How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO by Tom Taulli Page B
Authors: Tom Taulli
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Facebook raised a whopping $16 billion! We look at IPOs in more detail in Chapter 14 .
Types of Stock
The total number of shares available for a company to issue is referred to as authorized stock whereas the total number of shares that a company has already issued is referred to as outstanding stock . Now, let’s say that company XYZ has authorized the issuance of 10 million shares of its stock, and of those 10 million shares, 1 million have already been issued. In this case, if you own 100,000 shares of XYZ, then you own a 10% stake in the company. As XYZ cycles through the various rounds of funding that a company undergoes in its development, it issues more and more of its authorized stock to early-stage investors in return for infusions of capital, which usually means that your 10% ownership stake in the company likely becomes diluted over time.
A company will issue different types of stock to different types of investors, depending on the stage of funding it’s in. Common stock, for example, which represents a form of equity ownership in a company, is issued to founders, early-stage employees, and seed investors. It is also distributed, when applicable, to the startup accelerator that helped to launch the company. Angels and VCs, on the other hand, are interested in a different type of security: preferred stock. Like common stock, preferred stock bestows upon its holder equity ownership in a company, but it also confers an assortment of additional special rights, which are spelled out in the term sheet and shareholder agreements and can include liquidation preferences, veto rights, and board seats. We take a look at some additional preferred stock deal terms in Chapter 6 .
To continue our current discussion, however, an angel round of financing predicated on preferred stock can be time intensive (taking 2 to 4 weeks to finalize) and expensive (given that the legal costs of this process can easily soar to more than $25,000). In other words, for what amounts to a small infusion of capital—–say, $500,000—preferred stock can create some big problems. To avoid the delays and expense of issuing preferred stock during the angel round of financing, founders often distribute convertible notes instead, which essentially are loans with fixed interest rates (such as 5% to 10%) that mature within 1 to 2 years of issuance. As an added bonus, interestpayments are not due on accrual. Rather, any interest that accrues prior to maturity is added to the notes and can be paid off when the notes mature or are converted into equity.
Much easier to structure than preferred stock, and with legal costs that top out at maybe a few thousand dollars, convertible notes are an attractive alternative to preferred stock for founders for yet another reason: Their value is not tied to the company’s overall value. As a result, convertible notes allow founders to avoid a potentially contentious conversation about company valuation with their angel investors. Might as well “kick the can down the road,” right? Actually, it is rather smart for an early-stage company to put off valuation discussions because it is difficult to determine the fair value of a venture that has not yet had the time to prove its worth.
When a company is ready for a Series A round of financing, its valuation should be much easier for the founders and angels to agree on. As soon as they come to a consensus on the value of the company, the angel investors will convert their notes into preferred stock. However, convertible note holders want to receive special treatment during the Series A round in exchange for their willingness to make an initial investment in the company. You can reward your convertible note holders in one of two ways. The first approach is to put a cap on the premoney valuation of your company to ensure that note holders are cited a valuation that is no higher than a fixed amount. For example, suppose Jane invests $500,000 in XYZ. In 5 months, XYZ is
Types of Stock
The total number of shares available for a company to issue is referred to as authorized stock whereas the total number of shares that a company has already issued is referred to as outstanding stock . Now, let’s say that company XYZ has authorized the issuance of 10 million shares of its stock, and of those 10 million shares, 1 million have already been issued. In this case, if you own 100,000 shares of XYZ, then you own a 10% stake in the company. As XYZ cycles through the various rounds of funding that a company undergoes in its development, it issues more and more of its authorized stock to early-stage investors in return for infusions of capital, which usually means that your 10% ownership stake in the company likely becomes diluted over time.
A company will issue different types of stock to different types of investors, depending on the stage of funding it’s in. Common stock, for example, which represents a form of equity ownership in a company, is issued to founders, early-stage employees, and seed investors. It is also distributed, when applicable, to the startup accelerator that helped to launch the company. Angels and VCs, on the other hand, are interested in a different type of security: preferred stock. Like common stock, preferred stock bestows upon its holder equity ownership in a company, but it also confers an assortment of additional special rights, which are spelled out in the term sheet and shareholder agreements and can include liquidation preferences, veto rights, and board seats. We take a look at some additional preferred stock deal terms in Chapter 6 .
To continue our current discussion, however, an angel round of financing predicated on preferred stock can be time intensive (taking 2 to 4 weeks to finalize) and expensive (given that the legal costs of this process can easily soar to more than $25,000). In other words, for what amounts to a small infusion of capital—–say, $500,000—preferred stock can create some big problems. To avoid the delays and expense of issuing preferred stock during the angel round of financing, founders often distribute convertible notes instead, which essentially are loans with fixed interest rates (such as 5% to 10%) that mature within 1 to 2 years of issuance. As an added bonus, interestpayments are not due on accrual. Rather, any interest that accrues prior to maturity is added to the notes and can be paid off when the notes mature or are converted into equity.
Much easier to structure than preferred stock, and with legal costs that top out at maybe a few thousand dollars, convertible notes are an attractive alternative to preferred stock for founders for yet another reason: Their value is not tied to the company’s overall value. As a result, convertible notes allow founders to avoid a potentially contentious conversation about company valuation with their angel investors. Might as well “kick the can down the road,” right? Actually, it is rather smart for an early-stage company to put off valuation discussions because it is difficult to determine the fair value of a venture that has not yet had the time to prove its worth.
When a company is ready for a Series A round of financing, its valuation should be much easier for the founders and angels to agree on. As soon as they come to a consensus on the value of the company, the angel investors will convert their notes into preferred stock. However, convertible note holders want to receive special treatment during the Series A round in exchange for their willingness to make an initial investment in the company. You can reward your convertible note holders in one of two ways. The first approach is to put a cap on the premoney valuation of your company to ensure that note holders are cited a valuation that is no higher than a fixed amount. For example, suppose Jane invests $500,000 in XYZ. In 5 months, XYZ is
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