Sell 20% of the Equity Per Round of Investment

Back when we tried to raise venture money for Pardot in late 2009, we reached the term sheet stage with a number of investors. One of the investors that we talked to really wanted to invest $5 million in the company at a $7 million pre-money for a post-money valuation of $12 million. Divide 5 into 12 and you get 42% — the investor wanted to buy 42% of the business as our Series A round. After building a spreadsheet of different scenarios, especially taking into account the growth rate at the time, it was clear that we were better off not raising money and growing organically. Selling 42% of the business with our first round of financing didn’t make sense.

After talking to other entrepreneurs and reading about best practices online, my advice to entrepreneurs is to not sell more than 20% of the business per round, with 25% OK on occasion, if needed. The biggest reason why is that it’s likely there will be more rounds of financing in the future, and each round compounds the dilution to the entrepreneurs. Here’s how four rounds of financing works out selling 20% each time:

• Round 1 – 80% non-investors and 20% investors
• Round 2 – 60% non-investors and 40% investors
• Round 3 – 40% non-investors and 60% investors
• Round 4 – 20% non-investors and 80% investors
• Note: Investor ownership will be slightly reduced by new stock option plans as well as pro-rata non participation

If the amount the investors buy each time increases to 30% or 35%, you can see how little the non-investors have at the end. Now, if the company sells for a billion dollars, everyone is happy. In reality, most exits are for less than $50 million, making it ideal for entrepreneurs to minimize the amount of dilution for each round of funding knowing that most venture-backed startups raise multiple rounds.

What else? What are some more thoughts on the idea that entrepreneurs should sell roughly 20% of the equity per round of investment?