It can be overwhelming to understand the stock, preferred stock, options and convertible notes, and other fundraising instruments when you are starting your first company.
This is why I prepared this fundraise for startups 101 blog post…
If you are an early-stage startup in the tech space and looking for investment to grow your company the official term for this is “Raising Capital”. Especially at the early stage, the most common instrument to do is the “Convertible Note (SAFE for Y-Combinator)”.
To understand how the convertible note works, we first need to understand how equity or stock works.
You are probably familiar with the term stock. Basically 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. The percentage owned normally determines the shareholder’s claim on the company’s distributed profits. The term used here is “Dividends”. And also the voting power in certain key company decisions.
Now let’s use an example for you to understand it better.
Imagine a startup named “Enterprise” and it has two founders who put their professional time into this business as equal partners. The co-founders T. Kirk and Spock incorporated Enterprise.
Startups are usually issued about 1.000.000 shares of stock at the beginning.
Why so many? Well because it is complicated to break shares in half and I will get to that in a second.
After incorporating, each one of the founders owns 500k shares of stock which are equal to 50% of 1M total Let’s have a look at raising money for the exchange of a stock situation. The traditional approach for raising capital is called “Priced Round”. This means both the founder and the investor are able to agree on an accurate valuation for the company. So by that way, the investor gets shares of companies stock in return for his investment.
If we turn back to our company, let’s assume that Enterprise starts generating sales and things are going well for this startup. Let’s say they are generating 10k per month revenue and they are growing fast. So founders decide to raise money to scale up the business. They calculated a number of 500k USD in an investment that they need to accelerate the business and start looking for an investor.
Disclaimer! Companies rarely raise money without traction.
So the question is “how many shares do they offer an investor in exchange for that 500k USD?”
That question really relates to “Business Valuation”. In other words how much is the business worth? To understand it better let me give you an example.
If Kirk and Spock established a restaurant business instead of a tech company called Enterprise, then its value is calculated using a multiplier of their revenue or their profit. Kirk and Spock are making 10k months in this restaurant business that’s 120k a year. A traditional business can be worth 1X or 2X depending on how profitable they are and will be. (Excluding land or the building)
This means an investor can literally buy the whole restaurant business for 250k USD. However, tech startups are different!
They can have tremendous scale potential and fantastic margins.
Because of this, it is extremely hard to measure how large or fast can they grow iğn revenue or value. A software product, for example, can serve millions of customers around the world with minimal stuff.
Think UBER, they raised 500k in their first round and are now worth close to 80 billion USD.
So the value of startups is not directly related to their current assets or revenues but to their future potential, a capacity to innovate, and the ability to transform those innovations into value. While evaluating a startup some values are taken to account of course. For example, the “Addressable Market Size” means how many customers are there that the company serves and how much will they be willing to pay for this product or service? Then their “Technology Variable”, is there a unique piece of tech that nobody else has or optimizes a process drastically? Then “Potential Margin”, how much does it cost to serve a customer?
However all these numbers are variable and estimated and it is impossible to know for sure but based on them the valuation of the startup is defined by how much potential investor sees in the business, how risky it is and how much they are willing to gain in exchange if risking their money. Just like a bet!
So these days average valuation in silicon valley for a tech company could be around 4 million USD pre-money valuation. Don’t forget it is high scaled businesses, not the restaurants.
Now let’s turn back to the investment side. Our investor Pike accepted the terms and then he is willing to purchase a 500k USD chink of this business as an investment. Simple math tells us that if the full company is worth 4M USD then 500k represents 11% of the company.
So remember Kirk and Spock 500k shares of the business. Typically the original shareholders do not transfer or sell their shares. The company issues new shares for the investor Pike. In companies, stocks rarely change their owner, unless the business is actually acquired. In this case the company issue stock which dilutes the original shareholders’ percentage ownership.
What if the company issued 1 share for each founder?
To understand it better look below; Let’s say, Kirk and Spock had 1 share each which means they each own 50% of a 2 share business. If the company issues a new share of stock to Pike, then everybody still has 1 share but it’s no longer 50% of the company to the founders. It is 33% of it.
In our company Enterprise, the math to work is to issue 125k new shares of stock to investor Pike. When the company does this it is no longer 1M shares. The company will have 1.25M shares. So Kirk and Spock still own 500k shares each but it will no longer represent 50% of the business. It will be around 44% of it. The new 125k share issued to Pike now represents 11% of the company (remember 500k USD is 11% of the 4M value company) Post-money valuation is now 4.5M USD This is why we start with a million shares at the beginning. So we don’t have to issue the fractions of shares.
Think that, if the company would be issued let’s say 100 shares at the beginning, 50 shares for Kirk, and 50 shares for Spock then it would have to have to issue 12 or 13 stocks to Pike. We would need to round up or down.
Today rounding up could look worthless but a 0.01% equity stake in a company like UBER is worth actually 8M USD today.
What more to figure out?
Now the challenge with raising money this way is a priced round there are a lot of things to figure out.
For example how many votes each share represents in certain discussions. Actually, the standard is you get one vote for a share. But investors often want more control over certain key company decisions because they have minority ownership in the company.
Also, how does the board of directors look is very important for investors?
They would want to control a seat and wants to protect themselves against being removed from the board. All of these decisions will require negotiations, lawyers, and signatures to be put in writing and they can take a process up to 6 months or more.
Since most startups don’t have 6 months they often chose to go with a convertible note (SAFE). It is an instrument that delays the valuation conversation and allows the company and investor to agree and move forward on the investment much faster with less negotiation and fewer complicated costly legal expenses.
Defining the company valuation is tough. There are too many uncertain variables and too little data. So in the convertible note, the investor is basically saying “I give you the money to grow, in a year or so we should have the data to support a priced traditional funding round. So my investment will convert then”
This story will continue….