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Seed, Post-Seed, Series A, Series B.
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Convertible Notes vs. Priced Rounds.
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Common vs Preferred Shares vs. Stock Options.
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The fundraising process for a startup requires a crash course on some terminology that you've
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probably never heard of.
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There's no evil corporation making it confusing on purpose, you know, like banks and credit
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cards. This is just a complex topic that requires an understanding of some legal and financial
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terminology.
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When companies have such vast potential like startups, and when you deal with such large sums of money,
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everyone wants protection to make sure their time or their cash investments are safe.
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To better explain all of this, we are going to tell the story of a startup company,
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from funding to IPO.
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This is Startup Funding Explained, Part I.
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Ok, so let's take a classic scenario: 2 founders get together to start a business. They bring
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nothing but their skills and an idea, so they decide to split the company 2-ways. 50/50.
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Incorporating a business is expensive, plus there are tax and legal burdens of having
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a corporation, so they hold off on that for now.
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They both have day jobs and are building the product in their free time, so they seek out
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some capital to speed things up. At this stage, they can't go to Venture Capitals or even
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to Angel Investors. The money they can raise is from friends and family.
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It turns out they have a close friend who believes in them and is willing to invest
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$50,000 to give them a boost. Great! Now what?
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This is where a corporation is going to be necessary. A Delaware C-Corporation is the
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most standard type of legal structure you can use, and most investors in the US will
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want that.
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We have a video on the process of incorporating; we'll link that in the description.
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The corporation allows the founders and the investor to agree on the terms of ownership
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and decision-making. It provides a layer of protection, for example, in case the company
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gets sued.
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That lawsuit doesn't necessarily translate into a liability for the founders or the investors.
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A corporation is made up of shares. We are more
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used to hearing about the percentage of ownership. Still, in legal terms, ownership is represented
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in an integer number of shares. People own a given amount of shares of the business,
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which therefore represents a percentage of the total shares the company has issued.
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You can have a corporation with one share. Whoever owns it, owns 100% of the company.
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Our two founders, for example, could incorporate the business with two shares, one for each.
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1/2 shares represent a 50% ownership.
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The problem with such small numbers of shares is that splitting them is hard, and this will
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represent issues if they want to give shares to investors or their team. That's why most companies are
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established with 10,000,000 shares of stock, which provides enough pieces to be able to
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split the corporation with plenty of people.
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Without worrying about decimal numbers and rounding up or down.
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Well, get back to shares in a second.
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Let's remember our investor, who is willing to put $50,000 into the business. How many
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shares does he get?
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That question relates to how much the business is worth. Established companies typically
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base that Valuation on the number of sales, or the tangible assets they own- but our two
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founders just have an idea and a few lines of code.
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At this point, it's a matter of agreeing on something that feels fair to the investor
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and the founders. Those numbers can vary a great deal, but let's use 20% for this example.
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That's not out of the ordinary for a friends and family investor.
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The Founders and the Investor agree that he will invest $50,000 in exchange for 20% of
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this new business. If 20% of the company is $50,000, then that means 100% of the business
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is worth $250,000. That's the effective business valuation.
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In this case, $250,000 is just an arbitrary number; it's the 20% that showed the balance
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of risk/reward that the investor was willing to accept. However, that valuation number
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will be much more relevant in future rounds of funding.
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So, to accept this money, a corporation will be established, again, using the 10,000,000
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share standard.
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In basic terms, this is what's going to happen,
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A corporation will be established with 8,000,000 shares total, 4,000,000 shares for each founder.
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The company will define an arbitrary number for how much the shares are worth, usually
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$100: that's $0.0000125 per share.
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At this point, the owners own 50% of the company each.
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Each of their chunks is worth $50. This transaction uses a low number to avoid extra tax complications.
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Now for the investment,
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The company will issue new shares to the investor: 2,000,000.
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Issuing shares means the company will 'create' new shares. The number of shares each one
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of the founders has will remain unchanged. This is important.
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By issuing 2,000,000 new shares of stock, the company now has a total of 10,000,000
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total shares issued: a beautiful, round number.
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The 4,000,000 shares each founder remained unchanged, the difference is they used to
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represent 50% of the total number of shares, and now they represent just 40%.
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Once again, shares didn't change hands; nobody gave shares to the investor.
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The company issued new shares.
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This is all done simultaneusly, by the way. All you, founder, will see is a bunch of paperwork
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and a slot to sign.
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But it's all done within the scope of probably one business day.
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All the intellectual property (the code) and the assets will now be owned by the company,
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which means everybody legally owns those assets in the agreed proportion.
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Great!
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Now, the investor will also want some protection in case one of the founders decides to leave.
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If one of the founders left, 40% of the intellectual property and assets would be owned by someone
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who no longer works for the business. That's where VESTING comes in.
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In a nutshell, a vesting agreement says that each founder will only own their assigned
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shares after a certain period.
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A typical agreement has a one year cliff, and a 4-year period, with monthly installments.
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So,
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The total number of shares is divided into 48 months.
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During months 1-12, no shares are assigned to the founder.
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On month 12, 12-months worth of shares are vested.
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After that, 1/48 of the total number of shares gets assigned.
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For our founders, that means that by the time they work on the company for one full year,
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they will unlock 1,000,000 shares. The remaining shares will be 'unlocked' at the end of each
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calendar month, around 83,333 shares per month.
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Spoiler alert: in this hypothetical company scenario, one of the founders is going to
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leave before their shares are fully-vested. We'll get the chance to calculate that
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in next week's episode.
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Hit that subscribe. We'll see you next week.