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How to Balance Stake Dilution and Investment

{This article originally appeared in Wall Street Journal’s online edition and can be accessed at: http://blogs.wsj.com/indiarealtime/2011/09/07/chief-mentor-how-to-balance-stake-dilution-and-investment/ }

Let’s face it, raising money for a startup in its early stages is time consuming and challenging. The entrepreneur’s venture needs funding in order to survive and expand, but it is risky for investors to put money into a business that is only in its early stages. The whole process can get pretty frustrating.

Before searching for funding, entrepreneurs need to know, or at least have an idea, of how much money their venture needs. The entrepreneur may know the amount of money needed to keep the show running, but there might not be enough matrices–such as customer figures and sales forecasts–in the early stages to justify the figure. There is no single answer or fixed formula to calculate the required amount. To further complicate things, most entrepreneurs overvalue their ventures and hence feel that the investor is pressing for a hard bargain, or leaving them shortchanged.

Here are a couple of important factors that entrepreneurs should keep in mind when raising investment:

Quantifying the required investment: The funding that a startup receives comes in waves [or rounds or series], which are dependent on the milestones set up for moving the business from one stage to another. Milestones in the early stages could include designing and preparing a prototype, setting up a production and service location, having customers who have used the product and can vouch for it, and breaking even. The amount of investment should be enough to take the venture from one milestone to the next. Remember, investors become stakeholders, and they want to see how their money is being used.

To provide a clear picture to investors, calculate all the expenses and investments to be incurred during a specified period. Try to break up the costs into as granular level as possible—such as the amount of money required to set up a prototype, investment required to procure office space, the first manufacturing facility or a service center–so that it’s easier to defend your decisions with the investor. To be on the safe side, and to meet any eventuality, build a margin of safety, or a buffer amount, in the calculation. On a broad level, the investment required should be money needed to take the venture from one milestone to the next, plus the buffer amount.

For each of the line items in the break up, have a justification and the value that the cost will bring to the venture. The justification of these costs will help in proving the claim of the entrepreneur on the return on investment.

Stake dilution: Once the entrepreneur has an investment amount in mind and has identified the source of funding, the actual process for investment starts. But the money doesn’t come free. While the entrepreneur sees the value in the business, the investor also sees the risk attached to it. Investing in a startup is a big risk, so investors will look for a big reward as well. The investor will ask for a stake in the venture.

The next question for the entrepreneur is: How much stake should be diluted? Again there is no fixed formula for calculating this. The textbooks say the stake diluted should be in accordance with the valuation of the venture. The amount of money invested on the valuation gives the percentage stake to be diluted. But the reality might be different.

A key rule of investing in new ventures is: The one who holds the gold, makes the rules. If the venture is started by a serial entrepreneur with proven credentials in his earlier ventures, more money can be raised with smaller stake dilution. On the other hand, a venture capitalist who, along with the required investment, is able to bring in mentors and much needed access to contacts and customers, can demand a bigger stake for smaller investment.

A word of caution: Although entrepreneurs are desperate to have investment in the early stages, they should be very careful about the amount of money they raise. This is because the cost of investment in early stages is very high. One has to dilute a substantial chunk of stake in return for the investment. Even if the investor is willing to give out more money than required, don’t fall for it. My advice to the entrepreneurs is to take the money required only for moving from one stage to the next. If the next milestone is achieved, the cost of investment will be lower. Then you can raise bigger amounts for less stake dilution.

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