Navigating the Landscape of Venture Capital: A Founder’s Take on Funding Provisions

Venture capital, often hailed as the lifeblood of start-ups, can be a double-edged sword for founders. While it brings the promise of growth and innovation, it also introduces a complex world of financial intricacies and deal provisions. In this landscape, founders must tread carefully, understanding the nuances of different funding rounds, provisions, and agreements. This knowledge is essential not only for securing investment but also for safeguarding the integrity of your company and the rights of your fellow co-founders.

As a founder, it is crucial to immerse yourself in the intricacies of venture deals. Understanding the do’s and don’ts, as well as being acutely aware of potential pitfalls that can significantly impact your ownership and control of your company, is paramount.

Creating a capitalization table may seem straightforward at first glance, but things can quickly become complex when you must model various provisions, create scenarios, and consider different conversion thresholds. Calculating potential proceeds for different investors, some with liquidation preferences and others with conversion preferences, can be particularly challenging. To effectively model how different provisions impact exit scenarios, it is crucial to explore various exit scenarios comprehensively. This includes not only the ideal, highly successful exits but also the disastrous and modest outcomes. This exploration will help illustrate how different provisions can significantly affect investor returns and the distribution of proceeds.

Let’s take a closer look at a case involving Simple Agreement for Future Equity (SAFE) notes especially for an early-stage start-ups looking to join an accelerator. In a seed round, investors don’t acquire direct ownership but rather purchase rights to future equity. Understanding how to value the share price in subsequent rounds, including the consideration of conversion discounts and valuation caps, is essential for founders. Another critical aspect to consider is liquidation preferences. This involves assessing whether the exit value covers the liquidation preferences, and if it does, how the remaining proceeds should be distributed among various stakeholders. Determining who remains in the preferred position and who can’t be a complex decision that depends on various scenarios and possibilities.

In your journey through the world of venture capital, it’s essential to grasp the intricacies of different funding rounds, anti-dilution provisions, the purpose of “pay to play,” and the nuances of SAFE and convertible notes. These elements collectively contribute to the success of your start-up.

Early-stage cautions, factors to consider, usage, negotiation, and recommendations are all part of this intricate landscape. I hope you find this primer valuable and enlightening as you embark on your venture capital journey. If you need any assistance and insights in navigating this complex landscape, feel free to send me a private message; I’m happy to chat with you.

Company Founding: At the company’s inception, it has no value, but co-founders’ own shares.

Pre-Seed Options Pool: Before outside investment, the company establishes an options pool for employees, often around 10%. This pool dilutes the ownership of co-founders to allocate equity for future hires.

Seed Round Investment: The key elements are the investment size, pre-money valuation, and the concept of post-money valuation.

Series A vs. Seed Rounds: Series A investments typically involve larger deal sizes (low tens of millions), whereas seed rounds are smaller. Series A companies usually have some revenue and target 10x to 15x returns. Five years is the average time frame, but it can vary.

Ownership and Share Count: Ownership percentages are calculated based on the post-money valuation. The share count increases with outside investments. Both the founders and employees see their ownership diluted, while the seed-stage investors gain a stake.

Employee Stock Options:

o Employee options are typically used to incentivize long-term commitment.

o Options usually vest over time, with a typical n-year vesting schedule.

o If employees leave before options vest, their unvested options are forfeited.

o Vested options often have a grace period for exercising in case of an exit event.

Investor Groups and Share Types:

• Different investor groups have varying motivations and rights in venture capital deals.
• Venture capitalists typically hold preferred shares with additional rights, while employees and co-founders have common shares.
• Preferred shares often come with a liquidation preference, ensuring VCs get their investment back before common shareholders in certain exit scenarios.
• Liquidation preferences can have terms like 1x, 2x, or 3x, and they can also involve participation.

Participating Preferred Stock: Participating preferred stock is a feature that allows investors, typically venture capitalists (VCs), to receive both their initial investment back in the form of a liquidation preference (e.g., 1x, 2x) and a percentage of the common equity proceeds after that.

o Double Dipping: Participating preferred stock effectively allows investors to “double dip” by providing downside protection through the liquidation preference while also participating in the company’s upside.

o Caps on Participating Preferred: Often, there are caps (e.g., 2x or 3x) that limit the total proceeds to some multiple of the liquidation preference to prevent the deal from being heavily skewed in favour of investors.

o Usage and Negotiation: Participating preferred stock is used in negotiations, especially in situations where the company is under pressure to secure funding quickly or in late-stage growth scenarios. Companies might agree to it under certain conditions, but it’s generally discouraged, especially in early rounds, as it can disadvantage future investors.

o Early-Stage Caution: It is generally not advisable for early-stage start-ups to agree to participating preferred stock, even with a cap, as it can lead to complications in future funding rounds and reduce the founders’ and employees’ ownership stakes.

o Factors to Consider: The decision on deal structure should consider factors such as ownership percentage, exit multiples, and implications for future funding rounds. For Series A rounds, a higher valuation and standard terms often make more sense.

o Future Considerations: Adopting participating preferred stock in early rounds can lead to challenges in subsequent rounds when new investors may demand the same terms.

o Conversion Threshold: The concept of a conversion threshold indicates the exit value at which it becomes worthwhile for investors to convert their preferred shares into common shares.

Proceeds and Multiples Calculation: For proceeds calculation, one need to be careful by building scenarios where how one group of investors in a certain round stay in preferred stock, impacting another group of Investor in a different round proceeds. It is important to recalculate ownership percentages based on exit scenarios.

SAFE Notes and Convertible Notes: SAFE (Simple Agreement for Future Equity) notes and convertible notes are unpriced financing instruments used by start-ups instead of traditional priced equity rounds. They allow investors to provide capital without determining the company’s valuation immediately.

o Advantages and Disadvantages of SAFE Notes: SAFE notes offer simplicity, speed, and cost savings in fundraising. However, they are not debt or equity, potentially creating uncertainties for investors if the company fails. They can also lead to messy cap tables and sometimes lower investor returns.

o Changes during Seed and Series A Rounds: The seed round investors using SAFE notes do not receive direct ownership in the company. Instead, their investment terms include a discount or valuation cap. In the Series A round, it is essential to calculate the share price based on the pre-money valuation and share count. The seed investors’ shares are converted based on their terms, resulting in different share prices and ownership percentages.

o Options Pool Adjustments: Adjustments are made to the options pool to account for the seed round’s impact on ownership percentages and dilution.

o Deal Outcomes with SAFE Notes: While SAFE notes can offer simplicity, they often lead to lower investor returns compared to traditional priced equity rounds. The delayed conversion and the potential for complex terms can result in lower ownership percentages and returns for investors.

o Considerations for SAFE Note Usage: To mitigate the downsides of SAFE notes, companies should limit the dollar amount raised through unpriced rounds, establish clear terms for liquidation preferences, and create cap tables at different valuations to show the impact on investors.

Purpose of Anti-Dilution: Anti-dilution provisions are designed to protect existing investors, particularly VCs, from excessive ownership dilution when a company undergoes a down round (a financing round at a lower valuation than the previous one).

Anti-Dilution Overview:

• Anti-dilution provisions are used to protect the ownership stakes of preferred shareholders, typically venture capitalists, when a down round occurs.
• Preferred shareholders typically hold convertible preferred stock, which can be converted into common shares at a fixed conversion ratio.

Calculation of Conversion Prices and New Share Counts:

o To calculate the conversion prices and new share counts under different anti-dilution terms (Full-Ratchet, Broad-Based Weighted Average, and Narrow-Based Weighted Average), you need to consider the prices per share in previous rounds.

o For the Seed round, you can calculate the price per share by dividing the pre-money valuation by the number of shares before the investment or by dividing the investment size by the number of new shares issued.

o For the Series A round, calculating the price per share is more complex due to the employee option pool, so you should divide the investment size by the total number of new shares issued to Series A investors.

Full Ratchet Anti-Dilution:

• Full ratchet is the most aggressive form of anti-dilution. It allows existing investors to convert their preferred shares into common shares based solely on the new, lower per-share price in a down round.
• This method significantly increases the number of common shares received by existing investors, reducing their dilution but causing significant dilution for other shareholders.

Broad-Based Weighted Average Anti-Dilution:

• Broad-based weighted average anti-dilution considers the fully diluted share count, including preferred shares, common shares, employee options, warrants, etc., to calculate the average share price.
• This method provides more protection to existing investors than full ratchet but is less aggressive, resulting in a more modest increase in common shares for existing investors.

Narrow-Based Weighted Average Anti-Dilution:

• Narrow-based weighted average anti-dilution considers only outstanding shares, excluding options, warrants, and potentially dilutive securities that have not resulted in new shares yet.
• This method provides less protection to existing investors compared to broad-based weighted average anti-dilution.

Comparing Methods:

• Full ratchet is favourable to existing investors but detrimental to other shareholders.
• Broad-based and narrow-based weighted averages are compromise solutions, offering some protection to existing investors without overly diluting other shareholders.
• Definitions of these methods can vary in investment contracts, so careful review of the fine print is essential.

Purpose of “Pay to Play” Term: The “pay to play” term is designed to protect the founders, employees, and new investors in a start-up during funding rounds, particularly in down rounds where the company’s valuation decreases. It ensures that existing investors must invest additional capital to maintain their ownership stakes and certain key rights and preferences.

• Key Differences from Anti-Dilution: Unlike anti-dilution provisions, where investors receive extra shares for free, “pay to play” requires existing investors to pay for their additional shares. It ensures that they maintain their stakes and rights by contributing more capital to the company.
• Variations and Carve-Outs: There are various ways to structure the “pay to play” term, including proportional representation, where investors can maintain some rights even if they don’t fully invest. The term can also include exceptions and apply differently in up rounds and down rounds.
• Relation to Anti-Dilution: In some cases, “pay to play” may be traded for anti-dilution protection, meaning VCs get anti-dilution protection only if they continue to invest in future rounds.
• Considerations and Open Questions: “Pay to play” is not suitable for all types of investors or in all situations, and it’s typically not imposed in up rounds. Factors such as the investor’s capacity to invest more capital and the overall health of the company play a role in determining its appropriateness.
• Recommendation: Careful consideration is necessary when implementing “pay to play” terms, as they can have significant implications for existing investors, new investors, and the company’s ownership structure.

The venture capital journey is a tumultuous one, but with the right knowledge and strategic thinking, founders can emerge stronger and more in control of their companies. We’ve delved into the intricate world of funding rounds, anti-dilution provisions, the purpose of “pay to play,” and the nuances of SAFE and convertible notes. As you embark on your fundraising journey, remember that your understanding of these concepts will be your greatest asset. Always be vigilant, negotiate wisely, and never lose sight of the long-term vision for your company. By mastering the art of venture capital, you can not only secure the funding you need but also protect your co-founders, employees, and your start-up’s future success.

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