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Understanding Valuation, Liquidation Preferences, Board Of Directors And Expenses


Once your product begins performing well in the market, it may be time to consider a seed round of funding. Seed rounds are typically between $2–$5 million with a post-money valuation between $20–$30 million.

Though some seed funding is done on Simple Agreement for Future Equity (SAFEs) and convertible notes, the seed round is often the first round of equity financing. In equity financing, the company is selling preferred stock, which means that seed investors become part-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 notes common in pre-seed funding. But if you have raised money on SAFEs or convertible notes, they will convert into shares of preferred stock with all the rights of the new investors.

Preferred stock comes with negotiated rights and preferences that put investors on better footing than founders and employees. Since early-stage investments are risky, these preferences are designed to protect investors who take higher risks. Series Seed Preferred Stock may include 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 will sell approximately 20% of your company’s shares. 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 contentious and heavily negotiated term in the term sheet. Higher valuations are beneficial to 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 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 investors say, “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 confusion, founders should clearly indicate whether the valuation is pre-money or post-money. This shows an understanding of fundamental concepts and earns investors’ respect.

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 remainder is shared by the other shareholders. The liquidation preference 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. If an investor invested $1 million into your company at a liquidation event, the investor 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 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 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 take the preference from the original investment. Or, choose 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 a payout from the 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 seed deal is 1x nonparticipating. This ensures that investors make 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 important 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 a startup will have a board consisting exclusively of founders prior to the seed round.

Historically, it was indeed common for the board to be composed exclusively of the founders until Series A. However, as the size of seed rounds have increased, it’s become more common for investors to request a seat on the board. Simply put, if they are cutting a big check, investors want some control. For smaller seed rounds, it’s common to not give investors any board seats.

If you have a round that is large enough, then you want to ensure you have a balanced board. A typical structure is:

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

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

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

Pro Rata

A pro rata right, also called a participation right, is the right of existing investors to participate in future rounds of financing in order to maintain their current percentage of ownership. It is usually limited to major purchasers due to the legal fees for calculating pro rata rights for minor investors.

From the founder’s perspective, the participation right is a neutral concept because founders usually welcome investment. Furthermore, it is always positive for the startup to signal that prior investors are participating in future rounds.

However, this is usually a right that the current set of investors want, but the incoming investors don’t want. This is because the participation right will limit the ownership percentage that the incoming investor can purchase, while existing investors want to ensure their ownership percentage will not be reduced.

As your investor base grows, the participation rights could cause tension between investors from different series.

Expenses

The expenses term dictates who’s paying for the legal bills in this round of funding. Unfortunately, it is common practice for the startup to pay both investor and company counsel. We strongly recommend that every founder pushes back on this, especially in an early-stage financing.

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

The wealthy investors/firms are asking the startup that’s struggling to stay alive to pay not only their own legal bills but the legal bills of the investor. This is hands down the most short-term, unnecessary, power-grabbing term in the term sheet. It should be struck from all standard term sheets.

This clause forces the startup to pay the legal fees of the counsel that is negotiating against their best interest. Additionally, opposing counsel has the power to drag out the diligence process and negotiations of the deal, which increases their legal bill. Unlike company counsel, the startup has no ability to rein in costs. The startup is left covering a legal bill it had no control over.

Conclusion

Having a thorough understanding of these terms will help founders collaborate with their legal advisors to secure an advantageous deal for themselves and their team. Check out this video to learn more. For a deeper dive, read this guide.

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