Small Business funding; for startups requires a crash course on some terminology that you've probably never heard of.
Series A, Series B, Seed, Post-Seed, Priced Rounds vs. Convertible Notes Common vs Preferred Shares vs. Stock Options.
There is no evil corporation deliberately making it confusing, such as banks and credit cards. This is simply a complicated subject that necessitates an understanding of some legal and financial terminology.
When a company has such vast potential as a startup, and when dealing with such large sums of money, everyone wants protection to ensure that their time or money investments are safe.
Business funding for startups explained
To better explain everything, we'll tell the story of a startup company from funding to IPO. So, consider this classic scenario:
Two founders collaborate to launch a business. They bring only their skills and an idea, so they decide to divide the company in half. 50/50. Incorporating a business is costly, and there are tax and legal implications, so they put it off for the time being.
They both work full-time and are developing the product in their spare time, so they seek funding to expedite the process. They cannot approach Venture Capital or even Angel Investors at this stage.
Friends and family are the only people who can help them raise funds. They discover they have a close friend who believes in them and is willing to invest $50,000 to help them. Great! What happens next? This is where a corporation will be required.
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Incorporation A Startup Business
A Delaware C-Corporation is the most common type of legal structure, and most investors in the United States will prefer it.
The corporation enables the founders and the investor to agree on ownership and decision-making terms. It provides an extra layer of protection, for example, if the company is sued. That lawsuit does not necessarily imply liability for the founders or investors.
A corporation is comprised of shares. We are more accustomed to hearing about ownership percentages. In legal terms, however, ownership is still represented by an integer number of shares.
People own a certain number of shares in the company, which represents a percentage of the total shares issued. A corporation can be formed with only one share. Whoever owns it owns the entire company.
For example, our two founders could incorporate the company with two shares, one for each. 1/2 shares equal 50% ownership.
The issue with such a small number of shares is that splitting them is difficult, which will cause problems if they want to give shares to investors or their team.
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That is why most businesses are founded with 10,000,000 shares of stock, which provides enough pieces to divide the corporation among many people. Without having to worry about decimal numbers or rounding up or down.
Now, let's get back to the stock market. Let us recall our investor, who is willing to invest $50,000 in the company. How many shares will he receive?
That question is about how much the company is worth. Established businesses typically base their valuation on sales or tangible assets, whereas our two founders only have an idea and a few lines of code.
At this point, it's just a matter of reaching an agreement that feels fair to both the investor and the founders. These figures can vary greatly, but let's use 20% as an example.
That is not unusual for a friend and family investor. The Founders and the Investor reach an agreement in which he will invest $50,000 in exchange for 20% ownership of the new company. If 20% of the company is worth $50,000, then 100% of the company is worth $250,000.
That is an accurate business valuation. In this case, $250,000 is just an arbitrary number; it's the 20% that demonstrated the investor's willingness to accept the risk/reward balance. However, that valuation figure will be far more important in subsequent rounds of funding.
To accept this money, a corporation will be formed using the 10,000,000 share standard once more. In layman's terms, a corporation will be formed with a total of 8,000,000 shares, 4,000,000 of which will be allocated to each founder.
The company will set an arbitrary value for the shares, usually $100: that's $0.0000125 per share. At this point, each of the owners owns 50% of the company. Their chunks are each worth $50.
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To avoid additional tax complications, this transaction employs a low number. Now, for the investment, the company will issue 2,000,000 new shares to the investor.
When a company issues shares, it means it will 'create' new shares. The number of shares held by each of the founders will remain constant. This is critical.
With the issuance of 2,000,000 new shares of stock, the company now has a total of 10,000,000 shares issued: a lovely, round number. The 4,000,000 shares each founder received remained unchanged; the difference is that they used to represent 50% of the total number of shares, but now only 40%.
Once again, no shares were exchanged; no shares were given to the investor. The corporation issued new stock. By the way, this is all done at the same time.
All you'll see, founder, is a bunch of paperwork and a slot to sign. But it's all done in the course of one business day.
The company will now own all intellectual property (the code) and assets, which means that everyone legally owns those assets in the agreed-upon proportion. Great! The investor will now want some safeguards in case one of the founders decides to leave.
If one of the founders left, 40% of the intellectual property and assets would be owned by someone who no longer works for the business. That's where VESTING comes in.
What is a nutshell, a vesting agreement in simple terms?
A vesting agreement states that each founder will only own their assigned shares after a certain period of time. A typical agreement includes a one-year cliff and a four-year period with monthly payments.
So, The total number of shares is divided by 48. No shares are assigned to the founder during months 1-12. Twelve months' worth of shares are vested on month 12.
Following that, 1/48 of the total number of shares are assigned. For our founders, this means that after working on the company for a full year, they will have unlocked 1,000,000 shares.
The remaining shares, approximately 83,333 shares per month, will be 'unlocked' at the end of each calendar month. Spoiler alert: one of the founders in this hypothetical company scenario will leave before their shares are fully vested.
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A new round of funding is sought by the founders.
After incorporating and devoting time to the business, the company is doing well—the two founders built the product, launched it, and are now generating revenue. Assume our fictitious company is a SaaS provider (software as a service).
It earns $30,000 per month in recurring revenue from customer subscriptions. It is also growing at a rate of 10% per month, which equates to around 300% annual growth.
These are good Seed Round Metrics: they want to keep growing quickly and accelerate their pace even further, so the founders agree to seek new funding.
Find investor for startup
This time, they hope to raise $500,000. At this point, they can begin to approach Angel Investors outside of their family circle. They use Slidebean to create a killer pitch deck and start getting meetings.
The guys find an angel investor who is willing to participate in this round. So, what percentage of the company do these investors own?
If we used traditional methods to calculate the business valuation, such as a 5x multiplier of annualized revenue, we could say the company is worth around $2,000,000 (that's $30,000 x 12 x 5).
In that case, the new investors would receive a 25% stake in the company, which would not be fair to the founders. Knowing the potential of the product and how quickly it is growing, the founders believe the company is already worth $5 million.
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If that's the case, the new investors' $500,000 investment would buy around 10% of the company; however, the investor believes that's too small a percentage for the risk they're taking. So, which valuation should be used, $2MM or $5MM? What about somewhere in the middle? Neither. This is where a convertible note can help.
Given the inability of founders and investors to reach an agreement on valuation, they can use a convertible note to postpone the decision on how much the business is worth.
A convertible note allows investors to come in, the company to grow, and the conversion to stock to happen later.
A convertible note functions similarly to a loan, except that it is intended to be repaid in stock rather than cash. How many stock shares are there? This will be determined in the future based on the company's valuation.
Convertible notes, also known as bridge financing, provide quick capital with the expectation of a future round. So, for this company, a convertible note might look like this: The project will receive a $500,000 investment. Will be made in the form of a note (Loan).
The company anticipates that with this capital, it will be able to scale quickly, eventually raising a Series A round. More importantly, the funds will allow them to strengthen their market position.
It will make it easier for future investors to define a fair valuation for the company. As a result, the capital invested in this Convertible Note will be converted into stock at a later date.
The Series A round investors will determine the valuation, and the Seed Stage investors will receive the same terms. As a reward for taking a risk, this early-stage investor will receive a discount on the valuation of future investors. This is typically around 20%. Otes are issued, money is in the bank, and the company is expanding.
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Cap table funding rounds
This company's cap table or share distribution remains unchanged—this new investor is not yet a shareholder. At this point, the company will want to hire some employees.
These will be the first employees, and it is critical to keep them motivated! It is quite common in the startup world to offer stock options to the company's first employees, which is done through a Stock Option Pool.
The stock option pool now consists of a predetermined number of shares that are'set aside' to be issued to employees. Our example company could issue 500,000 new shares of stock for an option pool, bringing the total number of shares to 10,500,000.
Once again, the 4,000,000 shares that each founder began with no longer represent 40% of the company.
They will now account for approximately 38% of the total. Our original investor is also diluted: their 2,000,000 shares are no longer worth 20% of the company; they are now worth about 19%. Again, for tax reasons, the shares in the stock option pool are not distributed to employees.
An employee's stock options How is it calculated, and how is it set up?
If the company simply gave 100,000 shares to a new key employee, they would be receiving a valuable asset. Remember how the company was valued at $250,000 after the first round of funding? That means that each share is worth approximately $0.023. 100,000 shares are worth approximately $2,380, which is taxable income.
This isn't a lot of money at a low valuation. Still, as the company grows in size, this could have serious tax implications. Instead of distributing shares to employees, the stock option pool consists of.
The company is giving the employee the option to buy shares at a predetermined, fixed price. In this case, that price could be $0.023, because that was the company's last 'official' valuation: this is known as the strike price.
If the company's value rises and the price per share rises, the employee can still buy shares at the original strike price, allowing them to profit! For the purposes of this scenario, we'll assume that two key employees were hired, with each receiving 250,000 stock options. We'll investigate some scenarios for what happens with these stock options as our hypothetical company grows.
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What happens when a co-founder leaves a startup?
One of the company's founders leaves 18 months after it was founded. This is where the vesting period we established will come in handy to protect the rest of the company and the investors.
According to the vesting rules we established previously, the founder required a one-year cliff to receive their first tranche of shares. We're done with that.
The founder's 4,000,000 shares were to vest monthly, at the end of each calendar month. He is entitled to 18 out of 48 installments, representing 1,500,000 shares, because he worked for the company for 18 months.
What happens to the remaining 2,500,000 shares? Because they did not vest, the company repurchases them at the price the founder originally paid for them. In this case, the cost was $50.
The company now has 8,500,000 shares instead of 10,500,000, and the cap table changes once more. The remaining founder still owns 4,000,000 shares, or 50% of the company. Although the investor still owns 2,000,000 shares, they now account for 25% of the company.
Again, the number of shares remains constant, but the percentages change. Even after a co-founder left, the hypothetical company is doing well.
It generates about $160,000 in MRR, which equates to $2,000,000 in annualized subscriptions. It is still growing at a 10% monthly rate, and there is a clear market opportunity. These are the metrics required to prepare for a Series A round.
How do you prepare for Series A?
This time, the company hopes to raise $2.5 million in funding. The company will seek a $10 million valuation. That is 5 times their annual revenue. Remember that valuation criterion?
They now have the metrics to back up their valuation. A venture capital firm in Silicon Valley expresses interest, and the due diligence process begins.
Investors will want to learn everything they can about the company's legal structure, agreements, contracts, financials, and so on. The bargaining process also begins.
There are few points to negotiate with the convertible note, but this will be a priced round of funding: stock will be issued to new investors.
These new investors are bringing in $2.5 million, which is obviously a lot of money. They will want a say in important company decisions.
A Board Seat is one way to accomplish this. The Board of Directors has authority over critical aspects of the company.
Until now, the Board of Directors of this company was most likely not formally defined. The majority of company decisions are made by the Board with a simple majority.
The company should have three board members: the original founder, the new investors, and someone else to break the tie. Five is also a reasonable number.
The persona could be a senior company employee or an advisor. Investors will also want to protect themselves in the event that the company fails.
If the company continues to struggle, it may file for bankruptcy and be forced to liquidate its assets. Domains and code included.
Investors may request protection in that case, and if so, they will be paid first. Remember that these investors are considering a $2.5 million investment on a $10 million valuation. They would effectively lose half of their money if the company was acquired for $5 million, for example.
What is preferred stock?
LIQUIDATION PREFERENCE protects investors' cash investments by ensuring that they are paid out first.
They could, for example, request a 1x liquidation preference, which means that if the company is sold for $5 million, they will receive $2.5 million first, and the remaining $2,500,000 will be divided among the remaining common stock.
These special rules are known as 'preferred stock.' The rules, as well as the number of guarantees and safeguards available to investors, necessitate a lengthy and laborious negotiation process.
This entire process is likely to cost the company between $50,000 and $100,000 in legal fees. We're not going to get into that. But that's a reasonable number, according to a number of founders.
The point is that new investors are arriving, bringing $2.5MM in new capital and agreeing to a $10MM pre-money valuation. The round has begun, and the negotiations have concluded.
Let's see what happens to the cap table. Okay, so the Convertible Note is executed before the Series A investors arrive because there is a new round of funding.
A $500,000 investment will be made at an $8,000,000 pre-money valuation: $10,000,000 less the agreed-upon 20% discount.
To reward investors for investing early. Everything else will be the same as with the Series A investor. This includes, for example, preferred stock.
Convertible note investors effectively avoided the entire preferred stock negotiation process by simply trusting that the new investors will get a good deal and piggyback on the same terms.
Interestingly, the company now has 8,000,000 shares. This investor will receive 500,000 shares of stock, according to simple math. The company now has 8,500,000 stock shares.
For the time being, convertible note investors own 500,000 shares, or about 5.9% of the company. It's time to call in the Series A investors.
Series A round Investment round
Now, before they invest, they have asked the company to establish a new Option Pool for future employees. Also, because a founder resigned, the company requires a stock option pool to hire a new key employee.
This person will not be a co-founder but will be an important part of the company. Because they do not want those shares to come out of their end, Series A investors requested that the Option Pool occur BEFORE their investment.
This is standard operating procedure. This new Option Pool will have 500,000 shares once again. That currently accounts for 5.56% of the company.
However, there is a significant difference: the company has a new valuation. While the first Option Pool was established when the company was valued at $250,000, the company is now valued at $8.5MM and has issued 8,500,000 shares.
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That means the new Option Pool's STRIKE PRICE will be $1 per share. Our hypothetical company will be acquired. We'll see how much each of these option pool holders receives. This is how the company will react once the second Option Pool is established.
Now comes the Series A funding. Investors agreed on a pre-money valuation of $10MM. If the company has 9,000,000 shares of stock, that means each share is worth $1.1111.
They intend to buy shares at that price with their $2.5MM investment. So here's how it works: * New Investment * Shares Issued / Company Valuation $10,000,000/9,000,000 * $2,500,000 = 2,777,777.77 In total, 2,777,778 shares must be issued to new investors.
We can't have decimal shares, so this must be rounded up: fortunately, we incorporated with 10,000,000 shares, and those decimal positions aren't very valuable.
The company will now have 11,777,778 shares in total. This is how the cap table appears. I've never done a Series B or C, but the procedure is'similar.' It's more expensive and more complicated, but otherwise it's the same.
Companies such as Pinterest have raised a Series F, so you can imagine how complicated their cap table becomes. We're not going to look into it.
Finally, I hope that I have simplified the topic of small business funding, and if you have any comments or questions, please leave them in the comments section so that we can share the information.
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