Startup Funding Mechanics: Incorporation, Convertible Debt & Series A
What do first time founders need to know about fundraising mechanics? This post should help you understand the basic lingo of fundraising – so you don’t look surprised or sound like a noob when you’re discussing funding. An attorney will go into a lot more detail and it’s important that you understand investor motivations – not all capital is green.
Please keep in mind, this is a founder’s view, I am not a lawyer – this isn’t legal advice. There are always exceptions to every rule. Especially in legal where optionality creates billable hours. Ask about costs with lawyers in advance.
Starting at Incorporation
Let’s start with incorporation. Who owns what percentage and what is a common number of Issued and Granted share and how do Stock Options play into the equation.
When you incorporate, you will Authorize (Authorized) Shares and Issue (Issued) Shares. Authorized is the total number of shares the company many issue over the lifespan of the company without changing its Charter with the State (incorporating entity). Typically this is a large number of shares so you don’t have to go back to your state or government agency to issue additional shares at a later date. Your corporate Bylaws and Charter will dictate how you can access these additional shares.
Issued shares include the number of shared for Founders at the time of incorporation, the Stock Option Pool – usually 10-20% depending on if early employees get a grant or an option. As well as preferred shares that you anticipate selling in the early rounds of funding.
For example, if you wanted to increase your stock option pool, it would require documentation and a vote of the Board and perhaps shareholders. There are two types of shares at formation:
- Common – the most basic of the shares
- Preferred – as implied, these shares will have a preference of some kind – but the preferences will be determined later. The preferences will change with each Series – or round of funding and generally grow in complexity with preferences, see below
- These are the type of shares sold to investors
- The specific preferences can change with each round of funding
When you incorporate your company the value or basis of the stock is (hopefully) the least it will ever be. At that point in time, you are granting Issued shares to the founders. This grant is in exchange for an Assignment Agreement and anticipated work to be contributed to the organization. This is usually calculated in the fractions of pennies – so 3,100,000 shares may reflect a cash contribution of $3,100. This is likely the cash you and your partner(s) will be contributing to pay the legal fees or other costs associated with the early project work. This creates a Basis for your stock price – when you sell it later, it reflects the cost you have in the stock. Think:
- Total Sale
- = Taxable Income
Your Attorney Represents the Company
Not the founder. If you want someone to represent you and your founder team, you’ll need to pay them outside of the company funds.
The attorney also doesn’t represent the investor – but they may try to cozy up to them. In one of my startups we had a big name investor (I won’t name drop here) and our attorney decided that he might get more business by helping out the investor. This is not “good form” and professionals should know better. We ended up letting that attorney go and finding another one in the process.
Board Members also represent the interest of all shareholders – it’s called fiduciary duty. They will be required to vote their shares – especially if you have a class of shares to vote. However, they need to represent the best interest of the business. More on this topic in another post.
You’re now incorporated, you’ve established your basis for the stock. In the US you’ll need to file an 83B election.
Stock Options – are the shares held by the early team members or contractors. These are typically Incentive Stock Options (ISO) or Non Qualified Stock Options (NSO). ISO’s have favorable tax treatment of Capital Gains vs Regular Income (more in Joe Wallin’s Blog). They are shares granted at the time of employment or generally the next Board meeting.
- Strike Price – this is the price the shares are granted at the time, at incorporation, it’s likely $0.01 per share. As a later option it will be closer to the fair market value – for more details see Fair Market Value of a Startup. Keep in mind they can’t be granted at a cheaper rate than Fair Market Value without creating a taxable event. The price is the same price for everyone you grant options at that time.
- Vesting Schedule – is the term in years that the shares will vest. Usually three or four years, it can be monthly or quarterly. Let’s use the example of a four year schedule with a one year cliff. Cliff Vesting – usually the first 12 months is the initial vesting schedule
60,000 Share Grant example
Strike Price of $0.10 a share
365 Days = 15,000 shares vested
45,000/36 remaining months = 1,250 shares vested per month
- Reverse Vesting Schedule – for a founder, when you are granted shares at incorporation you own the shares, however, you may be asked to reverse vest those shares. The reason is simple, let’s say you own 35% of the company and you decide at month 13 that you want to go do something else with your life – things happen. If it was similar terms as above
|25% for year 1
|2.7778% (or 1/36)
|Total Founder Shares at Exit
This leaves 2.26M shares available for the company to use to hire your replacement or replacements over time. Think of this as a “must be present to win” tax. Remember, as much as you might think you are “owed” these shares as a founder, the market recognizes you have to keep contributing as an employee to keep the stock.
A Convertible debt is a debt instrument used to put money into a company without having to put a Price on the value of the company and the corresponding value of the shares. This funding mechanic is good for startups in a number of ways. First, you think your idea is more valuable than it really is, all of us do, so you don’t have to price the stock lower than you you would like. Second, the legal costs associated with this type of financing should be the cheapest option for your startup.
- Convertible Debt
- Amount – of the individual and as a total
- Term – accrued interest over what timeline
- Rate – usually in the 6-8% range
- Conversion at Qualified Financing – this stipulates reason for converting and the minimum amount to be raised – this would include accrued interest from the early investors
- Cap – a Cap is the reason a investor is interested in this financing mechanic. In the case of Techstars (you can download their documentation here) it converts at either the lessor amount of the financing or the “Cap”. For example, the cap may be $4M. If you raise a $1M at $5M pre-money, the original investors are effectively in the money from their original investment – though they can’t sell the stock at this point.
Debt is “first in line” to get paid if the company was to fail and you have to sell the assets (assuming there was value). What that means is that if you have IP that you can sell for $100k and you have $1M in convertible debt holders they would get a pro-rata % of that sale before shareholders – like founders – would get paid anything.
Keep in mind, these early investors are taking the most risk at this stage of your company and most don’t want to simply get paid back their principal and interest. They are looking to actually own the stock.
Selling Stock – Preferred Shares
Preferred Stock sales is a priced round of capital to be sold. Generally it “stands in front” of common stock until a company goes public, at that time all of the stock generally is the same – all common. Their are exceptions, like the Killer B stock, but in general an IPO converts all stock to common. The size of each of these Series depends on your location, e.g. the Valley has bigger funding rounds than Iowa City.
Keep in mind, when you sell new shares of stock in the company you are not selling your shares, you are taking shares from the Issued Preferred Shares. This will cause overall dilution to all shareholders, but the cash will go to the company and not to the founder.
- Series Seed – Series Seed documents are an open sourced set of documents designed to be both company and investor friendly. The goal of Series Seed is designed as a template you lawyer can use to keep the documents cheap – you don’t want $30k to go to the lawyers for a $250k round of funding
- Series A – the terms of a Series A round of funding is set by the Lead investor. It’s a negotiation, but you’re not completely in control of the process unless you are killing it on your forecast to actuals numbers and have multiple investors that want to lead the round. Having competitors always matters in getting the best Term Sheet.
- Participating Preferred Shares – this means that they investor will get their money back and then participate like the common shareholder
- Series A Extension – extending the previous round and fundamentally the same terms
- Series B – simply comes after the series A, can include a range of different terms
A Few Other Provisions
Here are a few other legal terms you’ll see on term sheets
- Pro-rata participation – this is a provision that allows the investor to keep their pro-rate percentage in future rounds. If they invested and have a 5% share, they have the right to keep that 5% share if they continue to invest in the up rounds
- Down Rounds – Cram Down Rounds – if you missed your numbers and are running out of cash, but your investors believe in what you are doing you may be faced with either a down round or a cram down round.
- Down round is simply a pre-money price that is lower than the post money price of your last round – your company has effectively gone down in value
- Cram Down is where an investor forces other investors to participate or effectively crams down their percentage of ownership.
- Drag Along/Tag Along is a provision that allows and protects majority shareholders to pull along a minority shareholder, specifically at the time of a sale.
Questions about fundraising? Use the comment function below.