Fundraising

When fundraising, the main topic of negotiation is often the pre-money valuation used to calculate the price of stock issued to investors. Pre-money valuation refers to the valuation of the startup prior to the fundraising. The pre-money valuation matters because it determines the percentage of the corporation an investor will receive in exchange for their investment.

Startup investors typically calculate their percentage ownership based on the fully-diluted capitalization of the corporation. Capitalization, in this context, refers to the capital structure of a corporation — i.e. the structure of the equity and debt of a corporation. The term diluted refers to the fact that the ownership percentage represented by each share of stock is diluted each time new shares are issued. The term fully-diluted means that the capitalization is calculated assuming that all plans and obligations (whether outstanding or potential) to issue shares have been fulfilled.

Thus, a startup's fully-diluted capitalization commonly assumes:

• all preferred stock has been converted to common stock;

• outstanding options, warrants, and other securities with a right to acquire shares have been exercised; and

• any shares reserved for issuance under a stock plan have been issued.

There is no single definition of fully-diluted capitalization. For example, un-issued shares reserved for issuance under a stock plan can be excluded from a fully-diluted capitalization. This is commonly done when the fully-diluted capitalization is being calculated in connection with the acquisition of a startup, since startups typically do not issue equity following an acquisition. By contrast, these shares are almost always included in a fully-diluted capitalization in the context of equity compensation. Another possible difference is with securities that convert into stock in connection with a preferred stock financing, such as convertible notes and safes. Some definitions of fully-diluted capitalization assume the conversion of these securities, while others do not.

The securities of a startup can almost always be ultimately converted into common stock, so it is common to see the fully-diluted capitalization expressed as a single number of shares.

One traditional way for startups to raise seed financing is to sell convertible notes (also referred to as convertible promissory notes). These seed financings are known as convertible note financings.

Notes (also referred to as promissory notes) are promises made by someone to pay a specified amount to the holder of the note (also known as the noteholder) at some time in the future, known as the maturity date. Convertible notes are notes issued by a corporation that convert into shares of the corporation's stock upon certain events. When startups sell convertible notes, the notes typically obligate the company to repay the purchase price plus interest in the event that the note has not converted by its maturity date.³

Although they are notes, both the startup and the investor (i.e. the noteholder) usually intend for the note to convert into stock, rather than for the corporation to repay the note. Typically, convertible notes convert into shares of the series of preferred stock issued in the corporation's next equity financing, as part of that equity financing. Convertible notes often also convert into shares of the corporation's stock if the company is acquired or does an IPO. Most convertible notes have features known as valuation caps or discounts which affect the number of shares the note will convert into. Valuation caps and discounts are explained in our article about safes.

Despite their popularity, many people consider convertible notes awkward to use. Even though investors and startups do not typically think of convertible notes as an obligation of payment, they must agree on an interest rate⁴ in order to issue a convertible note. If a note has not converted by its maturity date, the investor and company must spend time and energy deciding what to do (usually, they extend the maturity date).

These problems exist because convertible notes were not originally designed for seed financings. They were originally designed for bridge loans — loans made by VCs to companies they invested in, to help those companies survive until their next round of venture capital financing. Startups began using convertible notes for seed financings because the paperwork and negotiation was considerably simpler than for an equity financing.

Recently, various organizations have created alternative forms of investment designed for seed financings from the ground up, in order to address the problems with convertible notes. In Silicon Valley and other major startup ecosystems, these alternatives are gaining popularity over convertible notes.

The most popular replacement for convertible notes are safes (short for simple agreement for future equity), created by Y Combinator. Like convertible notes, safes can convert into preferred stock.

There are three major types of safes — safes with a valuation cap, safes with a discount, and safes with both. These correspond to the three major flavors of convertible notes.

The number of shares of preferred stock a safe will convert into is determined by dividing the amount of the safe investment by a price (per share) for the preferred stock. The lower this price is, the more shares a safe will convert into. The higher this price is, the fewer shares a safe will convert into.

When a safe has a valuation cap and the safe is converting into preferred stock as a result of a preferred stock financing, there are two ways of determining the per share price of preferred stock to use for the safe conversion. The first is to use the per share price of preferred stock from the preferred stock financing. The second is to calculate a price by dividing the valuation cap by the fully-diluted capitalization (referred to as company capitalization in safes). Safes convert using the lower of these two possible prices, making the valuation cap a limit on the valuation that is used for the conversion.

The fully-diluted capitalization can be calculated differently depending on the type of valuation cap on the safe. Traditionally, the fully-diluted capitalization is calculated excluding safes and convertible notes. If the valuation cap is a post-money valuation cap though, then the fully-diluted capitalization is calculated including them. The term post-money in post-money valuation cap refers to the fact that it functions as a cap on the valuation after (post) the safe financing (money) is taken into account.

By limiting the valuation used for conversion, valuation caps ensure that safes will convert into a minimum percentage of the company, as calculated prior to the preferred stock financing. For safes with regular valuation caps, this minimum will be lowered when the company issues additional safes. By contrast, for safes with post-money valuation caps, this minimum percentage remains the same no matter what other safes the company has issued.

Valuation caps are also referred to as conversion caps or target valuations.

The conversion price can also be set to have a fixed discount from the price per share of the preferred stock. This ensures that the safeholders will get a better deal than subsequent preferred stock purchasers.

Some safes have both a valuation cap and a discount. When safes with both a valuation cap and discount convert, the more investor-favorable method is used — i.e. the method that results in the safe converting into more shares.

By default, if a safe has not already converted by the time the company is acquired, the investor has the choice of (1) receiving their investment back⁵ or (2) having the safe convert into common stock using the same valuation cap or discount as for a preferred stock conversion.

When investors have significant negotiating power, they may negotiate to have the safe specify an option to receive a multiple of their investment back (typically 2×). This has the effect of increasing the minimum acquisition price at which founders and employees will receive proceeds from an acquisition.

While most startups issue convertible notes or safes in seed financings, some issue preferred stock (which is standard for post-seed financings). Financings where the startup sells preferred stock are known as equity financings, since preferred stock is a form of equity.

Typically, startups create a new series of preferred stock for each equity financing. Startups issuing preferred stock in a seed financings will usually call the new series Series Seed or Series AA. These financings often use forms based on those used in post-seed financings, but that are specifically adapted for seed financings.

By convention, for post-seed investments, the series are designated by letters in alphabetical order. For example, the series created for the first post-seed financing is typically called Series A Preferred Stock. The series created for the next financing is usually called Series B Preferred Stock, and so on.