Financing Options: Equity

19.01.2016 |

Episode #5 of the course “A guide to seed fundraising” by Geoff Ralston, Y Combinator

 

An equity round means setting a valuation for your company (generally, the cap on the safes or notes is considered as a company’s notional valuation, although notes and safes can also be uncapped) and thus a per-share price, and then issuing and selling new shares of the company to investors. This is always more complicated, expensive, and time consuming than a safe or convertible note and explains their popularity for early rounds. It is also why you will always want to hire a lawyer when planning to issue equity.

To understand what happens when new equity is issued, a simple example helps. Say you raise $1,000,000 on a $5,000,000 pre-money valuation. If you also have 10,000,000 shares outstanding then you are selling the shares at:

1. $5,000,000 / 10,000,000 = 50 cents per share*
and you will thus sell…

2. 2,000,000 shares
resulting in a new share total of…

3. 10,000,000 + 2,000,000 = 12,000,000 shares
and a post-money valuation of…

4. $0.50 * 12,000,000 = $6,000,000
and dilution of…

5. 2,000,000 / 12,000,000 = 16.7%
Not 20%!

There are several important components of an equity round with which you must become familiar when your company does a priced round, including equity incentive plans (option pools), liquidation preferences, anti-dilution rights, protective provisions, and more. These components are all negotiable, but it is usually the case that if you have agreed upon a valuation with your investors (next section), then you are not too far apart, and there is a deal to be done. I won’t say more about equity rounds, since they are so uncommon for seed rounds.

One final note: whatever form of financing you do, it is always best to use well-known financing documents like YC’s safe. These documents are well understood by the investor community, and have been drafted to be fair, yet founder friendly.

 

Recommended book

“The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail” by Clayton Christensen
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