Startup Financing Flashcards
The Two Main Types of Funding
- Debt
o Provided by lenders, not owners.
o No voting rights.
o May include restrictions (called covenants) and can be secured by company assets.
Stages of Startup Development
Early stages :
1) Seed stage : Funding to explore and develop a business idea. Used for: market research, prototyping, concept validation.
Sources: founders, friends/family, angels, crowdfunding. No revenue yet.
2) Start-up Stage : Funding to build the product and start marketing. Used for: product development, go-to-market strategy.
Firm just launched; little or no commercial sales yet.
3) Other Early Stage : Funding to start production and sales. Product is ready but firm is not profitable yet. Focus: scaling operations.
4) Expansion Stage : Funding to grow a firm that’s breaking even or profitable. Used for: larger production, new markets, working capital.
Later stages / Special Financing
5) Bridge Financing : Short-term funding to prepare for an IPO (Initial Public Offering).
6) Secondary Purchase / Replacement Capital : Buying shares from existing investors (not new money to the firm).
7) Rescue / Turnaround : Funding for struggling firms to recover and become profitable again.
8) Refinancing Bank Debt : Replacing old debt to reduce financial leverage or lower interest costs.
Funding the First Steps (Seed stage)
Personal Savings : The entrepreneur uses their own money to start the project.
Bank Loans Borrower can be:
o The firm → the company is liable.
o The owner → personal liability.
Family and Friends : Informal loans or equity contributions from close contacts.
Crowdfunding : Public fundraising via platforms (covered in Chapter 2).
Business Angels
Wealthy individuals (ex: ex-entrepreneurs, managers).
Invest for financial return and/or personal interest. Often bring more than money: skills, contacts, mentoring.
Can invest via networks or clubs. Typical investment forms:
* Equity
* Convertible bonds
What is Venture Capital (VC)?
- Venture capital funds invest in startups with high growth potential.
- They usually take minority equity stakes (small ownership).
- The risk is very high: many portfolio companies fail, but a few generate very large returns.
- VCs are not just financiers – they bring expertise, networks, and support.
- Financing is often done in stages (stage financing).
- VCs frequently co-invest with other funds to spread risk.
VC Fund Structure
- Limited Partners (LPs) are institutional investors (pension funds, insurance companies, sovereign funds, etc.).
- General Partner (GP) is the venture capital firm that manages the fund.
- The VC Fund (a limited partnership) is the legal structure that holds the investments in startups.
Structure: - LPs provide the capital.
- The GP manages the fund.
- The fund owns stakes in startup companies.
Types of Venture Capital Firms
- Vanilla VCs: Generalist funds investing across sectors.
- Seed Specialists: Focus on early-stage startups.
- Corporate Ventures: Investment arms of large companies (e.g., Orange, Air Liquide).
- International VCs: Foreign funds investing locally.
- Tech-oriented / DeepTech VCs: Specialized in highly technical or scientific startups.
Principal–Agent Relationships in Venture Capital
- Principal = the investor (VC, lender)
- Agent = the entrepreneur or fund manager
- The agent acts on behalf of the principal, but may not act in their best interest due to diverging incentives.
- This gives rise to agency problems.
Main Types of Agency Problems
1) Moral Hazard (ex post problem) :
- The agent may not exert full effort once funding is secured.
- Effort is not contractible (can’t be enforced by law).
- Solution: incentive-based contracts (e.g., equity, staged financing).
2) Adverse Selection (ex ante problem):
- Happens before the contract is signed.
- Low-quality projects/founders may be more likely to seek funding
- Contracts may attract the wrong type of agent.
3) Free Riding
- In syndicated investments, one VC may rely on another’s efforts (e.g., monitoring, support).
- If effort is substitutable, some agents may under-contribute.
4) Hold-up
One party uses bargaining power to renegotiate the deal:
- The entrepreneur may demand better terms after receiving funds.
- The investor may exploit their power during later rounds to impose stricter conditions.
5) Window dressing
The entrepreneur manipulates the firm’s appearance to look more successful than reality:
- Fake results, inflated projections, hidden problems.
- Aims to secure next funding round.
6) Underinvestment
- The entrepreneur lacks incentive to push the project, especially under debt financing.
- May not put in sufficient effort to maximize value.
7) Asset stripping
The entrepreneur uses firm assets for personal benefit (e.g., luxury expenses, misuse of resources).
- Difficult to detect or legally prove.
- Typical with external debt financing.
8) Risk shifting
- After receiving funds (especially debt), the entrepreneur switches to riskier projects.
- If upside succeeds → entrepreneur gains
If it fails → investor bears the cost
→ Creates misaligned incentives.
Preferred Stock
When issued by mature companies:
* Pays a fixed dividend (e.g., $2 per year per share).
* Investors have seniority in liquidation: they get paid before common shareholders if the company goes bankrupt.
* Sometimes includes special voting rights.
Example: A listed company pays $5 annually to preferred shareholders regardless of profits.
When issued by startups:
* Usually does not pay dividends, because startups don’t generate stable cash flow.
* Instead, it offers protection features to investors:
o Liquidation preference: the investor gets their money back (or more) before common shareholders if the company fails.
o Conversion rights: preferred shares can be converted into common shares, usually during an exit (like an IPO).
Example: A VC invests $1M in a startup. If the startup fails, they recover their $1M first. If the startup succeeds, they can convert their shares to benefit from the upside.
Convertible Preferred Stock
- This is a hybrid instrument: a preferred share with the option to convert into common stock.
- It gives the investor:
o A downside protection (the liquidation preference),
o And an upside opportunity (conversion to common equity if the company grows).
How it works: - If the company does poorly, the investor keeps the preferred shares and gets their money back first.
- If the company does very well, the investor converts to common shares to benefit from the growth.
Best of both worlds: security + upside.
o Pre-Money Valuation
The value of the company before receiving the new funding = Pre-Money Valuation + New Investment
o Post-Money Valuation
The value of the company after the new investment is added = = Post-Money Valuation − New Investment
o Investor’s Ownership %
New Investment / Post-Money Valuation
Liquidation Preference
- Guarantees a minimum amount paid to investors before common shareholders if the company is sold, liquidated, or merged.
- Typical range: 1x to 3x the original investment.
- Example: If an investor puts $2M with a 2x liquidation preference, they must get $4M back before any money goes to the founders.
Seniority
- Determines the order of repayment if there are multiple funding rounds.
- Later-round investors may request to be senior to earlier-round investors.
- Senior investors are paid first in case of liquidation or exit.
Participation Rights
- Without participation rights: → Investor chooses either:
a) Liquidation preference or b) Convert to common stock and share in the upside. - With participation rights: → Investor receives:
a) Liquidation preference and b) Additional share of proceeds as if converted to common stock.
→ This is often called “double-dipping.”
Anti-Dilution Protection
- Protects earlier investors if the company raises money at a lower valuation later (“down round”).
- Adjusts the conversion price of preferred shares downward.
- Result: earlier investors get more shares (higher % ownership).
- Dilutes founders and employees in these cases.
Board Membership
- Investors may negotiate the right to appoint board members.
- Purpose: gain control rights and oversight.
- Can be crucial for influencing strategic decisions.
Negotiability
- All terms are negotiable.
- The final deal depends on the bargaining power of the startup vs. the investor.
o Hot startup → better terms for founders
o Weak position or market → stronger protections for investors
