Tim Draper walks through early-stage financing mechanics, using a $150,000 for 10% example to explain valuation caps and term sheets. He shows how participating preferred stock, participation clauses, and cap levels change founder and investor payouts at exit, with concrete scenarios at $2 million and $1.5 million.
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You, all of you guys are negotiating with me, okay? So we've got this new company, NewCo, new whatever. By the way, I own new.co, which is kind of cool. I don't know what to do with it.
I have an idea.
And then we're going to have an investment. So let's say— so Mike, how much do you think your company is going to need?
Maybe $150,000. Okay.
So for $150,000, I want 10% of your business, roughly. You game? Okay. So this is— by the way, there's another Term sheet that we should probably go through before you're completely done. This is the Series A term sheet. This is the term sheet that after the note and all that happen, you get this. I can give you a quick rundown on what that note looks like. It's a note, it's a debt, okay? What all those angels are investing in is a debt. And if they say no cap, then it's a debt for mullet investors.
That's right.
Okay, you know what a mullet investor is? Mullet is the stupidest fish in the sea. So they— when they say there's no cap on the note, that means they're going to loan you money and they're not going to even value your company. They're just saying, sure, convert it to whatever happens. And they're assuming a Series A will happen like this. Normally, a note will have a cap, and the cap will mean what the valuation is. Okay, so for a lot of you, you got to turn your head around a little bit, because where I just said, 10% for $150,000. What that values the company at is— anybody know?
$1.5 million.
Wait, $1.5— wait, $150,000 buys 10%— yeah, it values the whole company at $1.5 million. So that $1.5 million is your market cap. The market cap is the value of your company. When people say there's a note and a 5 cap, they mean it's a note that converts into a market cap of $5 million. Or there's a note and it's a 2 cap, that means that they are valuing your company at $2 million. This company is being valued at $1.5 million.
Okay. Yes.
It's always an estimate, right? No, no, it's a fixed number. Yeah, but it's making money. Here's a note, I'm loaning you $100,000 at a 2 cap. That means I am getting— and cap means we're capping it there, okay, because if they value you lower in the Series A, I get that valuation. That's normally what those notes are. Okay.
Okay.
So yeah, it's a good question. So let's assume you had a note and it— or let's assume you never— yeah, this is better to assume that you didn't take any notes for angel funding, but you're just taking the— Standard Series A, and it's $150,000. Okay. Type of security is preferred stock. The reason it's called preferred stock, this was a weird tax thing where investors wanted to own a piece of a company, but they wanted to be paid back first. So if you bought your— if If they invested in your company and they paid $1 million for half your company and then you turned around and sold it for $1 million, they would have only ended up with half a million even though they had given you the million dollars. And they would get a lot more. So the investors said, wait a second, we need some preference on that, meaning we want our money out first. They're trying to get their money out first. When investors came up with this thing, the government said, no, no, that has to be— you can't just do that. You have to have a separate class of stock. This separate class of stock is preferred stock. There are some weird terms on preferred stock. just because it had to comply with some old government laws. So that's preferred stock. Now, there are 2 kinds of preferred stock. There's the— there's regular preferred stock and there's participating preferred. So participating is in effect a tougher— It's a convertible. term or more aggressive term on the part of the investor. Participating preferred would mean— can we get rid of some of this? Or did somebody take a picture of that?
Picture of what?
The board. It looks so beautiful. Here, I can do it over here maybe. You won't be able to see it. Oh, yeah. Well, it's okay. I'll explain it, and then maybe you can just go along with me. What about the other whiteboard? The other side of that? Other side of this?
Yeah.
Yeah, we can do that.
Okay. Okay.
Okay, everybody see that? Okay, so with regular preferred stock, I invest— let's say I invest $1 million for half of the company, okay? Regular preferred, if he sells that company for $2 million, Okay, sells for $2 million. All I get as an investor is my money back. Okay? So for regular preferred—
Tim?
Yeah?
Is there a marker pen? Yeah, it's hard to see.
Is there one? All I had were 2 red pens here. Oh, up here. My mother used to say, if it were a snake, it would have bitten you. Okay, $1 million, 50%. So if it sells— company sells for $2 million under regular preferred or straight preferred, what happens is, The first million comes right off the top, goes back to the investor. The investor has done his— made his million-dollar investment and they— and he owns 50% of your business. But if you sell it for $2 million, he only really gets his million back and the next million goes to you.
Okay.
In the case of participating preferred, Okay, so this is the investor, and this is you. Okay, you get $1 million and he gets $1 million. And he just basically gets his money back. So that's why they came up with participating preferred. If it were just common— let's do common too. Okay, we'll do it up here. Sorry about my handwriting. If it sells for $2 million, in the common scenario, he would— you would split the $2 million. So interestingly, that would have been the same million dollars each in this case. Now, if you sold it for—
$1 million.
If you sold it for $1 million, It would be a different deal. Okay, let's just do that. Let's say we sold it for $1 million and you only had common stock as an investor, how much would you get then?
Half a million.
You'd get half a million. But if you had preferred shares, so that'd be $500,000 and $500,000, but if you had preferred shares, The investor would get the whole million. You get that?
Yes. Okay.
And then participating preferred means, okay, if you sold this for $2 million and you had the 50% ownership as an investor, participating preferred means you get your money back and you get the ownership. So this is tougher on the entrepreneur. And so the investor in this case would get $1.5 million and you would just get $500,000. Okay? I didn't want to confuse you guys with this, but— so in this scenario, you sell the business for $2 million, common gets $1 million— if it were common shares the investor bought, They'd get $1 million and you'd get $1 million. If they were preferred shares, they'd get $1 million and you'd get $1 million. And if they were participating preferred, they'd get $1.5 million and you'd get $500,000. Okay, what if they sold it for $1.5 million? Okay, so if you sold it for $1.5 million— What would you pay for it? In the common case—
0.75.
Yeah, you'd each get 0.75, right? In the regular preferred case, it would be $1,500,000, right? That's $0.500 million. And in the preferred— in the participating preferred case—
$1.25 million.
Yeah, $1.25 million, and this would only be $250K, right? So you see that this participating preferred is the most aggressive, and sometimes people negotiate that participating preferred To go away after a couple of years or go away after somebody has made 3 times on their money or go away. So sometimes they want that participation in that case that you give them $1 million and they sell it for $1.5 million, but they don't mind if you give them $1 million and you sell it for $10 million. So that's— okay, so that— those are the various Some of the various choices for what kind of stock people would ask for. And notes, differently, notes are debt.
