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The Finance of Startups: For Dummies (Part 4)


I’ve somehow managed to keep this going for four months (including today) researching finance concepts, and blogging about them. Wow, it’s been a great exercise learning and sharing.

I admit my recent blog posts haven’t gotten me THAT excited where I’m openly sharing, but when I started researching and writing this post, I felt that excitement again.

So, anyways… moving on for today’s post – PART 4! The following topics will be covered:
  • Convertible Note
  • Discount (as part of Convertible Note)
  • Cap (as part of Convertible Note)
  • Dividend
  • Pro-Rata Rights

Convertible Note.

A convertible note is kinda, sorta, like-a hybrid of debt and equity financing. Here, the company and the investor delays setting a valuation for the company till a time when the company may raise another round with a valuation. Convertibles are a popular vehicle for early stage startups as it’s hard to discern the value of an extremely young company with little to no earnings.

So instead, the capital at the beginning is treated like a loan upfront. When the company raises another (or official) round, then the outstanding convertible note is converted to equity as a ratio of the valuation. However, to sweeten the deal for the inherent risk of investing early on, there are a couple levers that impact the conversion of the convertible:
  •  Discount – a percentage reduction the convertible note holders can convert to the principal loan amount relative to the purchase price of the next round. The discounts typically range from 0-35% with 20% being the most common. So if Series B round investors are paying $10 per share, the original investors who had a 20% discount on a principal amount of $100,000 can convert this loan amount at a per-share-price of $8 ($10 less 20%)… they’d get 12,500 shares at $8 each but valued at $10 per share.
Seed Round: You invest in a convertible note of…
Principal of $100,000 with a discount of 20% (convertible to Preferred Stock)
Series A: Awesome Venture Capital Firm invests…
$10 per share at a valuation of $10M (pre-money)


Your conversion price-per-share
$10 * (1 – (20%)) = $8 per share
Shares of stock
$100,000 / $8 = 12,500 shares of Preferred Stock
Book Value of stock (unrealized)
12,500 * $10 per share from round = $125,000 (25% unrealized return)
Series A investors would’ve gotten…
10,000 shares for $100,000 investment due to $10-per-share price
  • Cap – a maximum limit of the valuation that can be converted into equity at a later priced round. The investors will typically be priced at the lower of the cap or the valuation of the round. How this works…

Seed Round: You invest in a convertible note of…
Principal of $100,000 with a cap of $5M (convertible to Preferred Stock)
Series A: Awesome Venture Capital Firm invests…
$10 per share at a valuation of $10M (pre-money)


Your conversion price-per-share
$10 * ($5M / $10M) = $5 per share
Shares of stock
$100,000 / $5 = 20,000 shares of Preferred Stock
Book Value of stock (unrealized)
20,000 * $10 per share from round = $200,000 (100% unrealized return)
Series A investors would’ve gotten…
10,000 shares for $100,000 investment due to $10-per-share price

Dividend.

Dividends are disbursements of profits from a company to its shareholders. Dividends are post-tax, and typically abide by a dividends schedule. Though, companies can issues dividends at any time as “special dividends”.

On the opposite end of dividends, companies can also choose to reinvest its net profit into the business as retained earnings rather than issue dividends.

Dividends are more commonly issued as cash to its shareholders. Each dividend is fixed per share, but the total amount will vary depending on the percentage of the shareholder’s shareholding (ownership).

Pro-Rata Rights.

In PART 1, I talked about dilution – the outcome where ownership percentage may decrease when a company raises a round of capital at a higher valuation. Pro-rata rights enables investors from earlier investing rounds to maintain their shareholding percentage and avoid dilution by investing additional capital.

So if an investor invests $500,000 in Amazing Hair Gel Company with a post-money valuation of $2M, the investor has a 25% equity stake in the company ($500,000 / $2,000,000). If the company raises additional capital in a Series B with a post-money valuation of $40M, the investor has pro-rata rights to invest an additional $9.5M to maintain a 25% stake in the company (25% of $40M = $10M with an initial investment of $500,000 already).

Need Your Help Moving Forward!

All of this research has been making me so much more adept and savvy when reading posts about investments and valuations, and also much more knowledgeable talking to others about them. This has been a great exercise, but I think I can do better, but I need your help.

I’ve heard positive feedback so far, and I’m always looking for ways to explain things better. This stuff makes sense in my head as I’m writing it, but it’s largely been one-way communication. That is, I write and “teach” without the student-interaction that makes good teachers GREAT teacher. That is, in 1-to-1 teaching, the teacher (or presenter) and student (or audience) interact with thought-provoking questions. Heck, I oftentimes learn more through these interactions.

Short story – interactions help me learn and explain things even better. So if you have feedback, feel free to shoot me a message on Twitter (@TheDLu) or email so I can explain things better.

Till next month… Cheers!

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