The Startup to Venture Capital Financing Story

THE STARTUP TO VC FINANCING JOURNEY

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THE STARTUP FINANCING STORY: INTRODUCTION

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WORKANDPLAY’S FINANCING OPTIONS Founders

Angels

Venture Capital

Employees

Common Shares

Convertible Notes

Preferred Stock

Options

Workandplay Ltd. is a London based mobile-gaming startup. The company makes multiplayer games for use between employees at work. The four co-founders met in school and decided to launch the startup together three months ago. The company issued 4,000 common shares which were split equally between the co-founders when the company was established. Initially the team were concerned that if one co-founder left the business within the first year, they would walk away with 1/4 of the equity while not remaining active in the company. The team decided to include a three-year vesting schedule with a one-year cliff for its co-founders. With a one-year cliff any co-founder that left within 12 months of launch would not be eligible to receive their share of equity. The three-year vesting schedule meant (25% / 3 years) = 8.33% of equity would be released to each co-founder over the 3 year period after the initial cliff. All the co-founders remained in the business beyond 3 years and received their 25% stake of common shares.

THE STARTUP FINANCING STORY: CONVERTIBLE NOTES Convertible Note Principal Amount of the Convertible Note (£)

150,000

Annual Interest Rate

8%

Discount from Series A share price

10%

Date of the Convertible Note funding

01/01/2014

Estimated Date of Conversion (Series A funding)

01/09/2015

Days of Interest Accrued on Note

608

Interest Accrued (£)

20,267

Value of Convertible Note £ (Principal +Interest)

170,267

Value of Convertible Note into Series A £ (P+I+Discount)

189,185

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After 3 months of prototyping the game, Workandplay successfully raised £150,000 from a group of angel investors. The company used debt financing in the form of convertible notes. The angel investors effectively loaned capital to Workandplay at 8% interest. However instead of receiving their money back with interest, the investors would receive preferred shares should the company close a subsequent round of financing. By using convertible notes, the company raised money quickly and at low cost, as the legal documentation required was minimal. As convertible notes are a form of debt, this delayed placing a valuation on the company until it was more mature and easier to price. By raising debt, the co-founders postponed diluting their shareholdings until later financing rounds. A 10% conversion discount was applied to reward the angels for investing at the earliest stage of the business. The angels could convert the loan amount, plus interest (£150,000 + £20,267) at a discount £170,267 / (1-0.10) = £189,185 to the purchase price when company ownership is offered to venture capital investors (VCs).

THE STARTUP FINANCING STORY: VALUATION Capped vs Uncapped Angel Investment Cap

150,000 1,500,000

Series A Post-Money Valuation

Cap

Uncapped

500,000

30%

30%

1,000,000

15%

15%

5,000,000

10%

3%

10,000,000

10%

2%

Pre-Money Valuation + Investment = Post-Money Valuation

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The angels were concerned that if Workandplay succeeded in raising further financing, their initial stake would be diluted significantly. For their £150,000 investment, the angels requested a cap of £1.5million. This ensured investors would not own less than 10% of the company (£150k/£1.5million) when ownership is offered to external investors for the first time - also known as a Series A financing. However the co-founders negotiated an uncapped round with the angels. Now if Workandplay convinced Series A investors to agree to a £5 million valuation, the angels would be left with only 3% of the company and the co-founders would retain a larger stake. After 12 months, Workandplay entered into discussions with three VCs for a Series A financing. Based on the company’s prospects, the VCs agreed a £3 million company valuation before receiving funding, the pre-money valuation. They decided to invest £1 million, which made an after-funding or post-money valuation of £4 million. Post-money valuation = pre-money valuation + new funding

THE STARTUP FINANCING STORY: PREFERRED STOCK Participating Preferred Shares Initial Investment

1,000,000

Pre-Money Valuation

3,000,000

Post-Money Valuation

4,000,000

VC Ownership (%)

25.0%

Unpaid Dividend

20,000

Company Exit Value

During Series A negotiations, the founders discussed how investors would be compensated if the company is acquired, goes bankrupt or is sold on the stock market – a liquidity event. Liquidation preferences determine who gets paid when these events occur. The VCs requested preferred stock rather than common stock, which is held by the co-founders. In the event of an acquisition or bankruptcy, lenders get paid first, followed by preferred stockholders and anything that is left goes to the co-founders.

10,000,000

VC Exit Dividend Liquidity Preference

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20,000 1x

1,000,000

VC Share of Exit

2,250,000

Total Return

3,270,000

The company and VCs agreed a liquidation preference of 1x, so that during a liquidity event, the VCs will get 1x their initial £1 million investment back before the co-founders receive anything. At the time of a liquidity event, the VCs would also like to share in the gains of the company, unpaid dividends as well as redeem their initial investment. As such, they requested participating preferred stock. As the VC will own 25% of the company at the time of a liquidity event, they will get their money back plus 25% of the remaining proceeds.

THE STARTUP FINANCING STORY: PREFERRED STOCK Non-Participating Preferred Shares VC Exit

Dividend Liquidity Preference Total Return

20,000 1x

1,000,000 1,020,000

Pro-rata Rights VC investment - Series A Post-money valuation VC % Ownership

1,000,000 4,000,000 25%

Post-money valuation - Series B 50,000,000 Required Investment for 25% Holding 12,500,000 Additional Investment Needed

11,500,000

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As an example, if Workandplay sells for £10 million in 3 years, investors can exercise their 1x liquidation preference and receive any unpaid dividends (£20k). They are also entitled to share 25% of the remaining £9 million: £2.25 million, leaving them with a total return of £3.27 million. If the VCs accepted non-participating preferred shares, they would only redeem their initial investment and dividends, leaving them with £1,020,000 on exit. As with the angels in the convertible notes round, the VCs would like to protect against dilution in further financing rounds. With a 25% stake at Series A, if Workandplay attracts other investors at a £50 million valuation, to maintain their holding they would need to invest a further £11.5 million or be left with just 2% (£1 milion / £50 million) of the company. With pro-rata rights however, Workandplay must leave space in subsequent funding rounds so that investors can avoid being diluted.

THE STARTUP FINANCING STORY: OPTION POOLS

Workandplay - Option Pool % Option pool Effective Pre-Money Valuation

20% 2,810,815 %

Angel Stake

189,185

4.7%

VC Stake

1,000,000

25.0%

Option Pool

800,000

20.0%

Founders stake (Pre-Money valuation - Option pool)

2,010,815

50.3%

Post-money valuation

4,000,000

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Following a successful Series A round, the co-founders decide to hire their first employees to push their sales and marketing efforts. Like most VC-backed companies, Workandplay need to find great employees who are incentivised to see the venture succeed over the longer term. The company also has to manage its cashflows in the early years when resources are limited. As part of the funding round, the deal included a 20% option pool as non-cash currency for future employees. The 20% option pool is a percentage of the company’s post-money valuation giving an option value of (20% x £4 million): £800,000. As the option pool comes directly out of management’s stake, if the options are exercised only the co-founders are diluted in the process. The VC investors still retains 25% of the company. As such, the co-founders equity stake is the pre-money valuation less the option pool value £2,810,815 £800,000 = £2,010,815. Ultimately the co-founders stake is diluted further from their initial 70.3% holding to 50.3% (100% - 4.7% (Angel) - 25% (VC) - 20% (Options).

THE STARTUP FINANCING STORY: FOUNDER DILUTION

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CONVERTIBLE NOTE Workandplay Shareholders Shares (#) Investment (£)

SERIES A FINANCING

%

Founder 1

1000

-

25.0%

Founder 2

1000

-

25.0%

Founder 3

1000

-

25.0%

Founder 4

1000

-

25.0%

Total

4000

Workandplay Shareholders Shares (#) Investment (£) Founder 1

1000

-

Founder 2

1000

-

Founder 3

1000

-

Founder 4

1000

-

Founders

4000

-

Angels

269

Venture Capital Total

%

SERIES A + OPTION POOL Workandplay Shareholders Shares (#) Investment (£) Founder 1

1000

-

70.3%

Founder 2

1000

-

189,185

4.7%

Founder 3

1000

-

1,423

1,000,000

25.0%

Founder 4

1000

-

5,692

1,189,185

Founders

4000

-

50.3%

376

189,185

4.7%

Venture Capital

1,989

1,000,000

25.0%

Option Pool

1,591

800,000

20.0%

7,957

1,189,185

Angels

Share Price Calculation Post-Money Valuation - VC Investment - Angel Investment / No. Shares Share Price:

%

4,000,000 1,000.000 189,185 4,000 £702.70

Total

Share Price Calculation Post-Money Valuation - VC Investment - Angel Investment - Option Pool / No. Shares

4,000,000 1,000.000 189,185 800,000 4,000

Share Price:

£502.70