To the uninitiated, startup fundraising can be confusing. And even some of the resources designed to be approachable for the newcomer often raise more questions than they answer. So we’ve launched a series called “A Startup Takes Flight” to simply explain the dynamics of fundraising and deal terms.
To do so, we’re following two entrepreneurs who started a company and raised some money from investors. The people, company and funds involved are fictitious, but the math and deal terms are very much real.
After covering the basics of founding a company, dividing up founder shares, capitalization tables, the common financial instruments, deal terms used in the seed funding process and how those deal terms affect pre- and post-money valuations, in this installment we’ll see what happens when Jill and Jack raise their Series B round.
For the sake of our story here, what happens during the Series B round will illustrate two of the other primary levers of power venture capitalists can negotiate into their investing agreements with their portfolio companies. What follows is our best attempt at making the topic of “pro rata rights” approachable and, with some luck, fun. (And this will tee us up for a discussion of “ratchet-based antidilution protections” in the next article in this series.)
Here’s a quick recap of the key facts:
Here’s the company’s full capitalization table from where we left off, after Internet of Wings raised its Series A:
And here’s the company’s share structure as of their Series A round:
Let’s see what happens when a new round of financing comes in.
In overused Shakespeare quotes, college writing classes, American ambient electronic music albums and venture capital deals, “what’s past is prologue.”
In most cases, a startup’s fundraising history sets the trajectory for future investment. There are many deal terms that affect which investors can get in, how much stock they’re able to buy during a funding round and at what price they buy those shares. But here, we’re focusing on two: pro rata rights and pre- and post-money valuation.
One thing to note about venture capitalists and lawyers: they tend to use lots of Latin phrases, pro rata included. Literally translated, it means “according to the rate,” but for all intents and purposes it’s come to mean “proportionally” in both venture capital and other branches of finance and law.
In venture capital, a pro rata clause in an investment agreement gives the investor a right (but not the obligation) to participate in one or more future financing rounds to maintain their percentage stake in the company. One of the more cogent explanations of how pro rata affects investor dynamics comes from Fred Wilson, a well-known venture capital blogger and managing partner of New York-based Union Square Ventures. In a post about the subject, he gives the following example:
“You invest $50k in a seed round at a $5mm cap and own 1% of the company. The next round is a $3mm round at $9mm pre, $12mm post. If you don’t participate, you will be diluted 25% and will then own 0.75% of the company. On the other hand, if you buy 1% of the round, a $30k investment, you will continue to own 1% of the company. Your ‘pro-rata right’ in this situation is a $30k allocation in the next round.”
For all investors, these clauses are a risk management strategy, in that they add a layer of predictability to a generally unpredictable asset class. Especially for angel and seed investors, they guarantee a seat at the table during a Series A round. For other investors, pro rata clauses allow them to maintain percentage positions in their most successful portfolio companies as those scale.1 And for those companies where maintaining a certain percentage ownership stake is a requirement for keeping a board seat, pro rata rights help investors maintain that type of oversight.
For entrepreneurs, though, pro rata rights can be a bit of a double-edged sword. On the one hand, pro rata rights help to answer the question “who’s going to invest in the next round?” However, the clause is one of the main reasons why founders must be choosy with their early investors, if at all possible. Friendly seed investors or venture capitalists that add a lot of value to the company and make introductions and provide strategic guidance like it’s their job (because, well, it is) are the sort of folks that founders want to maintain influential equity stakes in their companies. If given pro rata rights, those investors who don’t add value beyond the check they signed, or have ulterior motives for investing in the company, can shut out the good ones from a round.
Catching up with our two intrepid co-founders, Jack and Jill, the business has been growing at a decent clip. It started as a cockamamie idea hatched over dinner at an uppity cantina in the gentrified side of San Francisco’s Mission District. It was, after all, an elaborate pun of a business idea at the outset, but it caught on and expanded in scale, if not quite yet in scope.
“The state of the Wing,” Jack proclaimed in his worst Obama impression, “is strong.”
The Internet of Wings now has a custom facility with a kitchen, packaging line and a hive of custom sandwich-delivering quadcopters Jill has affectionately dubbed “The Drone Zone.” Granted, it’s still just a couple of rooms hacked out of a defunct Pizza Hut near South San Francisco, but for a Series A-stage company, Jack and Jill feel like they’re doing well.
IoW has some revenue and a small, but very loyal, base of customers mostly consisting of college students and tech startup employees. The value proposition to them: the novelty factor of air-dropped chicken sandwiches, plus the cost savings of not having to pay a gig economy worker to wait in line and listen to podcasts. And an area venture capitalist has even made it a Thursday tradition to have a sandwich delivered through the sunroof of his Tesla Model S amidst the gridlock on Route 101. His Snaps reviewing the food and experience have all 12 tech journalists that care about this sort of thing atwitter on Mastodon.
In order to continue this hockey stick growth, Jill, Jack and the other board members decide that the company should raise a Series B round. The board encouraged a slight pivot in strategy, from what one member characterized as “a full-stack, on-demand delivery restaurant” to a generalized drone delivery platform for local restaurants in the Bay Area.
“Think of it like this, Jill,” BlackBox Capital’s Dirk V. Snodgrass Jr., relayed in an email after the meeting, “Internet of Wings can be an end-to-end service provider, a deployment solution for on-prem consumption of calories-as-a-service.”
Before we get into the math behind this particular round, let’s look at IoW’s investors and their pro rata rights.
Again, these investors have the right, but not the obligation, to invest proportionally in Internet of Wings’s Series B round.
Jill, Jack and the board decided to raise a Series B round to fund continued expansion of the Internet of Wings’s operations in the Bay Area and development of a platform for other restaurants to deliver their food via drone to hungry customers.
Jack and Jill, sitting at the same shabby, chic cantina where they came up with the Internet of Wings in the first place, decided to pursue this new direction.
“It was never about the chicken sandwiches,” said Jill to Jack, who seemed somewhat crestfallen at this admission. Jack, after all, had the food science background and had successfully recreated the sandwich he remembered from his youth.
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Jill continued, “I mean, like, the total addressable market of food delivery is ginormous. Billions of dollars a year.” She looked at her phone and pulled up a chart one of the board members sent her:
“Real-time follow up!” exclaimed Jill, “Tens of billions a year within the next year or two. If we’re able to do this, we won’t just be the internet of chicken wings and sandwiches… we could be the logistics layer for the calories-as-a-service industry!”
“You’re sounding like Dirk,” said Jack.
“Look, let’s try this. We’ve got the drone tech down. We’ve only dropped payload a couple of times. The limiting factor here is that we want to be an end-to-end food service business. And, to be honest, I’m having a hard time giving a cluck about chicken sandwiches. Jack, you’ve got the packaging science down… why not harness those talents for other kinds of food?”
Jack took a deep sip of his $14 artisanal yerba maté and looked down at the gourd it was served in. He admired it for a second, focusing on its natural insulating properties, the fact it was biodegradable and the fact that drinking vessels could literally grow on trees. “OK let’s do it,” Jack said as he snapped the clamshell to-go container.
Cormorant Ventures, the lead investor from Series A, takes the lead on Internet of Wings’s Series B round as well. Analysts and partners at the firm were impressed with the traction of Jill and Jack’s company, and they found the new platform direction compelling. They took the firm’s current revenue and book of business into account, its proprietary drone technologies and the engineering talent the company was able to recruit to date. All in, they’re valuing Internet of Wings at $35 million pre-money, a 21.2 percent step up from the company’s $28.875 million Series A post-money valuation.
In this round, IoW is looking for a $15 million cash infusion to continue building out its flock of drones, a spot market for its drone services, a new packaging design lab and a few test hives (“Drone Zones,” internally) with bays for more drones.
Unlike with the seed round, there were no discounts, valuation caps or other deal terms attached to the Series A round that would create a higher valuation for the company at Series B. So, here, the post-money valuation of the company is going to simply be the sum of its pre-money valuation ($35 million) and the amount of money being raised in this round ($15 million), a total of $50 million post-money.
Recall that after Series A, the company had approximately 19.25 million shares outstanding. To find the share price at Series B’s valuation, we divide the pre-money valuation ($35 million) by the number of shares outstanding just prior to Series B (19.25 million) to arrive at a share price of approximately $1.818.
So, if Internet of Wings is raising $15 million, that means the company will need to issue $15 million worth of stock at a share price of $1.818 per share. When all is said and done in this round, the company will create 8.25 million new shares.
Now, calculating the amount that each investor must invest in the round to maintain the same percentage ownership is simply a matter of multiplying their percentage stake prior to the round times the number of new shares being issued in this round, and in turn multiplying that by the current share price:
So, at minimum, given the current share price and the number of shares being issued in the round, Internet of Wings’s previous shareholders would have to invest approximately:
In this case, because the company’s valuation hasn’t increased by a huge amount and the company is raising a sufficiently large amount of money in this round, all investors are able to participate and maintain their pro rata stakes.
In this round, Cormorant Ventures invests $10 million of the approximately $15 million total round. Provident Capital invests $1.5 million, and BlackBox Capital fills out the rest of the round with an investment of $3.5 million. (So, to clarify, Cormorant Ventures had to put in a minimum of $2.077 million to maintain their 13.85 percentage stake from the previous round. By investing the additional $8 million, they grew their percent stake in the company to roughly 32 percent.)
Here’s the capitalization table of Internet of Wings after its Series B round is complete:
And here’s the company’s share structure:
And here’s where the company’s various shareholders sit with respect to one another:
This week, as we followed Jill and Jack through the process of raising their Series B round, we learned about pro rata, one of the most important clauses in a venture capital investment agreement because it ensures that investors aren’t diluted in a subsequent financing round. We also learned how to calculate how much an investor needs to invest to maintain their ownership stake in the company.
The question is, will Jack and Jill’s new vision of building a generalized transportation layer for restaurant delivery work? Rocky times may be ahead, so tune in to the next installment as we learn about ratchet-based antidilution protections and what happens during down-round financings.
This is part of the reason why there are an increasing number of so-called “opportunity funds,” which give venture capitalists and their limited partners more exposure to the late-stage rounds of their early successes.