Commentary

Funding: structure, post #7 of “Startup Briefs”


Raising money for a startup is hard. It takes a long time. It is distracting, meaning that you might not advance your business since you will be spending so much time fundraising. And, finally, you may not be successful, in which case you are worse off than before: you’re even higher risk, you haven’t progressed the business, and you probably have no cash.

The best advice that I can offer is to make sure that you know what you are getting into. That’s why it’s important that you understand the basics of debt, equity and dilution over time and multiple rounds. These are the subject of this post.

Debt. Tech startups have no assets and cannot raise straight debt from a traditional bank. The main debt instrument for startups is convertible debt. We’ve discussed some uses of convertible debt in an earlier post (Funding, the ABCs, post #5 of “Startup Briefs”). Put simply, convertible debt is a loan that is meant to convert to equity. It is one of the most common investment mechanisms for economic development organizations (non-profits, often called TBEDs for Technology Based Economic Development organizations). Many angels use convertible debt. One of the main reasons is that it delays the decision/discussion/argument about valuation. It’s a loan that will convert to equity when someone else, often a more sophisticated investor, like a VC, determines valuation. At the time of conversion, the convertible debt investor generally gets a discount on that newly determined valuation because they invested earlier, ie, at a higher risk time. Convertible debt has pros and cons, but the key benefit is that it maximizes flexibility for the startup while not hurting the investor.

In recent years, convertible debt has become less popular because of some of the complexities of the agreements. Like any debt, convertible debt accrues interest and this makes it challenging to include in a capitalization table when you don’t know exactly when the conversion will occur. Also, which party has the right to convert? Can the company force conversion? Can the investor force it?

Y Combinator, the Silicon Valley accelerator founded by Paul Graham, articulates other disadvantages of convertible debt:

“Debt instruments have maturity dates, are typically subject to certain regulations, create the threat of insolvency, and can include security interests and sometimes subordination agreements, all of which can have unintended negative consequences for startups.”

As a result, Y Combinator developed the SAFE (Simple Agreement for Future Equity) to address some of the problems with convertible debt agreements while preserving the flexibility that it offers. SAFE is not a debt instrument so it avoids the issues associated with debt. It basically avoids valuation except that it puts a cap on the valuation. This means that when someone converts their investment down the road they have the right to convert at the agreed-upon cap even if the valuation of the company at the time of conversion is higher.

Equity. Buying shares (or selling shares) of a startup is very similar to the public markets (NYSE, NASDAQ). An investor buys a share at $x price, which represents y% of the company. Very few early stage entrepreneurs that I have met understand the basics of equity and dilution. As a result, here goes the lecture.

dilutionIt’s important to understand dilution from the point of view of rounds. In the beginning, the founders own $100% of the startup. What is that worth? We can argue about this offline, but here I will posit – not much. Great, so you own 100% but it’s basically worthless.

Value starts to build as you do many things: build a team, create product, have customers, develop intellectual property and so on. Value is also partially correlated to investment dollars as I will show in the following examples.

 

1st round. I am calling thisRound 1 dilution series A, for simplicity sake, although you might think about this as being seed money. Investors invest $500K at a pre-money valuation of $1M ($1 per share). What percentage do they own of the company? As depicted, post-money, the investors own one-third or 33%, which translates to a post-money valuation of $1.5M. Who determined that valuation? It’s likely a combination of investor/entrepreneur. It’s a negotiation. It’s an art, not a science. There is no magic, exact valuation for a startup. It all depends, of course, on the risk.

Now, note that the founders are diluted from 100% to 66%. Is this good or bad? Given that there is now a clear valuation of the company (at least on paper) this is a good thing. Whereas before, the founders owned 100% of something worth next to $0, now they own 66% of something valued at $1.5M (or $1M).

 

Round 2 dilution2nd round. Time passes. The company needs more money. To keep the math simple, let’s look at a flat valuation for a second round. We know that the post-money valuation from the previous round was $1.5M. The new investors come in for $1M, purchasing shares at the same price as the previous round investors. What percentage of the company do they buy? They end up with 40%; the founders also get diluted to 40%. But the first round investors get diluted from 33% to 20%. They are not happy. Now, if they were sophisticated, they would have an anti-dilution clause in their investment agreement, a term covered in the previous post.

I ask you, what is wrong with this round? What did NOT happen? The valuation did not increase. There was no step up. Which means what? If the value of the business did not increase, then certain things didn’t happen: the business failed to meet revenue projections, develop customer pipelines, build a team, etc. Thus, the valuation stayed flat.

 

Round 2 with uptickWhat happens if the value did go up? That is the scenario below. The price per share actually doubled and the new investors ended up buying only 25% of the venture. This leaves the first round investors with 25% of the business and the founders at 50% – all at a post-money valuation of $4M (which means that their pre-money valuation was $3M).

This is the way it is supposed to work. The entrepreneur and his/her team build value. The valuation of the company rises. Each financing round has a step up in value.

 

 

Round 2 down roundBut sometimes bad things happen. What happens when the value of a venture goes down rather than up? That is depicted below. Instead of selling shares at $1, the price is only $.50. Maybe the CEO died or was fired? Maybe the product didn’t work? Maybe customer adoption proved to be more challenging than anticipated? There are a host of reasons that this might happen. But when it does, it’s scary. The second round investors come in with $1M and swoop up $57% of the company. Founders are diluted to 29% and first round investors to 14%. Unless of course they have anti-dilution, in which case the pain is borne by the founders.

 

 

Conclusions. Down rounds are one of the reasons that convertible debt became a viable alternative to priced rounds for straight equity. You can do either, it’s up to you, but know what you are doing before you start. Talk to other entrepreneurs who are either currently raising money or have just closed. Ask them about their experiences and what they recommend. They are in the trenches too, maybe just one or two trenches away from where you are, in the front line.

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