Updated: Jun 23, 2019
Many start-up founders dream or hope of one day raising money from investors. For this reason, we get many questions about the evolution of a start-up, from a shareholder perspective, when outside investors are brought in.
Question such as how to navigate concepts like “term sheets”, option pools, anti-dilution provisions, and all the other jargon you hear from investors in a fundraise.
Luckily at MBTN Connect, we have worked with many start-ups who have been on this journey and will outline some of our key learnings, in particular, with respect to how the structure of your company changes as you raise money to grow.
Let’s look at a hypothetical scenario for a Lagos, Nigeria based mobile app start-up focussed on helping local restaurants deliver takeaway food to hungry customers.
Registering the Company
So, let’s assume Femi and Chioma have come together to build this food delivery/ logistics start-up. Femi is a tech genius with experience in building mobile apps and will be the technical founder. Chioma, on the other hand, is an experienced business development and marketing professional, and will focus on the sales and business development aspect of the business.
They call the company “Okada Logistics”.
Because Chioma will lead on the business end, bringing in new customers and partners, they decide to incorporate the company with a 60/ 40 split. 60% to Chioma, and 40% to Femi.
They agree they will need to incentivise future employees with equity in the company, so set aside a 20% option pool for future employees.
So, at incorporation, the company structure looks like this:
Chioma – 48%
Femi – 32%
Employee Option Pool – 20%
Okada Logistics was set up with 10,000,000 shares (common equity), issued at ₦1 (one naira) per share, putting an initial valuation of ₦10,000,000 at incorporation.
At the founding stage, the shareholding/ capitalisation table of the company looks like this:
Femi immediately begins writing the code for the app, Chioma on the other hand goes on full-steam business development and marketing mode.
After 3 months, a beta version of the app is ready, and Chioma has successfully on-boarded 10 restaurants to test the service with. They go live with the app, with both partners doubling as delivery drivers, fulfilling the orders.
The service takes off to a flying start, and after only a couple of weeks, they find that they no longer have the bandwidth to fulfil all the customer orders they are getting.
Logistically, they can only do around 30 deliveries per day between the both of them, but they are getting demand for over 100 orders each day, and the demand is growing very fast.
In order to keep the service going, they decide they need to invest in and buy more delivery vehicles, hire more drivers, admin and marketing staff.
But they don’t have the capital to do this.
They decide to raise outside money from investors in seed capital. Based on their projections, they find they need to raise ₦5bn to take their start-up to the next level.
They begin working their networks, looking for investors, and after several meetings they find 2 investors who are interested in investing.
The Seed Round
Eko Capital agrees to put in ₦2.5bn and Aboki Ventures agrees to inject the other ₦2.5bn.
Because investing in start-ups is a risky affair, both investors ask for certain provisions as part of the terms of their investment.
Eko Capital structures their investment as a SAFE note – (Simple Agreement for Future Equity), with a 20% conversion discount at the next fundraising round.
A SAFE note is an agreement between an investor and a company that provides rights to the investor for future equity, at a price per share that is determined by a future “priced” funding round. Find out more here.
Aboki Ventures also utilises the SAFE structure, but insists on a valuation cap of ₦10bn at the next round of investment.
A valuation cap is the maximum valuation (price) an investor will convert their investment into shares at a future fundraising round. Find out more here.
Chioma and Femi are thrilled to have this new infusion of capital and gladly accept the deal. They sign the paperwork and have the funds wired into their bank account.
18 months later, business is booming, Okada Logistics has a fleet of delivery vehicles, hundreds of restaurants as partners, and more than 20 employees. They’re not making a profit yet, but their revenues are growing rapidly.
Things are good, but they look at their bank account and realise they will run out of money in 6 months at their current burn rate. They decide it’s time to raise their next round of financing; the Series A round.
They want to use the new funds to grow their business in Lagos but also to expand into 3 new cities across Africa. They look at their financial models and determine they need to raise ₦7bn in the Series A round.
The Series A round is typically the stage when outside investors put a “price” on the shares of the company, and also when seed stage investors who use SAFE notes convert their investment into equity.
During a Series A round, investors speak about the valuation of a company in the context of a pre-money and post-money valuation.
The pre-money valuation is the value put on the business prior to the investment, and the post money valuation is the value of the company after the investment has been made.
Series A Mechanics
Chioma and Femi once again go into fundraising mode. They speak to many investors and after 70 meetings, find 2 new investors willing to invest in the Series A round; Koboko Capital and BCC Partners. One of their seed stage investors, Aboki Ventures, also decides to invest in the Series A round.
The investors agree to structure the Series A round as follows:
Koboko Capital: ₦4bn
BCC Partners: ₦2bn
Aboki Ventures: ₦1bn
The investment analysts at Koboko Capital do their due diligence and determine that the pre-money valuation of Okada Logistics is ₦15bn, meaning a price per share of ₦1,500 (₦15bn divided by 10 million shares – number of shares at incorporation).
At this time, the seed stage investors now need to convert their original investments into shares in the company.
As stated earlier, Eko Capital negotiated a 20% conversion discount when they made their seed investment. So, at the Series A round, they get to convert their investment into shares at a price of ₦1,200 per share (instead of ₦1,500). Their initial ₦2.5bn investment will convert into 2,083,333 shares (₦2.5bn divide by 1200), valued at ₦3.125bn in the post money valuation.
Aboki Ventures negotiated a ₦10bn valuation cap (as stated earlier) when they made their seed investment, meaning they convert their seed investment into shares at a price per share of ₦1,000 (₦10bn valuation divided by 10 million shares).
Their ₦2.5bn investment converts into 2.5 million shares (₦2.5bn divided by N1,000 per share), valued at ₦3.75bn at the post money value.
Koboko Capital, investing ₦4bn in the series A round, at a price per share of ₦1,500, will get 2,666,666 new shares, BCC Partners gets 1,333,333 new shares with their ₦2bn investment and Aboki Ventures, having decided to participate in the Series A round with a follow on ₦1bn investment will get an additional 666,666 shares at the Series A price of N1,500 per share.
After the Series A round, the updated capital table/ shareholding of the company will be as below:
You will notice that on the post money valuation, Okada Logistics is now worth ₦29bn. The seed investors have also ended up with higher percentage holdings in the company because they insisted on valuation caps and conversion discounts.
Also notice that the percentage holding of the founders; Femi, Chioma and the employee option pool has decreased as a percentage of the overall company. This is known as dilution. Dilution is not necessarily a bad thing, as long as the value of your company goes up, why not have a smaller piece of a much bigger pie?
For entrepreneurs raising money or thinking about doing so one day, it’s advisable to familiarise yourself with the various dynamics that are involved as investors come into the picture.
On 26th February, MBTN Connect is hosting an event with a start-up lawyer, who will talk about what you need to know about the various terms (as above), when you go into a fundraise. To find out more and get tickets, have a look here.