Understanding Capital Structure and Valuation: Part I

All startups require cash and capital to get going. Startups funded by venture capital will raise their financing in various rounds, and the nature of investment and legal form of ownership in each round varies. The value or valuation of the total company also changes in each round. How all these concepts fit together is the subject of this two-part article. In this Part I, I discuss the different methods of investment that make up a startup’s capital structure and how it relates to the stages of equity funding, while Part II will tie these concepts together with valuation.

Before jumping further in, it’s helpful to define some of the terms we will be using:

• Equity is the residual interest in the company after all liabilities and obligations are deducted from the company’s assets.
  • Common Stock is the most basic form of equity.
  • Preferred Stock is equity that has terms that give its holders preferences over common stockholders, hence the term. Each round of preferred stock is denoted by a letter, thus giving rise to Series A, Series B, etc.
• Convertible Notes are a form of debt taken by the startup which is convertible into equity. The debt is a liability until it is converted into equity.
• Simple Agreements for Future Equity, or SAFEs, are instruments which are similar to convertible notes, but which lack the interest and repayment features.
• Seniority refers to the standing that a type of investment has, in terms of the rights attached to that investment or the place in line they have for recovery of the investment. Generally, the most recent round of financing has the most seniority.
• Dilution is the reduction in percentage ownership of the total company for existing shareholders as a result of the issuance of new equity.
• Valuation is the total value of the company.
• A syndicate refers to a group of investors investing in a single round collectively. This is often seen in a preferred stock round, where multiple venture capital investors may invest together. One of the investors will be the lead investor, who 

Money raised for a startup occurs typically occurs in multiple stages or rounds, in the following order:

1. Founders and Friends and Family
2. Angel
3. Seed
4. Series A
5. Series B
6. Series C
7. IPO

The amounts raised in each round typically get progressively larger as the company grows. The legal form of ownership of each round also tends to be distinct. 

The initial source of funding for the startup comes from the founder. The founder may contribute some savings to finance initial expenses, including his or her living expenses, but his or her main contribution is in the knowledge and time spent to develop new ideas and concepts. The founder may also have a co-founder or up to a few other key individuals who form the founding team. At this stage, these individuals own 100 percent of the company, which is in the form of common stock equity.

Friends and family may also be invited to invest in the company. This provides an additional source of capital during the early stages, before angel or seed funding might be justified. The investment from friends and family is high risk, but it could also translate to amazingly large gains down the road if the startup is successful.

Typical Range: $10,000 – $250,000

Typical Form of Investment: Common Stock, Convertible Note or SAFE

The angel stage is where you might receive funding from an angel investor, often a wealthy individual with a history of successful investments and experience in your space. Ideally, the angel can offer valuable advice and connections beyond just money. Their investment helps you validate your idea, conduct market research, and further develop your product.

Typical Range: $50,000 – $3,000,000

Typical Form of Investment: Convertible Note or SAFE

The seed stage is where the amounts funded become significantly larger. Some seed funding could come from angel investors, but traditional venture capital firms may also participate in the funding at this stage.

By the time of seed funding, the product need and market have been established, and the focus shifts to developing and refining the actual product. The seed funding could be used for hiring additional staff, acquiring additional machinery and equipment, and if needed, arranging for facilities. Some effort should also be devoted to developing the sales and marketing strategy and getting early customers and partners on board for revenue.

Typical Range: $3,000,000 – $30,000,000

Form of Investment: Preferred Stock

A startup that meets its seed goals can go on to raise Series A funding from one or more venture capital firms. At this point, the amount of investment is typically beyond the range of an angel investor.

Securing Series A funding marks a new phase where the startup transitions to execution on producing and delivering the company’s product and generating some consistent revenue. Given the size of the Series A round, the additional capital is used to accelerate hiring to meet development goals, as well as to build out the support structure that a fully-fledged company requires, like sales, HR, finance, and accounting.

Series B Typical Range: $10,000,000 – $50,000,000 or more

Series C Typical Range: $20,000,000 and up

Form of Investment: Preferred Stock

A company that demonstrates traction in its Series A is likely to see rapid growth, and the amounts raised in Series B and beyond are correspondingly higher and meant to provide the company with the capital it needs to keep up with its new-found success. In these stages, the company will be scaling its operations and infrastructure, but some of the funding may also be used to develop additional products or to target new markets. During Series B and beyond, the company continues to grow its revenue, a prerequisite for going public.

An initial public offering, or IPO, is where the startup graduates to a public company. The IPO raises money for the company to help it continue growing, and also to provide a liquid market for the investors up to this point to sell their shares and realize their gains. The IPO is not the end of the journey, but another major milestone along the way. By the time of an IPO, revenues should be solid and continuing to grow, even if the company is not yet profitable.

At the time of an IPO, all the preferred stock gets converted into common stock, and additional common stock is offered to the public. Any convertible notes or SAFEs will have typically already been converted into preferred stock along the way, or will convert at the time of the IPO.

The form that most investment by VCs take is preferred stock. Preferred stock is so-named because it has preferences over common stock. These preferences generally entail a combination of some or all of the following rights: board seats, dividends, veto rights over certain business actions, and liquidation preferences. These rights provide the VCs with certain protections in exchange for their investment.

Moreover, the rights of more recent investors or rounds will often have priority over those of earlier rounds, or in other words, the more recent rounds will have seniority over the earlier rounds. Thus, in a startup with several rounds of financing, the priority of investments, in descending order, may be Series C Preferred, Series B Preferred, Series A Preferred, and then common stock.

Some investors may invest in the form of convertible notes as opposed to equity. Convertible notes are essentially IOUs from your startup to the investor. Instead of getting shares right away, the investor gives you money that converts into shares at a later date, typically during a funding round.

Prior to conversion, the convertible debt investor is entitled to interest as well as repayment of the note on the maturity date if conversion is not triggered or achieved. In practice, the interest is often accrued into the total balance to be converted, and maturity dates can be extended at the investor’s discretion if a capital raise has not yet taken place.

One of the biggest benefits of investing using a convertible note is when the startup’s valuation is uncertain.

Convertible notes are usually used in the following situations:

1. When investment is made early in the capital raising process.

There may not be reliable information to make a valuation determination early in a startup’s life, before it has fully validated its product or achieved revenue.

• When capital is raised from a single investor between more significant preferred stock rounds.

The size of the convertible note investment may not be large enough to be considered a new equity round on its own and may not justify making a new equity valuation. For example, a startup may have completed a $5 million Series A funding 18 months ago, and has enough cash to last for up to another year before it needs to complete its Series B round. However, an investor may come along and both the startup and the investor agree to an investment of $1 million into the startup now.

Since the Series A was some time ago and the startup is now closer to its Series B raise, the valuation of the startup has likely changed. It doesn’t make sense to bring the new investment in as a follow-on to the original Series A, nor does it make sense to establish a new valuation for a $1 million investment knowing that a much larger Series B is coming soon.

• When there is doubt if the startup may raise any more funds.

An investor may have concerns about the whether the startup will be successful in raising capital to keep going. If it is unsuccessful, the company will need to liquidate and shut down.

Convertible notes give the investor some optionality. If the startup does have to shut down, the holders of the notes are considered creditors and are entitled to repayment and recovery before any equity holders. On the other hand, if the startup does successfully raise a new round, then the convertible notes will convert into equity.

Convertible notes are structured to convert into equity upon the next funding round at a discount to the valuation of that equity round, in exchange for the investor providing the investment to the startup sooner. To show how this works, let’s assume an investor made a $500,000 convertible note investment after the Series A but before the Series B round. After a few more months, the company proceeds to complete its Series B round. Suppose for every $500,000 invested in the Series B round, an investor obtained 500,000 shares; the valuation is therefore $1 per share. However, the convertible note investor would get more than 500,000 shares because their shares were issued at a discount; i.e., the convertible note investor is rewarded with more shares for the same dollar amount as the investors in the latest round.

SAFEs are similar to convertible notes, but they do not incur interest, and the startup is not obligated to repay the amount invested. When a future round of financing closes, the amount invested in the SAFE converts into shares of that equity round, again usually at a discount.

The features of SAFEs favor the startup compared to convertible notes. The biggest risk to the investor is if no future equity financing round occurs, then their investment will never convert to equity, but the investor also cannot demand repayment of the amount invested as they can with a convertible note. It is important therefore that the investor understand what happens to their SAFE investment in the event of a liquidity exit event like a sale to another company. In a worst-case scenario, the SAFE investor may have no legal recourse to any recovery of the amount invested. For this reason, SAFEs should generally be used earlier in the startup’s life cycle, when additional rounds of equity investment are likely.

Given these risks to the investor, why would they use SAFEs? SAFEs are simpler to negotiate and execute for both the startup and the investor. Additionally, if the startup has a choice between two investors willing to invest, one in the form of a convertible note and another via a SAFE, the SAFE is likely preferable for the startup, all else being equal.