Article about a company from startup to IPO
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ENTP325-Spring2018-Week9.pptx
ENTP 325 Early Stage Venture Financing Week #9
This week
Tuesday
Liquidation preference examples
409A valuations
The due diligence process
Thursday
Investor relations for early stage companies
Sunday
Quiz #4 (focus on venture capital and term sheets)
Final paper: from startup to IPO Due end of week 10, 7-8 pages double-spaced
You will pick one company that has gone public (or about to go public) over the past five years and analyze its trajectory from startup to IPO.
An in-depth analysis of their funding rounds, valuation timeline, ownership (cap table), investor profiles, investor pitches, other factors will need to be discussed.
You should also be prepared to evaluate the company’s investment decisions and analyze whether retrospectively they negotiated favorable terms.
Note the company selected must be approved by the instructor.
3
Read this week
K4 Mid-Atlantic Due Diligence Checklist
Liquidation preferences
In-depth
What is a Liquidation Preference?
Most term sheets will include a liquidation preference for the Preferred Stock
Basically ensuring that the investors are paid out first if the company dissolves or is liquidated through a merger or acquisition.
Nearly all venture financings have a liquidation preference
In some cases, the liquidation preference may be great than 1x – sometimes 2x or 3x
This is referred to as a preference multiple so the investor will first receive 2x or 3x their initial investment before the remaining funds are distributed.
What is Participating Preferred Stock?
In some transactions, after the Preferred Stock receives their initial liquidation preference (1x, 2x, 3x or more), then they also receive the right to receive a portion of the remaining proceeds.
Enter the concept of participating Preferred Stock.
After the liquidation preference is paid, then Participating Preferred Stock holders are entitled to share (participate) with the common stockholders in the remainder of the proceeds.
Three most common types of Participating Preferred Stock
Non-participating preferred stock does not receive distributions along with common stock and is therefore only entitled to the initial liquidation preference discussed above
Preferred stock with a participation feature is entitled to continue to receive distributions alongside holders common stock on an as-converted to common stock basis after the initial liquidation preference has been paid; may be subject to a “cap”
After receiving the initial liquidation preference distribution, holders of fully participating preferred will share in the remaining liquidation proceeds on a pro rata basis with holders common stock.
How Participating Preferred Stock Works
Say that Company A gets an outstanding offer to sell the company for $20 million a year after receiving funding.
The investors hold participating Preferred Stock and own 50% of the company from a $6M investment. This means that the investors will first receive their $6 million back, leaving $14 million to be allocated.
Now, the Preferred will participate based on their ownership (here 50/50) in the remaining amount -- $7 million going to each.
So the investors receive $13 million and the founders receive $7 million of the $20 million purchase price.
If the investors had held non-participating Preferred Stock, then the investors would have a choice:
(a) exercise the liquidation preference and receive only $6 million, or
(b) convert the Preferred Stock into Common Stock and take their portion ($10 million).
Why is Participating Preferred Stock important?
Participation rights are a major negotiating point in venture financings.
A non-participating preferred effectively requires that the preferred shareholders elect whether to retain their preferred stock and receive only their purchase price, or convert their preferred stock to common stock to share in the proceeds remaining after payment is made to any non-converted preferred stock.
Participating Preferred shareholders receive their original purchase price and then participate with the common shareholders in the distribution of the balance of the remaining proceeds.
Example for XYZ, Inc.
Pre-Money Valuation: $10m
Outstanding Shares of Common Stock: 2,500,000 (50% of post-closing equity)
Outstanding Shares of Series A Preferred Stock: 2,500,000 (50% of post-closing equity)
1x preference but non-participating
There are two critical valuations: (1) the valuation at which the initial preference is reached (which is also where holders of common stock will start to receive proceeds) and (2) the valuation at which the holders of Series A Preferred would receive greater proceeds if they were to convert to common stock (the inflection point).
Between these two valuations (here, between $5m and $10m), holders of Series A Preferred are indifferent as to the exit valuation.
This is frequently referred to as the “dead zone” and can lead to misaligned incentives between founders and VC investors
3x preference but non-participating
The larger (3x) initial preference means that holders of Series A Preferred fare much better than holders of common stock at lower exit valuations.
Similarly, the “dead zone” is much larger with the 3x preference (valuations between $15m and $30m) than the 1x preference (valuations between $5m and $10m),
This leads to greater potential for a misalignment of interests between preferred and common holders.
1x Preference, participating with 2x cap
The three critical valuation points are:
The initial liquidation preference amount ($5m)
The valuation at which the participation feature caps out ($15m)
The valuation at which conversion to common stock is optimal ($20m)
Fully participating preferred
Because there is no cap on the participation feature, there is never an incentive for holders of Series A Preferred to convert to common stock.
For this reason, the 1x preference ($5m) is constant and holders of common stock never “catch up” to Series A Preferred holders.
Compare a $10M exit
| 1x, non participating | 1x non-participating | 3x, non-participating | 1x participating with 2x cap | Fully participating |
| Investor | $5M | $10M | $8M | $8M |
| Founder | $5M | $0M | $2M | $2M |
Compare a $20M exit
| 1x, non participating | 1x non-participating | 3x, non-participating | 1x participating with 2x cap | Fully participating |
| Investor | $10M | $15M | $10M | $12M |
| Founder | $10M | $5M | $10M | $8M |
Compare a $30M exit
| 1x, non participating | 1x non-participating | 3x, non-participating | 1x participating with 2x cap | Fully participating |
| Investor | $15M | $15M | $15M | $18M |
| Founder | $15M | $15M | $15M | $12M |
409A valuations
Valuations
We’ve discussed valuations for early stage companies throughout the course
Valuations are difficult to determine at the early stages of a startup and sometimes can be delayed through the use of convertible securities
We did not dive deeply into DCF, NPV, discount tools and other ways that venture capitalists use to calculate your investment valuation
However, there are times, even at the earliest stages, when you need a more specific valuation assessment of your company
This is called a “409A valuation”
Why do startups need this?
The 409A name comes from IRS Section 409A.
Added as part of the American Jobs Creation Act of 2004, it states:
Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.
Stock options are considered deferred compensation. When you give stock options to your employees, you are giving them the option to buy equity in your company in the future at a price (the “strike price”) that is determined today.
A 409A valuation will determine a "strike price" (the price at which your employees can buy equity in your company) that must be at or above fair market value (FMV)
A 409A valuation is a formal report that tells you the value of your company's common stock.
In order to establish the FMV, you need a documented report that outlines the calculations and methodology used to arrive at a value per common share.
May be different than a negotiated investor valuation (who is looking at discounted cash flows, net present value, exit (terminal) value, exit timeline, investment stages, comparables, earnings multipliers (revenues, net income), debt, reversion value, surplus cash and more.
When your company starts issuing options or other forms of equity compensation, you should perform a 409A valuation at least every 12 months.
What Factors Influence Your 409A Valuation?
Essentially, a 409A is an appraisal.
To determine this, firms will generally take one of the following approaches to appraise fair market value:
Market approach: An analysis of comparable private and public companies and transactions.
Income approach: An analysis of a company's free cash flows to determine projections for the next five years.
Asset approach: An analysis of a company's tangible and intangible assets.
How Do You Get a 409A Valuation?
Do it yourself. This is the riskiest option of the three because there is no "safe harbor" protection should the IRS get involved. That means you have to prove that your valuation is correct. Although you might save money doing it yourself, you might also make mistakes. Unless you have the expertise and education needed to do a 409A, leave it in the hands of a professional.
Use software. This is equally risky. Only certain early-stage startups are eligible to do this (e.g., you don't have consistent revenue, you haven't raised $500,000, you're not within 180 days to an IPO or 90 days to acquisition, you have less than $100,000 in assets).
Hire a firm. Paying for a 409A is the least risky option because it offers safe harbor protection. That means now the burden of proof is on the IRS (rather than you) to show that your valuation is too low. You'll need to find a knowledgeable and experienced independent firm that has the right education and also a good reputation
Software-based example: https://www.capshare.com/409a-valuation-report
CAN ANY COMPANY USE THIS TOOL? Absolutely not.
This tool is designed only for companies in the earliest stages of development.
You should work with a valuation professional unless your company meets all of the following criteria:
No reliable source of revenue or cash flow
Raised less than $500K in investment capital
Cap table has no preferred stock or convertible debt instruments (KISS, SAFE, etc.)
Company does not reasonably anticipate an IPO in the next 180 days or an acquisition in the next 90 days
There has been no buying or selling of shares of the company's stock
Company's assets are worth $100k or less
The due diligence process
One-third to one-half of deals fall apart during “due diligence”
Great news! You have a term sheet! What’s next?
Due diligence!
A final integrity check on all aspects of your business model, team, product, customers, and plan.
Up to this point, the investor has primarily seen and talked to the founder and CEO, and studied written documents.
Before smart investors write a check, they, or a trusted consultant, will want to meet and talk with your key team members, several customers, and evaluate the real product.
If results don’t match what they have been told, all bets are off.
This is where they find out if your team is all behind you, your customers are truly excited, your product is ready to ship, and there aren’t any ghosts in the closet.
Defined…
Due diligence is the investigation and analysis the investor performs to see if an investment opportunity meets the investor’s criteria for funding.
The primary objective of due diligence is to mitigate investment risk by gaining an understanding of a company and its business as well as determining the suitability of the investment for the portfolio.
Major due diligence areas
Team strength and health
For small teams, every team member will likely be interviewed.
Investors are looking for your depth of talent, loyalty and commitment, strengths and weaknesses, teamwork, and management style.
Product or service readiness
Technical due diligence typically starts with a full one or two day review with the engineering and product marketing staff. Investors are evaluating your process as well as your product. Finally, they need to validate intellectual property protections and status.
Market need and size validation
Investors will likely talk to dozens of potential customers, starting with your (undoubtedly well prepped) reference list.
They will also speak to technical leaders and industry contacts where they have prior relationships. No validated pain, no deal.
Sustainable competitive advantage
They try to confirm from industry analysts that your differentiators are indeed unique, and that there are no future competitors or big gorillas in stealth mode just around the corner.
Business and financial status
How well have you met previous financial and business milestones? Investors will validate pre-existing investments and stock ownership to create an accurate market capitalization sheet for your company.
Y Combinator due diligence checklist
Corporate Records and Charter Documents
All minutes of directors’ and stockholders’ meetings, and all written consents of directors and stockholders.
Certificate of Incorporation, Certificates of Designation, Rights, etc., and Bylaws.
Similar information for the Company and subsidiaries, if any.
A corporate entity organizational chart, if there are any parents or subsidiaries.
Business Plan and Financials
Current business plan and any financial projections.
Most recent financial statements.
Intellectual Property
A list of the Company’s trademarks, patents, copyrights and domain names (or any applications therefore) including documentation of filing or registration with the appropriate governmental entities.
If any of the foregoing were assigned to the Company, please so state and provide documentation of the assignment and recordation with the appropriate governmental entities.
Y Combinator due diligence checklist
Security Issuances and Agreements Concerning Securities
A list of the Company’s stockholders, including issuance dates and original issuance price.
A list of the Company’s option holders, including grant dates and exercise prices.
Copies of agreements relating to outstanding options, warrants, rights (including conversion or preemptive rights) or agreements for the purchase or acquisition of any of the Company’s securities, and agreements relating to the Company’s past stock issuances.
Any documents evidencing registration rights for the Company’s securities, or evidencing any agreements among the Company’s shareholders or between the Company and its shareholders.
A summary of the vesting schedules of any stock or options subject to vesting, including any vesting acceleration.
Agreements relating to voting of securities and restrictive share transfers.
Evidence of qualification or exemption under applicable federal (including Rule 701) and state blue sky laws for issuance or transfer of the Company’s securities.
Y Combinator due diligence checklist
Material Agreements
The Company’s standard terms of service / terms of use for its customers.
Any agreements, understanding, instruments, contracts or proposed transactions to which the Company is a party or by which it is bound which involve obligations of, or payments to, the Company in excess of $25,000.
Any personal property leases.
Any agreements concerning the purchase, lease, or sublease of real property.
Any documents evidencing indebtedness for money borrowed or any other liabilities incurred by the Company.
Any documents evidencing any mortgages, liens, loans and encumbrances with respect to the Company’s property or assets.
Any documents evidencing any loans or advances made by the Company.
Any licenses or agreements of any kind with respect to the Company’s or others’ patent, copyright, trade secret or other proprietary rights, proprietary information or technology, including employee confidentiality and proprietary information agreements.
Any insurance policies held by the Company or of which the Company is a beneficiary and a summary of such policies, if available.
Any judgment, order, writ or decree by which the Company is bound or to which it is a party.
Any standard forms of agreements used by the Company.
Any joint venture and partnership agreements.
Any management, service and marketing agreements.
Any confidentiality and nondisclosure agreements.
Any agreements requiring consents or approvals in connection with the financing.
Any consulting contracts.
Any other agreements material to the business of the Company, or outside the ordinary course of business.
A list of officers and directors. If any officers are not currently devoting 100 percent of their business time to the Company, please note them on this list.
Y Combinator due diligence checklist
Information Regarding Disputes and Potential Litigation
Any correspondence or documents relating to any pending or threatened action, suit or proceeding or investigation, including, without limitation, (i) those involving the Company’s employees in connection with their prior or present employment or use of technology and (ii) those being conducted by or before any governmental entity or regulatory agency.
Any correspondence or documents relating to allegations of the Company’s infringement of the proprietary rights of others.
Any correspondence or documents relating to any labor agreements or actions, union representation, or strike or other labor dispute.
Y Combinator due diligence checklist
Information Regarding Employees and Employee Benefits
A list of the Company’s employees and consultants, including title, base salary, target bonus (if applicable), commission plan (if applicable), classification (including, if an employee, whether the employee is exempt or non-exempt) and state of residence.
Any agreements, understandings or proposed transactions between the Company and any of its officers, directors, affiliates, or any affiliate thereof, including without limitation, employment agreements and offer letters with severance benefits or vesting acceleration provisions.
Any plans, agreements or arrangements that provide benefits contingent upon a change in control.
Any severance or deferred compensation plans (including any salary deferral agreements, whether written or oral, with employees or consultants).
Any employee benefit plans
Any forms of agreements used in connection with any stock option plans
If the Company sponsors a 401(k) plan, any determination or opinion letter and Form 5500 filings for the last 3 years.
All documents or other information relating to any loans made by the Company to its employees, directors or consultants.
The Company’s employee handbook.
If the Company has any foreign employees, separately list (by country) all benefits provided to foreign employees.
Keiretsu Angel Investment Group Due Diligence Process – 6 week cycle
Stage 1 – Organization (1-7 days after presentation)
DD Team Leader Chosen, Initial Questions to Entrepreneur
DD Team Recruited From Interest List
Entrepreneur Provides Baseline Info
Meeting: Entrepreneur and DD Team
Stage 2 – Key Questions (1-6 days after Stage 1 Meeting)
DD Sub-Group Forwards Additional Questions to Entrepreneur
Entrepreneur Responds to Questions
DD Leader Polls Interest Level in Continuing
Stage 3 – Questions Addressed/ Site Visit
(1-6 days after Key Question responses)
Meeting: Site visit/Deep Dive w/ Entrepreneur
DD Team Subgroups Complete their Research
Stage 4 – Reports and Commitments
(6-14 days after On-Site Meeting)
DD Team Reports Prepared and Posted
Final Report Draft Reviewed by Entrepreneur
DD Team Discusses Final Report Draft/Conclusion
Soft Circled Interest Confirmed
Stage 5 – Deal Closure (6-14 days after final DD Meeting)
Terms Negotiated
Final Terms Sheet Distributed, Signed and Funds Delivered
Stage 6 – Post Mortem (1-3 days after funds delivered)
Meeting: Post-Deal Review with DD Team and Company
Tips
As you go through the due diligence process, there are some practical tips to keep in mind.
First, be proactive in asking if you have answered all the key questions, and ask how you compare to others.
Get to the truth early. Waste no time.
Use the feedback to strengthen your presentation and your company.
Second, conduct your own due diligence of the investor.
This process is the foundation for the long term partnership, so both sides need the same level of comfort and trust.
More information…
http://vc-list.com/startup-investment-due-diligence-checklist/
Angel Capital Association best practices https://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_BEST_PRACTICES_Due_Diligence.pdf?rev=C7C4
https://www.cooleygo.com/documents/sample-vc-due-diligence-request-list/
Investor relations for early stage companies
Why?
No surprises
Provide opportunity for entrepreneur self-reflection
The right thing to do
Help investors understand your business
Investor updates
How often?
Once a month is a good frequency if you have enough movement at your numbers to show: revenue, traction, business operations, etc.
To whom should I send it?
Your obligation is to investors but is a good practice to share information with advisors.
If not, quarterly reports are acceptable and can be a good option if the startup is too early. Sending updates too often can be a problem also.
What to include
Numbers first: Metrics and KPI´s
Month-over-month changes on your key performance indicators provide a quantitative and objective view of your startups.
Product updates
Know and understand changes in the product strategy, including new versions, UX/UI, new features, platform, etc.
Include 3–5 important metrics about finance, growth, and engagement.
What to include
Business Updates
What is relevant about people, office, partners, operations, etc.
Funding or Mergers and acquisitions
Inform if anyone has reached out to you, what is the strategy, terms of new rounds, lead investors, etc.
What to include
Notable events
Notable events are milestones from your company and can be divided into wins, fails, and challenges.
Questions
Tell investors what do you want, introductions, referrals, hiring, product feedback or anything else
Big and smalls ones, anything you believe is of great importance to the success of the company.
Tools to keep information flowing between founders and investors
Reportally (https://www.reportally.com)
Angelspan (https://angelspan.com)
Hockestick (http://hockeystick.co)
Visible (https://visible.vc)
Grow (https://www.grow.com)
Baremetrics (https://www.baremetrics.com/)
Fill in the blank investor update https://hackernoon.com/a-fill-in-the-blank-investor-update-template-for-busy-founders-d431c227347b?gi=faedfd569f23
Final paper: from startup to IPO Due end of week 10, 7-8 pages double-spaced
You will pick one company that has gone public (or about to go public) over the past five years and analyze its trajectory from startup to IPO.
An in-depth analysis of their funding rounds, valuation timeline, ownership (cap table), investor profiles, investor pitches, other factors will need to be discussed.
You should also be prepared to evaluate the company’s investment decisions and analyze whether retrospectively they negotiated favorable terms.
Note the company selected must be approved by the instructor.
45
Next week
Tuesday
Exits and going public
Thursday
Wrap-up topics: platforms for creating your startup and investor profiles
Sunday
Final paper
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