An Introduction to Startup Finance and Convertible Notes
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Transcript of An Introduction to Startup Finance and Convertible Notes
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STARTUP FINANCING 101Prepared for Cornell’s Entrepreneurship CWG 2015
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SOME BASIC TERMS Fully diluted: Taking into account all outstanding shares, including those
that may have not been exercised yet Options pool: Pool of equity set aside for new hires Post-money: A company’s value after receiving a round of funding Pre-money: A company’s value prior to receiving a round of funding Prorata rights: Right to partake in subsequent rounds of funding to
maintain ownership % Vesting: Period of time over which equity accrues Vesting Cliff: Period of time before vesting begins
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BRIEFLY ON VESTING Early employees at a start-up may receive some portion of their
compensation in the form of equity, drawn from the options pool (more on this later)
Typically this equity needs to be earned, and is a reward for effort and commitment. This is handled through a vesting schedule – note that founders can also be put on vesting schedules
A typical vesting schedule will include: the amount of equity, the period of time over which is accrues, and any period before normal vesting begins (the cliff)
For example a vesting schedule might be: 5% over 4-years, monthly, with a 1-year cliff This means my 5% will accrue monthly over the next four years, except in the
first year At the end of my first year, my cliff period, I will accrue the entire years worth of
equity at once: 1.25% and 0.104% monthly thereafter
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SOME FUNDING EXAMPLES If Investor A wants to invest $1M for a 10% stake in your company:
You have a post money valuation of: $1M/10% = $10M You had a pre money valuation of: $10M - $1M = $9M
Say you started the company with 900,000 shares (sole ownership) issued at a nominal price of $0.01/share Investor A would get 100,000 shares [0.1(900,000+X)= X] at $10/share Your portion grew from $9,000 to $9M!
Then Investor B comes in and purchases 10% for $2M ($20M Post, $18M Pre) B would be issued 111,111 shares [0.1(1,000,000+X)=X] at $18/share Your portion is now worth $16.2M, but you only own 81% of the company A’s portion is now worth $1.8M and owns 9% of the company
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ANOTHER EXAMPLE Options pool: Investor A wants to invest $1M for a 10% stake in your company,
but includes a provision for a 15% fully diluted post money options pool For a $10M post money valuation, there needs to be a $1.5M option pool pre-money This takes your pre-money valuation from $9M to an effective $7.5M
How much stock is issued (assuming you start with 900k)? 300,000 [0.25(900,000+x)=x] new shares have just been created for a total of 1.2M
shares 120,000 shares (10%) are issued to Investor A at $8.33/share, compared to the
$10/share paid in the same case without a pool. For A, this is essentially the same deal as $833,333 for 10% without a pool ($7.5M pre, $8.3M
post) However in this case you would truly only be diluted 10% as opposed to 25% with a pool
180,000 shares are set aside for the options pool (15%) You now own 75% of the company valued at $7.5M
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ONE LAST EXAMPLE Prorata example: Investor A owns 10%, and your company is raising a
$10M round at a $50M post money valuation (20% ownership up for grabs). Case 1: Investor A did not have prorata (or chose not to exercise it)
Investor A would be diluted to 8% ownership and the company would be split: 72% founder, 20% new investors, 8% A
Case 2: Investor A did have prorata and chose to exercise it Investor A will need to purchase an additional 2% equity to maintain 10%
ownership. This comes out to be 10% of the round (2/20) or an additional $1M. Note the percentage of the round is equal to Investor A’s current ownership stake.
Ownership is now: 72% founder, 18% new investors, 10% A
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CONVERTIBLE NOTES
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CONVERTIBLE NOTE TERMS Convertible note: a loan that converts into equity upon a subsequent
priced round; really only seen in angel and seed rounds Discount rate: The percentage off of share price that the note converts Valuation cap: The maximum price at which the loan converts into
equity In the notes where both a discount rate and a valuation cap are
included, the more favorable terms (for the investor) will be used Interest rate: Convertible notes are loans, so there will be an interest
rate and it will apply towards additional shares Maturity date: Date by which the company needs to pay back the note,
if unconverted, but investors will likely extend it if needed
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CONVERTIBLE NOTE EXAMPLE This is just one of the many ways a convertible note could be handled Assume we have a note for $100,000 (inclusive of interest) that converts with a
20% discount and a $5M pre-money cap from Angel C, and 1M shares outstanding
Investor A wants to purchase 10% of our company for $1M First we check what our discounted price/share is:
Let P be the price/share for Investor A Therefore Angel C will pay 0.8P (20% less than A) The number of shares that Investor A will get is then: $1M/P, and our angel will get
$100,000/0.8P Let T be the total number of shares after the round is closed We know that Investor A will own 0.1T shares in the end (10% of the company), and
Angel C along with the founders will own the remaining 0.9T
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CONVERTIBLE NOTE EXAMPLE CONT.
Thus we have two unknowns and two equations:1.
Solving these two equations we get: P= $8.875, 0.8P= $7.10 and T= 1,126,760 Now we need to check our capped price
Take the cap and divide it by the number of outstanding shares: $5M/1M shares = $5/share
We see that our capped price per share is less, so we apply those terms Founders remain at: 1,000,000 shares Angel C gets: $100,000/$5.00 = 20,000 shares
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CONVERTIBLE NOTE EXAMPLE CONT.
Now, Investor A won’t end up paying $8.88/share, because it would result in less than 10% ownership because Angel C converted at such a favorable rate
Instead, we calculate the total number of shares Investor A needs to own 10% of the company: 1,020,000 = 0.9T; T= 1,133,333 Then 1,133,333-1,000,000-20,000 = 113,333
Investor A receives then 113,333 shares at $8.82/share Our final breakdown is then: 88.2% founders, 10% Investor A, and 1.76% Angel C
If the note was uncapped, we would have just used the numbers we found solving for the discounted rated, and ended up with 88.7% founders, 10% Investor A, and 1.2% Angel C
The difference doesn’t seem like much, but with the cap in place Angel C received a 44% discount compared to the 20% on the note
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SOME BROAD GENERALIZATIONS
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THE DIFFERENT FUNDING ROUNDS Angel/Pre-Seed:
Company is extremely early stage, somewhere between an idea and a rough prototype Individual investors Median check size is roughly $600k usually in the form of a convertible note
Seed Company is on the path towards product-market fit and prototyping Company might be hiring a few additional employees outside of founders Can be a mix of individual and institutional investors Average check size is ~$750k-$1M could be a note but could also be priced
Series-A At this point product market fit has been solved, and business model is taking shape The funding here will go towards scaling operations
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THE DIFFERENT FUNDING ROUNDS CONT.
This is the first institutional only round Rounds are likely between $3M-$7M and priced
Series B All about growth and scaling Institutional rounds raising $10M+