Start a Business, Not a Startup Part 2: The Money
This is the second part in a 4-part series about why you should start a business, not a startup. You can access all of the posts below:
- Start a Business, Not a Startup Part 1: Introduction
- Start a Business, Not a Startup Part 2: The Money
- Start a Business, Not a Startup Part 3: Time and Customers
- Start a Business, Not a Startup Part 4: The Advantages of Not Taking VC Capital
Why You Shouldn’t Start a VC-Backed Startup: The Money
Let’s get right down to it: you’ve heard that startup founders can get rich. You’ve read glittering biographies of Bill Gates and Mark Zuckerberg. Now you want to take a crack at getting into that pantheon.
In this section, I’ll tackle exactly what it takes in practice to make a bunch of money as a startup founder. To do that, we need to work through an example.
Raising a Seed Round for Vendata.ai
You have a great idea for a new B2B SaaS tool that helps manage vendor spend. After some deliberation, you decide to call it Vendata.ai (I see what you did with the name there, very clever).
A friend from school joins as your co-founder. You start a C-corp, split the equity 40% each and leave 20% unallocated. You decide to use the allocated shares for future employees or for another potential co-founder. Here’s what the Vendata.ai cap table looks like at incorporation:
You start coding up the prototype. It takes 6 months of unpaid labor, but you put together a working prototype. You use your college connections to get a couple of intros to prominent venture capitalists on Sand Hill road. Back in the heady go-go days of 2019, it still took on average about 6 months to close a seed round. [source] So, by the time you close your round, you’ve been working full-time without pay for ~12 months. Here’s what a typical term sheet might look like:
Horodreezen Seed Term Sheet
Investment amount: $2M
Pre-money valuation: $14M
Investment vehicle: SAFE
Interpreting the Seed Round Term Sheet
Horodreezen is giving you $2M now in exchange for the right to purchase stock in a future equity round. But just because Horodreezen doesn’t technically own their shares yet, you have sold a stake in your company. There are generally two ways to do this: you can either “dilute” existing equity owners by issuing more shares, or give away existing shares. Since Horodreezen is giving you $2M and the pre-money valuation is $14M, that means they have a right to own 14.3% of the company. For simplicity, I’ll round that to 14%.
You decide to give the VC half of the unallocated shares (10% of the company), as well as 2% each from you and your co-founder’s equity. Normally, this would be done by actually issuing more shares rather than actually transferring them. The end result is roughly the same, however, so I’ll stick with the simpler explanation.
Your cap table now looks like this:
Raising a Series A for Vendata.ai
Venture investments are intended to last a company for ~18 months. [source] Unfortunately, it almost never works out like that. Sometimes it takes longer than expected to raise money. Sometimes the company spends faster than expected. The variations are endless.
Let’s give you the benefit of the doubt and say that you’re able to stretch the $2M for the full 18 months before you need to start fundraising again. 18 months of operation + 6 months to fundraise = 24 months. Since you had already been in business for 12 months, that means you will have been in business for 3 years when you close your Series A.
If you decide to pay yourself a salary during this period, it will typically be low relative to what you could earn if you were an employee of another tech company. $100,000 is in the ballpark of what you could expect. [source]
Putting The Round Together
But things are going well. Vendata is growing quickly. After another 24 months of building your product, your annual recurring revenue (ARR) is in the right range to raise a Series A: $1M:
You triumphantly go back to Sand Hill Road, and raise your entire Series A from Horodreezen. Normally, the more money a startup raises, the more investors are brought in to fill a round. But to prevent writing a whole novel about this example, we’ll assume that Horodreezen is the only investor in the Series A round.
As of 2019, Series A rounds averaged about $15M and investors tried to take no more than 30% of the company’s stock. The median pre-money valuation is normally around $50M. [source] The market is quite a bit softer now, but these are fine ballpark figures for our example.
Horodreezen Series A Term Sheet
Investment amount: $15M
Pre-money valuation: $50M
Investment vehicle: Priced Equity Round
Liquidation preference: 1x
Interpreting the Series A Term Sheet
Vendata.ai looks great in this round, and you desperately need the cash to continue expanding the company. So Horodreezen takes another 30% of the company for $15M at a pre-money valuation of $50M.
But Horodreezen also takes their shares in this round as preferred, not common stock. There are several key differences between common and preferred shares. The most important is who gets paid if the company sells for less than expected. Preferred shareholders get money first if the company sells for less than the established pre-money valuation. [source] So for our example, if Vendata.ai sells for less than $50M, Horodreezen will get their $15M before anyone else.
You and your co-founder decide to dilute everyone on the cap table by 30% to keep things fair.
Let’s fast forward to that holy of holies for VCs and founders alike: a liquidity event. You made the $15M last 3 additional years. Typically, companies need to seek additional funds to make it this long. But Vendata is growing so quickly that you’ve been able to keep your burn rate lower than expected. You’ve already tripled your yearly revenue to $3M. Less than .4% of SaaS startups make it past $1M in revenue, and you’ve won that lottery. [source] Congratulations!
But you’re not out of the woods yet.
Even though you made your funding last a long time, your burn rate is still negative. So, after 3 years of operating on the Series A funds, you start fundraising yet again. Just then, a strategic acquirer reaches out to inquire about buying the company. You take a look around and realize you may not have a compelling growth story if you wait another year or two. You stop looking for investors and start courting buyers.
The Acquisition Market for Startups
We’re now in the most shadowy part of the startup ecosystem. Acquisition data is notoriously difficult to find and there’s a lot of false signaling. Funds want to look impressive to their limited partners, so they encourage portfolio companies to announce acquisitions in the most positive light. That means that even when the sale is a money-losing event for the acquired company, everyone pretends otherwise. If you know what to look for, it’s easy to spot these acquisitions. The key phrase to look for is “an undisclosed sum” when discussing the sale price.
Because you raised your Series A at a $50M pre-money valuation, that’s the number you need to hit. Below that number, it’s hard for founders to make money due to the liquidation preferences on the preferred shares. Here’s a very naive breakdown of how that would look:
You’re reading that correctly: if you sold for a seemingly-impressive $20M, you, your co-founder, and all the employees would be left with a measly $4.5M to split amongst yourselves as payment for the 6 years of toil. So you’ll obviously push to sell at or above the pre-money valuation of $50M.
But that’s going to be pretty challenging. Here’s a bit of data to put this in perspective. Back in 2017, Crunchbase identified 63 investors at the top Venture Capital firms. As part of that article. they made a table that included the sale price of their most successful company:
Among this illustrious list of 63 entrepreneurs-turned-investors, 31 (49%) sold their companies for $50M or less. (Remember that “undisclosed typically means “less than the previous round’s valuation.”)
So the $50M target is pretty tough to hit.
Little-Known Acquisition Terms
Most mainstream media coverage of the tech industry doesn’t delve into the details of how acquisitions work. In this section, we’ll cover 3 important details to fully understand how a transaction would occur.
Stocks Instead of Cash
Acquirers usually offer a combination of cash and stock as part of an offer. The split between cash and stock depends on the acquirer, the stage of the business cycle, and a lot of other factors. With the advent of cash-rich acquirers like Google and Facebook, a lot more offers are now cash-only. But mixed offers are still common. For our example, we will assume that the offer is split equally between cash and stock.
Private Acquirer Stock is Illiquid
If a private company buys Vendata, you won’t be able to sell the stock that you are issued in the acquisition. You’ll have to wait until that company has a liquidity event. That could happen next month or never. And while you hold your acquirer’s stock, its value can fluctuate wildly or even go to $0.
At this point you might be thinking “dear god, this guy is paranoid!” but bear with me. Earlier in my career, I worked at a company that was publicly traded. They gave me and other employees RSUs as part of our compensation. About a year after I joined, they laid off my team. A couple of months later, they privatized the company. About a year after that, the company went bankrupt. I was unaffected because I make it a point to always sell RSUs as they vest, but if I had held, all of that value would have evaporated into the maw of bankruptcy court.
So I think it’s a good idea to risk-adjust the value of shares in private companies. You never know what will happen and it’s important to remember that you can’t spend ISOs. I’ve assumed a 30% discount on the value of the stock to adjust for the risk of something similar happening to the Vendata.ai team.
Capital Gains Tax
Finally, there’s taxes. Assuming you filled out your 83B election (you did that, right?!), you’ll still owe 20% in federal capital gains taxes for any income in excess of $459,751. [source] As we’ll see shortly, employees are unlikely to hit the $460k cap, but you and your co-founder probably will.
Factoring all of that together, here’s what you could expect to earn with three possible sales outcomes.
You might be looking at these tables and think “wow, that’s a ton of money!” and it is, but we aren’t done yet.
Overall Risk Adjustment for Possible Failure
Up to this point, we’ve been talking about one particular set of outcomes which is the golden path for any startup founder. But reality is much more complicated. More than 70% of startups die in the first 5 years. [source] If selling your company was a near-certainty, a lot more people would be entrepreneurs.
We need to adjust these acquisition numbers by the risk of total and complete failure. To do that, I’ve multiplied all of the cell values from the table above by 30% to adjust for the fact that only 30% of startups make it beyond 5 years.
Putting it All Together: The Money
After you do the necessary modeling and research (this is Overthinking Money after all), factor in dilution, liquidation preferences, cash/stock splits, capital gains tax, and the risk of total failure, the founders could expect to walk away with between $270k – $2.7M in upside, plus perhaps $500k in salary. I say “perhaps” on the salary front because I know quite a few founders who don’t pay themselves when liquidity is tight, even after raising Series A rounds.
But let’s be charitable and add in the salary. $100k /yr would be taxed progressively. With federal, state, local, and FICA withdrawn, it’s probably fair to say you would see ~$80/yr post-tax.
$80,000 * 5 (no salary the first year) = $400,000. If you add that to the acquisition payout, you get an all-in post-tax upside of $670k – $3.1M. That’s $96k – $516k /yr.
Those are still big numbers compared to the wages paid to most American employees, but there are still 2 big caveats:
HCOL or Bust
You would want to live in the Bay Area or NYC to pull this off. You could technically live elsewhere, but it would be really, really hard to raise capital. The average rent for a 1-bedroom apartment in San Mateo, CA is $3,300/mo. When I was living there, that would have been cheap. The last place we were renting in 2020 was $5,200/mo for a small, run-down single family home in San Carlos. So you would be living a decidedly meager existence during these 6 years.
If You Can Raise, You Don’t Need It
If you are the sort of person capable of convincing top VCs to invest, you are also probably capable of getting a job at Google or Apple. Technologists at those companies routinely make $500k /year. If you don’t believe me, go check the salary data at Levels.FYI. Even ignoring the added hours and stress, if you can earn $500k /yr with a very high degree of certainty, why roll the dice on a startup?
Of course the reason that people do it is because you could sell your company for a lot more than $60M. You could be Marc Andreesen and sell your company for more than $1B. At that point, the monetary payoff does seem very compelling. But even among successful startups that do exit, those kinds of exits are extremely unlikely. If you have a good grasp of statistics, you have probably already reached the conclusion that this startup game is pretty risky, indeed.
But it’s not just that it’s a bad financial deal. Starting a VC-backed company takes a lot more time.
Follow along for the next installment in the series: Why You Shouldn’t Start a Startup: The Time.
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