So your new business venture is gaining traction and you’ve managed to pique the interest of an investor. As exciting as this can be, for many entrepreneurs, bringing on investors can be a daunting task. In our next two articles, we’ll give you the scoop on what you need to be prepared for when going into negotiations with investors. In this week’s post, we’ll talk about some preliminary thoughts: What kind of money are you going to be raising? What kind of shares will you be issuing? What will the valuation of your company be? In next week’s post, we’ll get into the nuts and bolts of an investment agreement and break down some of the common terms and conditions you’ll see in a Term Sheet.
“Series” of Financings
Many tech startups will go through multiple rounds of financing. Your company’s first round of investment will likely come from your personal network and is referred to as the Friends and Family round. This round of financing can vary in size and structure, but is usually done by way of convertible debt under which the loan amount is convertible into shares at the next round of financing. Startups often need multiple Friends and Family rounds in order to fund the company to a point where it is attractive to angel or venture capital investors.
Your company’s first round of investment from experienced institutional investors is called the Seed round. This early-stage investment is often used to support initial operating expenses (such as market research, product development, and initial marketing) until the business can generate cash flow. Similar to the Friends and Family round, seed investments are usually in the form of convertible debt.
Subsequent rounds of financing are called Series A, B, C, etc., rounds. A Series A round is the first round of financing after seed capital. This is usually the company’s first significant round of venture capital investment and is used for “scaling up” the product or proving the business model. Investors in a Series A round will usually want preferred shares in order to get certain investment protection mechanisms (which we’ll get into in part two of this article).
A Series B round is used to scale up the business—this means bringing in the funds necessary to build or expand your company’s team and grow your market share, either domestically or internationally. The structure of a Series B round will be similar to that of a Series A, the primary difference being that Series B investors will get a different class of shares, which will rank in priority to all existing classes of shares.
As your company goes into its expansion stage, a Series C round may be used to continue and accelerate the growth of your business. Once again, the structure of a Series C round will be similar to that of a Series A or B, but now, the Series C investors’ class of shares will rank in priority to all existing classes of shares.
Common vs. Preferred Shares
Common shares are the basic form of shares and will often hold the three fundamental rights attached to shares: (1) the right to vote, (2) the right to receive dividends, and (3) the right to participate in the capital assets of the company at the time of liquidation.
Preferred shares, as the name suggest, have a “preference” or priority over common shares. This preference is usually in relation to dividends or participation on liquidation, meaning common shares will rank below preferred shares in terms of priority for dividends and liquidation amount. On the flip side, preferred shares are usually non-voting. For these reasons, founders of a company will usually hold the common shares and issue preferred shares to investors. However, preferred shares shouldn’t be given away lightly. We recommend that founders avoid agreeing to issue a class of preferred shares unless the investors have considerable value to add (read: a big swack of cash or industry experience and connections).
Valuation simply refers to the value of your company. This number is what investors will use to determine the price they are willing to pay for a piece of the action.
Valuation is calculated on a fully diluted and converted basis. This means the calculation is based on the total number of shares in your company and on the assumption that all founders’ shares have vested, that all Employee Stock Option Plan shares have been issued, and that any shares with a conversion right attached to them have been converted. The inclusion of these shares can significantly impact the resulting valuation numbers.
Another thing to keep in mind is the distinction between pre- and post-money valuation. “Pre-money valuation” refers to the value of your company before the investment transaction is completed whereas “post-money valuation” refers to the value of your company after the investment (for the mathematicians out there, that means: post-money valuation = pre-money valuation + value of investment). This distinction is important and, in your negotiations, you will want to be clear with your investors on whether “valuation” discussions are based on pre- or post-money valuation numbers.
These are just a few initial considerations to think about when you’re looking to bring in funding for your startup. In our next article, we’ll get into the details of a Term Sheet, which is the document that sets out the material terms and conditions of an investment agreement. We’ll outline some of the things you can expect to see in a Term Sheet, such as liquidation preference, dividend preference, and anti-dilution and other investor protection provisions.
Author: Ava Aslani
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