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Capitalization of the Venture: Founding & Funding.

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Frequently Asked Questions

Do I need a corporate lawyer?

For this reason, it is important to understand where you want your company to go and to have a roadmap for how you're going to get there. This roadmap is drawn in the documents created and decisions you make when you’re setting up your company. Finding an experienced corporate lawyer to handle all of the paperwork is key. Setting up a company takes more than filing the articles of incorporation and writing the bylaws. There are also investor agreements, employment agreements and IP agreements. If this documentation is not set up properly, it can have long reaching effects on the company's valuation, funding and your eventual exit.

What are investors looking for?

The story must be complete – meaning that when you tell your story, investors see a well-thought- out plan for bringing your idea to market and creating value that will attract acquisition.

In that plan, investors will want to see that you have identified the risks associated with the technology, product development and customer acceptance, and that you have sensible strategies for minimizing these risks.

They also want to see the estimates of market size, timeline to market entry, pace of acceptance, and scale of reimbursement to ensure that they are credible.

And, they will want to know all about the company you have formed– the details that are in all of those documents that we mentioned earlier. They will want to see that its corporate structure, equity distribution, financing terms, and employee compensation are understandable, appropriate, and consistent with typical arrangements.

How do LLCs and Corporations differ?

The LLC’s management structure may be more flexible, less formal.Owners may also be officers that are involved in the day-to-day running of the company. Corporations have a more formal management structure where directors oversee the major business decisions and officers are responsible for the day-to-day running of the business.

What is the difference between c-corps and s-corps?

There are also two types of corporations, c-corps and s-corps. Most life-sciences corporations are registered as c-corps because the founders intend to bring on multiple investors (often including institutional investors) and then exit through a merger and acquisition or IPO. But there are benefits to organizing as an s-corp. Like an LLC, an "s" corporation’s profits and losses flow through to the individual owners.

What are the roles of the Board, CEO and members?

So, Jill and Steve's company will have a Board of Directors. The board has the fiduciary duty to oversee the company on behalf of the shareholders. The board acts through the management team, especially the CEO.

The shareholders' role is to elect the Directors. They are dependent on the Board/Management to produce a positive return on investment (ROI). They can vote on fundamental changes such as financing, and exit opportunities, but they are not involved in day-to-day operations, except informally.

How do the Board and CEO work together?

The Board and the CEO work together to govern the company, with the CEO being the go between that translates the Board’s policies into the day-to-day operations of the company and reports back to them. Good oversight by the board means that it should not be simply either the CEO’s cheering section, or their firing squad. The Board-management relationship is influenced by how well the CEO communicates information (good and bad) and adheres to the policies of the board.

What are the different sources of funding for startups?

There are two sources of funding early in the life of a company– debt in the form of convertible notes, or equity, also called seed money or Series A funding.

A convertible note is issued to an investor in exchange for a loan that will be repayable in cash at a future date, along with interest at a set rate which is referred to as the coupon rate. Unlike other debt instruments, convertible notes also give the investor the right – or the obligation -- to convert the principal and interest into shares of stock. Any conversion terms will be spelled out in the note.

Investors like convertible notes because their repayment may be secured by the company’s assets. However,because the notes do not convey an ownership in the company when they are issued but may convert into an equity interest reflecting the – hopefully, higher -- valuation of the company at the time of that future equity offering, the conversion may not convey all of the equity interest these investors would have received if they had made an equity investment. Also, investors holding notes often do not have a voting interest in the company or other ability to participate in company decisions. The conversion feature of thesenotesis often triggeredby an equity financing, which means the company can force investors to convert at that time.

Investors who provide equity funding in the form of seed or series A money, typically get a portion of the business in return for their investments. This usually means that they have voting rights and certain other rights and protections, which may include the right to nominate someone to serve on the board or to participate in future equity offerings ahead of new investors.

And, of course, the details of each of these funding forms must be documented in the purchase agreements, shareholders’ agreements, investor rights agreements and other documents. For more information on each of these documents, look at the glossary on your left.

What are preferred shares?

Preferred stock combines features of debt, in that it may pay dividends, and equity, and in that it has the potential to appreciate in value. Equity investors with preferred stock have a prior claim on company distributions than common stockholders. And, any dividend for preferred shares generally must be paid out before dividends to common shareholders. The details of each class of preferred stock the corporation may issue are spelled out in the Certificate of Incorporation.

What is pre-money/post-money?

Until a company's stock is publicly traded, investors need to evaluate the company’s assets and any revenue stream to estimate its current value and the potential return on their investment. This can be especially challenging when the company is just starting out as it often has no assets, other than its IP, and has no revenue.

A pre-money valuation is the current value of the company before it conducts an investment round. A pre-money valuation at the pre-revenue stage, or even before the company has its product or service ready for release will be based on a variety of other factors. One such measure may be comparable businesses. An assessment of the revenue and market value of established, more mature companies that have a similar focus and operational approach can serve as a gauge of the current pre-money value.

This pre-money valuation may be a figure proposed by a potential investor. This valuation amount would then be used as a basis for how much ownership they expect in exchange for their investment. That ownership interest will be the percentage of the company’s post-money valuation (which is the sum of the pre-money valuation, the amount raised through the financing and any amount attributable to notes converting in the financing) represented by their investment. The leadership of the company may reject pre-money valuations proposed by others until they reach an amount that matches the aspirations of the company. This is when it pays to have done your research into risks, estimates of market size, and other parts of your investor “story.” You need to have a solid understanding of your company’s value in order to negotiate with potential investors on these terms.

Once the pre-money valuation is determined and you go through your first round of funding, the investments from both converting notes (if any) and new equity are added to this pre-money valuation to arrive at the "Post-money" valuation.

What is a down round?

Between the seed round and 1st round, the valuation of their company jumped from 7.4 to 9.6 million, indicating that they added value through their development efforts. However, if the valuation of the company had been set too high in the seed round and not enough additional value was created through the first phase of development, it would lose value between rounds, resulting in the existing shareholders' equity being diluted and losing value. Another issue when setting fundraising goals is the timing of each offering. Companies must anticipate when they will need new injections of funding to move their technology through the development cycle so that they don’t end up in a trough between financings, which can delay development.

What is the Preferred Participation payout?

If the purchase price for the company exceeds the liquidation preferences of all classes of preferred stock, then the excess will be distributed to preferred stock and common stockholders on an “as converted to common” basis. Sometimes the Articles of Incorporation may set a cap on the portion of the purchase price payable to a class of preferred stock, and that cap may be a multiple of the aggregate investment for that class.

How does the liquidation process work?

You can think of the liquidation process like a waterfall with several pools each being as deep as the liquidation preference of the class of stock it represents. Each series of investors must have their liquidation preference satisfied in full before the next series begins to see a payout. So, in this illustration, series C, B and A preferred stockholders must receive all of their liquidation preferences before the holders of common would receive any payout.