Any early-stage startup looking to raise money needs to understand the type of financing available from angel investors and venture capitalists, and how its choices at this first stage of life may impact the company’s capital structure in the long run.
While the early stage is focused on obtaining genuine product-market fit, the achievement that takes a startup across the line to the “growth-stage,” it also brings specific financing options that will determine its ownership in the future, and specifies who will benefit from the startup’s success.
Understanding capital structure
Investment means purchasing some claim on the firm’s future outcome, or a piece of the pie. We can think of different ways to slice up this ownership, each with its own particular characteristics.
There can be separate classes of claims with differing rights and obligations.
These differing rights are part of a waterfall called the capital structure.
Consider what happens when the company is sold. Let’s say that the buyer paid $10 million to purchase the net assets of the company.
When there are payments to be made to the claimholders, we start with the total amount at the top of the waterfall and make distributions at each layer as we move lower, until we get to the bottom layer. We pay each layer the minimum they are due, or what is available to pay them after making payments to those above them in the waterfall. We then take what is left over and repeat this exercise with the next level down in the capital structure, until we get to the common equity.
The holders of this bottom layer get whatever is left over.
There are two types of class of claims: debt and equity. Debt sits above equity in the waterfall with a higher priority to the resources for distribution, but with a cap on how much they are entitled to receive.
For someone to want to lend you money, they have to be highly confident that they will receive what is due to them (i.e., the return of their original principal along with some payment for your “rental” of their funding, in the form of interest). Since their participation in any distribution of proceeds is limited, we say that return of capital is as or more important than return on capital for lenders .
Consequently, for almost all early-stage companies and growth-stage companies, debt is not available to them. Early-stage companies and growth-stage firms are typically so risky that their capital structure is made up entirely of equity.
There are different types of equity. Common equity sits at the bottom. This is the truly residual piece. Common shareholders bear the greatest risk that there will be insufficient proceeds to pay them anything. Of course, there could be a terrific windfall for them, as well.
Next up from the bottom of the equity ladder is preferred equity. Preferred equity gets paid before the common equity, so it can be more attractive. As we shall see in a subsequent article, preferred equity also may enjoy a liquidation preference entitling it to even more of the distribution, depending on the terms of the financing.
You may have read about Series Seed, Series A, Series B, Series C, etc. financings. Each one of these deals is preferred equity. Subsequent rounds have a higher priority in the waterfall than earlier issues of preferred equity.
Setting value: the priced round
When we speak of raising money, we start with the pre-money valuation: What is the value of the startup before we take in money in the next round?
Consider a startup with a pre-money valuation of $4 million.
Assume that there are 10,000,000 shares of common equity outstanding and no preferred equity, for a per common share price of 40 cents.
If we raise $1 million in a Series Seed round, the post-money valuation will be $4 million plus $1 million, or $5 million. But what is the per share price?
It will depend on how many shares we issue as consideration for the $1 million in new money.
Preferred shares are convertible to common equity under certain circumstances, such as the sale of the company. So, in computing the number of shares of preferred equity to issue, we consider the valuation on an “as-converted” basis.
If the investor agrees that the pre-money valuation of the company is $4 million, then we would sell equity at 40 cents per share for $1 million in proceeds, issuing 2.5 million preferred shares. Now, we would have a capital structure of 12,500,000 shares valued at 40 cents per share, or $5 million.
Note that the new investors would receive a series of Series Seed preferred equity that is senior to the common equity until it is converted. (In addition to the per share price, there will be a laundry list of other terms and conditions).
This is an example of a priced round in which the existing shareholders and the new investors agree upon a per share price for the new money investment. This is the first type of early-stage financing.
The second type of early-stage financing is one in which the existing shareholders and the new investors cannot or will not agree on the number of shares the new money entitles the new investors to receive in consideration. Perhaps the existing investor thinks that the company is worth $10 million and the new investor thinks it is worth $2 million.
The new investors then agree to delay the valuation of the company for the purposes of allocating them equity.
Deferring valuation: forward purchase and convertible notes
When an investor hands money over to the company, he or she receives a security in return. Broadly, there are two types of security for this purpose.
In a way, this is analogous to a forward purchase of priced equity. The investor is obligated to hand over the funds today to receive shares in a Series Seed Preferred deal that will happen at some indeterminate point in the future, at some currently unspecified price. This is known as a SAFE note, popularized by a Silicon Valley accelerator called Y Combinator. It is commonly used, simple, and efficient.
The investor can protect themselves to an extent by including a valuation cap and/or a valuation discount to reflect the higher risk they are taking for investing early in a round that might not happen for a year or two.
A valuation cap is a limit on the pre-money valuation. This effectively imposes an upper bound on the per share price that they will be paying in the eventual Series Seed Preferred financing event.
A valuation discount is a pre-set reduction in the pre-money valuation at which the Series Seed Preferred deal takes place.
So, in a year, for example, when the company does execute a Series Seed Preferred, if the new money is willing to come in at a $5 million pre-money valuation, and the SAFE has a 20% discount, then the SAFE will convert at a $4 million pre-money valuation ($5 million multiplied by 80%). These may be combined to give the SAFE holder the more favourable of the valuation cap or the valuation discount. It all depends on what the SAFE holders negotiate at the term of their placement.
Investors can also opt for a convertible note structure.
Convertible notes are debt securities that convert into preferred equity on certain conditions tied to the execution of a financing event. When the company raises its subsequent round of preferred equity, the convertible notes convert into the same series of preferred. Like a SAFE, they often do so with a valuation cap and/or a valuation discount.
Convertible notes are senior to all preferred equity in the capital structure until these convertible notes convert into preferred equity themselves.
It’s a matter of choice as to which one of these contingently-priced securities the early-stage investors choose.
A subsequent piece will discuss the terms of these transactions.
This is the eighth of a series of articles about startups and venture capital, where we’ll explain some of the concepts people might see discussed in the press. We’d love to hear your feedback.