An Introduction to Startup Finance and Convertible Notes

STARTUP FINANCING 101Prepared for Cornell’s Entrepreneurship CWG 2015

SOME BASIC TERMS Fully diluted: Taking into account all outstanding shares, including those

that may have not been exercised yet Options pool: Pool of equity set aside for new hires Post-money: A company’s value after receiving a round of funding Pre-money: A company’s value prior to receiving a round of funding Prorata rights: Right to partake in subsequent rounds of funding to

maintain ownership % Vesting: Period of time over which equity accrues Vesting Cliff: Period of time before vesting begins

BRIEFLY ON VESTING Early employees at a start-up may receive some portion of their

compensation in the form of equity, drawn from the options pool (more on this later)

Typically this equity needs to be earned, and is a reward for effort and commitment. This is handled through a vesting schedule – note that founders can also be put on vesting schedules

A typical vesting schedule will include: the amount of equity, the period of time over which is accrues, and any period before normal vesting begins (the cliff)

For example a vesting schedule might be: 5% over 4-years, monthly, with a 1-year cliff This means my 5% will accrue monthly over the next four years, except in the

first year At the end of my first year, my cliff period, I will accrue the entire years worth of

equity at once: 1.25% and 0.104% monthly thereafter

SOME FUNDING EXAMPLES If Investor A wants to invest $1M for a 10% stake in your company:

You have a post money valuation of: $1M/10% = $10M You had a pre money valuation of: $10M - $1M = $9M

Say you started the company with 900,000 shares (sole ownership) issued at a nominal price of $0.01/share Investor A would get 100,000 shares [0.1(900,000+X)= X] at $10/share Your portion grew from $9,000 to $9M!

Then Investor B comes in and purchases 10% for $2M ($20M Post, $18M Pre) B would be issued 111,111 shares [0.1(1,000,000+X)=X] at $18/share Your portion is now worth $16.2M, but you only own 81% of the company A’s portion is now worth $1.8M and owns 9% of the company

ANOTHER EXAMPLE Options pool: Investor A wants to invest $1M for a 10% stake in your company,

but includes a provision for a 15% fully diluted post money options pool For a $10M post money valuation, there needs to be a $1.5M option pool pre-money This takes your pre-money valuation from $9M to an effective $7.5M

How much stock is issued (assuming you start with 900k)? 300,000 [0.25(900,000+x)=x] new shares have just been created for a total of 1.2M

shares 120,000 shares (10%) are issued to Investor A at $8.33/share, compared to the

$10/share paid in the same case without a pool. For A, this is essentially the same deal as $833,333 for 10% without a pool ($7.5M pre, $8.3M

post) However in this case you would truly only be diluted 10% as opposed to 25% with a pool

180,000 shares are set aside for the options pool (15%) You now own 75% of the company valued at $7.5M

ONE LAST EXAMPLE Prorata example: Investor A owns 10%, and your company is raising a

$10M round at a $50M post money valuation (20% ownership up for grabs). Case 1: Investor A did not have prorata (or chose not to exercise it)

Investor A would be diluted to 8% ownership and the company would be split: 72% founder, 20% new investors, 8% A

Case 2: Investor A did have prorata and chose to exercise it Investor A will need to purchase an additional 2% equity to maintain 10%

ownership. This comes out to be 10% of the round (2/20) or an additional $1M. Note the percentage of the round is equal to Investor A’s current ownership stake.

Ownership is now: 72% founder, 18% new investors, 10% A

CONVERTIBLE NOTES

CONVERTIBLE NOTE TERMS Convertible note: a loan that converts into equity upon a subsequent

priced round; really only seen in angel and seed rounds Discount rate: The percentage off of share price that the note converts Valuation cap: The maximum price at which the loan converts into

equity In the notes where both a discount rate and a valuation cap are

included, the more favorable terms (for the investor) will be used Interest rate: Convertible notes are loans, so there will be an interest

rate and it will apply towards additional shares Maturity date: Date by which the company needs to pay back the note,

if unconverted, but investors will likely extend it if needed

CONVERTIBLE NOTE EXAMPLE This is just one of the many ways a convertible note could be handled Assume we have a note for $100,000 (inclusive of interest) that converts with a

20% discount and a $5M pre-money cap from Angel C, and 1M shares outstanding

Investor A wants to purchase 10% of our company for $1M First we check what our discounted price/share is:

Let P be the price/share for Investor A Therefore Angel C will pay 0.8P (20% less than A) The number of shares that Investor A will get is then: $1M/P, and our angel will get

$100,000/0.8P Let T be the total number of shares after the round is closed We know that Investor A will own 0.1T shares in the end (10% of the company), and

Angel C along with the founders will own the remaining 0.9T

CONVERTIBLE NOTE EXAMPLE CONT.

Thus we have two unknowns and two equations:1.

Solving these two equations we get: P= $8.875, 0.8P= $7.10 and T= 1,126,760 Now we need to check our capped price

Take the cap and divide it by the number of outstanding shares: $5M/1M shares = $5/share

We see that our capped price per share is less, so we apply those terms Founders remain at: 1,000,000 shares Angel C gets: $100,000/$5.00 = 20,000 shares

CONVERTIBLE NOTE EXAMPLE CONT.

Now, Investor A won’t end up paying $8.88/share, because it would result in less than 10% ownership because Angel C converted at such a favorable rate

Instead, we calculate the total number of shares Investor A needs to own 10% of the company: 1,020,000 = 0.9T; T= 1,133,333 Then 1,133,333-1,000,000-20,000 = 113,333

Investor A receives then 113,333 shares at $8.82/share Our final breakdown is then: 88.2% founders, 10% Investor A, and 1.76% Angel C

If the note was uncapped, we would have just used the numbers we found solving for the discounted rated, and ended up with 88.7% founders, 10% Investor A, and 1.2% Angel C

The difference doesn’t seem like much, but with the cap in place Angel C received a 44% discount compared to the 20% on the note

SOME BROAD GENERALIZATIONS

THE DIFFERENT FUNDING ROUNDS Angel/Pre-Seed:

Company is extremely early stage, somewhere between an idea and a rough prototype Individual investors Median check size is roughly $600k usually in the form of a convertible note

Seed Company is on the path towards product-market fit and prototyping Company might be hiring a few additional employees outside of founders Can be a mix of individual and institutional investors Average check size is ~$750k-$1M could be a note but could also be priced

Series-A At this point product market fit has been solved, and business model is taking shape The funding here will go towards scaling operations

THE DIFFERENT FUNDING ROUNDS CONT.

This is the first institutional only round Rounds are likely between $3M-$7M and priced

Series B All about growth and scaling Institutional rounds raising $10M+