Convertible Notes, Equity and Startup Funding Explained

If you’re starting your first company, understanding stock, preferred stock, options, convertible notes and other fundraising instruments can be truly overwhelming.

We actually didn’t find a single video that covered this, so here we go.

This is Fundraising for Startups 101.

If you are an early-stage startup in the tech space, and you are looking for money to grow your company, the official term for that would be raising capital.

The most commonly recommended instrument to do so is called a Convertible Note.

However, to understand how those work, we first need to understand how equity (or stock) works.

By the way, if you are lost with one of the fancy words we are about to use, just rewind, or check out the video description for a glossary.

Also, a shout-out to our investors at Carao Ventures, for validating our legaldocuments here.

Ok, so Stock.

You are probably semi-familiar with the term ‘stock.

‘ 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.

Each shareholder, receives a certainnumber of shares of stock.

The number of shares a person or entity owns in the company, divided by the total number of shares that have been issued, reflects that person’s percentage ownership of the business.

That ownership is often acquired with a cash investment, but it can also be acquired through other forms of value contributed, like your hard work.

The percentage owned normally determines a shareholders’ claim on the company distributed profits, (the term used is dividends) and the voting power on certain key company decisions.

But, for you to understand better, use an example of a company we’ll call.

FounderHub.

Let’s say that FounderHub has two founders, who came up with the concept together, and have both committed all of their professional time to develop this business, so they’ll be equal partners.

The Co-founders, Walter and Jesse go ahead and incorporate FounderHub.

Startups are usually incorporated with about 1 million shares of stock.

Why so many? Because it’s complicated to break a share in half.

We’ll get to that in a second.

So, after incorporating, each one of the founders owns 500,000 shares of stock which represents 50% of the 1 million total.

Most startups are incoporated as Delaware C-Corporations, and they just are.

It’s the legal structure that is most familiar to investors, it is easy to set up, it’s easy to manage and is very tax friendly.

So let’s look at a Price Round.

Raising money for stock.

The ‘traditional’ approach towards raising capital is with what is called a “priced round”.

Meaning, a round in which both the founders and the investor are able to agree on an accurate valuation for the company, and so the investor gets shares of company stock in return for his investment.

Let’s imaging that FounderHub starts generating sales, starts operating and things are going very well.

Let’s say they’re selling $10,000/mo, and subscriptions are growing fast, so they decide to raise money.

They calculate a nice round number of, say, $500,000 in investment that they need to raise to accelerate their business, so they seek out an investor.

Remember, companies rarely raise money without traction; we made a whole video about that.

Check it out.

So, how many shares do they offer an investor in exchange for those $500,000? That question really relates to the business valuation.

How much is this business worth? If instead of FounderHub, Walter and Jesse owned, let’s say a car wash its value would be calculated using a multiplier of their revenue or their profits; it’s really, their EBITDA, but who has time to explain what that is? If Walter and Jesse are making $10,000/month, that’s $120,000/year, a traditional business could be worth maybe 1x or 2x this, depending on how profitable they are.

This means that an investor could literally buy the whole carwash business for $250,000 or so (excluding the value of the land or the building).

However, tech startups are different.

Tech startups could have tremendous scale potential and fantastic margins, so it’s extremely hard to measure how large and fas they can grow in revenues and in value.

A software product or an app, for example, can realistically serve millions of customers around the world, with a minimal staff.

Think of Uber, who raised $500,000 on their first round, and are now worth, well, close to $80B of dollars.

They did not need to invest billions of dollars on buying a car fleet, for example.

So the value of a tech startup is not related directly to their current assets or revenues, but to their upside potential, their capacity to innovate and transform those innovations into value.

Some variables to take into account here are: – The addressable market size.

So, how many customers are there for the company to serve and how much would they be willing to pay for this product or service.

– The technology variable Is there a unique piece of tech that nobody else has, or that optimizes a process drastically? – Potential margins.

How much does it cost me to serve an additional customer? For example, when Instagram had 300 million users, their staff was only 13 people.

However, all these numbers are variables andestimates, and nobody really knows for sure.

But based on them, along with some credible early results, the valuation of the startup is defined by how much potential an investor sees in the business, how risky it is, and how much upside do they expect in exchange for risking their money, just like a bet.

So, these days, an average valuation in Silicon Valley, for a tech company like our theoretical FounderHub would be around $4million pre-money valuation.

Again, assuming this is a high-scale, high-margin business, not the car wash.

So, let’s say that Gus, our investor, accepts these terms, and then he is willing to purchase a $500,000 chunk of this business, as an investment.

Simple math tells us that if the full company is worth $4 million, then $500,000 would represent about 11% of this company.

We are gonna dig deeper into this.

Remember Walter and Jesse both have 500,000 shares of this business.

Shares of stock Typically, the original shareholders do not transfer or sell their shares, what’s gonna happen is the company will issue new shares to Gus.

In businesses stock rarely changes owner, unless the business is actually acquired.

On the contrary, companies often issue new stock, which dilutes the original shareholders percentage ownership.

I’m gonna explain this in the easiest of ways.

Let’s say that if Walter and Jesse had one share each, they would each own 50% of a 2-share business.

If the company issues a new share of stock to Gus, then everybody still has one share, but it’s no longer 50% of the business, it’s 33% of it.

So, in this case for the math to work, FounderHub will issue 125,000 new shares of stock to Gus.

When the company does this, it will no longer have 1 million shares, it will have 1,125,000 shares.

So, Walter and Jesse will still own 500,000 shares each, but they no longer represent 50% of the business, but around 44.

4% of it.

The new 125,000 shares issued to Gus now represent 11.

11% of the company.

The post-money valuation of FounderHub is now $4,500,000.

And this is why we had 1 million shares to start with, so that we don’t have to issue fractions of shares.

If the company would have been incorporated with only 100 shares, for example; 50 for Walter and 50 for Jesse.

then it would have had to issue 12 or 13 stocks to Gus, so we’d need to round up or down.

That round up could be worthless now, but a 0.

01% equity stake in a company like Uber that’s actually $8 million today.

Now, the challenge with raising money this way, a priced round, is that there are a lot of things to figure out, for example, How many votes does each share get in certain discussions? Usually, the standar is that you get one vote per share, but investors will often want more control over certain key company decisions considering that’ll have a minority ownership in the company.

If the company goes bankrup, for example, and needs to liquidate assets, do investors get paid first? That’s another thing, that you’ll have to agree on, on a price round.

Also, how does the Board of Directors look? Investors will also want to control a seat and to protect themselves against being removed from the Board.

Now, all of these decisions require negotiations, and lawyers, and signatures to be put in writing, and they can make the process take six months or more from the verbal ‘agree to invest.

‘ Since most early companies don’t have six months, they often choose to go with a Convertible Note.

By the way, If you want to run your own calculations on this, you can download the free template we added at FounderHub.

Io A link is available below.

CONVERTIBLE NOTES A convertible note is an instrument that delays the valuation conversation, and it allows the company and the investor to agree and move forward on the investment much faster, with less negotiation, and fewer complicated and costly legal expenses.

A convertible note works a bit like a loan, but instead of using an asset like a house for collateral, the company stock is the collateral at a valuation for the company that is going to be decided in the future.

This means, obviously, that the investor also needs to believe in the business in order to invest, because it is the intention of the investor to convert this note into actuall company stock.

Like I said before, defining a company valuation is very tough.

Too many uncertain variables, too little data.

so with a convertible note, the investor is, is basically saying: I’ll give you the money to grow now.

In a year or so, we should have the data to support a priced, traditional funding round, so my investment will convert then, using a formula that would be based on the valuation and terms that the company and the investors define for such future priced round.

So, as you can see, convertible notes could have some terms that can be hard to grasp, so we’ll explain all of them through examples.

So let’s take case A.

Walter and Jesse take the money from their first investor, Gus, on a convertible note.

With the money they grow as expected, their business looks very healthy and promising and one year later they manage to attract a new investor, Madrigal, who is willing to invest $1 million on a priced round that values the company at $5,000,000.

When this new investment comes in, the convertible note with Gus is triggered.

Now, to compensate the original investors for believing in this company early on, notes have an interest rate, and a discount.

The interest rate is usually 5%-6%, and the discount is 10-25%.

That is a discount on the valuation set by the new investor.

In this case, again, Gus invested 1 year before Madrigal’s round, so he’s earned about $25,000 in interest.

When the day comes, to close the legal paperwork, Gus would be converting $525,000 at a $4MM valuation instead of the $5MM valuation that Madrigal got (that’s the 20% discount).

After the note converts Madrigal then invests their $1,000,000 at the $5,000,000 million valuation.

And the new company distribution would look something like this: Let’s look at another scenario, this is scenario B where the company grows tremendously fast.

In a couple of years, FounderHub finds a new investor that values the company at $50,000,000.

Even with the 20% discount, Gus’ valuation to convert is $40,000,000 so that original $500,000 investment plus interest, would translate to lessthan 1.

5% of the company.

The risk/upside tradeoff that was taken by Gus by investing early, was not compensated in this investment for Founderhub.

This is why notes have a Valuation Cap.

This Cap is a maximum valuation at which the note will convert.

Let’s say the agreed Cap in this case, for this investmen was $7MM.

So, what would happen is that, while the new investors will invest on a company valued at $50,000,000, Gus will convert his note at the Cap, resulting in a ~6x paper return on Gus’ investment.

Which is, not bad at all… and the company would look likethis: By the way, the same mechanism would apply if the company is acquired, while the the convertible notes are still withstanding.

The convertible notes would trigger theirconversion in order to participate in the sale of the company.

Allright, so let’s look at a scenario C, our third scenario, the one that is less frequently discussed: what if the company doesn’t grow? If the company can’t raise additional round of funding.

So, if the company doesn’t manage to show traction, and attract new investors, and in this case, There’s a maturity date, for the Convertible Note.

This is a date, in which Convertible Note owners can convert their notes and interest at their Cap that we just discussed, or request a payback from the notes.

Investors will probably request a convertible note payback only if the company can really afford it.

And, maybe they believe that converting at the Cap is too expensive a valuation for what the company has become.

If the company can’t afford to pay back the notes, and the investorsexecute them, the startup will probably need to file for bankruptcy.

The investors will also lose most or all of their money, since the company doesn’t have the assets to pay back the notes.

Using the same $500,000 example, maybe Walter and Jesse couldn’t find a good product-market fit, but they are still making say, $500,000/year in revenue.

What happens in these cases is that the company and the convertible note investors agree to one of the following: 1) Extend the maturity date on the notes and continue accumulating interest.

This gives the startup time and a chance to accelerate growth and maybeto attract a new round of financing, in the near future.

2) Enter into a repayment schedule, in which the company will pay the notes over a predefined period of time By paying the note in multiple installment instead of all at once The company cand afford to pay back ,without going out of business.

So summarizing again, a convertible note is an investment with an interest rate, a cap and a discount.

The note is triggered or executed,- Ideally, on a new round of funding.

– Also ideally, if the company gets acquired.

Or otherwise, at a predefined deadline or maturity date often 18 or 24 months after the original investment.

At this point, investors can negotiate a note extension, they can convert it at the Cap, or they can request a payback, again, usually if the company can afford it.

Now, YCombinator and 500 Startups have both designed documents inspired by the original convertible notes, but even simpler to execute, which means you can get the money from investors, and they’re free.

The KISS-A (Keep it simple security) and the SAFE (simple agreement for future equity) are simplified convertible note templates that you can use to raise money and skip som of your lawyer’s fees Again, they both work as a convertible note but reducing a lot of the paperwork requirements.

And the terminology on this documents is really the same that we’ve already discussed, so by now you should be able to understand them no problem You can also download both on our FounderHub site, and refer to the knowledge base for more details on completing it.

Alright.

We have videos coming up, on the process of incorporating a business, distributing founder stock and vesting.

Let us know which of those topics you would like us to prioritize.

And off course, If you found this useful, help us out by subscribingand sharing; and we’ll see you next week!.

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