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How entrepreneurs finance their company is one of the most critical decisions that they will make during the course of their startup.  The structure of their financing will be one of the key drivers of the financial return from their venture. 

There are financing structures for companies that have small potential and structures for companies that have big potential.  There is not a one-size fits all strategy for capitalizing a company.

Ultimately, financing a startup properly boils down to aligning the financing structure with the business opportunity and capital needs.  In other words, the way in which you elect to finance your company should at a high-level be determined by 1) how big of a business opportunity it presents and 2) how much capital is required to breakeven.  While there are a number of other considerations, but I would argue that these are the first two dimensions to consider as they should help entrepreneurs more quickly find the right direction for their financial strategy.

The 2x2 chart below should help to illustrate how to think about which fundraising category that they are in.

Venture Capital
If you have a big idea that can generate at least $50M in revenue and the business requires millions of dollars to get the company to a cash flow positive position, you should probably pursue venture capital. 

Not Viable
If your business requires significant capital, but is not poised to become a large business you may not be able to find a viable funding source.  You will either need to find dumb money or trick savvy investors into believing your company has bigger prospects.  If your company falls into this category, you should probably go back to the drawing board and find another opportunity to pursue.

Bootstrap
If you have the potential to build a small business - one that generates single-digit or low double-digit millions in revenue - while requiring little capital to achieve breakeven, you have a lifestyle business.  In my opinion lifestyles business are best financed when the founders take as little outside capital as possible - these are companies where it's really only exciting for founders if they own a large percentage of the equity.  Additionally, by raising less capital entrepreneurs will be able to avoid accruing a large amount of liquidity preference.  If there is a significant amount of liquidity preference in the company, it may be difficult for the entrepreneurs to realize a meaningful payout when the sell the company.

Depends On Barriers
If your company has the potential to become a big business and requires little capital to get there the decision between bootstrapping the company and raising venture capital generally boils down to your expected barriers.  If there is little risk of a competitor beating you to scale and taking the opportunity, because you have a unique approach, protected IP or otherwise, then you may want to bootstrap the company in order to maximize your ownership of the company.  If your barriers are limited, however, and additional capital can help you capture market share more quickly, securing the opportunity, then you should consider venture capital.

I frequently meet entrepreneurs that should be bootstrapping who are seeking venture capital or entrepreneurs that should be seeking venture capital when they are bootstrapping.  The former could limit their returns by loading too much liquidity preference into the business, the latter is often building the business too slowly to capture the opportunity properly. 

Picking the right fundraising strategy is often as significant of an indicator of the founder's payout as selecting the right business strategy.  Take the time to understand what type of company you are building and finance it properly.

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I'm often asked by entrepreneurs for equity compensation benchmarks.  They want to know how much equity they should give a COO, a VP or a CEO.  Understanding these numbers is important for sizing an option pool and important for creating compensation plans for new members of the team.

Wilson Sonsini Goodrich & Rosati, a venture law firm, recently published the results of a study on the typical equity compensation packages for key managers after a Series A investment.  These numbers provide pretty useful guidance not only for compensation at the time of the Series A, but also for compensation at the Seed or Series B round as these metrics can be adjusted for likely dilution to back into a benchmark for equity at the Seed stage or otherwise.

It is worth noting that these numbers are not the end-all be-all for equity compensation.  They might fluctuate as market dynamics change and may not be representative of the entire market.  That said, they should provide entrepreneurs with some directional guidance.

In my post, Dividends:  Common Structures, I talk about the three commonly used structures by which VCs accrue dividends.  The motivation behind each dividend structure varies. 

When Declared
The when declared structure is designed to ensure that the VCs aren't excluded from dividend payments.  This prevents the board from declaring dividends that only pay other share classes and leave the VCs out.

Cumulative
Cumulative dividends enable VCs to be compensated for investments that take longer to liquidate.  From an investor perspective this makes sense as the longer it takes to realize an investment (have the company exit) the worse their returns looks to the investors in the venture capital fund.  As a result, by accruing dividends a VC's return can be enhanced partially offsetting the effect of having a longer duration to liquidation.

Compounding
Compounding dividends can substantially increase investor returns over time.  While some VCs will use this structure simply to enhance returns, this approach may also be used to create incentive alignment.  In unique situations where there is either 1) additional risk to holding onto an investment for an extended period (e.g., a patent expiring) or 2) where the is concern that the entrepreneur will not be seeking an appropriately timed exit. 

In the situation of the patent expiration, the value of the exit may decline over time.  Having compounding dividends enables an investor to increase their liquidity preference thereby increasing the percentage of the exit value that they will have rights to as the company's value declines.  This may have the effect of stabilizing a return.  Conversely, in this scenario the operators will receive a smaller percentage of the payout as time passes creating an incentive from them to sell the company early.

In the second situation, where the investors are concerned about the entrepreneur's intent to pursue an exit, the compounding dividends does create an incentive for the entrepreneur to consider the timing of the sale (in addition to the size of the exit).

It's worth noting that it's most common to see the when declared or cumulative dividend structures in term sheets.

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Term sheets may include some provision for dividends to be "paid" to the investor.  These dividends are commonly structured in one of three ways:  when declared, cumulative and compound.

When Declared
In this structure investors only get dividends when the board declares a dividend for the firm.  The legal language will often ensure that a dividend cannot be paid to another share class without also paying the same dividend to the preferred shareholders (investors).  To be clear, if the board doesn't declare a dividend, then one isn't paid.  If the board does declares a dividend, the investors get to participate.

Cumulative
Another common structure is for the investor to require that an annual dividend be paid to them.  Usually the dividend amount is a percentage of their initial investment. 

Most early-stage companies do not have excess cash to pay dividends, however.  If they do generate excess cash they typically re-invest it into the company.  As a result, investors accumulate their dividends as liquidity preference, to be paid before common shareholders get to participate. 

Compounding
Compounding dividends are structured much like cumulative dividends.  They are paid based on a predetermined percentage and accumulate as liquidity preference.  Compounding dividends differ in that the annual dividend amount is not determined as a percentage of initial investment, it is determined as a percentage of the initial investment plus the total accrued dividends.  Investors are paid dividends on dividends.

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Tomorrow is the anniversary of America's independence - a great time to be thinking about how to be a better citizen both at home and globally.

With that spirit in mind, as of yesterday this blog has become internationalized.  I added (per the recommendation of my rock star intern Wayne) Google translator.  If you don't read English well, fear not - you can now read this blog in dozens of languages.  Hopefully this content will be able to help entrepreneurs everywhere.

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