Part 3 of a series about raising funds for startups: Series A round of fundraising, when a capitalization table becomes more important.
In a prior post, we provided an overview of the stages of fundraising in a startup. They are the “family and friends” round, the seed round, and the Series A through C rounds. We’ve written about the family and friends first round and the second, seed round. Now it is time to discuss the Series A round.
A Series A round is appropriate when it is clear that the startup has a successful product and the startup has proved itself through seed funding. The startup is now focused on creating revenue. It must have a business plan explaining how it will continue to promote its products to its intended market plus create revenue streams.
Series A round money commonly means an investment in preferred stock. Preferred stock is stock that typically gives the stockholder no voting rights in a corporation but guarantees a fixed stream of income. If the venture fails, preferred stockholders hold a priority position over common stockholders for distribution of assets upon liquidation, if there are any.
But how is the value of the preferred stock priced? This can be a complex question, especially if the startup used SAFE notes in its seed round. SAFE notes do not grant any equity in the startup to the note holder, but they are convertible to equity — in other words, shares of stock — upon completing a priced round, or in other words, a Series A round.
Capitalization tables are used to keep track of who owns what kinds of stock and at what value in a startup. Let’s use an example to explain.
Suppose Anaya has an idea for a startup. Anaya has noticed that a lot of edible produce is discarded because it isn’t “pretty.” A tomato, for example, might be lopsided instead of round, so the grocers and the restaurants don’t want to buy it. It gets thrown out.
But the misshapen tomato is still a nutritious vegetable. Suppose Anaya could start an “ugly produce” business by offering boxes of otherwise rejected produce for delivery to customers? Like the best business ideas, it is a win-win. The farmers can sell more of their produce, the consumer can pay less for good food, and Anaya can make money facilitating the process.
Anaya runs the idea past her friend Liam. He likes the idea and say’s he’s in. Anaya is the idea and people person, while Liam is the techie. Anaya will run the operations side of the business while Liam will build the website and the ordering and delivery software.
Anaya and Liam organized their business as a Delaware c corporation because they followed the advice of their lawyer. The lawyer told them that the Delaware c corporation is the gold standard if they eventually plan on outside investors.
Anaya and Liam name their corporation “Quirky Produce Inc.” The lawyer suggests capitalization of Quirky Produce by issuing each of them 4,500,000 shares, holding 1,000,000 shares in reserve for employee options, for a total of 10,000,000 shares. Anaya and Liam authorize issuance of the 10,000,000 shares at par value of $0.0001 per share. Each of them contributes $450 to Quirky Produce in exchange for their 4,500,000 shares.
At this point, the capitalization table of Quirky Produce looks like this:
Anaya and Liam decided they needed to raise $100,000 in their seed round. They convinced two venture funds to invest in Quirky Produce:
- Vegetable Capital invested $30,000 via SAFE note providing for a 25% discount on stock.
- Vitamin D Partners kicked in $70,000, also via SAFE note, but its note has a $1,000,000 valuation cap.
At this point, the SAFE notes are not reflected on the capitalization table for the anticipated Series A round because they grant their holders only a potential equity interest — i.e., preferred stock — in Quirky Produce.
Quirky Produce’s business has grown dramatically. It’s now time for a Series A round. Anaya and Liam estimate they need $2,500,000 to reach the next goal for Quirky Produce. Let’s say that they convince First Round Capital to invest $1,500,000, Plug & Play Ventures Group LLC to invest $500,000 and Vegetable Capital (which holds one of the SAFE notes) to invest the other $500,000. How many shares do the various stockholders own now?
First Round Capital conducts an analysis of Quirky Produce’s value prior to the Series A investment. It concludes that the company is worth $5,000,000 prior to the Series A investment. This is Quirky Produce’s “pre-money” value.
Vegetable Capital’s SAFE note granted Vegetable Capital a 25% discount when purchasing stock. The value of the Series A round shares equals $5,000,000 pre-money value divided by 10,000,000 shares issued, which is $0.50 per share. At a discount of 25%, the convertible price of each share under the discounted SAFE note becomes $0.375. Vegetable Capital’s $30,000 investment becomes 80,000 shares, calculated by dividing the $30,000 invested by the discounted share price of $0.375.
Vitamin D Partners invested $70,000 with a valuation cap of $1,000,000. Each share is thus valued at $1,000,000 divided by 10,000,000 outstanding shares, or $0.10 per share, in this Series A round. As a result of the $70,000 investment, Vitamin D Partners can purchase 700,000 shares from its original investment. As noted, Vitamin D Partners will also invest $500,000 as a straight stock investment at $0.50 per share, or 1,000,000 shares.
Now, the capitalization table after the Series A round looks like this:
Thus, after the Series A round, the shareholders own the specified types of stock in the number of shares indicated. The post-money valuation of Quirky Produce equals $7,610,000.
This capitalization table is essential so that after the Series A round, every investor knows where it stands, in type, percentage, number and value of shares held.Moreover, it will be critical moving forward to the next rounds of financing if Quirky Produce continues to prosper.
Originally published at https://www.carpenterwellington.com on March 24, 2020.