Equity financing is a complicated topic and one with a lot of facets associated with it. We'll today go over some of the details of how to think about equity financing and how it works and how diluted financing works in general. So a term sheet is the offer you get from a venture capitalist or other potential investor. You can see an example of this here. You can download copies of this online and there's open available term sheets. But we're going to cover today some of the basic ideas of dilution and preference etc. But there's a lot of terms in the term sheet, so legal documents. So, I don't want you to think that we're just discussing everything here. So, I want to give you the basics to understand this. But then, you'll need to go in a lot more detail in order to understand the terms of the bigger term sheet that's in front of you. So, let's walk through the details of how diluted funding works. You'll notice this chart here, there's actually two charts. The first chart is going to be telling you what percentage of ownership in the company is owned by which people, and the bottom piece is going to tell you on the funding side, how much the company is worth. So, let's imagine a startup where there's two founders. Founder one gets 40 percent of the company, and founder to get 60 percent of the company. You can see that in the upper left corner. The bottom left, you'll see there's no value for the company because it's just founded by these people. There's no money, it's not worth anything yet. So the situation associated more complicated with the seed round. In the seed round, an investor is actually putting money into the company. In this example, we have an Angel investor who's putting two million dollars into the company. So, suddenly the company goes from just two people to a number of people and number of investors involved. So, what happens when the seed investment comes in? Well, first of all, now the company has to have some sort of value. If I'm going to put two million dollars into your company as an investment, that means that I need to have an understanding what percentage of the company I'm acquiring as a result. So, I need to know how much your company's worth, what its valuation is and there's a lecture and entirely about evaluation that goes into this in more detail. But I'm going to give you the two million dollars, and I'm going to give it to you at some valuation, and the results of the valuation plus the money I give you, will be your post-money valuation. So in this case, I'm going to give you a two million dollars investment as an angel investor, and assume your company's worth eight million dollars in advance. That's what I've determined by my valuation method in this case, and that means your company's worth $10 million post-investment. So, we call those elements the investment, the pre-money value and the post-money valuation. So, the amount I invest two million dollars, plus the eight million dollars pre-money valuation equals $10 million post-money valuation. That's a very simple equation that will hold true no matter what. So investment plus pre-money valuation equals post-money valuation. So if I know that there's a $10 million post-money valuation and eight million dollars pre-money valuation, I know that there has been a two million dollars investment. Now, complicated things somewhat is the fact that this angel investor wants you to create an option pool. Option pools, as you'll see in other lectures, is our way of compensating employees. I'm reserving a piece of my company, I'll give out stock options in return for those employees works. In this case, I'm going to create a 15 percent option pool which will be worth $1.5 million post-money valuation. So, the angel investor wants the 15 percent of the company reserved after their investment. Now, the angel investor has a way of creating an advantage out of this. It's called the option pool shuffle. Even though that option pool we ask to be worth 15 percent of the company after the investment, so 15 percent post-money, they want you to create that pre-money before they make an investment. That means all the dilution that happens the founders from the options being created, happens before the angel investor invest in the company. So what does that mean for the effective valuation of the company? So nothing changes about the two million dollars investment, and nothing changes about $10 million post-money valuation. What changed is there's an additional $1.5 million option pool are being created. So, two million dollars investment plus a 1.5 million option pool plus the pre-money valuation has to equal the post-money valuation. So the post-money valuation is $10 million. That means that the pre-money valuation of the company is effectively $6.5 million after the option pool. So by doing this option pool shuffle, the investors have effectively lowered the amount of the pre-money valuation held by the founders. So, what that means is when the actual diluted ownership is calculated, founder one has gone down from owning 40 percent of the company to 26 percent of the company, and founder two has gone down from owning 60 percent of the company to 39 percent of the company, and the angel now owns 20 percent the company. However, the shares that were worthless before now owe something. So, founder one now has $2.6 million evaluation that they hold and founder two has $3.9 million evaluation they hold. So, even though their shares have been diluted, the valuation is increased. Now, let's consider the same thing in an a round. In the case of the A Round, we are now receiving a five million dollars investment, and the pre-money valuation is $20 million. So five million plus 20 million equals 25 million post-money. So again, the equation still works investment plus pre-money equals post-money. Again in this case, we have another option pool created, another 15 percent option pool, which is going to of $3.75 million in new options being created. So, we'll do the same thing we did in the series A Round which means that the effective valuation because the option pool is being created before the investment comes in, is the five million dollars investment plus the 3.75, new options. That means that the pre-money effective valuation is $16.3 million in order to equal the $25 million dollars post-money. Again, we have a dilution happening. Founder one's share dropped from 26 percent to 17 percent and founder two dropped to 39 percent to 25 percent, and the angel investor gets diluted to 13 percent. But see what happens again. Again in each case, the amount of actual dollar valuation that holding increases. So, even though the percentage decreases, founder one goes from 2.6 million to 4.2 million and the other founder other angel investors share of the actual money increases as well. But what that means is that in every round of investment, the value of the company goes up by considerable amount in this case by a 150 percent. But the value of the founders doesn't go up as much because the founders are being diluted in each round. So even though the company is worth a 150 percent more than it was before the founders and shares have only increased by 62 percent. So, that's what happens in each round of investment. The value held by the founders increases but by less than the valuation of the company. So some important caveats here. So, in that first round evaluation where it's just the founders there was that there's no friends and family round. There's no convertible debt, which is something we talked about in other lectures, and remember convertible debt is a loan that converts to equity, when you actually receive funding and say the A-round and has a cap and a discount rate. What does that mean? A discount rate means that it's going to buy equity in the seed round at a 20 percent discount and there's some caps, so the valuation in the next round can't be over $10 million. Otherwise, the friends and family a convertible debt round will be worthless. Because if you end up having a huge amount success and the company has a huge value, then the friend family investment only by very small amount of the stock. A seed round, a few things to caveat. So two million dollars is a very large seed round. Usually a seed round is going to be less than $1.5 Million and sometimes much less than that, and what's missing here is preferred shares. So oftentimes, investors will ask for a different class of shares and the common stock owned by the company. They are also not asks you a pro-rata. Pro-rata rights is the ability to make future investments in the company and to get the same rights as future investors, and there's also no convertible that. Sometimes angel investment is done as convertible debt. Once we get to the series A-round as a few missing things. It's a very small A-round. There's only a single investor. Investors usually invest in syndicates or with some multiple messages events at once and there's a bunch of terms that would be missing. So, terms include downround protection. So one of the worst things that can happen to you as a founder is that you have to raise capital at a lower valuation that you raised in the past, because there's all sorts of nasty things that trigger inside term sheets that will force you to reprice your stock and get a lot of stock to your early investors, so that's called down round protection. There's lot of ways of doing that. There's no control terms in this discussion, so usually there's a whole bunch of things to think about in terms of how the VC is going to maintain control of the company. So usually, a venture capitals will take board seats in the company. They might get special voting rights and it may have the ability to fire you as a founder. So that is all important stuff that happens in that A-round and there's no liquidation preferences. So I want to explain how liquidation preferences work briefly. A liquidation preference is worth a couple seconds to explain because it's very common and has a variety of important implications for you as a potential founder. So there are two kinds of liquidation preferences participating and non-participating. I'll explain how they work. But what I want to show you is a simple example of 50/50 equity split with a VC. So the VC owns 50 percent of the company, you own 50 percent and there's a onetime liquidation preference. Liquidation preference with two times a three times. In this case, the venture capitalists made a two million dollars investment, and they've got one time liquidation preference. Which means they have the right to take that two million dollars out of your company before anybody else can touch any of the returns. So, what that actually means, is that if you sell your company for less than two million dollars, the VC gets all the money. If you sell the company for between two million dollars and four million dollars. The VC will excise a liquidation preference, and they'll take a two million dollars because if you make less than four million dollars a 50/50 split is less than two million, so the VC would be better off taking the two million dollars than splitting equity with you. If you sell your company for more than four million in this example, the VC will not exercise their liquidation preference and instead, they'll just split the return with you 50/50. There are other variations on this. So, VC's can choose a two times liquidation preference, in this case, they will make $4 million before anyone who makes any money or they can choose to have a participating and liquidation preference which means they both get their liquidation preference and they get the 50/50 split. The reason why VC's do this as two-fold. One, is to offer some protection. So, if your company only sells for a couple million dollars they still get their money back. So it's a way of getting some return. But even more perniciously with the VC is trying to do is change your incentives. What you'll notice is that if it was a 50/50 split and you sold your company for two million dollars and you made a million dollars, you'd be very happy, but the VC would not be happy because they only make a million dollars and they put two million dollars in. So liquidation preference is a way of changing your incentives so that you as an entrepreneur can't make returns and less that you are going and swinging for the fences. So it's way VC's for motivating to motivate you to go for very high returns and that's why liquidation preference exist and that's why it terms like liquidation preferences or participation are are very complicated, I'm worth thinking about. Because it's not just about legal terms and not just economic, but they're also about changing the incentives of the entrepreneur. So, terms has to be really complicated and there's a lot of customary pieces in them. I rashly recommend the book Venture Deals by Brad Feld & company. It's a really great run through Brad Feld and well-known VC have all the terms that exist in term sheets and if you want a lot more detail, they're going to talk about here. You need to have a very good lawyer to solve this. You can't just sign a term sheet without getting a lawyer. So a lawyer who knows term sheets will help you out a lot in this process. But I hope you understand that some of the basics of the complications of dilutive funding and venture capital terms.
