Every field of study has its basic vocabulary of words and phrases that come up over and over again. This vocabulary is so fundamental that it is used to explain other concepts that are more advanced. Well, fundraising is no different. This article is intended to serve as a primer of sorts with a description of ten basic terms that must be understood by any startup pursuing fundraising.
Equity is simply ownership in your company. It is expressed as a percentage whereby the equity amounts of all investors and shareholders add to 100%. So if I say that I have 5% equity in your company it means I’ve got 5% ownership. See below a complementary term called “fully diluted”.
More casually referred to as the “cap table”, it is a ledger that keeps track of the various equity holders in your company and their relative equity stakes (ownership percentages). This includes investors, advisors and company employees alike – assuming all have some form of equity.
Authorized and Issued Shares
When US companies incorporate, they file for a certain number of shares to be created (authorized) but often only a subset of them are actually issued into the company at the start. This leaves unissued shares that could be issued into the company later without much additional legal work. For this reason, you’ll see a lot of US startups incorporate with something like 10M authorized shares but they will initially only issue 8M of those shares into the company.
Most cap tables include shares that have been issued into the company but not yet to any particular individual. The best example is the stock option pool. Over time, shares in the stock option pool will be granted to employees and advisors. Calculating someone’s equity on a fully-diluted basis means dividing their quantity of shares by all shares issued into the company, even those in the stock option pool that are still available to grant to individuals.
The other common way to calculate someone’s equity is on an “issued and outstanding” basis, which only takes into consideration shares actually held by a person or entity. Because of this, someone’s fully-diluted equity is usually less than their issued and outstanding equity. Below is an example to illustrate.
- Your share ownership: 1 million shares
- Total issued shares: 10 million
- Option pool shares available for grant: 2 million
- Your issued and outstanding equity: 12.5% (1M divided by 8M)
- Your fully-diluted equity: 10.0% (1M divided by 10M)
Dilution is the result of an activity that causes a shareholder’s equity to be reduced (diluted). Since equity is calculated by dividing the shareholder’s quantity of shares by the total shares issued into the company, the most common cause of dilution is issuing additional shares into the company. Why might this happen? Here are a few examples:
- Raising money via an equity round of funding
- Issuing previously unissued shares into the company to make room for a co-founder or to create a stock option pool
In all cases, the number of issued shares increases and this causes each of the previous shareholders’ equity positions to be diluted
Side note: Dilution is natural and is often evidence of a growing and successful company. For example, two co-founders might each have 50% equity in the early days when the company is only valued at $2M. Later, after the creation of a stock option pool and a couple of funding rounds they are diluted to 20% equity but the company is valued at $30M. Eventually, they are acquired for $200M when they each have 10% equity. Their starting position on paper was $1M each (50% of $2M) and they each ended up earning $20M in the acquisition (10% of $200M). As long as the amount of dilution is more than offset by an increase in valuation, the math works just fine.
Classes of Stock
These are typically two broad classes of stock (shares) created over time. Before taking on external funding, most startups only have what are referred to as “common” shares. But later when professional investors put money into the company, they want special rights for protection and control. These extra rights define a new class of shares referred to as “preferred” shares. In this way, a “class” of shares denotes a group of shareholders with the same rights. Sometimes this results in multiple sub-classes of shares being created to further differentiate the rights of a larger class. In other words, a company might have Series Seed Preferred, Series A-1 Preferred and Series A-2 Preferred classes of stock, each with a different set of rights, even if only slightly different.
A term sheet outlines the key and material terms of your funding activity. For a seed round of funding that uses a convertible security as the investment document, the company often conveys a high-level summary of their proposed terms via a term sheet. It is shared with interested investors first before later sending the full legal document for execution.
For an equity round of funding, the term sheet is instead produced by interested lead investors and used to communicate their proposed offer. It usually fits on 3-4 pages and is the key instrument during the negotiation phase of the funding round. Once the terms are agreed and the term sheet is executed, it serves as guidance for the attorneys as they produce the full set of legal execution documents to close the round of funding.
Your valuation is simply the implied value of your company. And since the value of your company is only what someone else is willing to agree it’s worth, the valuation is most easily determined during fundraising events, an acquisition or an IPO. During these activities, you and the investing parties must agree how much equity they will get for their investment. Because of this, you are effectively setting the value (valuation) of your company. And since the injection of new capital into your company immediately increases the value of the company, you will hear the terms “pre-money valuation” and “post-money valuation”. The only difference is the post-money valuation includes the cash that was invested into the company.
At the time the term sheet is written, it’s usually not certain how much of the authorized funding amount the company will actually raise. Because of this, the pre-money valuation is usually negotiated first. We often just say “pre” or “post” to designate which version of valuation we are referring to.
When trying to figure out how much equity an investor will get, remember to divide by the post-money valuation. In other words, if your negotiated pre-money valuation is $4M and an investor is putting in $1M, they will end up with 20% equity (post-money valuation = $5M and $1M / $5M = 20%)
If enough time goes by after the last fundraising event, the board of directors or the company accountant might suggest the company have a professional valuation done (called a 409A in the US) so that your stock price can be adjusted accordingly.
Side note: You might hear someone say they’re “doing a priced round”. A priced round is one in which company equity is sold to the investors. In order to calculate the amount of equity the investors will get, the company must first be “priced” (valued). We also refer to such rounds as an “equity round” to denote that equity is being sold.
A liquidation preference is a right that is often given to preferred shareholders. It protects them in the event the company is sold at a distressed value. The investors want to make sure they at least get their money back before non-investing equity holders get any money. If fact, these preferred shareholders with a liquidation preference get to choose between whatever is better – taking their liquidation preference or taking their relative equity % of the total acquisition price. Not a bad deal but that’s what they get for investing capital into your company.
The liquidation preference is expressed as a multiple of invested capital. So, a preferred class of shareholders with a 2X liquidation preference stands to get double their investment back before other equity holders get any acquisition proceeds. In this way, the multiple is very important for company founders and executives to understand and negotiate. 1X is most typical.
Side note: Be on the lookout for something called a “participation feature” or “participating preferred”, which means the investor don’t simply have to choose one option or the other but rather gets both (they get their preference multiple and then also get their pro rata share of whatever is left over). It’s often referred to as the “double-dip” provision and is definitely considered aggressive.
At the time of this writing, for most investments into private companies the US securities laws stress the importance of only selling equity in your company to investors that are “accredited”. There are various financial tests to determine investor qualification and the spirit of the laws are to protect those that don’t have enough money to be investing in the riskiest asset classes like startup venture investing. Search the SEC site for the current qualification criteria and consult with your attorney to make sure you don’t accidentally jeopardize your company’s future by taking investment from the wrong people or using the wrong process.