

Ask HN: How the hell do angel and VC investments work? - mappum

I have been trying to understand how investments work for startups. There is a plethora of information explaining it all, but it all assumes I know part of how it works or am familiar with the jargon. After just reading about convertible notes, I still would have no idea what was ripping me off or why.<p>Can anyone give a simple, made-for-developers explanation of how it all works, or give some links to guides that do the same? I assume the investment market changes, so what could I expect to see if I was raising funds for my company right now?
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eren_bali
I went through an angel round and a Series A myself. I will focus on a first
time entrepreneur's case and use realistic numbers.

1) You have and idea. You make as much progress as you can before trying to
raise.

2) Ideally, you network with some angel investors / micro VC's before you
start talking about your round.

3) You incorporate your company. You will issue an arbitrary number of shares
for the co-founders (typically 10M+) and you allocate some shares as an option
pool (typically 10-20%). Option pool will be used to give shares to employees,
advisors, consultants and board members.

4) You decide that you have made enough progress to raise a round (doing this
too early will be bad for you)

5) You talk to a lot of angel investors and early stage VC funds. Angel
investor is somebody who invests his/her own money, VC is a person who invests
other people's money. That's the only real difference.

6) If somebody is interested, you start talking about the terms. Now you
really have to learn the jargon.

Let's assume you will do a traditional priced round. You will negotiate a pre-
money valuation (typically $2-10M for first time entrepreneurs). Let's say an
investor proposes you $1M with a $4M pre money valuation (means your post-
money valuation is $5M) and you had initially issued 10M total shares. Each of
your shares will be worth $4M/10M = $0.25. Your company will issue $1M/0.24 =
4M new shares for your investors. So you don't actually sell shares, you just
issue new shares which will reduce your ownership percentage of the company(by
20% in this case). This deal could be done with a single investor (usually a
VC) or a group of investors who are each putting smaller chunks.

There's another format called "Convertible Note/Debt". It has become popular
in silicon valley. Instead of negotiating a pre-money valuation, you negotiate
for a discount rate (let's say 25%) and an annual interest rate (let's say
8%). In this case you don't immediately issue shares to investors. Instead you
promise to give them shares when you do your next priced round (Series A) with
the valuation that those investors pay / (1+discount rate) / (1+interest
rate). For example if you get a pre-money valuation of $20M a year after the
convertible note, your angel investors will get shares worth $1M _(1+0.25)_
(1+0.08) = $1.35M from the $20M pre-money valuation. That will be $1.35 /
($20M / 10M) = 675K shares.

The most common format these days is a convertible note with a cap on the
valuation. Typically the cap is negotiated just like a valuation. If you get a
valuation higher than the cap in your Series A, angel investors will get
shares from the cap you agreed on instead of the full price.

7) Typically, the investors give you a term sheet. When the negotiations are
over, they go through a due diligence period. They will ask for some docs to
check there was any BS in your pitch. In a seed round, this is usually very
lightweight.

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mrose
Regarding item 3, are you sure 10M+ shares is typical, and if so, why? I
recall a story of serious trouble as a result of issuing this many shares with
regards to tax implications down the line.

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brk
Here is a super-short version:

1) You have an idea

2) You do some work to prove the viability of this idea, generally in some
proportion to the complexity of implementing the idea (eg: if the idea is a
webapp, you write some code, maybe get a beta site going. If the idea is a new
fab process to build a 1 micron 1000-core supercomputer, then you tend to do
more research than actual real-world implementation)

3) You convince someone that your idea is worth $X(XXX(XXX(XXX)))

4) You form a legal corporation and issue shares of stock (typically
100,000,000 or so).

5) You now have a pool of shares (100,000,000) and an agreed upon valuation
for the company (let's say that valuation is $100,000,000 to make the math
easy). Each share is then worth $1.

6) You sell some number of those shares to one or more investors. Now you (you
being the corporation) have money to implement your idea and bring it to
fruition.

Again, grand simplification, but that is the general outline.

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ChiperSoft
So if the startup fails, the stock simply becomes worthless and the Investors
wasted their money?

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ronyeh
Yes. But you try your best not to fail (i.e., don't buy jumbo jets with your
Series A), so that your investors don't blame you. Maybe next time around,
they'll invest in your team again!

Or, they can convince a big company to acqui-hire your company. Say, Monopo-
soft purchases your company for $50,000,000. Then your investors can recoup a
portion of their original investment.

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jaredsohn
You may find David Weekly's "Introduction to Stock and Options for tech
entrepreneurs/startup employees" interesting.

[http://www.scribd.com/doc/55945011/An-Introduction-to-
Stock-...](http://www.scribd.com/doc/55945011/An-Introduction-to-Stock-
Options-for-the-Tech-Entrepreneur-or-Startup-Employee)

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tdorrance
I'm not recommending this site or principle but he does do great job of
explaining the intricacies of startup legal issues and investing.
<http://startuplawyer.com/category/convertible-notes>

