Startup funding can be a complex process for founders and first-time investors. For founders, it is a tussle over the right to protect their equity and company. For the venture capitalists, it's a tussle to secure high-yield investment portfolios.
So how do founders escape this sticky situation, raise the needed funding and not sell their future away?
The funding process
Let's talk about Seed and Series A.
When you decide to raise your very first round of investment, you are hoping to raise a seed money investment. At the seed stage, although there is some growth, the investor is not really investing in the idea, they are investing in the team. So how does this seed funding work?
Read this interview with a Nigerian early-stage investor
First off, at incorporation the company will issue shares, to be split between the co-founders. For instance, the company issues 100,000 shares, for example, split 50/50 between both founders.
Now assuming an investor decides to invest $20k for 20% of the company. they get 20,000 shares issued by the company. The founders' shares, on the other hand, will be diluted to represent their new 40% stake in the company.
That means if 20% of the company is now worth $20k, 100% of the company is now worth a post-money valuation of $100,000.
A year has passed and the company wants to raise another round of funding. This is known as Series A funding. The two main types of investors at this stage are angel investors and venture capitalists or VCs. As you did the last time, you reach out to prospects and potential investors.
But before any money or equity is exchanged, you first need to talk about valuation. This is important because whatever funds they invest in, will be added to the pre-money valuation to become your post-money valuation.
Pre-money valuation refers to how much your startup is valued before you received investment. Post-money valuation refers to how much your startup is going to be valued after raising capital.
The proposed post-money valuation divided by the series A investment is equal to the investor’s share in your startup.
Naturally, investors want a low post-money valuation so that they can get a bigger share in the company. Founders, on the other hand, want a high post-money valuation so you will not have to give up too much of the company.
Both parties agree on a post-money valuation of $4 million, and the lead investor decides to invest $200k, while the other investor puts in $100k. This means the new investors have a combined 13% stake in the company now.
Before both co-founders and the seed investor owned 100% of the company, now they own 87%. You and your cofounder now own a combined 67% of the company.
Just like the last time, you do not have fewer shares than you had before the investment round. The company just issues new shares to the new investors commensurate to the percentage stake owned. So, if 125,000 shares are now only 87%, that means the company will now issue 16,000 new shares for the Series A investors.
The later funding rounds, usually Series B, Series C, and Series D follow the same format and process as the Series A capital raise. This will go on and on till a bigger company buys you out, or you decide to list as a public company.
But don't get too excited yet.
Startup funding goes beyond just capital raises. The Term Sheet, which lists all the binding obligations may contain clauses that may limit or even take away your equity altogether.
Complex terms you'll come across in a term sheet
A term sheet is a bullet-point document that includes the important terms and conditions of a deal. It summarises the key points of the agreement set by both parties.
Most founders seeing this document for the first time just want to sign it off and be done with it. This is an example of a term sheet from Y-combinator.
However, it is important to take time out to read it. A term sheet can dictate how you enjoy seeing your startup grow. It outlines the key terms of your deal with investors. Here are some of the key terms you should look out for in a term sheet:
- Classes of Shares: First of all, there are different classes of shares and they serve different purposes. Some shares give the holders less voting rights than original shares. A term sheet may provide for the creation of Class B shares, which may have less voting power than original shares, which will be now Class A.
- Preferred Shares: Another related type of shares is preference shares. It has more weight than regular equity and holders of preferred shares have more claim to the company’s assets than regular shareholders.
- Liquidation Preference: by including a liquidation preference, venture firms try to protect their investments from risks. Liquidation preferences make sure that these ventures get their investment before other shareholders. It also ensures that they get paid first in the event of a liquidation, a bankruptcy, or a sale. In the event of liquidation, this can be of great implication. Preferred stock includes:
. Cumulative. This means that in the event expected dividends are withheld, they are considered dividends in arrears and must be paid before any other dividends.
· Participating. This is preferred stock that has a fixed dividend rate. If the company issues participating preferred, those stocks gain the potential to earn more than their stated rate. The exact formula for participation will be found in the prospectus
· Participating preferred stock: provides a specific dividend that is paid before any dividends are paid to common stockholders. It takes precedence over common stock in the event of a liquidation. The holders are also entitled to receive shares with the common stock (on an as-converted to common stock basis) in any remaining liquidation proceeds after they have already gotten back their liquidation preference.
· Non-participating preferred stock: limits the amount of dividends paid to its holders. This usually means that there is a specifically-mandated dividend percentage tied to the stock. The investor, therefore, has a stated liquidation preference.
- Capitalization Table: A cap table is, in essence, an overview of the total capitalization of the company. It is typically created and stored in a spreadsheet. The cap table is one of the most critical documents for a company. It tracks the equity ownership of all the company’s shareholders and security holders, as well as the value assigned to this equity.
- Redemption rights: With this clause, investors have a right to demand redemption of their stock within a specific window of time. The way the redemption is done can create a time bomb that creates a liquidity crisis for a startup.
- Drag-along: this clause is important in case an investor becomes the majority shareholder. It prevents any situation in which a minority shareholder can block the sale of a company approved by the majority shareholder. This can be very bad for as a founder, to see someone come in and force the sale of your startup.
- The right of first refusal: this protects the investor in the case of new stock issuance. It offers them the right to buy more stock directly in the company.
- No-shop clause: prevents the company from asking for investment proposals from other parties. This gives the investor leverage, as it prevents you from shopping around for better terms.
- Founder Vesting: this makes it hard for a founder to leave the company after it has been bought by putting shares at risk. As a founder, you already have done a lot and should be rewarded for it. Therefore negotiate a vesting program that works. It is not unreasonable to exclude part of your holding from this arrangement.
Three things to look out for at every funding round
- Dilution: Remember when I said that all shares will be diluted proportionally when there is a new capital raise and everybody gets to equally share the burden? Well… you see that is not always the case. Investors and even your co-founder (remember Eduardo Saverin from Facebook?) can include anti-dilution clauses in the term sheet. Basically, if everyone protects themselves and you are not proactive enough, you’ll take the hit on your own.
- Voting Rights: These are the rights of certain shareholders to vote on matters of corporate policy. While fundraising, you can create a new class of common stock that will grant equity but reduced or even no voting rights at all. This term is very important because a vote is a say in how the affairs of the company should be run.
For example, say that the term sheet for a preferred share deal stipulates that approval of a preferred majority is required for any company actions. That would mean that your preferred shareholders have a veto on virtually all the company wants to do.
As a founder, it is imperative that you watch how voting rights are split every time you raise money.
- Board Rights: this is a group of individuals chosen to represent the interests of the shareholders in the company. Its mandate is to establish policies for corporate management and oversight. It also sits on major corporate decisions. So who determines who sits on the board?
In the case of startups, it is the founders, investors, and other people like advisers. But, all votes are not equal. The number of votes a shareholder gets is ultimately determined by both the number of shares he owns and the class of shares.
It is critical to make sure that you understand the importance of the board’s decision-making and the impact of the proposed structure and provisions.
An example of a founder-friendly board structure is 2-1 with two founders on the board and one investor. A riskier example would be 2-2-1 with two founders, two investors, and one independent board member. Because if you lose control over the board, you effectively lose control over your company.