1. Funding Sources for Startups
2. The Way Investment Rounds Work
3. How Investors Manage Risk
4. What are Pro-Rata Rights?

Seed funding percentage ownership refers to the inevitable dilution of a company founder's ownership when the business receives funding from investors. A founder starts with full ownership of his or her business. However, the initial investment, usually made by family members and seed investors, takes away approximately 15 percent of ownership. When the company reaches another ceiling and cannot grow without further investment, funds coming in from venture capitalism can take up to half of the business's ownership rights. Later on, other investors will expect a mature business capable of delivering results and take up about a third of ownership.

The three levels, namely the initial investment, further investment, and investment coming at a time when the company is already mature, are typical stages in a company's life. They are absolutely required when company founders cannot continue to grow their business while relying on savings or donations from family and friends.

Funding Sources for Startups

The main funding sources for startups are seed investors, venture capitalists, credits and loans, or personal donations from those close to the founders.

  • More than $60 billion is invested every year into startups by friends and family.
  • Venture capitalists provide startups with an average investment of $2 million, to help them get to their next development stage.
  • Seed investors invest in 16 times more companies than venture capitalists, with almost 62,000 companies benefiting from such investments every year.
  • Most startups receive at least some of the funding from the entrepreneur's personal savings
  • Lately, a new source has evolved as more and more companies are crowdfunded. Billions are invested every year from online sources, with the numbers constantly rising.

The Way Investment Rounds Work

There are two main types of investment rounds: priced and unpriced. Priced investments work like other types of funding, with the company receiving a clear valuation and the amount invested representing a number of shares correlated with the sum that was invested. Unpriced investments are less regulated, and the company is not clearly evaluated at a certain amount. Instead, an agreement is reached between the founder and investor, which specifies that the investor will receive a fair number of shares at some point in the future when the company will be more valuable.

How Investors Manage Risk

Obviously, investing in a company at the early stages of its development is a risky move for any investor. For that reason, investors add extra precautions in the initial agreement to be absolutely sure that if and when the company grows, they will receive fair shares. Two of the most common precaution measures are called discount and valuation caps.

  • Discounts are clauses that allow investors to buy shares in future investment rounds at a reduced price. This is typically used in seed investments.
  • Valuation caps are limits that are placed on the company's value, preventing any unrealistic future valuation that would greatly reduce the initial investment's worth. The investor can be sure that after a future investment round, a fair number of company shares can be bought based on the initial investment.

What are Pro-Rata Rights?

A pro-rata clause in the contract between a company founder and venture capitalist offers the latter the possibility to participate in any upcoming financing rounds, so they can maintain their ownership percentages in the company. Otherwise, for example, a $10,000 investment in a company valued at $100,000 would give an initial 10-percent ownership to the investor, but a further $100,000 grow in the company's value would reduce that ownership to just 5 percent.

The pro-rata clause is vital to seed investors and venture capitalists, as they usually invest early in a company's existence and want a solid guarantee that they will be a part of the company even after later investment rounds. They are useful for other types of investors as well because these clauses allow them the flexibility of picking the most successful companies out of their investment portfolios to engage actively with their leadership. However, they are not always taken well by entrepreneurs. Although they pretty much guarantee future funding, they also take influence away from the founders.

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