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A couple of weeks ago, we started telling the story of a theoretical company: from incorporation
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to first rounds of funding.
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The idea was to use examples to explain how the company cap table evolves and how the
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legal process works through all these steps.
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This is part 3 of Startup Funding Explained.
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If you haven't watched parts 1 and 2, please make sure to check them out first.
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Otherwise, none of this stuff is going to make sense.
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18 months after the company started, one of the founders leaves.
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This is where the vesting period we defined will turn out incredibly useful to protect
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the rest of the company and the investors.
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According to the vesting rules that we had defined before, the founder needed a 1-year
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cliff to get their first chunk of shares.
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We're through that.
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The 4,000,000 shares assigned to the founder were to be vested monthly, at the end of each
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calendar month.
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Since he worked for the company for 18 months, he is entitled to 18 out of 48 installments,
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which represent 1,500,000 shares.
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What happens to the remaining 2,500,000 shares... well, since they didn't vest, they are repurchased
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by the company at the price the founder initially paid for them.
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In this case, that price was $50.
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Now he company no longer has 10,500,000- it's now back to 8,000,000 shares, and the cap
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table changes again.
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The remaining founder still has 4,000,000 shares, which now represents 50% of the company.
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The investor still has 2,000,000 shares, but they now represent 25% of the company.
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Again, the number of shares doesn't change, but the percentages do.
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The theoretical company is doing great, even
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after a co-founder left.
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It's doing around $160,000 in MRR, which translates into $2,000,000 in annualized subscriptions.
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It's still growing 10% Month over month, and there's a visible market opportunity.
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These are more or less the metrics needed to prepare for a Series A round.
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This time, the company is looking to raise $2.5MM in funding.
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The company will seek a valuation of $10MM.
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That is 5x their annualized revenues.
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Remember that valuation standard?
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They actually have the metrics now to justify that Valuation.
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A Silicon Valley Venture Capital firm takes an interest, and the diligence process begins.
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Investors will want to dig deep into the company's legal structure, agreements, contracts, financials...
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The negotiation process also begins.
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With the convertible note, there are very few points to negotiate on, but this will
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be priced round of funding: stock will be issued to the new investors.
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These new investors are bringing in $2.5MM, which is, of course, a shit ton of money.
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They'll want a say on critical company decisions.
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One way to do that is with a Board Seat.
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The Board of directors has control over crucial company aspects.
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It abides by the company Bylaws, which is a sort of rulebook.
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Up until now, the Board of Directors of this company was probably not defined formally.
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One founder, one Friends/Family investor with a small ~$50,000 investment.
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And there's the convertible note investor.
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They are not shareholders just yet.
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At this stage in the company, everyone needs to trust this founder to make the right decisions.
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But now, investors will want to check and potentially adjust the bylaws, to ensure there
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are no loose ends.
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The Board makes most company decisions with a simple majority, so it would make sense
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for the company to have 3 Board Members: the original founder, the new investors, and someone
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else to break the tie.
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Five would also be a fair number.
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This persona could be an advisor or even a senior company employee.
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Investors will also want to protect themselves
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in case the company goes down. Or if it gets acquired for less than the valuation that they invested.
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If the company ends up struggling in the future, it might file for bankruptcy and be forced
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to liquidate its assets: sell the stuff it owns, like cars, properties, or computers.
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Even the domains and the code.
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Or, it might be acquired/absorbed for a small amount, certainly less than the investors
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paid when the company was thriving.
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In that case, investors might request protection if that happens, they get paid first.
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Let's remember these investors are considering investing $2.5MM on a $10MM valuation.
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If the company got acquired for $5MM, say, they would effectively lose about 50% of their
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money.
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With LIQUIDATION PREFERENCE, investors can protect their cash investments so that at
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least they are paid out first.
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For example, they could request a 1x liquidation preference, so if the company is sold for
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$5MM, they get their $2.5MM investment first- and the remaining $2,500,000 are split between
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the remaining common stock.
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Special rules like that make up what we call 'preferred stock.'
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Which rules, how many assurances and protections investors have requires a long and tedious
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negotiation process.
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This whole process is likely going to set the company back anywhere between $50,000
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and $100,000 in legal fees.
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We won't dig into that. But that's a fair number I've heard from a good number of founders.
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The point is, new investors are coming, they are bringing $2.5MM in new capital and agreed
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to the $10MM pre-money Valuation.
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Negotiations are done, and the round is happening. Let's see how the cap table changes.
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OK, so before the Series A investors come
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in, the Convertible Note gets executed because there's a new round of funding.
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A $500,000 investment will be made, at an $8,000,000 pre-money valuation: that's $10,000,000
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minus the agreed 20% discount. To compensate investors for coming in early.
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All the other terms will be the same as the Series A investor.
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That includes the preferred stock, for example.
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The convertible note investors effectively avoided the whole preferred stock negotiations:
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they simply trust the new investors will get a good deal and piggyback on the same terms.
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Coincidentally, the company has 8,000,000 shares at this point.
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Easy math, 500,000 shares of stock will be issued to this investor.
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The company now has 8,500,000 shares of stock.
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The convertible note investors own 500,000 shares, which represent about 5.9% of the
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company- for now.
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Time for the Series A investors.
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Now, before they invest, they requested the company to create a new Option Pool for future
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employees to come.
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Also, a founder quit, so the company needs to have a stock option pool available to bring
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in a new key employee.
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This person won't be a co-founder but will be a crucial part of the business.
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Series A investors requested the Option Pool to occur BEFORE their investment because they
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don't want those shares to come out of their end.
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This is a standard procedure.
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This new Option Pool will again be 500,000 shares.
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That represents 5.56% of the company today.
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However, there's a major difference: the company has a fresh new valuation.
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While the first Option Pool was created when the company was worth $250,000- the business
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is now worth $8.5MM and has issued 8,500,000 shares.
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That means the STRIKE PRICE for this new Option Pool will be $1 per share.
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Our theoretical business is going to get acquired. We'll see how much money
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each one of these option pool holders will get.
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This is how the company looks after the second Option Pool is created.
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Now, time for the Series A money.
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Investors agreed to a $10MM pre-money valuation.
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If the company has 9,000,000 shares of stock, that means they are valuing each share at
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$1.1111.
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With their $2.5MM investment, they are going to purchase shares at that price.
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So here's the formula: Shares Issued / Company Valuation * New Investment
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$10,000,000/9,000,000 * $2,500,000 = 2,777,777.77 Effectively, 2,777,778 shares will need to
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be issued to new investors.
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We can't have decimal shares- so this needs to be rounded up: luckly, we incorporated
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with 10,000,000 shares and those decimal positions aren't worth a lot.
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The company will now have a total of 11,777,778 shares.
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This is how the cap table looks like.
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I've never done a Series B or Series C, but
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the process is 'similar'.
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It's more expensive, more complicated, but it's mostly the same.
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Companies like Pinterest have raised a Series F, so you can imagine how complex their cap
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table gets. We're not going to dig into that.
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In our next and final video, we'll look int to the company exit- our business will get
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acquired, and we'll figure out the logistics, and especially, how much money everyone ends up making.
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We'll see you next week.