How venture capital works part I

Intro

Last week I had a great lecturer at my university's startup course, an investment banker.
He has an extraordinary personality, smart, charming and always right.
If you don't know him don't worry, just take away this: He is one of those guys,
who really knows how the game of investment banking is played.
Think of what Albert Einstein said "You have to learn the rules of the game. And then you have to play better than anyone else". He manages a Venture Capital (VC) fund and has a great track record.

I will try to summarize some lessons learned about VC and companies in general.
My assumptions are based on corporate law in the U.S., but can be applied to great extent all over the world.

The Fundamentals

• A company is owned by its shareholders
• A company's primarily goal is to bring value to its shareholders

Definition of Terms

• pre money valuation: the valuation of a company that determines how many shares an investor will get for his investment
• post money valuation: pre money valuation + invested money (after the investor invested the company is worth more, because the assets of the company grow, through the investment)

What Forms of Equity Ownership Are There?

Often many parties own one company, this reduces risk for the individual investor. Company ownership is distributed by issuing "shares", one share represents an equal part of the company.
To protect investors different, forms of ownership exist. Each form has different rights associated with them. If it's not too clear why all this is needed, I will provide an example where things should come together.

Common Stock

Common stock is the most basic unit of ownership. Owners have voting rights, common stock has the lowest preference in a liquidation event (when the company is sold or goes bankrupt).

Example

Two people found a company, they agree to own half of the company each, which is turned into common stock.

Preferred Stock

Preferred stock has all rights common stock has. In a case of liquidation, money from the sale of assets is first distributed to preferred stockholders, only then to common stockholders, thus preferred. It can also be agreed upon that preferred stock has to be paid back at a multiple of the proceeds, or with a discount rate (i.e. each year the amount that has to be paid back increases by 20%).

Furthermore, there is the class of participating preferred shares, which means that when a company is liquidated, first the preferred shares are paid back. In the next step the remaining money is split among all other investors, including common stock owners and preferred stock owners, thus they participate.

Example

Let's consider the last example, the founders own the company to 100%. They need money and decide to raise capital from two investors, 1 million each at each 12.5%. This sets the pre money valuation to 6 million and the post money valuation to 8 million, 6 + 2. Investor Alice gets preferred shares and investor Bob gets preferred shares with 2x participation.
Let's consider the company shuts down and 4 million are left in the company. The preferred stock owners, Alice and Bob will get back their money back first. Bob will get 2 million because he has a 2x multiple, Alice will get 1 million. After that, the founders will split the remaining 1 million with Bob, because he is participating with his 12.5%. So even though the founders have each have 37.5% of shares, would each get only 437 thousand. As you can see preferred shares make sense because they protect the investors, on the other hand multiples are hidden costs for the company and extra insurance for the investor.
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Stock Options

A stock option admits the owner the right to buy common stock at an agreed upon price, the strike price. One option for one share. Usually, they are used for incentive and safeguard. Founders and key figures of a company will get options which they can turn into common shares at a later point. The strike price can be negotiated, usually for employees who receive stock options, it is determined at the latest valuation event (i.e. when a round was raised).

Vesting

Vesting is another term tightly coupled with options. If a startup launches and it is going well, people might have the incentive to just leave the company and work on something else, because they already own shares or options in a company. That is why vesting is important. With this mode a certain total amount of options is agreed upon founding a company or signing a contract to work for the company. The quintessence is that only after a certain amount of time the options are distributed to the employee or founder and they can be sold, this is the vesting schedule. There are different types of vesting schedules. Often it is agreed upon that every six months the employee will get ⅛ of all his outstanding options, so the total vesting period will be 4 years. This will protect investors from founders and other option holder that leave on bad terms, but would continue to own shares.

Convertible Notes

A convertible note is an instrument that is often used in early stages of startup funding. It is used when investors and the company's principals can’t or don't want to set a valuation for the investment but want to defer it to the next valuation event (i.e. capital injection). It has three parameters: A maximum runtime (e.g. 24 months), a discount rate (e.g. 20 % a year) and a cap (e.g. investor will get at least 10 % of shares). These are used to limit the flexibility.

Example

Like in the first example, two founders own the company. They raise 1 million, but can not agree with the investors how many preferred shares the investors should get. Instead, they agree on a convertible note with 20% discount, a 15 % cap and 24 months runtime, after which the note would be converted automatically to 25% share stake. Everybody is happy, after 12 months they raise the next round, 5 million at a pre money valuation of 20 million. The last investor would now get shares equivalent to 1.2 million of the 20 million pre money valuation, which is 6%.

Dilution

Dilution is not a form of ownership, it is exactly the opposite so to say. It means that if I have shares in a company and a new investor comes in, he will get new shares, making me own less of the total amount of shares.

Example

A company has 100 shares. Investor A holds 20 of those shares. Investor B comes in and for his investment another 20 shares are issued (Investor A does not have to give away any of his). Before, A held 20 / 100 = 20% of the shares, after Investor B gets his shares, A only owns 20/120 = 16.6% of the company with the same amount of shares.

Conclusions

I tried to give a small overview over important types and differences of ownerships, relevant especially for prospective founder or people working in startups. It is fundamental to understand that different types of ownership exist, which legitimation they have and what the differences are.

In the next post I will talk about the possibilities to put a price tag on a company and the different forms of valuation investment bankers use. Additionally, I will explain how VC funds work and get a bit into their motivations.