toward risk and return. In private equity investing, this is referred to as positive informational asymmetry—actionable information that is not available to all of the parties in a transaction. I have often posited that above all, the people responsible for executing the business plan are the most important ingredient to a successful startup and invaluable in due diligence.
Most venture-funded startups issue two classes of stock: common and preferred. Common stock is issued to the founders and set aside to be subsequently granted to employees through a stock option pool. Common stock can be considered a vehicle to provide currency in exchange for founder's and other early-stage employee's "sweat equity."
Preferred stock, on the other hand, is typically issued to investors and has considerably more rights and privileges than the common stock issued to employees. Preferred will generally have preferential rights in matters of liquidation that predicates investors will get paid back first, before the common stockholders if the company is acquired or liquidated.
So, what is a worthy founder worth in terms of equity interest in his startup? There are many factors in play that are necessary to address. Founders receive equity in the form of common shares based upon the value of what they are bringing to the table. Is the business the brainchild of the founder? Does he bring critical intellectual properties and relationships to the venture? Will this be his sole focus? Is he "all in?" Generally speaking, the larger the contribution, the more equity a founder should receive.
