Overview

Startups at the very early stages typically fundraise through convertibles. But when your startup has grown past this phase and needs to raise larger sums of money, you’ll probably need to go through what is referred to as an equity funding round (also sometimes referred to as an equity financing round). The key difference between an equity funding round and funding through convertibles is that you actually issue shares (typically preferred shares) to your investors in an equity funding round and formally bring them onto your cap table (and sometimes on to your board).

Clara Tip: What’s in a name? Equity funding rounds are often given names such as Series A or Series B or Series Seed. You might be wandering what the rules are behind what you call your round. The short answer is there aren’t any really. For example, some call their first round a Series A, others a Series Seed (or even Pre-Series A or Pre-Seed). If you feel your startup is at a particularly early stage in its development when you raise your first equity funding round, then maybe go for an earlier sounding name like Series Seed or Pre-Series A. At the end of the day, this is more about market signaling and marketing. It’s also important to keep your rounds named in sequence (e.g. if you start at Series A, then your next round would be Series B). The main reason rounds are labeled in this way is to organize each set of investors in a particular band where the order in which they invested in your startup is easily recognizable (each Series may also have different rights and may rank in the liquidation preference differently).

Equity funding round vs. convertibles

Here are some key differences between these two forms of funding:

  • Shares are issued to the investors.

  • You have to agree a fixed valuation at the time of the investment.

  • A shareholders’ agreement is entered into with the investors, founders and any other shareholders (or, for Delaware companies or those using US-style documents, a number of different documents, such as the Charter, Investor Rights Agreement, Co-Sale Agreement).

  • The process involves a lot more time and cost to complete (these things vary greatly, but as a very rough rule of thumb an equity funding round can take up to 4-5 times as long and cost up to 10 times as much in legal fees compared to convertibles – even more when you factor in that usually your startup will also bear the costs of the investors).

  • More extensive investor rights are granted (see below).

So why do an equity funding round at all? There are 2 main reasons:

  1. you can typically raise a lot more money in equity funding rounds versus convertibles; and

  2. after a certain stage of maturity in your startup and its business, investors typically refuse to invest through convertibles. This reflects your higher valuation and more complex operations, which now likely require a more formal investment, enhanced investor rights and monitoring (e.g. through a board seat).

Most common types of investor rights

Every round (and every investor) is different, but below are some key rights that you’ll typically see given to investors in an equity funding round.

  • The rights typically associated with preferred shares, such as liquidation preference, anti-dilution rights, board appointment rights, reserved matters and share transfer restrictions.

  • Preemption rights. These grant investors a priority right to invest in your startup’s future equity funding rounds. So if you want to issue new shares and bring on additional investors, you have to first offer these shares to any existing investors that have preemption rights. Only the portion not taken up by your existing investors will be available to new investors. From the investors’ perspective, this is an important right to be able to continue to invest and maintain their percentage shareholding in your startup. But from your perspective, too many preemption rights could hamper your ability to bring on new investors, who might bring additional value. They can also delay the funding process because you have to go through an initial offer process with your existing investors. A lot of the time, preemption rights will be waived by the investors so you can bring on new ones. But it's always good to try and keep this right limited to the bigger, more important investors in your startup.

  • Rights of first refusal. These grant investors a priority right to purchase any existing shares being transferred by another shareholder (as opposed to new shares being issued by the startup, where preemption rights apply). They can be structured in a number of ways, including requiring the selling shareholder or the existing shareholders to offer a price or establishing a price with the third party buyer first and then going back to the existing shareholders to see if they want to purchase it at that price, along with many more variations. While these rights are very common for investors, they can hamper the ability of a shareholder to sell their shares to the party of their choosing and add complexity to the sale process. As a result, they are often limited to transfers by non-investors (e.g. founders) and smaller investors, while exempting major investors from having to abide by them (though they sometimes apply to all shareholders).

  • Tag along rights. When a shareholder proposes to sell some of their shares to a third party, tag along rights allow investors to sell a portion of their shares as well to the same buyer on the same terms. Typically, the amount of shares that can be “tagged along” in this way will be proportional to the amount of shares being sold by the other shareholder. As with preemption rights and rights of first refusal, tag along rights can be limited so that they do not apply for transfers of shares by investors or major investors, but they will generally always apply to any transfers by founders.

  • Drag along right. When enough shareholders want to sell their shares to a third party buyer, the drag along right allows them to essentially force all other shareholders to sell their shares to that same buyer on the same terms. The portion of shareholders required to trigger this right is typically those holding at least a majority of all shares in the startup and including at least a majority of all investors (sometimes it also requires the approval of the founders as part of the overall majority). This is an important right to ensure the startup is “sellable” and that minority shareholders do not block a deal.

In addition to the above rights, your investors are likely to ask for some restrictions on you, the founder, and any co-founders, the two main ones are set out below.

  1. Lock-up. This is a period of time during which you are restricted from selling any of your shares. At the end of the day, investors are investing as much (if not more) in the founders as they are the business itself and want to make sure they stick around to run the business they just invested in (this can work in tandem with vesting – see below).

  2. Vesting. This concept is explained in detail here. This would be an example of reverse vesting, as founders typically already own all of their shares. Its primary purpose is to ensure your continued active participation in the business to deliver on the growth potential and business plan agreed when you raised money from your investors during the equity funding round. Time periods for the vesting vary, but can range between 3-4 years (sometimes less for very mature startups).

TL;DR

  1. Equity funding rounds are an important milestone in any startup’s journey. They involve issuing shares to investors at a fixed valuation.

  2. They are more time-consuming and costly than convertibles, but allow you to raise more money and continue to attract the right type of investors as your business grows and matures.

  3. Investors will be given a number of rights as part of the round, and these will be included in a shareholders’ agreement (or, for Delaware companies or those using US-style documents, a number of different documents, such as the Charter, Investor Rights Agreement, Co-Sale Agreement).

  4. One or more investors may get a board seat.

  5. Founders will be subject to restrictions, including share transfer restrictions and vesting.

Did this answer your question?