Convertible Notes have many benefits compared to other investment methods; they are quick to setup, inexpensive create and easy to understand. They also postpone the complexities of valuation and specific investment terms until the next official round of funding.
A valuation is a monetary value of a company at a specific stage of operation.
In relationship to private companies, a valuation is a hot button topic of conversation. The valuation is determined when founders and investors get together and agree upon how much the company’s equity should be worth.
A similar conversation takes place when a company goes through a merger or acquisition in order to determine the value and sale price of the company.
A pre-Money Valuation is a commonly used term in venture capital and private equity. It refers to the value of a company before an investment or financing round.
After capital is invested into a company, the valuation of the company rises. A pre-money valuation gives investors and founders a good idea of the company’s value prior to investment.
A post-Money Valuation is a commonly used term in venture capital and private equity. It refers to the value of a company after an investment or financing round is complete. After capital is invested into a company, the valuation of the company rises. A post-money valuation shows how much the value of the company increased after the funding round is finished, showing the total value of the company.
As an example, if a company with a pre-money valuation of $20 million raises $5 million from investors, the post-money valuation will be $25 million. The investor who invested the $5 million will determine their percentage of ownership in the company by dividing their $5 million investment by the $25 million post-money valuation.
The investor would own 20% of the company $5 million / $25 million = 20%.
The exact terms and rights that an investor has after making an investment will vary depending on the terms set forth in the investment documents. Each investment is unique and has different terms upon which the investment is made.
Specific rights, when in relation to types of stock equity (preferred stock vs. common stock) is generally as follows: preferred stock tends to come with various rights and terms to provide added investment protection to investors ahead of common stock, including liquidation preferences.
All preferred stock converts to common stock during an IPO, so the benefits of preferred stock are minimal in private equity for most investors.
A Liquidation Preference is a term widely used in venture capital to specify which investors get paid first and how much they are paid in the case of a liquidation event, such as an acquisition. It protects investors by ensuring they get their initial investment back before other investors. This preference also applies to profits and determines which investors get paid out first.
Pro-Rata Investment Rights give an investor the right to participate in the next round of funding to keep up his or her percentage of ownership in the company. When a new funding round takes place, the valuation of the company increases and more shares are issued which dilutes the ownership percentage of previous investor's. To prevent this ownership dilution, many institutional and professional angel investors expect to have pro-rata rights, allowing them to maintain their ownership percentage by having the option to re-invest in the next round of funding.
Pro-rata rights are not always offered or guaranteed. Typically pro-rata rights are given to large investors. Since DreamFunded raises large amounts of funding from many investors writing smaller checks, we sometimes can receive pro-rata rights, allowing our investors to be able to re-invest in later rounds.
Anti-Dilution Rights provide investors with protection against dilution if the company’s next round of funding is at a lower valuation than the previous round. Anti-dilution rights are typically used for venture capital equity financing activities for preferred stockholders.