Insight into valuation, liquidation preferences, board of directors and costs

by Ana Lopez

Once your product starts to perform well in the market, it might be time to get one seed round of financing. Seed rounds are typically between $2 and $5 million with an after cash valuation between $20 and $30 million.

While some seed funding is done on Simple Agreement for Future Equity (SAFEs) and convertible bonds, the seed round is often the first round of equity funding. In equity financing, the company sells preferred stock, which means that seed capital investors become co-owners of the company. Many seed rounds are based on the Series Seed documents. However, depending on the size, some are based on the National Venture Capital Association documents.

This is different and more complicated than SAFEs or convertible bonds that are common in pre-seed financing. But if you have raised money on SAFEs or convertible bonds, they will be converted into preferred stock with all the rights of the new investors.

Preferred stock comes with negotiated rights and preferences that give investors a better footing than founders and employees. Since early stage investments are risky, these preferences are designed to protect investors who take greater risks. Series Seed Preferred Stock may consist of liquidation preference(s), a right to a board seat, a right to participate in future rounds, and various other preferences.

valuation

In a typical seed round, you sell about 20% of your company’s stock. Valuation is one of the most crucial aspects of the round, as it determines the amount of capital you can raise for that 20% stake.

The valuation is the value of the company agreed upon by the investor and the founder. This is often the most controversial and heavily negotiated term in the term sheet. Higher valuations are good for founders, while lower valuations are better for investors. It is the founder’s responsibility to present a compelling vision of the company that warrants a higher valuation.

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

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

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

● $20 million against $100 million For money valuation would result in the investors owning 16.67% of the company.

To avoid confusion, founders should clearly state whether the valuation is pre-money or post-money. This demonstrates an understanding of fundamental concepts and earns the respect of investors.

Liquidation Preferences

This term describes how the money from an acquisition will be distributed. Investors with a liquidation preference get their payout first and the rest is shared among the other shareholders. The liquidation bias is designed to ensure that investors make money – or at least break even on an acquisition. There are two major components in a liquidation preference:

Participation—Whether and how the shareholder will receive the money that will be distributed to the shareholders after the preference has been paid.

Preference—The money distributed to the shareholder before being distributed to other classes of shareholders.

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

The most common liquidation preference in Series A financing is 1x. If an investor invested $1 million in your company during a liquidation event, the investor will be paid back $1 million before the common stockholders receive any money.

Next, let’s look at participation. After the preference has been distributed to the investor, the question becomes whether and how participation will work during the remainder of the distribution to shareholders. If an investor invested $1 million in your company with a 1x liquidation preference and you sell it for $21 million, the investor will get $1 million first. But how will the other $20 million be divided? That depends on the investor’s right to participate.

There are three types of participation:

Non-participating. A non-participating liquidation preference indicates that the preferred shareholders receive their liquidation preference, but no additional proceeds from the liquidation event. In this case, the investor may choose to prefer the original investment. Or choose the yield of 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 the remaining proceeds as common shareholders. Referred to as “double-dipping,” liquidation preference entitles shareholders to receive a payout from the revenue pool and “participate” in proportion to ownership.

Limited Participation. Capped participation is a variant of full participation, where the investors can take their liquidation preference, as well as proceeds from the sale price based on their ownership percentage, with a payout limited to a certain amount. This determines the ceiling amount for the participating liquidation preference.

The most standard liquidation preference in a seed deal is 1x non-participating. This ensures that investors get their money back first, but the founders and employees are rewarded for their hard work.

Board of Directors

The board of directors is the highest legal authority in a company and is responsible for major decisions such as budgets, options and dividends. It also approves mergers and initial public offerings (IPOs) and has the power to fire the CEO. Typically, prior to the seed round, a startup will have a board consisting solely of founders.

Indeed, historically it was common for the board to consist solely of the founders until Series A. However, as starting rounds have increased, it has become more common for investors to apply for a seat on the board. Simply put, when they cut a big check, investors want some control. For smaller seed rounds, it is common practice not to give investors board seats.

If you have a big enough round, you want to make sure you have a balanced board. A typical structure is:

● two founders (elected by a majority of the common stock),

● one investor representative (elected by a majority of the Series Seed investor), and

● one independent director. The independent director must be mutually agreed between the founders and the investors.

Proportionally

A prorated right, also known as a participation right, is the right of existing investors to participate in future funding rounds to maintain their current ownership percentage. It is usually limited to large buyers due to the legal costs of calculating pro rata rights for small investors.

From the founder’s perspective, participation law is a neutral concept because founders are usually happy with investments. In addition, it is always positive for the startup to indicate that previous investors are participating in future rounds.

However, this is usually a right that current investors want, but incoming investors don’t. Participation right limits the percentage of ownership that the incoming investor can purchase, while existing investors want to ensure that their percentage of ownership is not reduced.

As your investor base grows, participation rights can create tension between investors from different series.

Expenses

The expense term determines who pays the legal bills in this funding round. Unfortunately, it is common for the startup to pay both the investor and the corporate attorney. We strongly advise any founder to push back on this, especially with early stage funding.

To put it bluntly, this term is abuse of power.

The wealthy investors/firms are asking the startup struggling to stay alive to pay not only their own legal bills, but those of the investor as well. This is without a doubt the most short, unnecessary, power grabbing term in the term sheet. It should be deleted from all standard term sheets.

This clause forces the startup to pay the legal fees of the attorney negotiating against their interest. In addition, the opposing party’s attorney has the power to delay the due diligence process and deal negotiation, which increases their legal bill. Unlike corporate lawyers, the startup has no ability to rein in costs. The startup is left with a legal bill it had no control over.

Conclusion

A thorough understanding of these terms will help founders work with their legal advisors to secure a beneficial deal for themselves and their team. Checking out this video learn more. For a deeper dive, read this guide.

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