This is the first of four parts in this series.
When you're raising money for your startup, you may be solely focused on getting great investors (like Quake!) on board, but you also need to understand what goes into the terms that you are offering these investors. Here's a list to make it easier.
1. Issuer: VCs or angel investors will likely issue the term sheet. If there is a more diverse pool of investors, the company will issue the term sheet to coordinate the funding round. Many funding rounds (like Series A, B, and C) may have multiple investors. In this case, the company may issue the term sheet.
2. Securities/Type of equity: The type of security offered can be several things, including equity, preferred shares, or warrants. However, in venture capital, this defines the round a company is raising. For example, if a company is raising a Series A round, they would define this as “Series A Preferred Stock.” There are several types or “rounds” of funding. First is a family/friends or angel round, where individual investors have the option of funding a startup. Next is a seed round, when early-stage venture capital companies and more angel investors come into the mix. This is followed by a Series A round, which is usually for companies looking to optimize their product and increase their user base after gaining traction. Series A rounds usually raise $2 million to $15 million. Series B rounds are for further building the company and generally led by the venture capital firms that led the Series A round. Series C and D rounds are generally where institutional and growth equity investors come in to further scale the business. Because the company is less risky at the Series C and D rounds, institutional investors are more ready to invest.
3. Pre-money valuation: The worth of the company before investment, which determines how many shares the investor gets upon investing in the company. The valuation is determined by the traction a company has generated, the addressable market, and future revenue projections. At the early stage, it is harder to generate valuations, particularly for pre-revenue companies, due to the lack of financial data. However, it becomes easier to generate valuations as companies grow, gain traction, and generate investments.
4. Post-money valuation: The worth of the company after investment, in other words, the pre-money valuation plus the money invested. The post-money valuation after a round will become the pre-money valuation of the next round unless significant events like a large increase in traction affects the valuation.
5. Amount of shares: The amount of shares issued is simply the shares being given to investors. For example, if a company is raising $2 million, it would issue 2 million shares of preferred stock. This would give investors proportionate rights to amount they invested. Amount of shares also helps calculate price per share.
6. Conversion: Conversion rights give VCs protection. Conversion rights are generally issued to those who received preferred stock, or a higher class than common stock due to special rights like voting rights. People who hold preferred stock are given the option to convert to common stock. Mandatory or automatic conversion rights may be used in the case of IPOs or majority votes to make sure the Preferred class can be retired when they get paid. Conversion is calculated using a conversion ratio that generally begins at 1:1 but can be adjusted if there are diluting events like further funding rounds.
Stay tuned for the rest of Understanding the Investor Term Sheet, coming soon!