Articles • 02 March 2020
Get the non-exhaustive rundown on topics fundamental to startup investing—fundraising rounds, deal structures, and alternative investing methods.
Grab. Alibaba. Airbnb. Impossible Foods. These multibillion-dollar companies are household names today, but they all began as humble startups, and the investors who had the opportunity to invest in these companies at their nascent stage have seen their initial investments multiply in value.
For instance, Softbank, which began investing in Alibaba in 2000, logged USD11 billion in profits after selling some of its shares. That sale was only a fraction of its total holdings; Softbank still holds a 26% stake in Alibaba, down from 29%. Khosla Ventures led the Series A round for Impossible Foods Inc.—the creator of the Impossible Burger—at a valuation of about USD30 million. Its latest Series E round saw its valuation soar to USD2 billion, with secondary market transactions trading at a level that imputes an even higher USD5 billion valuation, benefitting early investors like Khosla.
Combine that level of potential returns with today’s low-yield environment, and it’s no surprise that investors all around the world are being drawn to private equity markets. McKinsey reports that private equity assets have grown twice as fast as public equity. This shift is happening in tandem with a diminishing number of public listings in the US, as well as several countries in Asia, including Singapore and Indonesia. Modern companies are increasingly shying away from IPOs, resulting in more limited public investment opportunities.
Consequently, McKinsey’s report notes that large investors who had previously stayed away from private markets now view them as necessary to get diversified exposure to global growth. Research by leading wealth management firms now recommend a 12-15% allocation to private equity. Unfortunately, the doors to such deals have typically remained closed to all but large institutional and ultra-high net worth investors.
At Fundnel, we are committed to offering accredited investors that same opportunity. In this guide, we will cover a few topics fundamental to startup investing, but which often perplex investors—fundraising rounds, deal structures, and alternative investing methods.
Understanding Fundraising Rounds
Startups, lacking collateral, rarely qualify for bank loans. As such, they frequently turn to equity financing—offering a portion of ownership of the company to investors in exchange for capital. Every time a startup raises money, it is called a funding round. Each round usually, but not always, has a valuation attached to it*.
*Valuation refers to the figure the company’s founders and investors determine the business is worth. Valuation figures are used to calculate the amount of equity offered for each funding round. Pre-money valuation refers to the valuation before accounting for the capital raised in the funding round; post-money valuation includes said capital.
While the concept is simple enough, grasping the different funding round terminologies and what they entail can be confusing. Here is a quick primer.
Angel and Pre-Seed Rounds
The very first funding round a company undertakes. Sometimes colloquially referred to as a ‘friends and family’ round, the capital raised is usually from individuals and non-institutional investors. The total investments received from this round can vary from as low as USD10k to above USD250k. Startup founders often hold this round just to get the company up and running.
Not all startups go through angel and pre-seed rounds; some go straight to seed rounds. Since this may be the first funding round for many startups, total investment can be as low as USD10k to USD2 million and above. Crunchbase also notes that larger seed rounds are becoming increasingly common.
Pre-A/Series A Rounds
Pre-A, or Series A if a startup bypasses a Pre-A round, is the first ‘significant’ funding round, and here companies will typically look to include institutional investors, such as venture capital funds. The total funding raised is typically at least USD1 million, although it can reach over USD25 million. The name comes from the type of stock offered commonly offered to investors in this round—preferred stock, also known as class-A shares. In general, if a company can successfully raise a Series A round, it should be close to launching its product or service.
Airbnb, for example, raised USD11 million in its Series A round in November 2010, with a USD70 million post-money valuation.
Series B Rounds
Series B is simply the funding round subsequent to Series A. At this stage, the startup typically would have achieved several milestones, such as releasing a viable product or service. The money raised in this round is usually directed towards helping the business further develop its operations e.g. beefing up sales and marketing teams. Airbnb’s Series B round in July 2011 raised USD115 million at a USD1.3 billion post-money million valuation.
Series C (and above) Rounds
This third significant funding round is considered ‘later stage’ funding. By this stage, the company is already deemed ‘successful’. Series C capital is used to scale the business, e.g. entering new markets or developing new products. As companies are staying private for longer, these late stage funding rounds can continue for quite a while (e.g. Grab is currently at Series G) before companies potentially opt for an IPO as the next step.
At Fundnel, we offer our investors the opportunity to participate in funding rounds as early as the Series A stage and as late as the pre-IPO stage.
A Guide to Deal Structures
Deal structures specify the means by which investors make their investments in startup deals. Common structures are: equity, convertible debt, SAFEs, and KISSes.
Equity – Common Stock
In what is likely the most often seen and straightforward means of investment, the company directly issues common shares to its new investors in exchange for capital. Common stock gives investors ownership rights—such as the right to share in profitability and dividends—depending on the number of shares held.
Note that each subsequent funding round entails the issuance of more shares, which will dilute the ownership percentage of current shareholders.
Equity – Preferred Stock
While similar in nature to common stock, preferred stock typically comes with additional rights for investors—sitting higher in the capital structure compared to common shareholders (i.e. they will get paid first if the company is liquidated) and enjoying more benefits such as preferred dividends and anti-dilution. Briefly speaking, anti-dilution protection comes in two main forms:
- Full Ratchet Anti-Dilution: This form prevents any dilution in percentage shareholdings by issuing new shares to previous shareholders to match their initial ownership percentage. Very rarely issued as it would leave little room for future investors.
- Weighted Average Anti-Dilution: The most common type of anti-dilution protection. While preferred shareholders will receive additional shares to combat dilution, it will not fully prevent their holdings from being diluted. The number of additional shares issued is based on a weighted-average formula which accounts for the latest valuations and number of new shares issued.
Another beneficial characteristic of preferred stock is liquidation preference, which gives investors certain advantages in the event of a liquidation (whether through a merger and acquisition or a forced sale from bankruptcy). While liquidation preferences vary on a case-by-case basis, they have four broad features:
- The Multiple: Determines how much of an initial investment an investor must be repaid before common shareholders. A 1.5x multiple implies that preferred shareholders must receive 1.5 times their initial capital back before any distributions to common shareholders.
- Participating and Non-Participating: Preferred shares can be classed as either participating or non-participating. In a liquidation, non-participating preferred shareholders can either elect to receive their payout (e.g. USD10 million on a 10% stake in a USD100 million exit) or their liquidation preference based on the above multiple. Participating preferred shareholders are entitled to receive both liquidation preferences plus a percentage of any additional proceeds (based on their ownership stake) above said liquidation preference. This essentially allows for ‘double dipping’ into the proceeds pool.
- Payout Caps: Participating preferred shares can create highly unbalanced payouts in favour of the investor. Hence, they may also have payout caps which is a multiple that limits the total return of the participating preferred shareholder on payouts where they don’t convert into common equity.
- Seniority Structures: Determines how senior preferred shareholders are to each other. Usually depends on which stage of the financing they invested, or can be set to be equal regardless of invested stage.
Preferred shareholders may also have pro-rata rights, giving them the ability to participate in future funding rounds to maintain their ownership percentage. Other rights typically conferred may include requiring approval prior to new financings, mergers or sales, or increasing the option pool*. In the event of an IPO, merger, or sale, preferred shareholders may also opt to convert their holdings to common shares.
*The option pool is the number of common shares reserved for distribution to employees, consultants, advisors etc. after they exercise their options (the right to buy shares at a certain price).
In many cases, especially at early stages, startup founders may be unsure of a reasonable valuation to impute. Without a valuation, it is difficult to raise straight equity financing. In such scenarios, they may instead elect to issue convertible notes (also called convertible bonds), which are a form of debt which can later convert into equity. This allows them to put off imputing a valuation until a later date—speeding up the fundraising process.
Convertible notes can convert to either common stock or preferred stock. This usually depends on when the note converts; earlier conversions typically mean preferred shares while later conversions are more likely to be common shares.
The four most important features to look for in a convertible note are:
- Repayment conditions: Convertible notes are debt instruments, and thus have interest rates, maturity, and repayment requirements.
- Conversion conditions: Defines circumstances under which the note converts into equity. Some may convert automatically upon a specific milestone (e.g. the next round of funding), or upon maturity of the note.
- Valuation cap: The maximum price at which the convertible security converts into equity. For instance, if the valuation cap is USD50 million, then holders of the security will always be able to convert at that valuation, even if the latest valuation round is at USD500 million.
- Discount rate: The ‘discount’ on the latest valuation convertible note holders will receive—if the discount rate is 20% and the latest funding round has a valuation of USD100 million, the noteholders will be able to convert at a USD80 million valuation. A note may have either a valuation cap, discount rate, or both.
Investors can get immediate, albeit paper returns, upon conversion thanks to the valuation caps and/or discount rates. In addition, because convertible notes are debt instruments with a maturity date and accrued interest, investors can also receive reassurance on a more definitive timeline.
However, it should be noted that in practice, if the maturity date has been reached and the company is not yet able to hit the milestones it needs (e.g. IPO requirements) or repay the note plus interest, noteholders will usually allow an extension of maturity instead of calling the note, which would be self-defeating to investors.
SAFE – Simple Agreement for Future Equity
SAFEs were developed by famous startup accelerator Y Combinator and are another popular financing instrument for raising funds. Unlike convertible notes, SAFEs are not debt instruments, although they are functionally a similar alternative.
Since SAFEs are not a debt instrument, there are only three salient things to consider: conversion conditions, the valuation cap, and the discount rate. Without the burdens of debt repayment, SAFEs are considered highly ‘founder-friendly’—an even faster and more cost-effective method for conducting fundraising. These makes them more popular at the early fundraising stages.
Although the expediency at which SAFEs can be executed is beneficial to both founders and investors, their other ‘founder-friendly’ characteristics are generally perceived as more biased toward the former. For instance, while the lack of a maturity date gives the startup maximum flexibility and freedom, this can be disadvantageous to investors who might want a more definitive timeline of equity conversion. Since SAFEs are also neither debt nor equity, investors also don’t have any control over the company prior to equity conversion.
You can find Y Combinator’s SAFE templates here.
KISS – Keep It Simple Security
KISSes, created by global venture capital firm 500 Startups, is another alternative to SAFEs. Unlike SAFEs, KISSes have both equity and debt versions, and the latter also accrues interest with a set maturity date. Further, KISSes also have a ‘Most Favoured Nation’ clause. If the company issues another convertible note, KISS, or SAFE with more favourable terms (e.g. a lower valuation cap), then said clause allows those improved terms to apply to KISS holders as well. This clause is optional in SAFEs.
As such, KISSes are considered to protect investors’ interests better than SAFEs. Venture capital firms may thus require that companies use KISSes for fundraising instead of SAFEs.
Alternative Methods of Investing in Private Equity Deals
There are other methods of investing in private equity deals beyond the common deal structures described above. Such methods include: secondary market investments, revenue sharing models, and funds investments.
Secondary Market Investments
A secondary deal structure is when an investor invests in a company by buying an existing shareholder’s equity or financing instrument (e.g. common stock or convertible note). Unlike a primary deal structure, the company doesn’t receive the proceeds of these sales. Secondary sales have become increasingly popular as companies are now staying private for much longer, incentivising early investors and employees to try to monetise some of their stakes.
Shares bought on the secondary market will almost always come with terms and conditions. These may include restrictions and lockup periods, such as not being able to sell on the public market for at least six months post-IPO.
Secondary deals also aren’t just limited to smaller shareholders. In January 2018, for instance, early Uber shareholders, including its former CEO and an early stage venture capital fund, sold USD8 billion worth of shares to Japan’s SoftBank group.
Revenue Sharing Model
Some startups have come to the realisation that offering equity is not the only way for them to raise financing. Sometimes called revenue-based investing, this is a revenue sharing model rather than an equity-based one. It is a newer innovation in venture capital financing and is thus much rarer compared to the traditional equity model.
In this model, the investors and company usually sign a revenue sharing agreement. Beyond just how much revenue is to be shared, the agreement should also specify what is to be shared (e.g. revenue vs. operating profit vs. net income), and how it is going to be measured and tracked.
This is when investors invest via a venture capital fund, rather than in the company itself. It is an indirect method of startup investing, and it is fundamentally no different than investing in a mutual fund. In a venture capital fund, investors are known as Limited Partners or LPs.
However, investors should take note not only of the minimum investment required in a fund, but also the lockup period. Because of the nature of venture capital, these funds often have a set lockup period during which investors cannot withdraw their funds.
Investing in a fund is also very different from investing in individual companies. Instead of assessing a company, investors are evaluating whether a fund’s managers are skilled enough to deliver superior returns through their own startup investment choices. Investors are taking on the risk (and potential return) of the fund.
With Fundnel, investments in a fund-based deal are usually done through a nominee structure. Instead of investors directly holding shares in the fund itself, we consolidate all their interests via a trustee. This is opposed to a direct structure whereby investors hold the shares/notes/SAFEs etc. in their own names.
Understanding the Role of Due Diligence in Startup Investing
While due diligence is important in any form of investing, it is even more crucial in startup investing, where there is much less publicly available information to go on. Here is a quick list of things investors should analyse when evaluating startup investments.
- Sector and Industry: Investors must assess the economic and financial condition of the sector the startup is operating in. This will help in understanding the various sectoral and industry-specific factors that can affect the company (e.g. business cycles) as well as provide a benchmark to better gauge the startup’s potential performance.
- Market Opportunity and Risks: This will help determine the amount of market opportunity the startup can hope to capture, how it is positioned competitively, and the risks it faces. Key steps include estimating the Total Available Market (TAM), Serviceable Available Market (SAM), and Serviceable Obtainable Market (SOM) as well as conducting a SWOT (strengths, weaknesses, opportunities, threats) analysis.
- Company Details: This is a broad topic that covers everything from the startup’s financials and business model to its management team and operational capabilities.
- Investor Deep Dive: This is an extra step that startup investors, unlike public investors, must do. This involves studying factors like the cap table*, proposed valuation, possible exit plans, deal structures, legal due diligence requirements, as well as other investors, advisors, and partners.
*The cap table is a detailed breakdown of a company’s shareholders’ equity. It is a crucial document as it tracks ownership percentages, equity values, and dilution amounts after each funding round.
Our Value-Add to the Due Diligence Process
At Fundnel, we simplify the due diligence process using a proprietary data-driven due diligence process that amalgamates >1,500,000 data points, across 50 parameters and sub-parameters, for each company to determine funding viability. Our scalable tech-augmented processes mean that our investors do not have to spend unnecessary time and resources hiring large teams of analysts to evaluate opportunities, and enables our platform to present investors with the ones that are relevant to their investment mandate. Thereafter, investors within our network may then conduct their own assessment or further diligence before making an investment in any opportunity of interest.
For more information on the factors to consider when conducting more in-depth due diligence, refer to our complete guide to due diligence when startup investing here.
How to Invest Via Fundnel
At Fundnel, we not only offer accredited investors access to private investment opportunities at varied stages with diverse deal structures, we cater to different types of investors as well. If you are:
An Angel Investor
Accredited angel investors will find Fundnel to be a curated source of both primary and secondary private investment opportunities. Through our platform, individual investors will be able to co-invest alongside institutional investors in high-growth companies.
Investment Club or Syndicate
Similarly, investment clubs and syndicates may access Fundnel as a source for private investment opportunities typically available to larger institutional investors, including opportunities to co-invest or lead investment rounds in a company’s deal on our platform, should there be an agreed interest. At present, investment clubs and syndicates may directly reach out to us to discuss details.
Startup Incubator, Accelerator, or Ecosystem Partner
Fundnel works with companies looking to raise capital at all stages. We work with ecosystem partners who support, incubate and accelerate high potential startups by offering our platform to distribute their fundraising opportunity to a curated network of accredited investors. Interested incubators, accelerators, or other ecosystem partners may reach out to us for partnership opportunities to provide further support to their cohort's startups post-programme participation.