One thing that a lot of start-ups and entrepreneurs often lack in understanding are things related to the financial realm. Company capitalization, equity compensation, valuation and fundraising sounds like a lot of very technical terms with complicated definitions. It is true that these terms are not exactly the most straightforward concepts, but a high level understanding of some basic financial concepts empower start-up founders to be in a better position during negotiations and key business decision making points.
Equity represents the ownership interest in the company. The boundaries are set by 0% on the bottom and 100% on the top end with the specific percentage someone holds representing the ownership interest in the company. For start-up, equity is often provided in return for labor and work (sweat equity) or capital (cash) contributions. Founders should typically retain a large portion in order to retain control of the company during the growing phase and ensure that future dilution doesn’t result in loss of this control. We will talk about dilution as well.
There are some start-ups that will borrow money in order to start a business, but is a rare form of capital for early stage businesses as there is no business model to be analyzed as a credit risk. Without cash flow and or clear projections on revenues, lending institutions will most likely be hesitant in lending funds. Money that is borrowed is not given ownership in exchange, which is one of the benefits of debt. Borrowed money must be repaid, while equity takes full risk and has no promise of any sort of return.
Capitalization represents how the company is funded in terms of equity and debt. A company’s capitalization = equity $$ + debt $$. Most start-ups’ capitalization will be 100% equity funded and make this equation much easier to comprehend.