With the end of the ZIRP era, it is now more than ever critical for founders to understand the implications of the financing terms they agree to – especially the opaque and complex ones.

The most opaque clause of them all? The antidilution clause. 

It’s the lovely mix of law and math. It’s the part where your lawyer might just say “it’s complicated”. Or where your investor will mutter something about “the term sheet template”.

What is antidilution protection?

A mechanism for compensating investors in case of a future down round, where shares are issued at a lower price than what the investor paid in the earlier round. Shares held by the investor are “re-priced” based on the terms of the downround.

Re-pricing can be based on a ratchet or a weighted average calculation, and can be done by either an additional issue of shares for free (common in Europe), or by adjusting the conversion rate between preferred and common shares (common in the US).

Anti-dilution rights are a standard feature in VC financing. There are arguments both for and against the inclusion of antidilution clauses (but let’s stick to the mechanics here). The clause can be combined with a limitation in time, pay-to-play requirements and/or waiver rights for the investor majority holding AD rights.

It should be assumed that the down round investors will not agree to be diluted by the AD clause, so share price calculation in the down round will include the antidilution shares.

Examples

Here are some examples of mechanics (for the antidilution clause calculations – see the link for some simple examples that you can play around with)

Assumptions:

• 100k founder shares + 10% ESOP (post-seed) = approx 114 750 shares. 
• Seed round of 2M raised at 7M pre-money = 32 786 new shares. 
• Downround of 1.1M raised at 4.5M pre-money
• ESOP dilution = 12,85%
• Seed round dilution = 22,22% (2M/9M post money)
• Founder ownership post seed = 67,78%

1. Downround w/o antidilution protection
   • round dilution = 19,64% (1,1M/5,6M post money)
   • Founder ownership post downround = 54,46%
2. Downround with broad based weighted average AD (share price in the seed round is repriced to the average “price” of all the company’s shares)
   • AD dilution = 2,48%
   • round dilution = 19,64%
   • Founder ownership post downround = 53,12%
3. Downround with narrow based weighted average AD (share price in the seed round is repriced to the average price of all the shares issued in the seed round and downround)
   • AD dilution = 8,56%
   • round dilution = 19,64%
   • Founder ownership post downround = 49,80%
4. Downround with full ratchet (share price in the seed round is repriced to share price in the downround)
   • AD dilution = 28,57%
   • round dilution = 19,64%
   • Founder ownership post downround = 36,96%

spreadsheet with calculations

https://docs.google.com/spreadsheets/d/1vwLwZo4Uw4rHfd8vrSQc7GwGNby-k8FnnpPNbEI18Yg/edit

The post VC Financing Terms: Antidilution appeared first on Øresund Startup News.

TL;DR – keep your eyes on the upside!

Legal and financial DD is usually the one step during the investment process that founders find burdensome and borderline meaningless. So investors (and their advisors) should be crisp and clear on what information they ask for and why.

At the seed stage, investors invest based on the company’s future potential, not on its current assets or customer base. So DD should focus on risks regarding the former, not the latter.

Here are the essential questions that should be asked (and for the founders, why the investor is asking):

1. Is the cap table true and robust? Will the investor receive the intended ownership?
   • If the cap table is incorrect, the valuation is incorrect. VCs are looking for multiples on invested capital and normally follow strict fund models on ownership in portfolio companies.
     
2. Has the company signed license agreements, exclusivities etc that limits the potential to grow and/or enter new markets? Does the company own and protect its IP?
   • Limitations to the commercial strategy of the company, or reliance on IP licensed from third parties and/or with unclear ownership, can severely limit the possibilities for the company to grow and expand into new markets.
     
3. Are there liabilities or law suits that will materially affect runway?
   • If the company needs to raise new money sooner than expected this will have dilution effects on the cap table, and may not fit investors’ fund models.
     
4. Are the founders withholding information? Or are there double agendas (excessive salaries, fundraising fees, related companies involved)?
   • Alignment and the ability to build trust is critical to create a working relationship with investors and scale the company.
     
5. Is there fraud or money laundering involved?
   • Contrary to what was said above, this one is indeed downside focused. But also quite obvious, no one wants to invest in a non-existing company or be part of a mondey laundering scheme. The investment will be worthless and a potential net negative/legal liability for the investor.

Stay tuned for more insight and perspectives from Rickard in the future.

The post What’s the point of due diligence (DD) in seed stage companies? appeared first on Øresund Startup News.

Let’s take a startup with the two founders holding 2,000,000 shares, raising €500,000 through a convertible note with a 20% discount (ignoring interest, which if applicable would just get added to the conversion amount).

A new investor enters with €1.5 million at a pre-money valuation of €10 million. The price per share (“PPS”) for the new investor would w/o the convertible be calculated as:

(Pre-money valuation/number of Outstanding shares) = 10,000,000/2,000,000 = €5

This would give:

• new investor (Investment/PPS) = 1,500,000/5 = 300,000 shares
• the noteholder (conversion amount/(PPS*(1-discount)) = 500,000/(5*((1-0.2)) = 125,000 shares

Meaning that the ownership would post-round be:

• founders 2,000,000 shares = 82,47%
• noteholder 125,000 shares = 5,15%
• new investor 300,000 shares =12,37%

Only this is NOT what you can expect to actually happen.

The new investor will almost certainly ask that their post investment ownership is equal to investment/(pre-money valuation + new investment), or in other words that existing convertibles are “included in the pre-money valuation” (and so does not dilute the new investor).

In our example, this would be €1,500,000/(€10,000,000 + €1,500,000) = 13,04%.

To effectuate this, the calculation for the new investor’s PPS would therefore instead be: Pre-money valuation/(number of Outstanding shares + conversion shares).

As you can see this is a circular calculation, where the PPS depends on the number of conversion shares, and the number of conversion shares depends on the PPS. And a lower PPS is also beneficial to the converting noteholder.

In our example we would get the following result:

• PPS for the new investor: €4,69
• New investor shares (Investment/PPS) = 1,500,000/4,69 = 320,000
• Noteholder shares (conversion amount/(PPS*(1-discount)) = 500,000/(4,69*((1-0.2)) = 133,333

Meaning that the ownership would post-round be:

• founders 2,000,000 shares = 81,52%
• noteholder 125,000 shares = 5,43%
• new investor 300,000 shares =13,04%

Stay tuned for more insight and perspectives from Rickard in the future.

The post How do discounts in convertible securities work? And how do they affect the next round? appeared first on Øresund Startup News.

Gentle reminder to consider the terms of your stock options. And for European startups to understand rather than blindly follow US market standards.  

Another really great data visualization by Peter Walker and the Carta team on the dubious value of stock options in private companies and the market standard in the US. 

For me this highlights the importance of understanding the origins behind market standards (many which originate from specific tax and/or regulation) and their implications, especially cross-border. 

In short, the standard 90 days post termination exercise period (“PTEP”) for US stock options means that a LOT of (vested) stock options will be unexercised as leaving employees will not be able to exercise in the short time window. Many leaving employees will be under financial stress, and deciding whether to exercise and hope for a future liquidity event can be a very difficult decision. Unexercised options will be lost to the ex-employee and returned to the option pool. While this has positive dilution effects for founders and investors, it is obviously bad for employees.

However – and this is important – the 90 days exercise window exist as a direct effect of US tax. So there is very little reason why this market standard should be applied outside of the US where the same tax rules doesn’t apply (and in fact there seems to be ways for US companies to implement an extended PTEP).

That’s why it’s surprising to come across European startups using 90-day exercise periods, believing that it’s “market standard” and what their investors expect. 

If the US tax issues aren’t applicable, the company is simply choosing to issue low-value stock options — sadly, in many cases, because neither the company nor the employee understands that there are other options (pun intended) available.

Stay tuned for more insight and perspectives from Rickard in the future.

The post Terms of stock options appeared first on Øresund Startup News.