More often than not when starting out, it’s best to learn from examples such as how different types of financial instruments and deal structures work.
Founding A New Company
Let’s start at the beginning. Imagine two founders who have the idea of a chicken restaurant featuring drone delivery.
They work with a legal team to set up a corporation and decide to split their stakes at a 60-40 ratio, with the majority going to whomever has the technical background to make the scalable part of the business – drone-based delivery – a reality. They will also serve as CEO and decide to set aside 20 percent of the shares in an equity pool for future employees.
The company is established as a Delaware C corporation – a standard type of legal entity for venture-backed startups – with 10,000,000 shares of Common Stock outstanding, issued at a par value of $0.001 per share. With this, in the eyes of the law, the company is now valued at $10,000.
Founder 2 sets to work developing a chicken sandwich that appears to be lovingly hand-crafted, even when produced at industrial scale. They create packaging to keep the sandwiches intact and warm, but not soggy, during the short airlift from their rented kitchen space to the customer. Meanwhile, Founder 1 gets a drone built that is capable of flying chicken sandwiches longer distances than the locale.
After months of working nights and weekends, they go to a park and successfully make their first flight, which is captured on video. With demonstrated demand for the novel idea but no cash to cover the costs of the business, Founder 1 decides it’s time to raise some outside capital in a Seed round.
Seed Round Dynamics
Seed rounds are normally priced and unpriced. A priced Seed round is much like any other round of funding in that the company is given a valuation, and shares in the company are purchased for cash by investors at a price determined by that valuation. However, due to their popularity, as well as their unique structures and financial instruments, we’re going to focus on unpriced seed rounds in this section.
The company is not given a valuation in an unpriced round, and the investor isn’t necessarily purchasing a known amount of equity at the time of investment. Rather, it’s an agreement between the investor and the company to issue shares in a future, priced round in exchange for an infusion of cash at the time the unpriced Seed deal is struck.
The two most common financial instruments used in unpriced seed rounds are convertible notes and so-called Simple Agreements for Future Equity (or “SAFE notes”). A convertible note is a financial instrument that is issued first as debt, but then converts to equity under predetermined conditions, such as raising a priced round.
A SAFE note is like a convertible note, except it’s not a debt instrument, meaning that SAFE notes don’t carry an obligation to pay interest. SAFE notes are generally thought to be more founder-friendly than convertible notes precisely because they aren’t treated like debt, so they don’t have a maturity date or interest payments associated with them.
And as an added point of convenience, the agreements tend to be short, and there are comparatively fewer terms for founders to negotiate.
Because Seed investors take on a lot of risk by investing in very early-stage companies, they’ll often add a number of provisions to their investment agreements to ensure they get a sufficiently large piece of the company to justify that risk. Two of the most common provisions in unpriced rounds are ‘discounts’ and ‘valuation caps.’
True to its name, a discount provision grants investors the right to purchase shares at a discount from the price of shares in the next funding round. In this case, the next round is Series A, which is typically the first priced funding round a company experiences (and the point at which the convertible note or SAFE would convert to shares).
Separately, a valuation cap puts a ceiling on the valuation of the company such that the investor can ensure they get a certain percentage share of a company. This helps to prevent a runaway valuation from squeezing the percentage share they’d be able to purchase in the company.
The Seed Deal
Back to Founder 1 and Founder 2.
They have to raise $5 million to get their company off the ground. After introductions from their network they find two investors eager to commit the entirety of the round.
One agrees a $2.5 million SAFE with a 20% discount provision, and another has $2.5 million in a SAFE that has a $10 million valuation cap on the company’s pre-money valuation. Agreements are signed, money is wired to the company’s bank account, and Founders 1 and 2 resume the process of building their venture.
It’s important to note that no new shares have been created and the value of the company remains the same because of this being an unpriced round.
Series A Dynamics
Business is booming after 18 months with the founders having invested heavily in R&D, a few good engineering hires, and a few agreements with drone manufacturers overseas. However, despite rapid growth, the company isn’t profitable and only has eight months left before it runs out of cash.
It’s time to raise a Series A round. If a company hasn’t already raised a priced round, Series A is typically when the shares of a startup receive their first valuation.
Amongst venture capitalists and other startup investors, it’s common to hear two types of valuations mentioned: ‘pre-money’ and ‘post-money.’ A pre-money valuation is the value of the company prior to the round’s infusion of capital.
The post-money valuation is the value of the company after the round is complete.
Founders 1 and 2 want to raise $7 million. One of their previous investors opts to participate in the round.
- New Investor 1 – $4 million
- New Investor 2 – $2 million
- Previous Investor – $1 million
Analysts at New Investor 1 determine that the company is worth $15 million prior to any investment. This is its ‘pre-money valuation.’ We’ll see that the post-money valuation is actually a bit higher due to the discount and cap provisions used by the seed investors.
The final signing of cheques and legal paperwork sets off a cascade of conversions and capitalisation table adjustments as the company issues new shares to its investors.
Original Investor 1 had $2.5 million in a SAFE with the ability to purchase shares at a 20% discount to the pre-money valuation at Series A. The Series A price is $1.50 per share ($15 million pre-money valuation divided by 10 million shares, the number of shares originally created when the firm was incorporated, which we noted earlier), so at a 20% discount ($1.20 per share).
Therefore, their $2.5 million investment converts to 2,083,333 shares ($2.5 million divided by $1.20 per share) valued at $3.125 million, a 1.25x multiple on invested capital.
In the Seed round, Original Investor 2 put $2.5 million in a SAFE with a valuation cap of $10 million. This allowed them to purchase shares at $1.00 per share ($10 million cap / 10 million shares outstanding), resulting in the purchase of 2.5 million shares from their seed investment. At the new $1.50 share price, their Seed investment is now valued at $3.75 million, a 1.5x multiple on invested capital.
Series A Investors
At a Series A stock price of $1.50, New Investor 1 purchased 2,666,666 shares with its $4 million investment. New Investor 2 purchased 1,333,333 shares with its $2 million investment. And with its $1 million follow-on funding in the Series A round, Original Investor 2 purchases an additional 666,666 shares of Series A stock.
Here’s how the ownership of the company breaks down after the Series A round.
The post-money valuation of the company after raising its Series A round is roughly $28.875 million. Clauses like valuation caps and discounts allow investors to purchase shares at a price lower than the prevailing price per share. This increases the number of shares they are able to purchase, and thus results in more shares being created.
The terms they put into their investment agreements both raised the post-money valuation of the company by generating more shares, and they served to give these investors a larger chunk of the company than they’d otherwise be entitled to if they purchased shares at the $1.50/share price paid by Series A investors.
One of the other important things to note is that, on a percentage basis, Founders 1 and 2, and the employee equity pool’s relative share of the company has decreased on a percentage basis. This is known as dilution. So long as share prices continue to increase in subsequent rounds, the value of their stock will continue to increase as well even as they continue to be diluted.
Where dilution does matter, though, is in the control and voting structure of the company. In most voting agreements, voting power is often tied to the number and type of shares held by a given shareholder, founders and other investors can find themselves outnumbered during key votes as their percentage ownership of the company is diluted.
This is the principal reason why many investors include anti-dilution provisions, to maintain their control in a company.