To be honest, Almost everything I know about raising funds is because of stories like this one from Buffer (How they raised 3,5 millions in funding)
So I decided to take a step forward and learn a few things about the basic glossary that any entrepreneur should manage about an Investment Term Sheet, at least for a first meeting with a potential investor.
Here is what I learned :)
Pre-money Valuation = Post-money valuation – Venture Capital Investment
Valuation of a company: Simply the value of the company before an equity investment is made
Post-money Valuation = Venture Capital Investment/Venture Capital Ownership Percentage
Post-money valuation of the company: Value immediately after the investment.
Determine share price by the following equation:
Share Price = Pre-money Valuation/Number of Pre-money shares.
You can determine how many shares to issue the venture capital firm by this equation:
New Shares Issued = Venture Capital Investment/Share Price
Investment Structure (Angel or Seed Round):
Shares are offered at a price per share agreed upon by the company and investors. Investors receive shares with the same voting rights and the same terms as founders and employees holding stock options.
Convertible preferred shares:
A convertible preferred share investment provides investors (VCs and angel investors) with an ownership position in the startup, at a price per share agreed upon by the company and investors.Preferred shares tend to be issued in series, with a separate series (A, B, C) denoting each round of investor financing.
These types of investments appeal to the widest audience of potential sophisticated investors
- Convertible debt: Involves the investors loaning money to the company, with the loan amount being convertible into equity shares of the startup. The principal advantage of this structure is that the parties can defer fixing a valuation on the enterprise until a future financing round. When the future round is complete, the debt converts into equity shares at the purchase price determined at that time, sometimes subject to a 10% to 25% discount to reward the angel for investing early.
- Safe: A safe is a Simple Agreement for Future Equity. An investor makes a cash investment in a company, but gets company stock at a later date, in connection with a specific event. A safe is not a debt instrument, but is intended to be an alternative to convertible notes that is beneficial for both companies and investors.
Uncapped Notes vs. Capped Notes
These terms relate directly to the previous discussions of Investment structure. As discussed, convertible notes delay placing a valuation on a company until a later funding round. When entrepreneurs and investors agree to a “capped” round, this means that they place a ceiling on the valuation at which investors’ notes convert to equity.
If a company raises $500,000 in convertible notes at a $5 million cap, that means that investors will own at least 10% of the company when it raises a later round of funding (500,000/5M). An uncapped round, more favorable to the entrepreneur, means that the investors get no guarantee of how much equity their money purchases. Let’s say the same company raises $500,000 in an uncapped round. If they’re able to convince new investors to value their company at $10 million, convertible note investors are instead left with just 5% of the company.
Pro-rata rights refer to the right of investors to participate in later funding rounds so they can maintain the amount of equity they own in a company.
A Company raises a $5 million Series A round from an investor at a $20 million post-money valuation, leaving that investor with 25% of the company. In a later round, the company brings in other investors at a $100 million valuation. In order to maintain a 25% stake, the investor needs to throw in another $20 million, otherwise they would be left with just 5% of the company. Pro-rata rights obligate the company to leave space in subsequent funding rounds so investors can avoid such dilution.
Key Economics Terms
- Quantifying the preferred return: Preferred returns represent an amount that the start-up must return to the angel before it distributes any assets (payments) to other stakeholders. With angel deals, this amount should generally not exceed the original investment amount, and founders should negotiate any term sheet that proposes a different formula.
- Quantifying any accruing earnings: Accruing returns can take the form of accrued dividends on equity shares, or of an accrued interest rate on convertible debt. It is rare in angel deals that such interest would actually be payable in cash. Rather, such amounts accrue and are converted into equity shares at the same time as the principal amount of the loan, most commonly the rates vary between 5% and 12%.
The venture capital (VC) industry uses due diligence to describe what the investor does to evaluate a potential investment opportunity. Due diligence is a rigorous process that determines whether or not the venture capital fund or other investor will invest in your company.
There are three states of Due diligence:
- Screening due diligence: The opportunity is determined to “fit” the fund’s investment criteria
- Business due diligence: Tends to involve reviewing the management team, market potential, the product or service (and the need it meets) and the business model.
- Legal due diligence: Once the fund has reached the stage of moving toward a favourable decision, their lawyer will complete a legal review.
So far with SlidePick we have been working bootstrapped and has been quite a ride! But anyday soon we will need to take our Startup to the next level, and starting to get familiar with these terms has been very useful.
I think almost everything you should know (in the theory) about raising capital can be found here. The guys from MaRS have done an amazing job explaining this topic.
My only advice on this is:
P.S. If you found value in this article, it would mean a lot to me if you hit the share button. I would love to hear your comments! Let’s connect at @mati_honorato or firstname.lastname@example.org.
Any grammar, spelling or punctuation mistake, please let me know. So I can keep improving my english…my best to all of you!