Back when Flybits was still a research group out of Ryerson University, we began to search for funding that would allow us to spin off into what is now our current company. This initial funding came in the form of seed funding, and we also went on to secure additional funding through a Series A from local and international investors. Needless to say, an infusion of funds is always welcome when you’re growing fast, but choosing a path to follow can be overwhelming. There are so many factors to consider when deciding what type of financing is best for our business. Who should we take funding from? How much? What will the cost of equity be? What are the terms?
The seed round: This was fairly straightforward – we had to deal with balancing our priorities:
- The amount of money that would allow us to develop the prototype, and
- The stake (%) we were prepared to give away
This is similar to what you would see on Dragons’ Den or Shark Tank for those in the US. I am looking for X amount of dollars in exchange for Y percentage in my business. In this round, it’s all common equity so there isn’t much to worry about when it comes to analyzing the terms.
The convertible debenture: While negotiating the Series A financing, we had the need for some additional funding, kind of like a bridge loan. A convertible debenture made the most sense here, as we wanted quick funding and didn’t want to deal with valuations and other terms. In this case, we would receive an interest bearing loan that would convert to preferred equity (discussed below) with the same terms as our Series A. Essentially, the holders of the debenture would become participating Series A investors.
The Series A: Welcome to the world of venture capital. This is where the factors to consider really came to life. What a stressful time that was! Hossein (former CEO and current Chief Product Officer) and I spent significant time talking to potential investors and after the selected term sheet, negotiating with them. Because we were trying to raise from international investors, it took some intercontinental travel and time difference coordination to make it happen. The due diligence process was quite something, and I have also learned to always keep the data room up-to-date in case we need to do this again. The only easy aspects of the due diligence were the customer interviews. We have a great relationship with our customers and they really made us look stellar in front of the investors. Overall, the process felt lengthy, stressful and took away from the focus on the business. However, we as a team shared the pain and the details of this process, and collectively felt that it was a necessary step to continue our rapid growth.
Who do we take money from?
We wanted investors that were strategic and would open doors for us by introducing us to their business units and customers. But, we also wanted some traditional VC money that would provide us with discipline and input.
How much should we take and at what cost?
We have generated revenue since the first quarter we started, and we allocate capital only where we had to. Though it would be great (and possible) to bootstrap from here on and keep a greater chunk of our company, we also recognized that being first in a new market and grabbing market share matters. As a result, external financing requirements were necessary to accelerate our growth. We wanted to make sure that we raised enough to allow us to build our next generation product, and also increase customer traction while still retaining value for common shareholders and not incur unreasonable dilution. So we ended up raising just under $5M CAD including the conversion of the debenture mentioned above in exchange for a chunk of the company.
What are the terms?
It seems like every company we hear about in the news is raising $50M, $100M, $200M at very impressive valuations. Usually when raising a Series A and beyond, a VC investor will be issued preferred stock instead of common stock. Preferred stock, as the name suggests, is preferable because it grants key rights to the holders, including dividends, which make it far more valuable than common stock. In the case of our seed funding, we only focused on amount and stake we were giving away and so we wanted to raise a lot and give up a little. In the A round, there are there are a few more terms to focus on. Two particular items of interest are the amount you raise, and something called a liquidation preference, which guarantees the preferred investors some amount of capital to be returned to them.
Let’s say things go well and a few years later someone wants to buy the company (liquidity event). In this case, the preferred shareholders will be entitled to their original investment plus any accrued dividend of their preferred stock (1x), and some investors may push for a multiple such as 2x or maybe 3x (greedy). Investors may also request participation rights allowing them to participate as common investors on an as converted basis. Meaning, they have received their liquidation preference, and they will convert their preferred shares into common shares, and participate in the remaining cash and/or stock to be divided among stakeholders.
Example (not the case of Flybits):
Let’s say you raise a seed round of $500K at a post money valuation of $2M, $8M Series A at a post of $18M, $20M Series B at $100M, 50M Series C at $250M, $100M series D at $400M valuation and end up selling the company for $500M. Under this circumstance, the founders and employees would net over $60M for the 1x liquidation preference, just under $30M for the 2x preference, and negative $7M under the 3x preference. Essentially, you could build a half a billion-dollar company and walk away with nothing if you have onerous liquidation preferences. In this scenario, we are excluding dividends
In summary, contrary to popular belief, the ideal outcome purely based on math is to raise as little as possible as you may have to give it back if you have a liquidation preference as part of the terms, grow the business as fast as possible and pay your employees, and never settle for a multiple liquidation preference.