Startup Funding Explained – Seed Round and Stock Option Pool (Part II)
Welcome to part II of our "Starting a Company" video. In this video, we're going over the journey of the company. From the founders getting together, to fundraising, to issuing stock, to vesting agreements, and all the way to the company exit. We'll explain how the process works for each one of those steps. If you haven't watched part I, go and watch it. Otherwise, this won't make sense. Let's get started. 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 raising $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. We have a video on the process of finding investors, so go check that out if you have questions. 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. We also have a full video on convertible notes if you want to dive deeper- but I'm going
To explain it in simpler terms. 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%. Again, check out our video on Convertible Notes if you want to understand these variables with more detail. For the purpose of this video, 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. At this point, the company will want to recruit some talent. These are going to be the first employees, and it's important 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! For the purpose of this scenario, we're going to assume two key employees were hired, each
One getting 250,000 stock options. As our theoretical company grows, we'll look into some scenarios on what happens with these stock options.