Paul Graham- How to fud a start-up? November 2005 Venture funding works like gears. A typical startup goes through several rounds of funding, and at each round you want to take just enough money to reach the speed where you can shift into the next gear. Few startups get it quite right. Many are underfunded. A few are overfunded, which is like trying to start driving in third gear. I think it would help founders to understand funding better—not just the mechanics of it, but what investors are thinking. I was surprised recently when I realized that all the worst problems we faced in our startup were due not to competitors, but investors. I don't mean to suggest that our investors were nothing but a drag on us. Apparently our situation was not unusual. Let's start by talking about the five sources of startup funding.
Friends and Family A lot of startups get their first funding from friends and family. If your friends or family happen to be rich, the line blurs between them and angel investors. Consulting Angel Investors Why? Venture Capital Deal Algebra. Fred Wilson wrote a useful post on valuation today. It reminded me of a document I had Dave Jilk write when he was doing some work for me. I decided to write this “bladon” (Blog Add-on) post – inspired by Fred.
Please read Fred’s post first – it lays the groundwork for why VCs do things this way. I’ve found that even sophisticated entrepreneurs didn’t necessary grasp how valuation math (or “deal algebra”) worked. VCs talk about pre-money, post-money, and share price as though these were universally defined terms that the average American voter would understand. In a venture capital investment, the terminology and mathematics can seem confusing at first, particularly given that the investors are able to calculate the relevant numbers in their heads. The essence of a venture capital transaction is that the investor puts cash in the company in return for newly-issued shares in the company. Pre-money Valuation = Share Price * Pre-money Shares Investment = Share Price * Shares Issued. Term Sheet: Price - Mozilla Firefox. A the end of the year, I completed a financing that was much more difficult than it needed to be.
As Jason Mendelson (our general counsel) and I were whining to each other we decided to do something about it. At the risk of giving away more super-top-secret VC magic tricks, we’ve decided to co-author a series of posts on Term Sheets. We have chosen to address the most frequently discussed terms in a venture financing term sheet. The early posts in the series will be about terms that matter – as we go on, we’ll get into the more arcane and/or irrelevant stuff (which – ironically – some VCs dig in and hold on to as though the health of their children depended on them getting the terms “just right.”)
In general, there are only two things that venture funds really care about when doing investments: economics and control. Obviously the first term any entrepreneur is going to look at is the price. Alternatively: Price: $______ per share (the Original Purchase Price). Venture Capital Deal Algebra. Unnamed. There’s this dance that entrepreneurs and venture capitalists do when it comes time to negotiate the economic terms of an investment. And it all revolves around valuation. The question is what is the fair value of the business?
This supposedly establishes how much of the company the venture capitalists will own for their investment. But I think the concept of valuation is often misunderstood by the people engaged in this process. And it’s particularly true in early stage investing. I do not believe that negotiating a valuation on an early stage venture investment has much to do with the current value of the business. The fact is that almost all venture capital deals are done as convertible preferred stock investments. It’s only in the event that the deal works out that the percentage of the business (the thing that valuation is supposed to determine) matters in terms of how much money we make. The 1/3 rule goes as follows: 1/3 of the deals end up going mostly sideways. How Many Shares Should a Startup Company Authorize at Incorporat.
An often overlooked aspect of filing a certificate of formation or articles of incorporation is determining how many shares the new corporation should authorize. This decision doesn’t really matter to most businesses (I don’t have a clue how many shares I authorized when I incorporated my law firm), but startup companies aren’t like most businesses.
Most businesses don’t grant stock options or seek venture capital. Thus, the organization and capitalization of your startup is important from the outset. The number of shares to issue at incorporation is somewhat arbitrary, but my preference is to authorize 10,000,000 shares. Now, that doesn’t mean all 10,000,000 shares will be issued to the founders. For example, say you authorize 10,000,000 shares. Of course, you could obtain the same result by authorizing 1,000,000 shares with an option pool of 100,000 and a 900,000 issuance to the founders. How do you calculate Series A price per share? : Startup Company. Browse > Home / Series A / How do you calculate Series A price per share? The formula is: [Series A price per share] = [valuation] / [fully-diluted pre-money shares] Obviously, there are two ways to affect the Series A price per share (and the resulting dilution to pre-Series A stockholders): (1) change the valuation, or (2) change the number of fully-diluted pre-money shares.
Arguing for a change in valuation is probably difficult. Fully-diluted pre-money shares typically includes (1) all outstanding common stock, (2) all outstanding preferred stock (if any, on a converted to common basis), (3) outstanding warrants, (4) outstanding options, (5) options reserved for future grant, and (6) any other convertible securities on an as converted to common basis. Decreasing the size of the option pool is one way to increase the Series A price per share. Comments. What is preferred stock and why is it issued to investors? : Sta. Browse > Home / Series A / What is preferred stock and why is it issued to investors? Preferred stock generally has rights senior to common stock. Startup companies typically issue common stock to founders (and options to purchase common stock to employees) and preferred stock to investors.
One reason for issuing preferred stock to investors is to preserve the ability of a company to issue options to purchase common stock at an exercise price at a significant discount from the preferred stock price. Before accounting and tax rules became more stringent on the valuation of common stock, companies generally used to value their preferred stock as ten times more valuable than common stock until the 12 to 18 month period before an IPO. In other words, if Series A preferred stock was sold for $1.00/share, an option to purchase common stock would have an exercise price of $0.10.
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