Home IT services Learn The Five Most Important Terms In A Series A Funding Round

Learn The Five Most Important Terms In A Series A Funding Round

0
Learn The Five Most Important Terms In A Series A Funding Round

[ad_1]

The next round of equity financing after the Seed Round is a Series A. Generally, a startup has demonstrated product-market fit and has some traction in the form of user growth and/or revenue. The Series A funding is about trying to scale the product and the team to take the company to the next level.

There are many macro-economic and company-specific variables, but a Series A typically raises between $10 million and $20 million. The investor base is usually professional venture capital (VC) firms, though a few strategic angels may be involved.

Most Series A rounds in the United States are based on the model National Venture Capital Association (NVCA) documents. This standard set of documents is a good starting point for negotiations, but revisions are common. In the end, the total document set is hundreds of pages. It’s important for founders to have counsel familiar with NVCA docs to draft and negotiate on their behalf.

Founders don’t need to know every paragraph in the document set. However, it is essential that they understand the term sheet. The Series A term sheet is a summary of the deal. A founder that understands the term sheet can advocate for themselves in negotiations and communicate their wishes to their counsel.

Below are the five most important terms in a Series A funding round.

Valuation

The valuation is the value of the company agreed on between the investor and the founder. The valuation is often the most hotly contested and heavily negotiated term in the term sheet.

The valuation may be expressed in two ways: pre-money and post-money. The pre-money valuation refers to what the investor is valuing the company prior to the investment. On the other hand, the post-money valuation is the value the investor is assigning to the company once the round has closed. To calculate the post-money valuation, simply take the pre-money valuation and add the amount raised in this round.

When an investor says, “I’ll invest $X at $Y valuation,” they usually mean the post-money valuation. At the same time, the founder often understands the valuation as pre-money. As you’ll see below, the interpretation of the valuation matters:

● $20 million at a $100 million post-money valuation would result in the investors owning 20% of the company.

● $20 million at a $100 million pre-money valuation would result in the investors owning 16.67% of the company.

To avoid ambiguity, founders should explicitly state that the valuation is pre-money or post-money. This demonstrates an understanding of basic terms and earns the respect of the investors.

Liquidation Preferences

The liquidation preference determines how much the preferred shareholders will be paid from the proceeds of an acquisition before the other shareholders are paid. It is designed to ensure that investors make money or at least break even in an acquisition. There are two major components in a liquidation preference:

Participation—Whether and how the stockholder receives the money distributed to stockholders after the preference has been paid.

Preference—The money distributed to the stockholder prior to distribution to other classes of stockholders.

Let’s start with the preference. Preferences are stated in terms of multiples of the money an investor invested. For example, 1x means the preference is for 100% of the amount invested, while 1.5x means 150%.

The most common liquidation preference in Series A financing is 1x. So, if an investor invested $1 million into your company at a liquidation event, they will be paid back $1 million before the common shareholders receive any money.

Next, let’s look at the participation. After the preference is paid to the investor, the question becomes if and how they will participate in the remainder of the distribution to shareholders. If an investor invested $1 million in your company with a 1x liquidation preference and you sold it for $21 million, then the investor would first get $1 million. But how will the other $20 million be distributed? That depends on the investor’s participation right. There are three types of participation:

Nonparticipating. A nonparticipating liquidation preference indicates that the preferred shareholders receive their liquidation preference but no additional proceeds from the liquidation event. In this instance, the investor can elect to either take the preference of their original investment or the proceeds from the sale price based on their ownership percentage in the company.

Full Participation. Investors receive their preference (multiple of original investment) first, then their percentage of remaining proceeds as common shareholders. Referred to as “double-dipping,” liquidation preference gives shareholders the right to receive payout from proceeds pool and “participate” in proportion to ownership.

Capped Participation. Capped participation is a variation of full participation, where the investors get to take their liquidation preference, as well as the proceeds from the sale price based on their ownership percentage, with a payout capped at a certain amount. This sets the ceiling amount for participating liquidation preference.

The most standard liquidation preference in a Series A deal is 1x nonparticipating. This ensures that investors make their money back first, but the founders and employees are rewarded for their hard work.

Anti-Dilution

The anti-dilution clause is there to protect an investor if the company has a “down round.” A down round is a round of financing in which the company is raising at a lower valuation than the previous round of financing. Down rounds should be avoided if possible as they are generally seen as a signal that the company is not doing well.

The anti-dilution mechanism enables investors to convert their share price to a new price that allows them to maintain their stock ownership percentage prior to the down round. There are two major categories of anti-dilution provision: full rachet or weighted average.

Full ratchet is a “do over” for investors; it prices original shares purchased in earlier rounds at the new, lower price of a down round. Full ratchet dilutes founders and employees heavily, so it’s seen as very investor-friendly.

Weighted-average is a more reasonable approach to anti-dilution. Weighted average also adjusts the amount of investors’ shares. But rather than a pure share price adjustment, weighted average accounts for the amount of shares sold in the down round relative to the total outstanding shares. This approach results in less dilution for founders and employees, so it’s more founder-friendly.

The best-case scenario for founders is to remove anti-dilution from the deal. However, this is highly unlikely, so founders should instead focus on ensuring that the anti-dilution provisions are broad-based weighted-average. Fortunately, this has become the most standard version of the term.

Drag Along

Drag along rights may allow the Series A investors to force a sale of the company. The drag along rights allow a certain set of investors to force the rest of the shareholders to sell the company. This term is investor-friendly, so the best possible outcome would be to negotiate this term out of the deal.

In the event that the investors insist on the term, then the founder should attempt to negotiate for the decision-makers to be a broader set of shareholders. The most investor-friendly version of this clause allows a majority of Series A investors known as the Requisite Holders to unilaterally make the decision to sell the company. In some cases, this could mean that literally one VC firm could force a sale. It’s better for founders if that decision-making power is diffused. So, founders should negotiate to add approval by the board of directors as well as holders of a majority of shares held by employees of the company. This entire group of decision makers would be known as the Electing Holders.

The most investor-friendly version of this term puts the life or death of the company in investors’ hands. Since it may pose an existential threat to the company, it is a term that founders should spend energy negotiating.

Board of Directors

The board of directors has the highest level of decision-making power in the company. The board must approve all major actions. They have the power to hire and fire the CEO. They shape the direction of the company, so this may be one of the most important terms in the whole term sheet.

Founders should keep two goals in mind when negotiating this term.

First, the founder should optimize for voting power. Founders want to maintain a strong ratio of friendly board members versus investors. Let’s assume that prior to the round, the board consists of four board members: three founders and one investor from the seed round. If the company accepts an additional investor on the board in this round, then the balance shifts from three founders to two investors. This is not a bad situation for the founders. Assuming the three founders agree, then they should be able to pass anything they wish. However, the general rule of thumb is that the lead investor in each round will get a seat on the board. At Series B, the founders and investors will each have three seats. At Series C, the founders will have three seats, and the investors will have four. Founders should consider the long-term impact of delegating board seats in the Series A.

Second, the founder should optimize for good people. Board members are the people you’ll be in the trenches with, working through challenging decisions together. You want people in the room that understand the vision, have a unique perspective / expertise to add and are great to work with.

Conclusion

A clear understanding of these terms will help founders work with their counsel to ensure that they are negotiating a smart deal for them and their team. Check out this video to learn more, and for a deeper dive, read this guide.

[ad_2]

Source link

LEAVE A REPLY

Please enter your comment!
Please enter your name here