When as startup company needs to raise money to finance growth, they typically will do either an equity round or a debt round.
(article continues below)
Let's take a look at how these financing rounds work and how they change the capitalization structure of the company.
How Equity Financing Rounds Work
When outside funds are invested in a company, the investors are issued stock based on the valuation set by the round of financing.
For example, an investor could contribute $1,000,000 and agree to 50% ownership of the company. This would result in a post money valuation of the company of $2 million (since one million can control 50% of the company, simple math indicates that two million can control all of the company).
In this example, let's say that the founders have one million shares of common stock. So, the equity investor is granted one million new shares at a price of one dollar a share. These shares represent an ownership of 50% of the company – one million shares out of a total of two million issued shares.
Since there was $1 million invested and the post-money valuation is $2 million, we say that the pre-money valuation was $1 million.
If instead an investor invests one million dollars and agrees to 25% ownership of the company, then the post-money valuation is $4 million. He will be issued 333,333 shares at a price of $1 per share. In this case, the total number of issued shares becomes 1,333,333 and the new investor has 25% of those shares.
In this second scenario, the pre-money valuation is $3 million. That's because $1 million in cash was added to the pre-money valuation, and that resulted in a $4 million post-money valuation.
While in both scenarios investors contributed one million dollars, the first investor owns a higher percentage of the company because the terms on his round of financing valued the company at $2 million after the financing round while the second investor's terms valued the company at $4 million dollars after the venture round.
From the entrepreneur's perspective, the key is to get the maximum pre-money valuation you can get. This allows you to give up less of the company for less money. Mind you, the quality of the investor and what value they can add often makes it worthwhile to accept a lower pre-money valuation, but all things being equal, you want the highest pre-money valuation possible.
How Debt Financing Works
For capital needs, a company may decide to take on debt rather than issue additional shares. One option is for a company to issue what is called convertible debt—which is essentially an interest yielding loan given by an investor to a company which has the option to be converted to shares at the next financing round.
Let's say that the company takes on $500,000 of convertible debt at an interest rate of ten percent. This transaction does not affect the valuation of the company since it does not include the issuing of stock.
Let's assume that the company has already issued the $500,000 worth of convertible debt at ten percent and a financing round takes place exactly one year later. If the first scenario round of financing takes place, then the investor is given his million shares at one dollar each and the debt issuer decides to convert his debt into an equity stake of the company. With interest included, the debt issuer is granted $550,000 worth of founder's stock—550,000 shares at one dollar which represent a 27.5% (550,000/2,000,000) stake in the company. After this transaction, the owners of the company retain 22.5% ownership, while the debt issuer and investor have a combined stake of 77.5% in the company.
The terms of the equity and debt agreements may impact exactly how these percentages play out. A key question would be whether the debt conversion to equity dilutes only the founders or both the founders and the new investor.
Small details like these, spelled out in the fine print of financing agreements, can have a big impact on how much an entrepreneur will ultimately make, when the company eventually has a financial exit of some kind.
The key takeaway here is that it is important for entrepreneurs to understand how a company may issue stock or debt when meeting capital needs, especially at an early high growth stage. If you are new to the game, hire the best counsel you can find.