Money funds day to day operations, pays salaries, power bills etc.

Stock determines ownership, and in most corporations governance.

Now day to day you spend money and ideally you also get revenue. If the revenue that comes in for any given month/quarter is more than the money going out that month/quarter then you are 'operationally cash flow positive' meaning that other than something like a big lawsuit or a promissory note coming due or some big financial event you can keep working and the lights on. It doesn't necessarily mean you can hire anyone or 'grow' or fund a PR campaign.

Then there is stock which represents ownership in the company, there can be multiple classes of stock which convey different rights, and there can be corporate bylaws which change how decisions are made while private vs public, but for the simple case we'll assume that 1 to 1, one share of stock is worth 1/(total-stock) of the company and exerts an equivalent amount of control. When you make a decision for the company you at the board level you effectively 'vote your stock' when you vote. If 50.1% of the stock votes one way that is the way the decision goes.

So lets consider a couple of scenarios:

Lets say the Company is :

   1,000,000 shares
   Investor A - 10% stock (100,000 shares)
   Investor B - 15% stock (150,000 shares)
   Investor C - 15% stock (150,000 shares)
   Founder A  - 25% stock (250,000 shares)
   Founder B  - 25% stock (250,000 shares)
   (everyone else in the company) - 10% remaining stock.

Now you need more money (revenues aren't covering it) so you try to sell more stock which is going to change the numbers around. Lets say you need $10M for the next 24 months and none of the investors want to invest any more money. You've got a crisis. But if you are also independently wealthy you can say "I'll put in the $10M but I'll take 2 million shares." So the 'totals' after that transaction are 3 million shares in total (up from 1 million) and as a strict percentage we've got:

   3,000,000 shares
   Investor A - 3.3% stock (100,000 shares)
   Investor B - 5% stock (150,000 shares)
   Investor C - 5% stock (150,000 shares)
   Founder A  - 8.3% stock (250,000 shares)
   Founder B  - 75% stock (2,250,000 shares)
   (everyone else in the company) - 3.3% remaining stock.

This is the bit I don't understand. Is the founder/investor essentially holding everyone else to ransom in such a situation, and saying they'll allow the company to go bust if the other participants don't accept a 2/3 cut in their voting power?

If so, how does a company or a co-founder protect against such tactics? I know about anti-takeover strategies like poison pills and so on in the corporate world, but I wonder whether they are really effective in the early stage rounds.

In this sort of scenario nobody is being held hostage. The situation is that more money is needed to keep the company operating, there are three ways of getting money, revenue from products, a loan, and selling equity (stock).

Generally revenue isn't a real choice, if it was there then the question wouldn't come up. A loan is trickier, a large loan wants some sort of collateral and if you don't have assets that the lender would take as collateral you are looking at an extortionate interest rate if you can get a loan at all. Worse it adds a re-payment schedule that adds to the burn rate. That leaves selling stock.

So how much is the company "worth?" and what percentage of it would an investor want to buy in order to participate? These are fuzzy numbers, you can say "well sales are X and as a multiple of sales its worth Y" or "the addressable market is Q and these guys capturing 10% would be worth P" but really it comes down to if you believe or don't believe the business is a going concern. It is the place startups go to die, because if they can't convince someone to trade dollars for stock, the next step is bankruptcy.

But if someone is willing to invest they will do so "on their terms" which is to say they will give the conditions under which they will invest. They write this out formally in something called a term sheet. It talks about shares outstanding before the transaction, the transaction itself, and the resulting ownership percentages and valuation post transaction.

So nobody steps forward, next step is bankruptcy. Someone does step forward, well now you have a choice.

A lot of funding agreements have a 'participation right' which basically says Investor A who has 10% has a 'right' to participate in any funding to keep their percentage at 10% or sometimes 10% of the round. So in our example Founder B says I'm setting the terms at $5/share and I'm buying 2M shares for $10M with a post money valuation of $6.66 per share. Then Investor A is offered a chance to participate at that price, so they figure out how many shares they would buy at $5/share such that their ownership would remain at 10% after the transaction. Or they decline. It is their choice. And they may decline because they think its not a good deal, or they think the company is toast anyway and they have already written off that investment as a loss.

Their choice is same voting power in a non-existent entity (bankruptcy) or 1/3 the voting power in a continuing entity. The latter is better than nothing as they say.

If so, how does a company or a co-founder protect against such tactics? I know about anti-takeover strategies like poison pills and so on in the corporate world, but I wonder whether they are really effective in the early stage rounds.

The board votes on whether or not to do the funding round or turn the company assets over to the creditors (bankruptcy) You protect against this scenario by making sure the company is always more valuable as a going concern than as piece parts. The board can try to negotiate a 'better deal' which is to say reduce the percentage stake the new investor is getting in order to approve it, but if they are not participating then that is not a compelling argument.

For example, if someone with 20% shares is trying to sweep up to 51%, a poison pill can come into effect when someone gains 40% ownership of the company, which would then give shares to existing board members, etc. This creates new shares and dilutes shares, but it also dilutes the person's shares who is trying to do the hostile takeover.

You could ask, "Why would anyone ever need to insure against this?" but it happens. Publicly traded companies can represent a massive wealth in assets, which can be stripped away, sold, and cashed out as dividends.

If a company's share price is getting abnormally low, there is a risk that someone could see the assets as being worth more than what it would cost to do a hostile takeover.

For example: Chuck Conway did it with KMart back in 2002 when the company declared bankruptcy. They sold off thousands of the Kmart stores for their land.

If it's between founders, you work out how you want these situations to play out and then you see a lawyer to form a contract that will bind you.

so i'm not sure why the original example needed to place an odd value on the newly issued shares. as far as i can tell, it just muddies things.

i wrote this on rights issues, which is kind-of related (works through a similar kind of argument, except this time framed so people keep the same fractional shares) - http://acooke.org/cute/EnersisEnd0.html [edit: just fixed url] (i'm no expert, i was just interested in that particular case in the chilean press recently).

in short: you don't need to screw anyone over. it can just be that the person putting most money in ends up with most of the ownership.

the two key points are: (1) people need to agree on the company's value before; (2) the company gets the cash (and so its value goes up). of course, that cash won't sit in the bank - but it's the company's responsibility (and the investor's hope) that it is spent in a way that increases the value of the company.