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A Share Dilution Spreadsheet for Convertible Note and Y combinator SAFE Startup Funding - YouTube
Channel: StartupSOS
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in this video we'll walk through a
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spreadsheet that you can download
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that'll help you analyze a convertible
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note or a primo nice safe to see what
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the impact of that instrument will be on
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your share dilution will walk through
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two additional spreadsheets in
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subsequent videos the next one will walk
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through the post money safe to analyze
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how it can have an effect on your shared
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dilution and then finally we'll walk
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through what I think of as the ultimate
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share dilution spreadsheet which will
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look at multiple convertible notes
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multiple pre-money safes and multiple
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post money saves so you can analyze a
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broad range of situations to see how
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they will affect your share dilution I'm
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Steve Morse and I use this startup SOS
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channel to provide practical how-to
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advice for first-time entrepreneurs so
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again the topic this time analyzing the
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pre-money safe and/or convertible note
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to see how it will impact your share
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dilution
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let's jump right into that the scenario
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is you've closed a note or a safe for
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some current funding and later then you
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have a Series A funding that converts
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that convertible security into stock
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will walk through two different
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situations on the one hand the Series a
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investors requires that you issue some
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additional stock options prior to the
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series investment once those are issued
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then they make the investment against
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that larger base of fully diluted shares
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and then the convertible security
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converts and it dilutes both the Series
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A and the founders it's a reasonably
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balanced approach and a very typical
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approach for an early stage investment
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but option number two is the fixed
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percent approach here the investor
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decides they don't want to be diluted by
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all of those convertible securities that
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you have so they're going to require
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that the option pool and the Series A
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ownership at the end of the round after
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everything converts is some fixed
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percentage of percentage for the option
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pool and a percentage for the Series A
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so the Series A is not getting diluted
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by the convertible security instead it's
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the founders they're getting diluted one
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of the note on the spreadsheet you'll
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see that some of the cells have green
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text others have black text the green
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text is where you plug in your numbers
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the black text is either no titles or
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descriptions or the results of actual
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formulas you won't want to change the
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formulas unless you really understand
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the spreadsheet and understand what
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you're doing here's the first part of
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the spreadsheet where you get to plug in
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how much stock initially to the founders
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have here we're starting with a million
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shares and we assume you've closed
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either a note or a pretty money safe for
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some funding plugged in $500,000 and I'm
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assuming this is a note so it has an
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interest rate of 8% and it has a period
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that you expect it will go until it
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converts in that series a around we need
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to put that in because that becomes you
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know part of the funding that will
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convert and in this case we're assuming
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the conversion happens in 12 months it's
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8% so that'll add $40,000 to that
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$500,000 note and we're assuming a
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pre-money cap of 4 million and a
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discount of 30% again all of these green
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numbers you can plug in whatever other
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numbers you want if you want to plug in
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for a safe just make the interest rate
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zero and the calculations work exactly
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the same for a pretty money safe as for
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a convertible note next we assume
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there's a series a investment series a
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investor gives you a pre-money valuation
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of 8 million dollars and invests 2
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million and they're going to require
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that up front you issue an additional
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10% of the company shares to build up
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your option pool know without any
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convertible securities converting this
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implies that the Series A investors
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would own 20% of the company right
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they're investing 2 million the post
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money would be 8 million plus that 2
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million or 10 million and two million is
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20% of 10 million so their ownership
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would be 20% again assuming there aren't
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any other securities converting so let's
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look at scenario 1 where they're
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requiring you to allocate options before
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they invest in this scenario you've got
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a million shares sitting there owned by
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the founders so you'll need to issue an
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additional
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111111 shares to get a total of just
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over 1.1 million because that's how many
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shares it takes such that 10% of the
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full capitalisation fully diluted shares
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the company give you that stock option
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number okay so that's how that math
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works now that we've figured out how
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many options or how much stock we have
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to allocate to options
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next we figure out what is a share price
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that the series a investors okay
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well simple enough to calculate it's the
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pre-money value divided by that fully
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diluted capitalization pre monies 8
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million fully diluted capitalization is
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just over 1.1 million do that division
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and the price per share comes out to
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seven dollars and 20 cents next we'll
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figure out what the convertible security
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holder either the note or the safe will
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pay for their shares to do that we'll
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calculate what is the price that the cap
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would dictate what's the price that the
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discount would dictate what's the price
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that the series a investors will pay and
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just take the minimum of those three
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numbers that's what the convertible
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security holder will pay in this case
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the best deal comes from the cap because
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it's a very low cap compared to the
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pre-money value so that's going to
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determine the price that is paid by the
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convertible security holder now that we
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have the prices we can figure out the
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cap table so we begin with million
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shares that the founders have and then
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we calculate that the convertible
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security will get 150,000 shares just
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the amount they invested five hundred
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thousand plus the 40 thousand and
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interest in this example divided by the
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price that we calculated for the
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convertible share holders next we have
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already calculated the number of options
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we needed one hundred eleven thousand
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one hundred and eleven and then finally
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we calculate the number of shares that
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go to the series a investors which is
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simply the amount that they're investing
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two million dollars divided by the share
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price
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they pay which is seven dollars and 20
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cents so that then gives us a total
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number of shares of just over 1.5
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million you can see that the founders
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have been deluded some fair amount now
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they started out with a hundred percent
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of the company now they have sixty five
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percent the convertible security holders
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have nine point seven percent the option
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pool got diluted by the convertible
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securities converting it's not ten
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percent anymore at 7.2 percent and the
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Sirius and vespers got diluted also they
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don't have twenty percent they have
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eighteen point one percent so again
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that's a very common approach to doing a
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Series A and converting the convertible
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securities where the dilution after the
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options are issued the dilution of the
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convertible securities is shared by
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founders and the Series A investors but
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that's of course not the only approach
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let's look at scenario number two where
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we're going to fix the percent of both
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the option pool and the series a
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investment post investment so how do we
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figure that out well we know that the
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founders have a million shares now let's
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assume the same stock price for this
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round as in the earlier simpler case
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seven dollars and 20 cents well in that
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case the convertible security holder
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either the convertible node or the safe
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holder will pay that low price
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determined by the cap and and get the
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same number of shares as in the previous
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example one hundred fifty thousand the
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series a then is going to come out with
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twenty percent and the stock options are
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going to come out with ten percent after
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all of those shares are issued for the
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the note holder or the safe holder so
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how do we figure out how many additional
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shares have to be issued well we have a
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total of 1.15 million shares the the 1
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million plus 150 thousand for the
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convertible security and we want that to
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be equal to 70 percent of the total
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number of shares so that we have room
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for you know ten percent for the options
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twenty percent for the Thursday
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investors how do you figure out how many
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shares that will take if you simply
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divide 0.7 into 1.15
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million and that gives us just over 1.6
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million shares that we need now we can
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build the cap table so again the
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founders have a million shares we've
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calculated with an assumed Series a
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price of seven dollars and 20 cents
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which means that the convertible
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securities have a price lower than that
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we've assumed that and calculated their
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share count we have a required option
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pool that's 10% of the total one point
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six four million ten percent of that
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about a hundred sixty four thousand and
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the series a investors will get shares
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determined by their investment divided
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by the stock price against seven point
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two dollars two hundred and seventy
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seven point seven thousand shares but
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now we have a problem that adds up to
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about one point five million shares
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that's not the number we calculated
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before that was over one point six
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million the other problem is the series
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a investors don't own twenty percent at
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the end of the round they own sixteen
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point nine one percent okay so what went
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wrong
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well what went wrong is we chose the
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wrong stock price we started with a
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reasonable enough guess seven dollars
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and twenty cents the same prices was
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paid in the first scenario but clearly
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in order to give the series a investors
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twenty percent of the company that price
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is too high the price needs to be lower
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than that
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in order to get more stock to those
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series a investors so their money will
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go farther to get them up to twenty
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percent well how do we calculate what
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that exact price is to get them the
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right number of shares and that is the
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tricky part
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and here's why let's start with a share
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price that determines how many
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convertible shares whether it's
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convertible note or saves there are it
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also determines the number of Series A
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shares and that added up gives you the
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total capitalization along with the
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pre-existing shares for the founders
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that total capitalization then
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determines the share ownership and the
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share ownership depends on the share
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price
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well that's a problem now we've were
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circular we've mapped right back up to
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the share price you need the share price
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to figure out the total capitalization
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you need the total capitalization to
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figure out the share price so in other
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words this is an iterative calculation
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now some spreadsheets like Excel can do
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iterative calculations if you set that
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mode in the spreadsheet but that can be
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a little bit of a challenge sometimes
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those iterations can like go on forever
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so it's a little tricky
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also the spreadsheet I usually use is
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numbers on a Mac and it doesn't do that
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kind of iteration so the approach I took
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in this spreadsheet so it'll work on any
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spreadsheet and so it won't get into an
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endless loop is to let the user do the
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iteration so you get to iterate the
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price so let's walk through how that
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works so looking at the spreadsheet
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there's this part that's labeled the
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iterative share price and it's green
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meaning you get to set that now we set
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that initial eight to seven dollars and
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20 cents you can see now the target
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ownership for the Series A is 20% and
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the calculated ownership with that share
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price is sixteen point nine one percent
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so clearly that price is too low to make
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the spreadsheet work what you get to do
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is to crank down that price try at lower
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prices until you get to the right price
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that sets that percent to twenty percent
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well we know it has to be a lower price
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because we know that the series a
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shareholders need more shares so they're
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two million investment needs to pay a
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lower price so they get more shares so
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we're going to ratchet the price down to
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something below seven dollars and 20
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cents after a little experimentation
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you'll find that six point zero eight
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six dollars is the right number out to
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at least four digits that gets you the
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20% that the series a investors are
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insisting that they have so now that we
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have the right price let's plug that
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into our captive
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so now we have 1 million shares for the
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founders as before the convertibles are
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still at 150,000 shares because they're
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pre money cap is still a better deal for
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them than say the discounted price of
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even this new lower series a price so
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they're still at 150,000 the required
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option pool is 10% of that earlier
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number that we calculated for the total
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fully diluted number of shares and the
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Series A investors now get three hundred
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and twenty eight point six thousand
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shares and again that's their 2,000,000
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divided by that new lower share price
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that we just calculated now the
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percentages turn out right things do add
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up to the total number of shares we
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calculated before the series a investors
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do have 20 percent of the company the
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option pool has 10 percent and you can
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see that the founders now have been
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diluted down to sixty point nine percent
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of the company so let's see how that
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compares to our first scenario the prior
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simpler approach with this second
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calculation we had sixty point nine
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percent ownership by the founders and
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that compares to sixty five percent
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ownership in the earlier example that's
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four point one percent difference in
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dilution that's an important difference
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to founders and it's not just the
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founders of course that are affected in
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this particular scenario the convertible
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security holder either the convertible
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note or safe had nine point one percent
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in this new calculation before they
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ended up with nine point seven percent
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so they too are ending up with less of
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the company the reason for that is that
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it's their pre money cap that's driving
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in their price if the discount had been
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driving in the price then their price
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between this two scenarios would have
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come down in this this newer example and
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their ownership actually would have
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increased in this new scenario so you
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never know until you run the numbers
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whether it's going to be good
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for the convertible security holder or
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not so good for them but this this
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scenario of fixing both the options
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percent and the stock percent for the
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series a investors pretty much always
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going to be bad thing for for the
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founders because they're going to absorb
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at least the majority of the dilution
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quick summary when it comes to dilution
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of series a different approaches to
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conversion of your convertible
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securities can have very different
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implications specifically different
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implications for the founder dilution
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the spreadsheet that we put together
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which you can download there's a link in
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the notes will help you work through
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some different scenarios to understand
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the implications in more detail and
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that's a wrap of our discussion of a
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spreadsheet to forecast your dilution
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this is helpful please click the like
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and share it with other entrepreneurs
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leave a comment if you have any feedback
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or questions and please do hit that
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subscribe button because the next video
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you want to hit the bell to get notified
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for describes these two scenarios but
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with the post money safe and how that
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works now we'll add that to the playlist
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of this whole series there's a link to
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that right below me so use that link to
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make sure you don't miss anything
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in this series that's it for now thank
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you very much for watching
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