Startup Funding Explained – Series A Funding (Part III)
A couple of weeks ago, we started telling the story of a theoretical company: from incorporation to first rounds of funding. The idea was to use examples to explain how the company cap table evolves and how the legal process works through all these steps. This is part 3 of Startup Funding Explained. If you haven't watched parts 1 and 2, please make sure to check them out first. Otherwise, none of this stuff is going to make sense.
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.
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 visible 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, contracts, 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. 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. And there's the convertible note investor. They are not shareholders just yet.
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.
Five would also be a fair number. This persona could be an advisor or even a senior company employee. Investors will also want to protect themselves in case the company goes down. Or if it gets acquired for less than the valuation that they invested. 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.
Even the domains and the code. 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 protection if that happens, they get paid first. Let's remember these investors are considering investing $2.5MM on a $10MM valuation. If the company got acquired for $5MM, say, they would effectively lose about 50% of their
Money. With LIQUIDATION PREFERENCE, investors can protect their cash investments so that at least they are paid out first. For example, they could request a 1x liquidation preference, so if the company is sold for $5MM, they get their $2.5MM investment first- and the remaining $2,500,000 are split between the remaining common stock.
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. But that's a fair number I've heard from a good number of founders.
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. Let's see how the cap table changes. OK, so before the Series A investors come in, the Convertible Note gets executed because there's a new round of funding. A $500,000 investment will be made, at an $8,000,000 pre-money valuation: that's $10,000,000
Minus the agreed 20% discount. To compensate investors for coming in early. All the other terms will be the same as the Series A investor. That includes the preferred stock, for example. 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 again be 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. Our theoretical business is going to get acquired. We'll see how much money each one of these option pool holders will get. This is how the company looks after the second Option Pool is created. Now, time for the Series A money. 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. This is how the cap table looks like. 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're not going to dig into that. In our next and final video, we'll look int to the company exit- our business will get acquired, and we'll figure out the logistics, and especially, how much money everyone ends up making. We'll see you next week.