Article about a company from startup to IPO
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ENTP325-Spring2018-Week5.pptx
ENTP 325 Early Stage Venture Financing Week #5
Events incl entr coop
Student surveys
Enrolled Student Survey
https://drexel.qualtrics.com/jfe/form/SV_6r705G6pMlupXGB
Grading Student Exit Survey
This week
Tuesday
Valuation timelines and determining investment needs
Market sizing
Thursday
Angel investing introduction
SAFE, convertible notes, equity
Sunday
Finish reading Angel Investing – Gust Guide (Rose)
No assignments/quizzes
Accelerators as funding vehicles
Valuation timelines and determining investment needs
a.k.a. Your funding strategy
The challenge for high-growth startups
High-growth startup companies need to raise capital to sustain very high growth over several years.
The management teams of these companies will soon face a dilemma: how to raise the capital necessary for sustained growth?
One option is to raise more money to sustain the maximum growth rate.
The second is to grow more slowly and organically, that is, using cash generated by the business and later bank debt
This is a complex decision and there is no standard answer to this quandary.
It depends on the nature of the business and the appetites of the founders and early investors
Why is this important?
Angels typically invest $200,000 to $1 million in seed/startup and early stage companies
The average round of investment by angels is $250,000 to $400,000.
Most companies raise less than a total of $2 million in angel capital.
Why is this important?
Venture capitalists, on the other hand, have raised huge amounts of capital in the past two decades from their limited partner investors.
Consequently, each VC must invest more money per deal than in the past. The average VC round has steadily increased to $7-8 million
As a general rule, later stage investments tend be much larger than earlier stage investments.
VCs often invest $25 million or more in total (multiple rounds) in portfolio companies
But there’s a funding gap
With most VC money being invested in larger and later stage deals, there are very few investors interested in the $3 million deal size.
There are over 100,000 angel investors interested in rounds of investments less than $1 million in size and
Nearly 1000 venture capital firms interested investing in deals with capital requirements of $5 million and larger.
What does a company that needs $3 million to meet its objectives do to raise this capital?
An entrepreneur who needs to raise $3 million in capital will waste a lot of time without success pursuing this amount of capital.
A savvy entrepreneur who needs $3 million to reach positive cash flow (from profits) in commercializing a new product, will stage funding-raising efforts to match the capital markets.
He/she might, for example, raise $500,000 and plan to raise two additional rounds of $1.25 million each as the company achieves milestones.
An entrepreneur who needs to raise $6 million to achieve positive cash flow might raise enough money to achieve an important milestone, say $750,000, and then seek $5.25 million from VCs.
Understand the capital markets and to design a funding strategy that matches nicely with those markets.
The first task is to establish a list of the dozen or so key measurable milestones for your company.
With the list in hand, estimate how much money it will take to achieve each of these milestones.
The object of creating the milestone list is to plan when you will need to raise money for your business.
Use your milestone list and your knowledge of capital markets to match milestones with your rounds of investment.
Tell your early investors that their investment will be enough to get you to positive cash flow or that you will need to raise another round after you have achieved a specific milestone
Select these milestones carefully, because investors will expect you to meet these objectives prior to raising more money.
What are some measurable milestones?
licensed technology from university
developed working prototype in laboratory
hired qualified CFO
received reasonable production quotes from three reputable Chinese firms
hired super VP of Sales
negotiated agreement with channel partners in five regions of US
based on testing prototype, three potential customers provided letter of intent to purchase products at our price, assuming quality sufficient to meet their needs
closed $450,000 round of angel investment
received and tested first production runs from China
delivered first product to US customer
received working line of credit from local bank
first customer paid first invoice
achieved $100,000 per month in revenues
cut burn rate to $5,000 per month
When to fund
Put off raising money as long as possible
Because the more milestones you can achieve prior to raising angel money, the more valuable the company will be to angels (and the more ownership you will be able to keep).
As a general rule of thumb, angels prefer to invest in companies who have shown a product or a prototype of the product to potential customers.
Most angel investors want to talk to customers to validate the solution
Angels will invest at an earlier stage in the company’s development, but will likely demand a greater ownership share of the company for their investment
Because there is more risk involved in earlier stage investments.
When to seek more funding
Assuming you created the milestone-driven funding plan described above; you will know approximately when you will need to raise more money.
Most investors suggest that each round of investment should provide 12-18 months of “runway,”
That is, months of operations before you run out of cash.
And, knowing that it takes 3-6 months to raise money, a prudent entrepreneur will begin raising cash 12 months before running out of cash.
It should be becoming clear that fund-raising is a critical and time-consuming part of the entrepreneur’s job.
Dropbox
Snapchat
Fitbit
Let’s do a scenario at http://ownyourventure.com/equitySim.html
Two founders at 50%
Round 1
Set pre-money valuation at $1M
Investment money raised at $500K
Option pool at 15%
What is the post-money valuation?
What is the founder ownership (total and each)?
What is the value of the company for each founder?
Let’s do a scenario at http://ownyourventure.com/equitySim.html
Round 2
Set pre-money valuation at $4.5M
Investment money raised at $2M
Option pool at 10%
What is the post-money valuation?
What is the founder ownership (total and each)?
What is the value of the company for each founder?
Let’s do a scenario at http://ownyourventure.com/equitySim.html
Round 3
Set pre-money valuation at $14M
Investment money raised at $4M
Option pool at 7%
What is the post-money valuation?
What is the founder ownership (total and each)?
What is the value of the company for each founder?
Click the “Master Summary” link
Down round scenario
Assume an Earlier Investor agrees to fund the company with $500K and negotiates a $4.5 million pre-money valuation for the company.
10% equity to the investor
90% for founders
Now assume the entrepreneur has missed milestones and new competitor has entered this market.
The company now needs more money ($2 million) and the investment, in the eyes of the Later Investor, is much more risky.
The Later Investor negotiates a lower pre-money valuation of $2 million and invests another $2 million,
So the Later Investor owns 50% of the company:
Since the Later Investor now owns 50% of the company, the ownership % of both the entrepreneur and the Earlier Investor are “crammed down” or reduced by half
So the Earlier Investor now owns only 5% of the company.
Later investor 50%
Founders 45%
This cram down of the Earlier Investor can be avoided if the new investors had allowed the earlier investors to invest proportionally in the later investment.
Market sizing
…and your opportunity sizing
Why is the size of the opportunity important and how is it determined?
The size of the opportunity is used by investors to determine the likelihood that a company, if successful, will scale to a very high valuation and therefore a home run exit.
For companies that need only a round or two of angel funding to achieve optimum growth, achieving a valuation of $20-50 million in five years is viewed as highly scaleable.
For a company that requires venture capital investment of as much as $10 million, the company must show the opportunity to grow to at least $100 million or more in revenues.
Approaches to market sizing
Calculated by determining the total market, then estimating your share of that market.
Evaluates where products can be sold, the sales of comparable products, and the slice of current sales you can create
Top-down
Bottom-up
TAM: Total addressable market SAM: Serviceable addressable market SOM: Serviceable obtainable market
If I can get $1 from every person in China… If I can get even just 5% of the market…
Entrepreneurs are often seduced by market size data from research firms and their potential to achieve even just a small portion of that
A bottom-up estimate is usually more realistic for startups:
How much budget will you need to build your achievable market?
Hours per sale times cost per sale (customer acquisition cost)
Estimating TAM and SAM and target market is a good starting point for the market size hypothesis.
Customers will help turn these hypotheses into facts.
Accelerators
Startup accelerators, also known as seed accelerators, are fixed-term, cohort-based programs that include seed investment, connections, mentorship, educational components, and culminate in a public pitch event or demo day to accelerate growth.
Typically take a % equity (e.g. 6%) in the startup for their services and cash (e.g. $25K)
History and data
Modern-day accelerators emerged in 2005 with the launch of Y Combinator, followed closely by Techstars in 2006
Grew from 16 programs that year reaching 170 programs in 2014.
There are also an increasing number of “corporate accelerators”
Provide information that business angels and VCs need for diversifying their portfolios of high-potential companies.
Push “investor-ready” startups further down the investment pipeline.
Accelerator graduates have earned a seal of pre-approval when they present themselves to seed-stage investors.
This week’s readings (complete by end of week)
Best Practice Guidance for Angel Groups – Deal Structure and Negotiation
Angel Investing – Gust Guide (Rose)
No paper or quiz this week
32
Next week: Angel investor analysis paper
Using what you’ve learned from the David Rose book, the lectures, guest speakers and suggested resources, develop a 4-5 page paper on your perspectives of angel investing.
Specifically address topics such as:
what does it take to be an angel investor
what types of companies qualify for angel investing
what do angel investors look for
when do they invest
how do they invest (evaluate their investment decisions)
how can startups most effectively pitch to angel investors
Including examples, references, interviews (startups and investors) and other information to support your analysis
Angel investing introduction
SAFE, convertible notes, equity
Angels Provide
Source of Funding – Early Stage Startup / Seed
Expertise
Funding Contacts
Industry Expertise
Technical / General Business Experience
Board Members
Advice
35
Angel Investors (who are they?)
Private high net worth individuals
Corporate Executives
Entrepreneurs
Investments ($10K - $1.5M+)
Frequently work in informal Groups
Usually invest in their area of expertise
36
Angel groups
Comprised of individuals acting on their own behalf
But sometimes organized into loose or tightly organized groups
Let’s say you have $1 million of hard earned money to invest What characteristics are you looking for in an entrepreneurial / early stage investment?
42
Angels Want
Strong Management Multi-Skilled Experienced Team
High-performance Growth Companies
A niche, patent, uniqueness
An Exit – Return On / Of Investment
IPO
Strategic Buyer
Don’t want the “living dead”
No Problems
Open Communication
43
Angels Want
44
An Equity Share of the Company (15-30%)
A Return of/on their investment (30%)
Have fun and satisfaction
How Entrepreneurs attract Angel Investors
45
Find
Convince
Cash the Check
Finding Angels
Network
Find the Gatekeepers (Attorney’s, Accountants)
Referrals – Other Entrepreneurs, incubators, accelerators
Angel Venture Fair
https://angel.co/philadelphia/investors
http://nextplex.com/philadelphia-pa/resources/funding-sources
46
What’s the process (btw can be quite long)
Get
Get the meeting
Make
Make the pitch
Gauge
Gauge interest
Find
Find lead investor
Find
Find remaining investors
Secure
Secure a term sheet
Diligence
Complete due diligence process
Sign
Final docs
$$$
In the bank
The Potential Roles of an Angel - More than $’s
“Smart money”
A Board Member / Advisory Board
Technical Advice / Experience / Network
Active Involvement - Employee or Partner?
48
Entrepreneurs Want / Need
Money ($)/Equity
Board Members
Advice
Industry Knowledge
General Business Knowledge
49
Entrepreneur /Angel Relationships Tests
What happens when Problems occur?
Missed Projections
Cash Flow Problems
Reporting Requirements
Commitment Authority Levels
Capital Investments, Compensation, Contracts
Leadership Changes
50
Using Angels to Build Your Business
Wise entrepreneurs choose “smart money” as angel investors in their companies.
Harvard Business School reported in 2010 that mentoring and business contacts from angels seemed to be even more important that the capital angels provide.
Smart money brings more than cash to the investment; that is, business acumen, valuable networks and a willingness to assist in growing the startup venture.
More about angels
https://angel.co/big-data/investors
(good place to research investors)
Angel Capital Association
May 4th - Angel Venture Faire - Largest gathering of Investors & Entrepreneurs in the Mid-Atlantic region
https://www.angelventurefair.com/
Angel Investment Deal Structures
Important terms
Common stock
Founders, friends, family
Preferred stock
For investors
Protects investors who get paid out first upon exit event but only the amount that was paid for it … plus dividends (interest)
Convertible preferred stock
Preferred stock that converts to common stock
Protects investors downside while participating in the upside with founders
Convertible debt – loan that may be repaid or converted by the investor into equity
Angel investing – basic approaches
Loan
Equity
Convertible debt/note
SAFE (convertible equity)
Loan approach
Debt instrument
Interest rate
Payment terms
Equity approach
Uses the formulas we’ve seen to-date in the course
In the 1990’s it was typical for angels to take common stock
Though today a convertible preferred is generally used
Relatively simple approach but challenging due to valuation
Convertible note/debt approach
Angel can convert what starts as a loan to equivalent of cash and use the money to buy stock in the company
Reduces complexity and costs of documenting an equity round
Allows you to postpone the valuation discussion
Mainly need to agree on
The interest rate and timeframe on the loan
When in the future the debt will convert
Uses the valuation of the next round to determine conversion rate
Vehicles in convertibles to compensate angels for early-stage risk
Discount
Angel gets discount to whatever the next investor sets the valuation
Typically 10-30 percent
So the term used is Discounted Convertible Preferable
Valuation cap
If your company ends up raising money at a valuation above the “cap,” then the earlier investor gets to convert at a share price equivalent to the cap.
Protects the angel when the next round is priced substantially higher
Convertible note cap example
Rough estimate is the company is worth $1M at $100,00 angel funding with 20% discount
Without cap
Next VC round the company is worth $5M
With discount the angel’s investment converts at $4M valuation
The angel’s $100,000 is pretty small part of a $4M valuation when maybe he/she could have gotten about 9% of equity if done as a straight equity round
Instead they are at about .025%
With a $1M cap
The angel is protected since their equity converts at $1M regardless of the VC round valuation
S.A.F.E. (convertible equity) approach
Simple Agreement for Future Equity
Created by Y Combinator (accelerator) with open-sourced documents
SAFEs were developed in Silicon Valley as a way for venture capital investors to quickly invest in a hot startup without burdening the startup with the more labored negotiations an equity offering may entail.
Like a convertible note, a SAFE is an agreement between the investor and the company in which the company generally promises to give an investor a future equity stake in the company if certain trigger events occur.
However, a SAFE is a convertible security (not debt) and there is no interest accruing or maturity date.
May make sense for very early investments at lower dollar amounts
SAFEs have a few common terms that can change how they convert to shares in the company.
Discounts (discussed)
Valuation caps (discussed)
Most favored nation provisions
Pro rata rights
Most Favored Nation Provision
Let’s assume SAFE “A” has a MFN Provision.
If another SAFE is issued, let’s call it SAFE “B,” the company has to tell SAFE “A” about it.
If the terms of SAFE “B” are better for the investor than SAFE “A,” then SAFE “A” can ask for the same terms as SAFE “B.”
Pro-rata rights
With pro rata, or participation rights, investors can invest additional funds to maintain their ownership percentage during equity financings subsequent to the financing where the SAFE initially converted to equity.
Gives early investors opportunity to not be diluted
If exercising pro rata rights, the investor pays the new price of the round rather than the price they paid when the SAFE initially converted.
SAFE cautions for investors
Investor not getting equity
SAFEs may only convert to equity if certain triggering events occur.
Depending on its terms, a SAFE may never be triggered.
SAFE cautions for entrepreneurs
Many CEOs don’t realize the impact that multiple SAFE notes at various valuation caps have on the capitalization table and how these notes can negatively impact the financial viability of the company moving forward.
https://techcrunch.com/2017/07/08/why-safe-notes-are-not-safe-for-entrepreneurs/
How Dorm Room Fund invests with SAFE’s: https://medium.com/@joshephraim/complete-guide-to-understanding-safes-how-we-invest-at-dorm-room-fund-bbb37855ec4e
Equity investment simulation
http://ownyourventure.com/equitySim.html
Try clicking “convertible debt” in first scenario and see impact on founder ownership
Compare investment scenarios w/ examples and cap tables at http://captable.io
Start a new cap table with two founders at 4M shares each
Option pool with 2M shares
Review cap table
Click “quick create” button
Add convertible instrument
Review note type to see different options
Principal $100,000 with maturity date two years out
Conversion discount 20%
Valuation cap $2M
Review cap table. What do you notice?
Now go to Scenarios
New investment $1M with $4M post money and effective date and keep existing option pool
What did convertible debt investor get with this round?
Now edit the note (go to cap table / timeline) and lower valuation cap to $1M and go back to scenario
What is the new convertible debt investor %
This week’s readings (complete by end of week)
Best Practice Guidance for Angel Groups – Deal Structure and Negotiation
Angel Investing – Gust Guide (Rose)
No paper or quiz this week
69
Next week: Angel investor analysis paper
Using what you’ve learned from the David Rose book, the lectures, guest speakers and suggested resources, develop a 4-5 page paper on your perspectives of angel investing.
Specifically address topics such as:
what does it take to be an angel investor
what types of companies qualify for angel investing
what do angel investors look for
when do they invest
how do they invest (evaluate their investment decisions)
how can startups most effectively pitch to angel investors
Including examples, references, interviews (startups and investors) and other information to support your analysis
This week (slight change from syllabus)
Tuesday
Getting in front of Angels
Thursday
Guest speaker: Angel investor Glenn Gaddy
Sunday
Angel investor paper
Angel math (what investors want)
Early-stage risk assessment
Pitchbot team exercise
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