5. Series A
‘Series A' refers to a company's first venture capital investment round. The term is meant to reflect the first issuance of preference shares - preferred A shares. In this chapter, we will take a close look at the Series A term sheet, negotiations, and preferred shares.
Our company is now performing really well, growing fast, and sees several venture capital funds showing interest in investing. The company is generating revenue, but is not yet cash-flow positive and will need a boost to achieve ambitious growth plans. The management decides it's time for a Series A. The ambition is to raise £15M at a £20M pre-money valuation to fuel international expansion.
Three VCs are expressing interest to invest; the VC with most domain knowledge is appointed to be lead investor. The lead investor will be responsible for negotiating the investment deal terms with the company on behalf of all the investors. A VC round is more complex than the angel rounds which the company has prior experience with and which can be closed with a simple handshake. VCs are complex entities, with investors of their own, and have to go through a strict selection process before any capital is committed. The first step for a company raising VC money is to attract the attention of one partner. If the partner likes the business and its potential, they will present it to the other managing partners. The company will often be invited to present the business in front of the partners, and if all partners agree on the business they will proceed to the term sheet stage.
Term Sheet
A term sheet is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made. A term sheet serves as a template to develop more detailed legal documents. The key here is to agree that the parties will negotiate and invest legal resources in a deal.
The company can bring their own term sheet, but most often the VC will bring their term sheet to the deal. The term sheet will typically map out a time frame within which the parties involved will negotiate between them, and not negotiate with any other parties.
One of the tasks at hand during the term sheet stage is to present a cap table for the investment round - both pre- and post-money. To do so, the company first has to make a new pre-money valuation and convert the outstanding note.
Converting the Note
The first step in organising cap table scenarios for the round is to convert the note from debt to equity. The note has accrued interest over the last year and the initial loan of £1,000,000 has grown with £50,280.75 to £1,050,280.75. The updated cap table is looking like this:
Shareholder |
Ordinary Shares |
% Ownership |
£ Value |
Founders |
200,000 |
70% |
£3,500,007 |
Seed Investor |
57,142 |
20% |
£999,987 |
Employees vested options |
20,000 |
7% |
£350,000 |
Option Pool |
8,571 |
3% |
£149,993 |
Convertible note |
0 |
0% |
£1,050,280.75 |
Total |
285,713 |
100% |
£4,999,987 |
The company had agreed a valuation cap of £15,000,000 with their investor. This is the highest valuation that the loan can be converted to. It was also agreed to implement a discount of 20% on all valuations lower than £15,000,000.
The Series A investors will invest in the company at a pre-money valuation of £20,000,000. Alas, the new valuation is higher than the valuation cap for the convertible note and thus triggering the conversion of the note from debt to equity at £15,000,000. The discount would only kick in at valuations under the cap and is no longer eligible for conversion.
To calculate the number of shares after conversion, we need to find the pre-money share price. This can be done by dividing the valuation cap by the total number of shares: £15,000,000 / 285,713 = £52.50 per share.
Knowing the share price, we can now divide the investment amount by the price per share: £1,050,280.75/ £52.50 = 20,005 shares after conversion.
Shareholder |
Ordinary Shares |
% Ownership |
£ Value |
Founders |
200,000 |
65% |
£3,500,007 |
Seed Investor |
57,142 |
19% |
£999,987 |
Employees vested options |
20,000 |
7% |
£350,000 |
Option Pool |
8,571 |
3% |
£149,993 |
Convertible note |
20,005 |
7% |
£1,050,281 |
Total |
305,718 |
100% |
£6,050,268 |
Convertible Note Shuffle
We previously explained the option pool shuffle. “Convertible debt shuffle” is a similar phenomenon which can appear in relation to the conversion of convertible notes. In short, the convertible debt shuffle impacts the shares allocated to an investor, when a convertible note conversion is triggered by an investment. Like the option pool shuffle, there are two ways to determine the shares to be allocated and the price paid per share. Let's see what happens to the allocation of shares to our new investors in two different scenarios:
The Investor Friendly Approach
The company converts the debt round first, allocating their shares using the number of shares outstanding. Then, using the revised number of shares outstanding, they allocate the new investor their shares, based on the amount they've invested.
We already converted the debt note earlier, which led us to the following cap table:
Shareholder |
Ordinary Shares |
% Ownership |
£ Value |
Founders |
200,000 |
65% |
£3,500,007 |
Seed Investor |
57,142 |
19% |
£999,987 |
Employees vested options |
20,000 |
7% |
£350,000 |
Option Pool |
8,571 |
3% |
£149,993 |
Convertible note |
20,005 |
7% |
£1,050,281 |
Total |
305,718 |
N/A |
£6,050,268 |
The new investment of £15,000,000 at £20,000,0000 pre-money will result in: pre-money valuation £20,0000,000 / outstanding number of shares 305,718 = £65.21 per share.
The conversion of the note results in a lower price per share than if the note had not been converted. Now the £15M investment is calculated as £15M / £65.21 = 223,469 new shares.
This leads to the following ownership percentage for the investor-friendly approach:
Shareholder |
Ordinary Shares |
Preference shares |
% Ownership |
£ Value |
Founders |
200,000 |
- |
37% |
£13,041,508 |
Seed Investor |
57,142 |
- |
11% |
£3,726,089 |
Employees vested options |
20,000 |
- |
4% |
£1,304,151 |
Option Pool |
8,571 |
- |
2% |
£558,894 |
Convertible note |
21,000 |
- |
4% |
£1,369,358 |
Series A |
- |
230,035 |
43% |
£15,000,000 |
Total |
536,748 |
- |
100% |
£35,000,000 |
The Founder Friendly Approach
The company allocates both the convertible debt and the new investor shares based on the same amount of shares outstanding. To calculate the allocations through this method we will use the cap table pre-note-conversion.
Shareholder |
Ordinary Shares |
% Ownership |
£ Value |
Founders |
200,000 |
70% |
£3,500,007 |
Seed Investor |
57,142 |
20% |
£999,987 |
Employees vested options |
20,000 |
7% |
£350,000 |
Option Pool |
8,571 |
3% |
£149,993 |
Convertible note |
0 |
0% |
1,050,280.75 |
Total |
285,713 |
100% |
£4,999,987 |
The new investment of £15,000,000 at £20,000,0000 pre-money will result in: pre-money valuation of £20,0000,000 / outstanding number of shares 285,713 = £70.00 per share.
The Series A investor will convert using the following formula: £15M / £70 = 214,285 new shares.
We also have to convert the outstanding convertible note, which is done by using the valuation cap share price of £54 and converting the outstanding debt. So £1,102,500 = 20,400 new shares.
This leads to the following ownership percentage for the founder friendly approach:
Shareholder |
Ordinary A |
Preference A |
% Ownership |
£ Value |
Founders |
200,000 |
- |
38% |
£14,000,063 |
Seed Investor |
57,142 |
- |
11% |
£3,999,958 |
Employees vested options |
20,000 |
- |
4% |
£1,400,006 |
Option Pool |
8,571 |
- |
2% |
£599,973 |
Convertible note |
21,000 |
- |
4% |
£1,470,007 |
Series A |
- |
214,285 |
41% |
£15,000,000 |
Total |
520,998 |
- |
100% |
£36,470,007 |
To sum up: in the VC friendly approach the VC ultimately received more shares; in the founder friendly approach, the VC gets fewer shares. So how does one decide which one to choose? The answer is that it depends on negotiations and the investors approach. We've listed some different opinions in the section below.
Further reading on convertible debt:
Take a look at AVC's explanation of the subject.
Series A Negotiations
With an understanding of the two methods of debt conversion and their impact on ownership, the founders evaluate the best approach for them. They decide to take the founder friendly approach and negotiate the deal from that standpoint. So the post-money cap table scenario sent to the investors is:
Shareholder |
Ordinary A |
Preference A |
% Ownership |
£ Value |
Founders |
200,000 |
- |
38% |
£14,000,063 |
Seed Investor |
57,142 |
- |
11% |
£3,999,958 |
Employees vested options |
20,000 |
- |
4% |
£1,400,006 |
Option Pool |
8,571 |
- |
2% |
£599,973 |
Convertible note |
21,000 |
- |
4% |
£1,470,007 |
Series A |
- |
214,285 |
41% |
£15,000,000 |
Total |
520,998 |
- |
100% |
£36,470,007 |
The Series A investors are very experienced and doing several funding rounds every year. They immediately notice the conversion when receiving the cap table, and have a prepared response: preference shares with participation rights and liquidation preferences. A preference share refers to share classes with a set of preferences to a company's capital. Preference shares usually do not have voting rights, but instead come with liquidation preference - meaning first rights to monies coming out of a company when paying out dividends, exit proceeds, or leftovers after liquidation.
Shareholder |
Ordinary shares |
Preference shares |
% Ownership |
£ Value |
Founders |
200,000 |
- |
38% |
£14,000,063 |
Seed Investor |
57,142 |
- |
11% |
£3,999,958 |
Employees vested options |
20,000 |
- |
4% |
£1,400,006 |
Option Pool |
8,571 |
- |
2% |
£599,973 |
Convertible note |
21,000 |
- |
4% |
£1,470,007 |
Series A |
- |
214,285 |
41% |
£15,000,000 |
Total |
520,998 |
- |
100% |
£36,470,007 |
Preference shares are standard in VC deals. VC investing is about beating the odds and finding the unique investments that can pay back 10, 50, or 100 times the initial investment. However, it's also about protection against bad investment outcomes through provisions, such as liquidation preferences.
The investors are looking to commit £15 million in the company, and insist on a liquidation preference with 1x multiple and participation rights. This will ensure that the investor is paid the first £15 million in the event of exit or winding up of the company. They will also participate in monies paid out after the first £15 million on an equal basis with other investors. Let's take a look at outcomes in the event of selling the company at different valuations:
Worst Case Scenario
Exit: £0 - £15,000,000
Shareholder |
Ordinary |
Preference A |
% Ownership |
Monies out |
Founders |
200,000 |
- |
38% |
£0 |
Seed Investor |
57,142 |
- |
11% |
£0 |
Employees vested options |
20,000 |
- |
4% |
£0 |
Option Pool |
8,571 |
- |
2% |
£0 |
Convertible note |
21,000 |
- |
4% |
£0 |
Series A |
- |
214,285 |
41% |
£0 - £15M |
Total |
520,998 |
- |
100% |
- |
The worst case is the company going under and having to liquidate. The VC's will get all proceeds up to £15M. In this example everybody is losing, but the VC at least has some downside protection. Nobody wants this.
Bad Case Scenario
Exit: £0 - £35,000,000
Shareholder |
Ordinary |
Preference A |
% Ownership |
Monies out |
Founders |
200,000 |
- |
38% |
£7,826,621 |
Seed Investor |
57,142 |
- |
11% |
£2,225,656 |
Employees vested options |
20,000 |
- |
4% |
£432,662 |
Option Pool |
8,571 |
- |
2% |
£0 |
Convertible note |
21,000 |
- |
4% |
£1,168,788 |
Series A |
- |
214,285 |
41% |
23,346,273 |
Total |
520,998 |
- |
100% |
£35,000,000 |
Although this is a better situation than the worst case scenario, it is still a suboptimal result for VCs - i.e. a company where growth stagnates and the value does not increase post-investment. In this case, the liquidation preference and participation right secure a small upside for the VCs. However, this simultaneously puts founders, employees and early investors in a financially worse position than before the investment. Notice that the VC receives a disproportionate amount back compared to their ownership percentage. Also, the options granted to employees have the same ownership percentage as convertible note holders, yet receives under half the payout. This is because the options have to be exercised first, which means the employees have to pay the strike price before getting actual shares. In this case, for reasons of simplicity, the exercise price is set to £17.50 and corresponds to the seed investment.
Before the Series A investment, shareholders only had to share the £20 million exit proceeds among founders, seed investors, and employees. Now, because the company has not increased the value beyond the £35 million post-money valuations, the VCs take out the first £15 million corresponding to their investment, and participate in the remaining £20 million on equal terms with other shareholders. This has happened in reality to many companies and is one of the reasons why founders are often hesitant towards liquidation preferences. Nobody is happy about this outcome - founders, employees, and early stage investors are disappointed that the cash value has dropped significantly since the last funding round. The VCs are also unhappy, as they have invested in a low growth company, spent considerable time on it, and possibly lost out on other opportunities.
Best Case Scenario
In a best case scenario, the company meets the VC metrics and exits at 10x the last valuation. Everybody wins. The VC still takes out the first £15 million, but it's negligible compared to the windfall that comes for everyone else too.
In the simple scenarios presented here, the takeaway should be: liquidation preferences are a downside protection for VCs, that gives them the first right to the capital paid out of the company. Founders should be aware that the liquidation preference will seriously hurt their pay-out if things do not work out as planned. But, if things do work out, everyone can reap significant benefits.
Further reading on liquidation preferences:
Series B-G
You have probably heard about unicorns, meaning startups with a valuation of more than $1 billion. At first these were few, but now they've increased in number significantly and several have become decacorns - companies with a valuation of more than $10 billion.
In recent years, it has become increasingly normal for companies to avoid IPO's and stay in the private market longer. There are many reasons for this, but it's clear that high regulation of listed companies and a robust private equity market are contributing factors. Companies simply do not have to go through the hassle of public scrutiny to receive large investments anymore. The result is the occurrence of Series B-G funding rounds.
As an example, Uber is one of the companies that have operated in the private market until a Series G round, which they secured in 2016 with Saudi Arabia's Public Investment Fund as lead investor. Even later, in 2017 they secured a $10B Softbank investment, but without a Series label on it.
Just as the term Series A was used for the first time a company issued preferred shares, the subsequent series is similarly tagged with a letter to indicate new categories of preferred shares with the later rounds having seniority over the previous rounds. This means that new liquidation preferences can have preference over a previously issued preference. In other words, if a Series B preference share has liquidity preference, its holders will receive their money first, then the Series A investors, and finally ordinary shareholders.
Further reading on funding rounds:
Startups.com have written extensively on this topic