Startup Funding Explained – Incorporation and First Investor (Part 1)

by birtanpublished on August 17, 2020

Seed, Post-Seed, Series A, Series B. Convertible Notes vs. Priced Rounds. Common vs Preferred Shares vs. Stock Options. 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 like startups, and when you deal with such large sums of money, everyone wants protection to make sure their time or their cash investments are safe. To better explain all of this, we are going to tell the story of a startup company, from funding to IPO. This is Startup Funding Explained, Part I.

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.

We have a video on the process of incorporating; we'll link that in the description. 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. That lawsuit doesn't necessarily translate into a liability for the founders or the investors. 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 or their team. 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. Without worrying about decimal numbers and rounding up or down. Well, get back to shares in a second.

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. That's not out of the ordinary for a friends and family investor. 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. 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 owners own 50% of the company each. Each of their chunks is worth $50. This transaction uses a low number to avoid extra tax complications. Now for the investment, The company will issue new shares to the investor: 2,000,000.

Issuing shares means the company will 'create' new shares. The number of shares each one of the founders has will remain unchanged. This is important. By issuing 2,000,000 new shares of stock, the company now has a total of 10,000,000 total shares issued: a beautiful, round number. The 4,000,000 shares each founder remained unchanged, the difference is they used to represent 50% of the total number of shares, and now they represent just 40%.

Once again, shares didn't change hands; nobody gave shares to the investor. The company issued new shares. This is all done simultaneusly, by the way. All you, founder, will see is a bunch of paperwork and a slot to sign. But it's all done within the scope of probably one business day. 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. 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. Spoiler alert: in this hypothetical company scenario, one of the founders is going to leave before their shares are fully-vested. We'll get the chance to calculate that

In next week's episode. Hit that subscribe. We'll see you next week.

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