Convertible Notes, Equity and Startup Funding Explained for a startup company

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If you're starting your first company,
understanding stock, preferred stock,
options, convertible notes
and other fundraising instruments
can be truly overwhelming.
We actually didn't find a single video
that covered this, so here we go.
This is Fundraising for Startups 101.
If you are an early-stage startup in the tech space,
and you are looking for money to grow your company,
the official term for that would be raising capital.
The most commonly recommended instrument
to do so is called a Convertible Note.
However, to understand how those work,
we first need to understand how equity
(or stock) works.
By the way, if you are lost
with one of the fancy words we are about to use,
just rewind,
or check out the video description for a glossary.
Also, a shout-out to our investors
at Carao Ventures,
for validating our legal documents here.
Ok, so Stock.
You are probably semi-familiar with the term
'stock.'
Stock is what represents the company ownership
and it is distributed in parts to reflect
how much of the company each owner
or shareholder possesses.
Each shareholder, receives a certain number of shares of stock.
The number of shares a person
or entity owns in the company,
divided by the total number
of shares that have been issued,
reflects that person's percentage ownership
of the business.
That ownership is often acquired
with a cash investment,
but it can also be acquired
through other forms of value contributed,
like your hard work.
The percentage owned
normally determines a shareholders' claim
on the company distributed profits,
(the term used is dividends)
and the voting power
on certain key company decisions.
But, for you to understand better,
use an example of a company
we'll call...
FounderHub.
Let's say that FounderHub has two founders,
who came up with the concept together,
and have both committed
all of their professional time
to develop this business,
so they'll be equal partners.
The Co-founders,
Walter and Jesse
go ahead and incorporate FounderHub.
Startups are usually incorporated
with about 1 million shares of stock.
Why so many?
Because it's complicated to break a share in half.
We'll get to that in a second.
So, after incorporating,
each one of the founders
owns 500,000 shares of stock
which represents 50% of the 1 million total.
Most startups are incoporated as
Delaware C-Corporations,
and they just are.
It's the legal structure that is
most familiar to investors,
it is easy to set up,
it's easy to manage
and is very tax friendly.
So let's look at a Price Round.
Raising money for stock.
The 'traditional' approach
towards raising capital
is with what is called a “priced round”.
Meaning, a round in which both the founders
and the investor are able to agree
on an accurate valuation for the company,
and so the investor gets shares of
company stock in return for his investment.
Let's imaging that FounderHub starts
generating sales, starts operating and
things are going very well.
Let's say they're selling $10,000/mo,
and subscriptions are growing fast,
so they decide to raise money.
They calculate a nice round number of, say,
$500,000 in investment that they need to raise
to accelerate their business,
so they seek out an investor.
Remember,
companies rarely raise money
without traction;
we made a whole video about that.
Check it out.
So, how many shares do they offer an investor
in exchange for those $500,000?
That question really relates to the business valuation.
How much is this business worth?
If instead of FounderHub,
Walter and Jesse owned,
let's say a car wash
its value would be calculated using a multiplier
of their revenue or their profits;
it's really, their EBITDA, but who has time to
explain what that is?
If Walter and Jesse are making $10,000/month,
that's $120,000/year,
a traditional business could be worth
maybe 1x or 2x this,
depending on how profitable they are.
This means that an investor could literally
buy the whole carwash business
for $250,000 or so
(excluding the value of the land or the building).
However, tech startups are different.
Tech startups could have
tremendous scale potential
and fantastic margins,
so it's extremely hard to measure
how large and fas they can grow
in revenues and in value.
A software product or an app, for example,
can realistically serve millions of customers
around the world, with a minimal staff.
Think of Uber,
who raised $500,000 on their first round,
and are now worth,
well, close to $80B of dollars.
They did not need to invest billions of dollars
on buying a car fleet, for example.
So the value of a tech startup
is not related directly
to their current assets or revenues,
but to their upside potential,
their capacity to innovate
and transform those innovations
into value.
Some variables to take into account here are:
- The addressable market size.
So, how many customers are there
for the company to serve
and how much would they be willing
to pay for this product
or service.
- The technology variable
Is there a unique piece of tech
that nobody else has,
or that optimizes a process drastically?
- Potential margins.
How much does it cost me
to serve an additional customer?
For example,
when Instagram had 300 million users,
their staff was only 13 people.
However,
all these numbers are variables and estimates,
and nobody really knows for sure.
But based on them,
along with some credible early results,
the valuation of the startup
is defined by how much potential
an investor sees in the business,
how risky it is,
and how much upside do they expect
in exchange for risking their money,
just like a bet.
So, these days,
an average valuation in Silicon Valley,
for a tech company like our theoretical FounderHub
would be around
$4million pre-money valuation.
Again, assuming this is a high-scale,
high-margin business, not the car wash.
So, let's say that Gus,
our investor, accepts these terms,
and then he is willing to purchase
a $500,000 chunk of this business,
as an investment.
Simple math tells us that if
the full company is worth $4 million,
then $500,000 would represent
about 11% of this company.
We are gonna dig deeper into this.
Remember Walter and Jesse
both have 500,000 shares of this business.
Shares of stock
Typically, the original shareholders
do not transfer or sell their shares,
what's gonna happen is the company will
issue new shares to Gus.
In businesses stock rarely changes owner,
unless the business is actually acquired.
On the contrary,
companies often issue new stock,
which dilutes the original shareholders
percentage ownership.
I'm gonna explain this in the easiest of ways.
Let's say that if Walter and Jesse
had one share each,
they would each own 50%
of a 2-share business.
If the company issues a new share of stock to Gus,
then everybody still has one share,
but it's no longer 50% of the business,
it's 33% of it.
So, in this case
for the math to work,
FounderHub will issue
125,000 new shares of stock to Gus.
When the company does this,
it will no longer have 1 million shares,
it will have 1,125,000 shares.
So, Walter and Jesse will still own
500,000 shares each,
but they no longer represent 50% of the business,
but around 44.4% of it..
The new 125,000 shares issued to Gus
now represent 11.11% of the company.
The post-money valuation of FounderHub
is now $4,500,000.
And this is why we had 1 million shares to start with,
so that we don't have to issue fractions of shares.
If the company would have been incorporated
with only 100 shares, for example;
50 for Walter and 50 for Jesse...
then it would have had to issue
12 or 13 stocks to Gus,
so we'd need to round up or down.
That round up could be worthless now,
but a 0.01% equity stake
in a company like Uber
that's actually
$8 million today.
Now, the challenge with raising money this way,
a priced round,
is that there are a lot of things to figure out,
for example,
How many votes
does each share get in certain discussions?
Usually, the standar is that you get one vote per share,
but investors will often want
more control over certain
key company decisions
considering that'll have
a minority ownership in the company.
If the company goes bankrup, for example,
and needs to liquidate assets,
do investors get paid first?
That's another thing,
that you'll have to agree on, on a price round.
Also, how does the Board of Directors look?
Investors will also want to control a seat
and to protect themselves
against being removed from the Board.
Now, all of these decisions require negotiations,
and lawyers, and signatures to be put in writing,
and they can make the process take six months
or more from the verbal 'agree to invest.'
Since most early companies
don't have six months,
they often choose to go with a Convertible Note.
By the way,
If you want to run your own calculations on this,
you can download the free template we added
at FounderHub.io
A link is available below.
CONVERTIBLE NOTES
A convertible note is an instrument that delays
the valuation conversation,
and it allows the company and the investor
to agree and move forward
on the investment much faster,
with less negotiation,
and fewer complicated and costly legal expenses.
A convertible note works a bit like a loan,
but instead of using an asset
like a house for collateral,
the company stock is the collateral
at a valuation for the company
that is going to be decided in the future.
This means, obviously,
that the investor also needs
to believe in the business in order to invest,
because it is the intention of the investor
to convert this note into actuall company stock.
Like I said before,
defining a company valuation is very tough.
Too many uncertain variables, too little data...
so with a convertible note,
the investor is,
is basically saying:
I'll give you the money to grow now.
In a year or so,
we should have the data to support a priced,
traditional funding round,
so my investment will convert then,
using a formula that would be based on the valuation
and terms that the company and the investors define
for such future priced round.
So, as you can see,
convertible notes could have some terms
that can be hard to grasp,
so we'll explain all of them
through examples.
So let's take case A.
Walter and Jesse take the money
from their first investor, Gus,
on a convertible note.
With the money they grow as expected,
their business looks very healthy and promising
and one year later they manage to attract
a new investor, Madrigal,
who is willing to invest $1 million on a priced round
that values the company at $5,000,000.
When this new investment comes in,
the convertible note with Gus is triggered.
Now, to compensate the original investors
for believing in this company early on,
notes have an interest rate,
and a discount.
The interest rate is usually 5%-6%,
and the discount is 10-25%.
That is a discount on the valuation
set by the new investor.
In this case, again,
Gus invested 1 year before Madrigal's round,
so he's earned about $25,000 in interest.
When the day comes,
to close the legal paperwork,
Gus would be converting $525,000
at a $4MM valuation
instead of the $5MM valuation
that Madrigal got (that's the 20% discount).
After the note converts
Madrigal then invests their $1,000,000
at the $5,000,000 million valuation.
And the new company distribution
would look something like this:
Let's look at another scenario,
this is scenario B
where the company grows tremendously fast.
In a couple of years,
FounderHub finds a new investor
that values the company at $50,000,000.
Even with the 20% discount,
Gus' valuation to convert is $40,000,000
so that original $500,000 investment
plus interest,
would translate to less than 1.5% of the company.
The risk/upside tradeoff
that was taken by Gus
by investing early,
was not compensated in this investment
for Founderhub.
This is why notes have a Valuation Cap.
This Cap is a maximum valuation
at which the note will convert.
Let's say the agreed Cap
in this case, for this investmen was $7MM.
So, what would happen is that,
while the new investors will invest
on a company valued
at $50,000,000,
Gus will convert his note at the Cap,
resulting in a ~6x paper return
on Gus' investment.
Which is, not bad at all…
and the company would look like this:
By the way,
the same mechanism
would apply if the company is acquired,
while the the convertible notes
are still withstanding.
The convertible notes would trigger their conversion
in order to participate in the
sale of the company.
Allright, so let's look at a scenario C,
our third scenario,
the one that is less frequently discussed:
what if the company doesn't grow?
If the company can't raise additional round of funding.
So, if the company doesn't manage
to show traction,
and attract new investors, and in this case,
There's a maturity date, for the Convertible Note.
This is a date,
in which Convertible Note owners can convert
their notes and interest
at their Cap that we just discussed,
or request a payback from the notes.
Investors will probably
request a convertible note payback
only if the company can really afford it.
And, maybe they believe that converting
at the Cap is too expensive a valuation
for what the company has become.
If the company can't afford
to pay back the notes,
and the investors execute them,
the startup will probably need to file for bankruptcy.
The investors will also lose most or all of their money,
since the company doesn't have the assets
to pay back the notes.
Using the same $500,000 example,
maybe Walter and Jesse
couldn't find a good product-market fit,
but they are still making say,
$500,000/year in revenue.
What happens in these cases
is that the company
and the convertible note investors agree to
one of the following:
1) Extend the maturity date on the notes and
continue accumulating interest.
This gives the startup time
and a chance to accelerate growth
and maybeto attract a new round of financing,
in the near future.
2) Enter into a repayment schedule,
in which the company will pay the notes
over a predefined period of time
By paying the note in multiple installment
instead of all at once
The company cand afford to pay back
,without going out of business.
So summarizing again,
a convertible note is an investment
with an interest rate, a cap and a discount.
The note is triggered or executed, - Ideally, on a new round of funding.
- Also ideally, if the company gets acquired.
Or otherwise, at a predefined deadline
or maturity date
often 18 or 24 months after the original investment.
At this point, investors can negotiate a note extension,
they can convert it at the Cap,
or they can request a payback,
again, usually if the company can afford it.
Now, YCombinator and 500 Startups
have both designed documents
inspired by the original convertible notes,
but even simpler to execute,
which means
you can get the money from investors,
and they're free.
The KISS-A (Keep it simple security)
and the SAFE (simple agreement for future equity)
are simplified convertible note templates
that you can use to raise money
and skip som of your lawyer's fees
Again, they both work as a convertible note
but reducing a lot of the paperwork requirements.
And the terminology on this documents
is really the same that we've already discussed,
so by now you should be able
to understand them no problem
You can also download both on our FounderHub site,
and refer to the knowledge base for more details
on completing it.
Alright.
We have videos coming up,
on the process of incorporating a business,
distributing founder stock
and vesting.
Let us know which of those topics
you would like us to prioritize.
And off course,
If you found this useful,
help us out by subscribing and sharing;
and we'll see you next week!