Startup Funding Explained
Caya
June 4, 2020
  |  

Startup Funding Explained

Caya
June 4, 2020
  |  

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Starting the company - Part 1

The fundraising process for a startup requires a crash course on some terminology that you've probably never heard of. 

There's no evil corporation making it confusing on purpose, you know, like banks and credit cards. This is just a complex topic that requires an understanding of some legal and financial terminology. 

When companies have such vast potential, and when you deal with such large sums of money, everyone wants protection to make sure their time or their cash investments are safe. 

Understanding Startup Funding

So, to better explain all of this, we are going to tell the story of a startup company, from funding to IPO. 

OK, so let's take a classic scenario: 2 founders get together to start a business. They bring nothing but their skills and an idea, so they decide to split the company 2-ways. 50/50. 

Incorporating a business is expensive, plus there are tax and legal burdens of having a corporation, so they hold off on that for now. 

They both have day jobs and are building the product in their free time, so they seek out some capital to speed things up. At this stage, they can't go to Venture Capitals or even to Angel Investors. The money they can raise is from friends and family. 

It turns out they have a close friend who believes in them and is willing to invest $50,000 to give them a boost. Great! Now what?

This is where a corporation is going to be necessary. A Delaware C-Corporation is the most standard type of legal structure you can use, and most investors in the US will want that. 

Recommended: The process of incorporating

The corporation allows the founders and the investor to agree on the terms of ownership and decision-making. It provides a layer of protection, for example, in case the company gets sued. 

A corporation is made up of shares. We are more used to hearing about the percentage of ownership. Still, in legal terms, ownership is represented in an integer number of shares. People own a given amount of shares of the business, which therefore represents a percentage of the total shares the company has issued. 

You can have a corporation with one share. Whoever owns it, owns 100% of the company. Our two founders, for example, could incorporate the business with two shares, one for each. 1/2 shares represent a 50% ownership. 

The problem with such small numbers of shares is that splitting them is hard, and this will represent issues if they want to give shares to investors. That's why most companies are established with 10,000,000 shares of stock, which provides enough pieces to be able to split the corporation with plenty of people. 

Well, get back to shares in a second. 

Valuation 

Let's remember our investor, who is willing to put $50,000 into the business. How many shares does he get? 

That question relates to how much the business is worth. Established companies typically base that Valuation on the number of sales, or the tangible assets they own- but our two founders just have an idea and a few lines of code. 

At this point, it's a matter of agreeing on something that feels fair to the investor and the founders. Those numbers can vary a great deal, but let's use 20% for this example. 

The Founders and the Investor agree that he will invest $50,000 in exchange for 20% of this new business. If 20% of the company is $50,000, then that means 100% of the business is worth $250,000. That's the effective business valuation. 

In this case, $250,000 is just an arbitrary number; it's the 20% that showed the balance of risk/reward that the investor was willing to accept. However, that valuation number will be much more relevant in future rounds of funding. 

Back to Incorporation

So, to accept this money, a corporation will be established, again, using the 10,000,000 share standard. 

In basic terms, this is what's going to happen, 

  • A corporation will be established with 8,000,000 shares total, 4,000,000 shares for each founder. 
  • The company will define an arbitrary number for how much the shares are worth, usually $100: that's $0.0000125 per share. 
  • At this point, the founders own 50% of the company each.
  • Each of their chunks is worth $50. This transaction uses a low number to avoid extra tax complications. CAP TABLE MATH 1

Now for the investment, 

This is all done simultaneously, by the way. All you, founder, will see is a bunch of paperwork and a slot to sign. 

All the intellectual property (the code) and the assets will now be owned by the company, which means everybody legally owns those assets in the agreed proportion. 

Great! 

Now, the investor will also want some protection 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. 

Vesting

 In a nutshell, a vesting agreement says that each founder will only own their assigned shares after a certain period. 

A typical agreement has a one year cliff, and a 4-year period, with monthly installments. So,

  • The total number of shares is divided into 48 months.  
  • During months 1-12, no shares are assigned to the founder. 
  • On month 12, 12-months worth of shares are vested. 
  • After that, 1/48 of the total number of shares gets assigned. 

For our founders, that means that by the time they work on the company for one full year, they will unlock 1,000,000 shares. The remaining shares will be 'unlocked' at the end of each calendar month, around 83,333 shares per month. 

Seed round - Part 2

So after incorporating and dedicating time to the business, the company is doing great- the two founders managed to build the product, launch it, and are generating revenue. 

Let's assume that our fictitious company is a SaaS business (software as a service). It has $30,000 in monthly recurring revenue: that's customer subscriptions. It's also consistently growing at 10% per month, which translates to around 300% in annual growth. 

These are good Seed Round Metrics: they want to keep growing fast and accelerate their pace even more- so the founders agree to seek out a new round of funding. This time, their goal is to raise $500,000. 

For this stage, they can start to reach out to Angel Investors outside their family circle. They use Slidebean to create a freaking awesome pitch deck and start getting meetings. 

RecommendedThe process of finding investors

The guys find an angel investor willing to come into this round.

So, what % of the company do these investors get? 

If we used traditional methods to calculate the business valuation, for example, a 5x multiplier of their annualized revenue, then we could say the business is worth about $2,000,000 (that's $30,000 x 12 x 5). In that case, these new investors would get a 25% chunk of the company, which doesn't feel fair to the founders. 

Knowing the potential of the product and how fast they are growing, the founders feel that the company is already worth $5MM. If that were the case, the new investors would be buying around 10% of the business with their $500,000 investment; however, the investor believes that's too small of a percentage for the risk they are taking. 

So what Valuation to use, $2MM or $5MM? Somewhere in the middle? 

Neither. 

This is where a convertible note comes into play. 

Convertible notes

Considering founders and investors have no way of agreeing in Valuation, they can use a convertible note to hold off on the decision of how much the business is worth. With a convertible note, investors can come in, the company can grow, and the conversion to stock occurs later. 

A convertible note works much like a loan, except that it's designed to be paid back in stock instead of cash. How many shares of stock? That will be determined based on company valuation in the future. 

Convertible notes are also known as bridge funding because they provide quick capital with the expectation of a future round. 

So, a convertible note for this company could look like this, 

  • A $500,000 investment will be made in the form of a note (Loan). 
  • The company assumes that with this capital, it will be able to scale fast, getting to a point where they can raise a Series A round. 
  • More importantly, the money will allow them to solidify their market presence. It will make it easier for future investors to define a number that's fair for the company valuation. 
  • So, the capital invested in this Convertible Note ill convert into stock at a future valuation. That Valuation will be defined by the investors of the Series A round, and the Seed Stage investor will get the exact same terms. 
  • To compensate this early-stage investor for taking a risk, they will get a discount over the Valuation of the future investors. That's usually around 20%. 

Recommended: Convertible Notes

For the purpose of this example, notes are issued, money is in the bank, and the company continues to grow. 

The cap table or share distribution of this company is still unchanged- this new investor is not a shareholder, yet. 

Stock option pool

At this point, the company will want to recruit some talent. These are going to be the first employees, and it's essential to keep them motivated! 

In the startup world, it's quite common to offer shares of stock to the first employees in the company; this is done with a Stock Option Pool. 

Now, the stock option pool consists of a defined amount of shares that are 'set aside' to be issued to employees. 

For an option pool, our sample company could issue 500,000 new shares of stock, bringing the total number of shares to 10,500,000. 

Once again, those 4,000,000 shares each founder started with no longer represent 40% of the business. They will now represent around 38%. Our original investor also gets diluted: their 2,000,000 shares no longer represent 20% of the company, they are now approximately 19%. 

The shares on the stock option pool are not given to employees, again, because of tax purposes. 

If the company just gave, say 100,000 shares to a new key employee, they would effectively be receiving an asset that has a value. Remember how the company valuation was $250,000 after the first round of investment? 

Well, that means that each share is worth around $0.023. 100,000 shares represent about $2,380, which would be considered a taxable income. 

At a small valuation, this doesn't represent much money. Still, as the company scales more, this could bring serious tax implications. So, instead of giving the shares to employees, the stock option pool is made up of <Stock Options>. The company is offering the employee the option to purchase shares at a defined, fixed price. 

In this case, that price could be $0.023, because it's the last 'official' Valuation the company had: this is called the strike price.

If the company increases in value, and the price per share increases, the employee still has the option to purchase shares at the original strike price, which lets them turn a profit! 

A founder quits - Part 3

18 months after the company started, one of the founders leaves. 

This is where the vesting period we defined will turn out incredibly useful to protect the rest of the company and the investors. 

According to the vesting rules that we had defined before, the founder needed a 1-year cliff to get their first chunk of shares. We're through that. 

The 4,000,000 shares assigned to the founder were to be vested monthly, at the end of each calendar month. Since he worked for the company for 18 months, he is entitled to 18 out of 48 installments, which represent 1,500,000 shares. 

What happens to the remaining 2,500,000 shares... well, since they didn't vest, they are repurchased by the company at the price the founder initially paid for them. In this case, that price was $50. Now he company no longer has 10,500,000- it's now back to 8,000,000 shares, and the cap table changes again. 

The remaining founder still has 4,000,000 shares, which now represents 50% of the company. The investor still has 2,000,000 shares, but they now represent 25% of the company. Again, the number of shares doesn't change, but the percentages do. 

Series A Funding

The theoretical company is doing great, even after a co-founder left. 

It's doing around $160,000 in MRR, which translates into $2,000,000 in annualized subscriptions. It's still growing 10% Month over month, and there's a definite market opportunity. 

These are more or less the metrics needed to prepare for a Series A round. This time, the company is looking to raise $2.5MM in funding. 

The company will seek a valuation of $10MM. That is 5x their annualized revenues. Remember that valuation standard? They actually have the metrics now to justify that Valuation. 

A Silicon Valley Venture Capital firm takes an interest, and the diligence process begins. Investors will want to dig deep into the company's legal structure, agreements, financials... 

The negotiation process also begins. 

With the convertible note, there are very few points to negotiate on, but this will be priced round of funding: stock will be issued to the new investors. 

These new investors are bringing in $2.5MM, which is, of course, a shit ton of money. They'll want a say on critical company decisions. 

The board

One way to do that is with a Board Seat. The board of directors has control over crucial company aspects. It abides by the company Bylaws, which is a sort of rulebook. 

Up until now, the Board of Directors of this company was probably not defined formally. One founder, one Friends/Family investor with a small ~$50,000 investment. At this stage in the company, everyone needs to trust this founder to make the right decisions. 

But now, investors will want to check and potentially adjust the bylaws, to ensure there are no loose ends. The Board makes most company decisions with a simple majority, so it would make sense for the company to have 3 Board Members: the original founder, the new investors, and someone else to break the tie. 

This persona could be an advisor or even a senior company employee. 

Preferred shares

Investors will also want to protect themselves in case the company goes down. If the company ends up struggling in the future, it might file for bankruptcy and be forced to liquidate its assets: sell the stuff it owns, like cars, properties, or computers. 

Or, it might be acquired/absorbed for a small amount, certainly less than the investors paid when the company was thriving. In that case, investors might request that if that happens, they get paid first. So, if the company gets acquired for $3MM, they get their $2.5MM investment first- and the remaining $500,000 are split between the remaining shareholders. 


Special rules like that make up what we call 'preferred stock.' Which rules, how many assurances and protections investors have requires a long and tedious negotiation process. 

This whole process is likely going to set the company back anywhere between $50,000 and $100,000 in legal fees. We won't dig into that. 

The point is, new investors are coming, they are bringing $2.5MM in new capital and agreed to the $10MM pre-money Valuation. 

Negotiations are done, and the round is happening. 

Series A Math

OK, so before the Series A investors come in, the Convertible Note gets executed, remember? 

A $500,000 investment will be made, at a valuation of $8,000,000: that's $10,000,000 minus the agreed 20% discount. All the other terms will be the same as the Series A investor. The convertible note investors effectively avoided the whole preferred stock negotiations: they simply trust the new investors will get a good deal and piggyback on the same terms. 

Coincidentally, the company has 8,000,000 shares at this point. Easy math, 500,000 shares of stock will be issued to this investor. 

The company now has 8,500,000 shares of stock. The convertible note investors own 500,000 shares, which represent about 5.9% of the company- for now. 

Time for the Series A investors. 

Now, before they invest, they requested the company to create a new Option Pool for future employees to come. 

Also, a founder quit, so the company needs to have a stock option pool available to bring in a new key employee. This person won't be a co-founder but will be a crucial part of the business. 

Series A investors requested the Option Pool to occur BEFORE their investment because they don't want those shares to come out of their end. This is a standard procedure. 

This new Option Pool will be again 500,000 shares. That represents 5.56% of the company today. However, there's a major difference: the company has a fresh new valuation. 

While the first Option Pool was created when the company was worth $250,000- the business is now worth $8.5MM and has issued 8,500,000 shares. That means the STRIKE PRICE for this new Option Pool will be $1 per share. 

Don't worry; when our theoretical business gets acquired, we'll see how this math translates into money. 

This is how the company looks after the second Option Pool is created.

Now, time for the Series A. 

Investors agreed to a $10MM pre-money valuation. If the company has 9,000,000 shares of stock, that means they are valuing each share at $1.1111. 

With their $2.5MM investment, they are going to purchase shares at that price. 

So here's the formula: 

Shares Issued / Company Valuation * New Investment

$10,000,000/9,000,000 * $2,500,000 = 2,777,777.77

Effectively, 2,777,778 shares will need to be issued to new investors. We can't have decimal shares- so this needs to be rounded up: luckly, we incorporated with 10,000,000 shares and those decimal positions aren't worth a lot. 

The company will now have a total of 11,777,778 shares. 

Series B and Series C

I've never done a Series B or Series C, but the process is 'similar'. It's more expensive, more complicated, but it's mostly the same. Companies like Pinterest have raised a Series F, so you can imagine how complex their cap table gets. 

We'll cover more in the next section of this series.