What is Series A funding?
Series A funding refers to the process of raising the first round of institutional capital from outside investors. This round is one of the most significant milestones for most founders. At this stage, your startup is probably not turning a profit even though it might be generating a steady revenue stream.
Out of the four to five funding rounds that most successful startups raise, it is the Series A round that normally proves to be the most exciting opportunity to accelerate the growth of the company.
But there’s a catch:
You have probably had little to no experience negotiating a standard Series A term sheet until now. What can put you at a serious disadvantage is that while VCs and other kinds of venture-stage investors already know equity financing term sheets inside-out, you don’t -- yet.
However, once you’re armed with the right information and expectations, navigating through a Series A term sheet will not be overwhelming. In fact, if you pay genuine attention while going through this guide, there’s a strong chance that you’ll succeed in executing the Series A round in your favor.
This article outlines everything that you should understand to be able to negotiate a fair Series A agreement. This includes:
- The fundamentals of raising a Series A round
- How it differs from your previous and future rounds
- Key terminology and components of the quintessential Series A round
First things first: The basics of Series A funding
A Series A round is usually the first equity round of funding for most companies.
While seed rounds are typically raised using convertible securities such as Convertible Notes and/or SAFEs and generally include a wider range of investors (from institutional seed funds to angels), your Series A funding focuses on VCs and other kinds of investors who provide funding in exchange for shares of preferred stock.
In your Series A round, you will most probably have one lead investor who will invest most of the total amount. You will have some room for other investors as well, including your current seed investors who might be interested in investing more money in your startup.
Investors in your Series A round look for more than an innovative idea. They want to see growth from your seed stage, as well as a business model that can generate profits with a fair level of continuity and certainty. Typically, investors want you to utilize the funds raised in your Series A to continue to grow your customer base and develop your product.
The experience of raising Series A funding varies from founder to founder. You’re not going to find a one-size-fits-all formula to base your fundraising experience on.
Why does this matter?
The length of time that you’ll spend raising money could easily differ from that of other startups. Some businesses receive their Series A term sheet before they’ve even begun raising in earnest, while others spend months having round after round of meetings with VCs.
(Speaking of meetings with VCs, check out these five great pointers on how to engage with investors while raising capital.)
That’s not all …
It’s essential to recognize that neither the amount of this financing nor the ease (or difficulty) with which you raise it is a direct reflection of your company, despite your perception of Series A rounds. It’s merely the first round of institutional money flowing into your company.
Setting the right precedent
You receive your first Series A term sheet after meeting two criteria. These are:
- You’ve reached the Series A round. Founders often falsely assume that they’ve reached the Series A stage when they’re really at the seed stage, so it’s worth confirming that you’re genuinely ready for the Series A.
- You have found a VC who is interested in you and who you think has values that align with your startup's.
After these criteria are satisfied, you'll receive your first Series A term sheet.
This may feel like a huge accomplishment — and it sure is — but the Series A ride has only just begun, and has not been completed.
So, now what?
It’s very likely that you got away with a one- or two-page term sheet in your seed round. However, with a typical Series A term sheet, you should expect something much more detailed -- along the lines of six-to-seven pages.
Here’s a Series A term sheet template from Y Combinator.
Here’s the deal:
While it’s true that investors during each round of fundraising will have different expectations for your startup, it’s also true that the terms negotiated in your Series A tend to serve as the baseline for negotiation terms during subsequent rounds of funding. This means that you will have a significantly smoother process in your next financing round if the foundation in your Series A is solid, sensible, and strategic.
While you may - understandably - want to hurry the process along, avoid the temptation of agreeing to nonstandard terms in your Series A term sheet. Refrain from telling yourself that you’ll cut that term out in the next round.
Not only can retaining nonstandard terms complicate future fundraising, but you might also find your investors reluctant to drop any previous less-than-ideal terms or even asking for the addition of similar terms (no matter how problematic they might be for you).
A few examples of nonstandard terms include:
- Warrant coverage
- Participating preferred
- Liquidation preference that’s more than 1x
- Cumulative dividends
Bottom line?
Terms that are significantly problematic for you should be nipped in the bud. The Series A term sheet is a fundamental document that should not be executed prematurely merely for the sake of convenience, conflict-aversion, or sycophancy.
The good news?
Once the fundamental principles are spelled out thoroughly in the Series A term sheet, the terms in future term sheets (for subsequent rounds of funding) wane in complexity as they build on the Series A term sheet.
The more you know: Key terms in Series A term sheet
You will certainly come across several crucial terms in your Series A term sheet (such as the ones listed in the sample Series A term sheet shared above). This implies that understanding the implications of these terms is essential to the term sheet negotiation process.
Outlined below are five common terms and standards that you can expect to see in the Series A round. These are:
- Liquidation preference
- Dividends
- Available option pool
- Protective provisions
- Board composition
Liquidation Preference
What is a liquidation preference?
Liquidation preference is the right of the investors to receive a specified amount of cash (before common stockholders) when a sale or other liquidation event takes place. This is often expressed in terms of a multiple of the initial amount invested.
1x non-participating is the norm in early-stage VC fundings when the startup fundraising environment is good (as in recent years). Here, “1x” is the liquidation preference multiple. This determines what portion of the investors’ original investment has to be returned before the common stockholders receive any portion of the liquidation proceeds. “1x” implies a 100 percent return of the initial amount invested.
What does non-participating mean?
This means that the investors are entitled to either:
- The liquidation preference amount
- The amount that they would receive if they converted their preferred shares to common stock (in other words, sharing proportionately with common stockholders)
This post gives a rundown on the difference between non-participating and participating preferred stock, which are the two primary kinds of liquidation preferences.
Liquidation preference is essentially downside protection. The investors -- in the event of a successful exit -- will choose to share the liquidation proceeds proportionately with common stockholders.
However, in a downside scenario, an investor will most likely choose the liquidation preference to safeguard their original investment amount.
Dividends
A dividend is a distribution by the startup to its stockholders. It’s usually paid in cash out of the startup’s profits.
Paying or declaring dividends is rare in the case of early-stage startups because:
- It requires the company to be profitable
- At the early stage, profits (if any) are typically reinvested in the startup to fuel product development and business growth
Nonetheless, that doesn’t stop investors from negotiating dividends in Series A term sheets.
In fact, we often see dividends for Series A preferred stock organized as “when, as and if declared” by the board. This means that without the startup's board of directors' approval, no dividend is paid.
Why does this matter?
Even though dividends are rarely paid in early-stage startups, it is common to see Series A term sheets that call for a stated dividend at usually 6-8 percent of the preferred stock’s original issue price, payable prior to any common stock dividend.
Available option pool
Often, term sheets call for a portion of the post-money capitalization of your startup to be included in the pre-money valuation as well as to ensure that this portion is made available to grant to service providers.
By including this available option pool in the pre-money valuation, only your company’s existing stockholders (prior to financing) are diluted by the expansion of the pool along with the financing.
We typically observe the available pool set at around 10 percent in a Series A term sheet. This percentage could differ depending on factors such as:
- How long the initial capital raised will keep your startup afloat
- Anticipated hiring after the financing has closed
There are two critical problems seen in regard to the available option pool. These are:
- The investor requesting too much of an available option pool
- The adverse impact of not raising a “fully committed” round since a percentage of the round will be set aside as the available option pool
Protective Provisions
What are Protective Provisions?
Protective provisions are a negotiated set of actions that your startup can take only after holders of a certain percentage of Series A stock have consented to the action(s) (usually by a simple majority).
The question is:
What actions do protective provisions restrict?
The actions that protective provisions restrict usually include those that could affect the Series A round or negatively impact your company.
The lead investor might want to negotiate for a threshold that is higher than a simple majority based on:
- How much of the round they are financing
- The dollar amount of convertible securities (like SAFEs and/or convertible notes) that are converting into the round (i.e., being absorbed into the round)
We can’t emphasize this enough:
It is beneficial to have an accurate pro forma capitalization table when negotiating the Series A term sheet. This will allow you to determine which investors will be required to take any action covered by the protective provisions.
Board composition
As the executive tier, your board of directors is responsible for the oversight and management of your startup.
Rather than holding formal, regularly scheduled board meetings, the initial board (usually the founders themselves) for most early-stage startups make decisions as required and document these decisions as actions undertaken by unanimous written board consent.
But there’s a catch:
While this process is more or less the norm at the early stage, things become different at the Series A stage. When your Series A finally comes around, investors tend to push you to incorporate a board structure that is favorable to them.
Based on what we’ve observed through our extensive experience with helping startups grow, founders usually retain control of the board at Series A, while the lead investor has the right to designate one board seat.
How can you actually use this?
Any term sheet at the Series A stage or earlier, that has the founders losing significant control of the board should be approached cautiously -- and generally not agreed to.
What happens after the Series A term sheet is signed?
Your Series A term sheet has been signed.
Well, now it’s time to sprint to the destination.
Your next steps should include document drafting and negotiation, legal due diligence, signature collection, disclosure schedules, and, eventually, closing. On average, we observe this entire sequence of events -- starting from Series A term sheet execution to closing -- taking about 30-40 days.
A final note:
Whether you’re researching (and perfecting your pitch) before Series A season actually comes around or you are already waist-deep in negotiating your Series A funding, always remember that your priority should be getting a clean deal.
The best part?
Establishing everything the way you want it is great, but it’s not the end of the world when the developments in your Series A don’t align perfectly with how you had planned and hoped that they would.
While it’s certainly beneficial to know how to negotiate the Series A round so that you get a fair deal, there’s far more to building a successful and profitable business than picture-perfect Series A negotiations.
We can help!
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