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THE STARTUP TO VC

FINANCING JOURNEY
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THE STARTUP FINANCING STORY:
INTRODUCTION
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Workandplay Ltd. is a London based mobile-gaming
startup. The company makes multiplayer games for use
between employees at work. The four co-founders met in
school and decided to launch the startup together three
months ago. The company issued 4,000 common shares
which were split equally between the co-founders when the
company was established.
Initially the team were concerned that if one co-founder
left the business within the first year, they would walk away
with 1/4 of the equity while not remaining active in the company.
The team decided to include a three-year vesting schedule
with a one-year cliff for its co-founders. With a one-year cliff
any co-founder that left within 12 months of launch would not
be eligible to receive their share of equity. The three-year
vesting schedule meant (25% / 3 years) = 8.33% of equity would
be released to each co-founder over the 3 year period after
the initial cliff. All the co-founders remained in the business
beyond 3 years and received their 25% stake of common shares.
Angels
Venture
Capital
Employees
Founders
Common
Shares
Convertible
Notes
Preferred
Stock
Options
WORKANDPLAY’S
FINANCING OPTIONS
THE STARTUP FINANCING STORY:
CONVERTIBLE NOTES
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After 3 months of prototyping the game, Workandplay
successfully raised £150,000 from a group of angel investors.
The company used debt financing in the form of
convertible notes. The angel investors effectively
loaned capital to Workandplay at 8% interest. However instead of
receiving their money back with interest, the investors would
receive preferred shares should the company close a subsequent
round of financing.
By using convertible notes, the company raised money
quickly and at low cost, as the legal documentation required
was minimal. As convertible notes are a form of debt, this
delayed placing a valuation on the company until it was more
mature and easier to price. By raising debt, the co-founders
postponed diluting their shareholdings until later financing rounds.
A 10% conversion discount was applied to reward the angels
for investing at the earliest stage of the business. The
angels could convert the loan amount, plus interest
(£150,000 + £20,267) at a discount £170,267 / (1-0.10) = £189,185
to the purchase price when company ownership is offered to
venture capital investors (VCs).
Convertible Note
Principal Amount of the Convertible Note (£) 150,000
Annual Interest Rate 8%
Discount from Series A share price 10%
Date of the Convertible Note funding 01/01/2014
Estimated Date of Conversion (Series A funding) 01/09/2015
Days of Interest Accrued on Note 608
Interest Accrued (£) 20,267
Value of Convertible Note £ (Principal +Interest) 170,267
Value of Convertible Note into Series A £ (P+I+Discount) 189,185
THE STARTUP FINANCING STORY:
VALUATION
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The angels were concerned that if Workandplay succeeded in
raising further financing, their initial stake would be diluted
significantly. For their £150,000 investment, the angels
requested a cap of £1.5million. This ensured investors would
not own less than 10% of the company (£150k/£1.5million)
when ownership is offered to external investors for the first
time - also known as a Series A financing.
However the co-founders negotiated an uncapped round
with the angels. Now if Workandplay convinced Series A
investors to agree to a £5 million valuation, the angels would
be left with only 3% of the company and the co-founders
would retain a larger stake.
After 12 months, Workandplay entered into discussions with
three VCs for a Series A financing. Based on the company’s
prospects, the VCs agreed a £3 million company valuation
before receiving funding, the pre-money valuation. They
decided to invest £1 million, which made an after-funding or
post-money valuation of £4 million.
Post-money valuation = pre-money valuation + new funding
Capped vs Uncapped
Angel Investment 150,000
Cap 1,500,000
Series A Post-Money Valuation Cap Uncapped
500,000 30% 30%
1,000,000 15% 15%
5,000,000 10% 3%
10,000,000 10% 2%
Pre-Money Valuation + Investment =
Post-Money Valuation
THE STARTUP FINANCING STORY:
PREFERRED STOCK
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During Series A negotiations, the founders discussed how
investors would be compensated if the company is acquired,
goes bankrupt or is sold on the stock market – a liquidity
event. Liquidation preferences determine who gets paid
when these events occur. The VCs requested preferred stock
rather than common stock, which is held by the co-founders.
In the event of an acquisition or bankruptcy, lenders get paid
first, followed by preferred stockholders and anything that is
left goes to the co-founders.
The company and VCs agreed a liquidation preference of 1x,
so that during a liquidity event, the VCs will get 1x their initial
£1 million investment back before the co-founders receive
anything.
At the time of a liquidity event, the VCs would also like to
share in the gains of the company, unpaid dividends as well as
redeem their initial investment. As such, they requested
participating preferred stock. As the VC will own 25% of the
company at the time of a liquidity event, they will get their
money back plus 25% of the remaining proceeds.
Participating Preferred Shares
Initial Investment 1,000,000
Pre-Money Valuation 3,000,000
Post-Money Valuation 4,000,000
VC Ownership (%) 25.0%
Unpaid Dividend 20,000
Company Exit Value 10,000,000
VC Exit
Dividend 20,000
Liquidity Preference 1x 1,000,000
VC Share of Exit 2,250,000
Total Return 3,270,000
THE STARTUP FINANCING STORY:
PREFERRED STOCK
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As an example, if Workandplay sells for £10 million in 3
years, investors can exercise their 1x liquidation preference
and receive any unpaid dividends (£20k). They are also
entitled to share 25% of the remaining £9 million: £2.25
million, leaving them with a total return of £3.27 million.
If the VCs accepted non-participating preferred shares,
they would only redeem their initial investment and
dividends, leaving them with £1,020,000 on exit.
As with the angels in the convertible notes round, the VCs
would like to protect against dilution in further financing
rounds. With a 25% stake at Series A, if Workandplay
attracts other investors at a £50 million valuation, to
maintain their holding they would need to invest a further
£11.5 million or be left with just 2% (£1 milion / £50 million)
of the company. With pro-rata rights however,
Workandplay must leave space in subsequent funding
rounds so that investors can avoid being diluted.
Pro-rata Rights
VC investment - Series A 1,000,000
Post-money valuation 4,000,000
VC % Ownership 25%
Post-money valuation - Series B 50,000,000
Required Investment for 25% Holding 12,500,000
Additional Investment Needed 11,500,000
Non-Participating Preferred Shares
VC Exit
Dividend 20,000
Liquidity Preference 1x 1,000,000
Total Return 1,020,000
THE STARTUP FINANCING STORY:
OPTION POOLS
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Following a successful Series A round, the co-founders
decide to hire their first employees to push their sales
and marketing efforts. Like most VC-backed companies,
Workandplay need to find great employees who are
incentivised to see the venture succeed over the longer
term. The company also has to manage its cashflows in
the early years when resources are limited. As part of
the funding round, the deal included a 20% option pool
as non-cash currency for future employees.
The 20% option pool is a percentage of the company’s
post-money valuation giving an option value of
(20% x £4 million): £800,000. As the option pool
comes directly out of management’s stake, if the
options are exercised only the co-founders are diluted in
the process. The VC investors still retains 25% of the
company.
As such, the co-founders equity stake is the pre-money
valuation less the option pool value £2,810,815 -
£800,000 = £2,010,815. Ultimately the co-founders
stake is diluted further from their initial 70.3% holding to
50.3% (100% - 4.7% (Angel) - 25% (VC) - 20%
(Options).
Workandplay - Option Pool
% Option pool 20%
Effective Pre-Money Valuation 2,810,815
%
Angel Stake 189,185 4.7%
VC Stake 1,000,000 25.0%
Option Pool 800,000 20.0%
Founders stake (Pre-Money valuation - Option pool) 2,010,815 50.3%
Post-money valuation 4,000,000
THE STARTUP FINANCING STORY:
FOUNDER DILUTION
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Workandplay Shareholders
Shares (#) Investment (£) %
Founder 1 1000 -
Founder 2 1000 -
Founder 3 1000 -
Founder 4 1000 -
Founders 4000 - 70.3%
Angels 269 189,185 4.7%
Venture Capital 1,423 1,000,000 25.0%
Total 5,692 1,189,185
Workandplay Shareholders
Shares (#) Investment (£) %
Founder 1 1000 -
Founder 2 1000 -
Founder 3 1000 -
Founder 4 1000 -
Founders 4000 - 50.3%
Angels 376 189,185 4.7%
Venture Capital 1,989 1,000,000 25.0%
Option Pool 1,591 800,000 20.0%
Total 7,957 1,189,185
Workandplay Shareholders
Shares (#) Investment (£) %
Founder 1 1000 - 25.0%
Founder 2 1000 - 25.0%
Founder 3 1000 - 25.0%
Founder 4 1000 - 25.0%
Total 4000
CONVERTIBLE NOTE
SERIES A FINANCING
SERIES A + OPTION POOL
Share Price Calculation
Post-Money Valuation 4,000,000
- VC Investment 1,000.000
- Angel Investment 189,185
/ No. Shares 4,000
Share Price: £702.70
Share Price Calculation
Post-Money Valuation 4,000,000
- VC Investment 1,000.000
- Angel Investment 189,185
- Option Pool 800,000
/ No. Shares 4,000
Share Price: £502.70