Establishing and nurturing a company can be a very difficult task given the huge complexities involved in virtually all aspects, including raising the necessary funds. The issue becomes more complicated since the interests of the entrepreneurs and that of the funding agencies are not necessarily aligned. Engaging in discussions regarding funding, valuations, control, and exit policies is sometimes downright perplexing due to the financial jargon that investors tend to throw at entrepreneurs. If you are an entrepreneur thinking of approaching lenders for infusing funds into the business, there are some technical terms that you should be familiar with so that you don’t end up holding the short end of the stick. Some typical examples explained:
Pre-Money and Post-Money Valuation
Pre-money valuation is the valuation of your business before you have received any funding while post-money valuation is its corresponding worth after the funding. Understanding the terms is important because it has a direct impact on how much your shareholding will be after receiving the funds. For example, a pre-money valuation of $10 million of your company that raises another $5 million will take the post-money valuation up to $15 million and you have two-thirds ownership, whereas if the valuation is $10 million post-money, it will imply that you control only half the company’s shares.
In its very early stages, valuation of a business may be quite difficult; however, it is still important for the business to raise funds. Convertible debt is a financial mechanism that permits companies to raise funds without setting a value to the company. Convertible debt, as its name implies, can be converted into equity down the line, usually when the company goes in for a funding exercise. The usual practice is to issue warrants at a discount to the investors who display confidence in the company’s potential so that at the time of conversion, they receive a better deal than the investors coming in the first funding stage.
Quite often venture capitalists are not issued common stock but given preferred stock that has certain rights attached. Since the primary aim of investors is to make money by liquidating equity, the liquidation preferences determine who gets paid and by how much whenever any liquidation event, including a bankruptcy, happens. Preferred stockholders get priority over common stockholders after the company’s creditors have been paid off. Even for more successful outcomes, preferred stockholders get their money back before the common stockholders. The Liberty Lending website has excellent explanations of the different types of liquidity preferences of investors.
There can often be different types of preferred stock, each giving different rights to their holders. If the company is successful, it may so happen that while preferred stockholders get back their money, the common stockholders get a lot more. This situation makes it sensible for the preferred stock to be converted into common stock to enable the non-participating preferred stockholders to share in the benefit. For holders of participating preferred stock, the benefits are double. They not only get the value of their preference shares back at 1X but also get to share in the payout just like common shareholders according to their post-valuation shareholding.
The term pro-rata gets bandied about a lot during discussions on funding; it is Latin for “in proportion” and not something out of this world. It is simply a term that allows investors participating in subsequent funding rounds to maintain their holdings in the same proportion as before. With pro-rata rights accorded to the investor, the company has to ensure that investors can prevent dilution of their equity as the company engages in more funding. There are even “super pro-rata rights” that permit investors to increase their stakes when the company raises further funds. Entrepreneurs will do well to be extremely circumspect about these terms if they encounter them in discussions.
Option pool refers to the equity that is kept aside for distribution to employees at a later date. Even if it sounds innocuous, the option pool size can have a direct impact on the company valuation and therefore your ownership. The reason is that the pre-money valuation of the business includes the option pool. Typically, option pools are expressed as post-money valuation percentage. The impact of the option pool size on the ownership is illustrated best by this example. A $10 million company will have a post-money valuation of $12 million after a funding of $2 million. If there is a 20% option pool, the size of the pool is $2.4 million. You now have $7.6 million pre-money valuation company instead of $10 million since the option pool comes out of your holding. From a 100% holding in your business, your holding is now 63.3% instead of 83.3% that you may have assumed after the funding. Considering the impact of the size of the option pool on the holding of the entrepreneur, it can be a good idea to create a hiring plan for the coming year or so and figuring out the equity that you would want to distribute. This exercise may well lead to a smaller option pool size.
When you own the company fully, you don’t have to worry about shareholder accountability, however, the minute you get outside funds on board, this is no longer possible. After the financing, if you take on three board members, you would have effectively lost control of the company even though you may still be a majority shareholder. It may be entirely possible for the other directors to get together and fire you from your own company. Therefore, the board composition after the funding is extremely important and under no circumstances should you allow a situation to develop that has a possibility of going against you. Appointment of neutral board members acceptable to both you and the investors can be a good option.
Establishing and running a startup is a big task and when you add in the complexities of funding and ownership, it can often overwhelm entrepreneurs. Getting to know the technicalities can prevent you from getting confused