Startups Funding and Capital Raising are two concepts closely related.
Raising capital is crucial to the life of startup companies, that often make the choice to be unprofitable at inception and, therefore, crave regular injections of cash to survive and continue to grow. These companies, in fact, strategically choose not to focus on profitability, instead they prefer to use their resources to grow the business as quickly as possible, to attack large portions of the relevant market.
Seed round. Seed financing is the first round of startup financing, typically known as a seed round, which generally occurs when the product is at the idea stage, or a very first version of such product has been delivered. Seed round investors are typically friends & family and angel investors. The legal financing instruments for this round are convertible notes and simple agreements for future equity (SAFEs).
Convertible Promissory Notes. Commonly referred to as Convertible Notes, CPN are structured as regular debt instruments, except that they are subject to conversion into preferred equity should a “conversion event” occur at some point in the future. Basically, investors rather than getting repaid with principal plus interest at the note maturity date, may choose to receive equity of the company instead. Most important events that trigger conversion into equity are:
- A subsequent financing round (next equity financing conversion);
- Sale of the company or its asset (corporate transaction conversion);
- Note maturity date (maturity conversion). The most attractive feature of the CPN is that the noteholders may receive equity at a price lower than the price paid in the next investment round, based on a discount rate or a valuation cap. In simple words, the lower conversion price works as a reward for investors who took the risk of financing the company at its early stages.
SAFEs. Simple Agreements for Future Equity are debt instruments featuring, a structure identical to the CPNs except that:
- there is no maturity date, therefore the SAFE will remain outstanding until a conversion event occurs;
- interest will not accrue. Resorting to SAFEs rather than CPNs, startups will not bear the risk of repaying a promissory note, if the note maturity date occurs before the next investment round, leaving the company without funds.
Series A Financing.
When startups succeed in proving that their product is marketable, what comes next is raising a more substantial round of capital. This round often occurs when companies enter the building phase of the product and Series A investors typically are represented by venture capital funds that purchase convertible preferred stock. Terms and documents of a Series A round are largely standardized so that the process may move forward quickly and funds don’t leave the company in the form of lawyers’ fees.
Most relevant Series A terms are as follows:
- Liquidation Preference: the Series A holders must first receive a liquidation preference equal to the original purchase price of their preferred shares, before any proceeds from a sale or liquidation of the company can be distributed to the common stock holders.
- Dividends: typically, common stock cannot be paid a dividend unless the preferred stock receives the same amount on a per share basis.
- Conversion: Shares of Series A Preferred Stock are convertible into shares of common stock on a 1:1 basis (subject to adjustment in case of certain dilutive events) at the holder’s option at any time. Conversion is generally automatic in case of IPO.
- Price-Based Anti-Dilution Protection: right to downward adjustment to the purchase price of the preferred shares if the company later issues common or preferred equity at a price below the Series A price to give the Series A investors more than one common share for each share of Series A preferred stock they hold, if and when the Series A stock converts to common.
- Protective Provisions: Series A investors may be entitled to veto rights on crucial company actions, such as: (i) actions that adversely affect the rights, preferences, or privileges of the Series A holders; (ii) amendment of certificate of incorporation and bylaws; (iii) Issuing senior securities; (iv) Declaring or paying dividends; (v) Increasing or decreasing the size of the company’s board of directors.
- Board Matters: The lead investor is typically entitled to one seat on the board of directors.
- Registration Rights: demand, piggyback, and shelf registration rights.
- Financial Information and Inspection Rights: investors may be entitled to receive certain financial information regarding the company.
- Rights of First Offer: right to purchase new securities offered by the company, allowing investors to maintain their proportional ownership of the company.
- Rights of First Refusal: right to purchase the shares of common stockholders in the event that such stockholders are planning on selling their shares to a third party.
- Tag Along: Should (the company and) Series A holders fail to exercise their rights of first refusal in a certain proposed transfer, the Series A holders have the right to sell their preferred shares in proportion together with the common stockholders on the same terms.
- Drag-Along: smaller stockholders of the company may be forced to agree to a sale of their shares if the majority of the common stockholders and a majority of the Series A investors are willing to move forward with the sale.
Series B Financings and Subsequent Rounds
Through post- Series A rounds, startups continue to raise increasingly large amounts of capital focusing on fast growth. These ensuing rounds of financing are typically named by progressing through the alphabet (Series B, Series C, and so on).
The amounts raised in these rounds go from $5 million to $10 million in a Series B round to up to $100 million in a Series E. In these stages, investors are mostly represented by Venture Capital funds and sometimes corporate strategic investors, mutual funds and hedge funds.
Financing Instruments: also in these later rounds investors receive convertible preferred stock. After issuing Series A preferred stock, startups generally continue issuing same type of stock with different terms on top of the existing Series A documents by amending and restating them.