Mastering Seed Round Financing - A Must-Watch for Startups

Mastering Seed Round Financing - A Must-Watch for Startups

Table of Contents:

1. Introduction
2. Incorporation
3. Founder Equity Splits
4. Unissued Shares
5. Cap Table Management System
6. Dilution and its Impact
7. Issuing Shares to Advisors
8. Raising First Round of Funding
9. Convertible Instruments: Convertible Notes and SAFEs
10. Adding Investors to the Cap Table

Article

Introduction

In the first three lessons, we discussed the basic concepts and terms of a cap table. Now, let's dive into the exciting part where we put it all together. In this article, we will follow the Journey of a fictional company and its founding team, exploring the process of legally creating a company, building a cap table, raising funding rounds, and eventually selling the company. Along the way, we will uncover the meaning and importance of each change in the cap table.

Incorporation

The first crucial step in the journey of our fictional company is incorporation. The founders file a certificate of incorporation, declaring their new company called Meetly. The process is relatively simple, requiring information about the founders, the business, and the number of shares being authorized. In this case, the founders authorize 10 million shares.

To split equity between the co-founders, they need to make important decisions. They can split the 9 million common shares equally or allocate them unequally Based on various factors like the brainchild of the company, time devoted, or special expertise. For this example, let's assume a 55-45 split. Additionally, the founders leave 1 million common shares unissued to allocate to future stakeholders.

Founder Equity Splits

Deciding on the equity split between co-founders is a crucial task during incorporation. It sets the foundation for ownership percentages and plays a significant role in future dilution. Co-founders can use tools like Carta's Equity Split Calculator to help them determine the split. In this example, the founders decide on a 55-45 split, which is a common ballpark for equity splits.

Unissued Shares

The cap table includes authorized and issued shares. The founders issue themselves a total of 9 million common shares, leaving 1 million authorized but unissued shares. These unissued shares are reserved for future stakeholders such as advisors, employees, or consultants. The cap table provides a clear view of the authorized and issued shares, ensuring transparency and accountability.

Cap Table Management System

Using an automated cap table management system like Carta provides various options to view the cap table. It allows You to Visualize the share classes, authorized and issued shares, and the distribution of shares among stakeholders. The cap table management system simplifies the complexity and provides an organized overview of your company's ownership structure.

Dilution and Its Impact

The introduction of new stakeholders and the issuance of unissued shares lead to dilution. Dilution is a common concept in the startup ecosystem and impacts the ownership percentages of existing stakeholders. Contrary to popular misconception, dilution does not involve giving away existing shares but rather the addition of new shares to the overall ownership pool. As new investors, advisors, or employees join the company and receive shares, the ownership percentages of existing stakeholders decrease.

Understanding dilution is crucial for founders and stakeholders as it affects their ownership stakes in the company. Dilution should be carefully tracked and managed, especially as the company raises funds or adds new stakeholders. Keeping a close eye on the cap table ensures that founders are aware of the impact of dilution on their ownership and can make informed decisions.

Issuing Shares to Advisors

As the company progresses, the founders may need to bring in additional talent or expertise. In this Scenario, an early advisor, who is not a co-founder but plays a critical role, is granted shares in the company. The founders agree to issue a hundred thousand shares to this advisor from the previously reserved 1 million share option pool. This allocation of shares acknowledges the advisor's contribution and provides an incentive to be actively involved in the company's success.

Raising First Round of Funding

After making significant progress and gaining traction, the company attracts the Attention of investors who are willing to provide financial support. In the early stages, the funding usually comes in the form of convertible instruments such as convertible notes or SAFEs (Simple Agreements for Future Equity). These instruments allow investors to invest in the company with the intent of converting their investment into shares at a later stage.

Convertible Instruments: Convertible Notes and SAFEs

For our fictional company, let's assume the founders decide to Raise their first round of funding using a Safe agreement. A Safe is an investment vehicle in which the investor provides capital upfront in exchange for future equity. The terms of the Safe agreement include a discount and a valuation cap on the next financing round. This early investor, Carol, offers $100,000 and becomes part of Meetly's cap table.

Adding Investors to the Cap Table

The entry of external investors introduces complexities to the cap table. The specifics of how the shares from the safe agreement will convert will be determined by the next financing round. At this stage, the cap table shows Carol as an investor, but the exact number of shares she will receive is yet to be determined. As the company progresses and attracts further investments, the cap table will evolve, and the ownership percentages of the founders and early stakeholders will be influenced by dilution.

In summary, building a cap table involves incorporating the company, splitting equity between co-founders, maintaining unissued shares for future stakeholders, and managing dilution effectively. As the company grows and attracts funding, it is crucial to track and update the cap table accordingly. Cap table management systems like Carta provide valuable tools to simplify this process and ensure transparency and accuracy in the ownership structure.

FAQ:

Q: What is the purpose of incorporating a company? A: Incorporation is the process of legally forming a company. It provides the company with a separate legal entity, protecting the founders from personal liability and enabling them to raise funds and conduct business.

Q: How are equity splits determined between co-founders? A: Equity splits between co-founders can be determined based on various factors such as the level of involvement, contributions, expertise, or the need to attract key talent. It is crucial for co-founders to have open and transparent discussions to reach a fair and mutually agreed-upon split.

Q: How does dilution impact ownership percentages? A: Dilution occurs when new shares are issued, resulting in a decrease in the ownership percentages of existing stakeholders. Dilution is a natural consequence of adding new investors, employees, or advisors to the cap table.

Q: What are convertible instruments? A: Convertible instruments are financial instruments that allow investors to provide capital in exchange for the right to convert their investment into shares at a later stage. Examples of convertible instruments include convertible notes and SAFEs.

Q: How can cap table management systems help with tracking dilution? A: Cap table management systems like Carta offer features that allow founders to track and manage dilution. These systems provide real-time updates on ownership percentages, share issuances, and the impact of new stakeholders on the ownership structure.