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  • 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.

A couple of weeks ago, we started telling the story of a theoretical company: from incorporation

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B1 US company valuation founder stock pool funding

Startup Funding Explained - Series A Funding (Part III)

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    吉川友章 posted on 2020/07/15
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