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  • 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.

Seed, Post-Seed, Series A, Series B.

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B1 US corporation investor company founder total ownership

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

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    吉川友章 posted on 2020/07/15
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