After a company raises funds from an angel investor through a convertible note, the next progression is generally to get their product or service to market and attempt to lure a larger investment in the form of a Series A. This is typically a more complicated transaction with serious long-term implications for the company and its founders. I will address the agreements and terms typically included in a Series A transaction in a later post. The purpose of this post is to address what may seem like relatively simple questions to answer: How much stock is the company selling and how will the Series A affect the founders?
Seemingly subtle distinctions among offers from Series A investors can have significant consequences for the founders and the company. It is critical that the founders understand which shareholders will be diluted by the conversion of any notes. If investors simply agree to buy 2,000 shares of a company with an original capitalization of 10,000 total issued and outstanding shares, based on a pre-money valuation of $5,000,000, both the founders of the company and the Series A investors will be diluted by conversion of the note. In a previous post, I described a scenario where the note holder received 1,080 shares, the Series A investors ultimately end up owning 2,000 shares out of 13,080 total shares which equates to roughly 15% of the company. However, they invested $1,000,000 for roughly 15% of a company with a post-money valuation of $6,000,000.
Alternatively, imagine the Series A investor instead structured the deal as an acquisition of 1/6th of the stock of a company with a $6,000,000 post-money valuation in exchange for $1,000,000. In that scenario, the per share purchase price for the Series A investors would need to be manipulated to result in the Series A owning 1/6th of the shares post-conversion. This causes the founders to absorb all dilution arising from the issuance of conversion shares to the note holders. I’m going to omit the detailed calculation for purposes of this article, but it is critical that both founders and investors are aware of the difference between an investment at a fixed valuation versus an investment in exchange for a fixed percentage of the shares of a company.