How Startup Financing Works

by Andrew Boardman

Valuation

There are two basic levers to determine ownership after the investment.

Pre-Money Valuation
and
Investment Size

Stock Option Pool

Stock options are created from the
Option Pool
, shares set aside by the company to attract and retain key employees. It can be created from either the
Pre-Money
Post-Money
side of the Financing Round.

Convertible Debt

Convertible Debt is a popular way to do early financing. It allows the company to raise money while deferring the Valuation of the company until the next Financing Round.
To reward the Angel Investors for risking their money early at an unknown Valuation, they normally ask for a
Discount
to the next round's Share Price, and/or a Pre-Money
Valuation Cap
. The
Convertible Debt
converts into the same type of stock as the next round of financing, with the same terms.

Exit Terms

The
Liquidation Preference
determines how much of the investment is returned to the investor before others receive any money, based on the round's Stock Type:
Convertible Preferred
Participating Preferred

The shares are either converted into Common, or the investors take the amount they invested times the Liquidation Preference, whichever returns more money.

The shares are converted into Common, as well as the investors take the amount they invested times the Liquidation Preference.

This is known as a Double Dip, and the effects are pronounced at lower exits. To reduce that impact, a
Liquidation Cap
can be applied, which removes the Liquidation Preference once that investor's returns reach the cap.
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