Funding Options Deep Dive - Equity Options
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Funding Options for High Growth Companies
September 5, 2012
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Today’s Experts • Jeremy Halpern
– Partner, Nu8er McClennen & Fish LLP – Director, MassVentures
– Director, The Capital Network – Angel Investor – Former entrepreneur
– Geek
• Ben Li8auer – Member, Launchpad Ventures – Advisory Board, The Capital Network – Member, Walnut Ventures – Member, Boston Harbor Angels – Director, Lots of Startups – Former Entrepreneur – Geek 2
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Funding the Company
Jeremy Halpern Nu8er McClennen & Fish LLP
[email protected] @startupboston
Ben Li8auer [email protected]
vizibility.com/li8auer @li8web
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Funding the Company
Assuming you plan to be a “high growth” company…
What are your funding opXons?
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Entrepreneurship comes in many types
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NORMAL GROWTH COMPANY
HIGH GROWTH COMPANY
EXTREME HIGH GROWTH COMPANY
SOCIAL VENTURE COMPANY
• Includes all service businesses
• Exploiting a local market need
• Team has ‘great jobs’
• Growth by adding resources one by one
• Exit will be based on value of cash flow (mature biz.)
• Growth profile ultra-scalable
• Team focus is exit • Revenue $40M+
with lots of room for growth (5 yr.)
• Based on $20M+ investment
• Exit targeted to IPO or by ‘large’ M&A event
• Goal is to fulfill a social need
• Has mission orientation
• Team needs to support mission
• Growth profile often one resource at a time
• Exit …much harder to find fit
• Company can grow fast (on-line) or has a scalable system
• Team often motivated by exit
• $10m revenue in 5 yrs & market size allows significant additional growth
• Capital efficient total investment$2-4M
• Exit by M&A
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Close Up: Extreme High Growth vs High Growth
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Capital Needs
Time
High Risk
Low Risk
Formal Venture Capital
M&A or IPO
Crystallize Ideas
Demonstrate Product
Early Scaling Growth
Sustained Growth
Angel Group (or Micro-cap) Syndication
Angels or Accelerators or Micro-cap
funds Angels or Accelerators or Micro-cap
funds Business Angels
Market Entry
M&A
Later VC Rounds
Extreme High
Growth High Growth
Friends, Family & Founders
Friends, Family & Founders
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High Growth Company CharacterisXcs
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• DisrupXve InnovaXon with Strong value proposiXon – CorrelaXon between Large Unmet Need : SoluXon
• High Margin Product (RaXo of Revenue : COGS) – SomeXmes Massive Volume Products where innovaXon is incremental
• High Rate of Revenue Growth over sustained period • Scalable (Fixed cost is a low percent of Revenue)
• No major barriers to conXnued growth (ex. blocking IP; geography; regulatory)
• Repeatable sales and distribuXon model with many credit worthy customers
• Large Total Addressable Market (TAM)
• Defensible innovaXon able to withstand compeXXon and changing condiXons
• [Capital efficient]
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Return on Equity Return on Debt Income High Return
NON PROFIT ORGANIZATION
Capital Source View
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Debt- Pay it back Fixed Amounts
Equity – Ownership stake % of Future Value
Charity $$
Impact / Tax Write off
NORMAL GROWTH COMPANY
HIGH GROWTH
(COMPANY)
EXTREME HIGH GROWTH (COMPANY)
Risk / Return
SOCIAL VENTURE COMPANY
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Match Funding Sources
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NORMAL GROWTH COMPANY
HIGH GROWTH COMPANY
EXTREME HIGH GROWTH COMPANY
SOCIAL VENTURE COMPANY
• Friends family, founders
• Debt Bank and other
• (Future) Crowd funding (portal style)
Early on • Accelerators • Individual Angels • Micro Cap VCs • Seed from VC Later stages • Venture Funds • Strategic VCs • Angel
Syndication
• Friends family, founders
• Charity$$ • Crowds (Kick-
starter) • Impact Angels • (Future)
Crowd funding (portal style)
• Angels • Angel Groups • Angel Group
Syndication • Angel List • Micro-cap Funds • (Future) Crowd
funding (portal style)
• Increasingly Strategic Corporate VCs
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Non-‐Equity Sources
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• Accelerators (some)
• Kickstarter type donaXons
• Pre-‐orders from end-‐customers • Credit from vendors
• Strategic VCs • Strategic NREs • DistribuXon Contracts
Common Theme: Providing early cash in exchange for a be8er commercial opportunity
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Equity Sources
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• Accelerators (some)
• Friends & Family
Common Theme: SupporXng success of the entrepreneur; business terms vary
• Portal Funding
• Early Angels • Super Angels
• Angel Groups
• Micro VC
• TradiXonal VC (1st Round)
Common Theme: All are looking for
– sale (or IPO) of the Company at 4-‐10 x original investment
– Capital gains treatment on all sale proceeds – PreferenXal treatment on subopXmal exit versus the founders
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Sources of Equity Capital
Must have exits for equity model to work!! – 2011 US IPOs -‐ $36B – 2011 US M&A -‐ $57B – 2011 US Private Equity -‐$35B
• Exit sources extremely variable … health of economy • All exits: indicaXve of future cash flow or market control
Idea Stage • Friends family, founders
• Grants • Crowds (Kick-‐ starter)
Demonstrate Product & Market Interest • Accelerators • Individual Angels • Angel Groups • Accelerators • Micro Cap VCs
Market Entry & Early Growth • Crowdfunding (portal style) • Angel Groups • Angel Group SyndicaSon • Angel List • Micro-‐cap Funds
Early Scaling Growth • Most Venture Funds
• Angel SyndicaSon
Repeatable Growth • Most Venture Funds
• Strategic VCs • Angel SyndicaSon
• Private Equity
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High Growth Capital by Stage &Amount
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Venture Stage
Investment Size
Friends & Family
Vendors
Angels
Traditional VC
Angel Groups
Corporate Venturing
Grants
Customers
Crowdfunding
Portal Funding
AngelList
Micro VC
Equipment Financing
Founder
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Capital Sources: Size & Cost
Investment Size
Investment “Cost”
Traditional VC
Micro VC
Equipment Financing
Angel Groups Angels
AngelList
Corporate / Strategic Venture
Customers
Portal Funding
Vendors
Founder Friends & Family
Crowdfunding
Grants
Venture Debt Bank
Loans
Personal Loans
Private Equity
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So What is Equity Anyway?
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• Stock = right to residual economic interests upon sale/liquidaXon + stockholder voXng rights (usually limited to Board of Directors and Sale of the Company)
• Preferred Stock = right to be paid before Common Stock ParXcipaXng = original investment PLUS a pro rata share of remainder Non-‐ParXcipaXng = original investment OR a pro rata share
• Common Stock = whatever is lev aver all other creditors and preferred stockholders are paid
• Dividend = a right to an addiXonal amount upon liquidaXon measured as a funcXon of Xme x percentage of original investment . Ex. 6.0% per annum
• OpSons / Warrants = Contracts allowing holder to purchase an amount of stock in the future at a pre-‐determined price
• Control Rights = Statutory and Contractual
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Equity Type Comparisons
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Solo Angel Super Angel Angel Group MicroVC VC
ValuaXons High relaXve to stage
High relaXve to stage
Low relaXve to stage
Low relaXve to stage
Medium
Type -‐ Likely (less likely)
Common (Warrants)
Conv Note (Preferred)
Preferred (Conv Note)
Preferred (Conv Note)
Preferred
Board Seat Maybe 1 or none 1-‐2 of 5 +/-‐ Observer
1 of 5 +/-‐ Observer
1-‐2 of 5 +/-‐ Observer
Audited Financials
No No No (reviewed) Yes Yes
NegaXve Covenants
No SomeXmes Yes Yes Yes
PreempXve Rights
No SomeXmes Yes Yes Yes
VerXcal ExperXse
SomeXmes Rarely Some Usually Always
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Equity Type Comparisons
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Solo Angel Super Angel Angel Group MicroVC VC
Exit Horizon (from $ in)
7 years 5 years 4 years 5 -‐7 years 4-‐5 years
Exit Range $20m+ $40m+ $50m+ $100m+ $250m+
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Structure of an Equity Deal
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• Company and Investors agree on a “pre-‐money valuaXon” (PM) which leads to a price per share
• Investors put in $X • Investors then own: X / (X + PM) of the company
Example: PM = $1M X = $0.5M Investors own 0.5/1.5 = 33%
Remember: New issuance NOT transfer
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Understand the Funding Path
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• We’re talking about 1st funding here • What is the probable complete funding picture?
– This is only funding – Another small round then probable small exit – Big money needed before exit
• Each funding event should occur at an “inflecXon point” – Hopefully at a point where risk is removed – Increased PM = so-‐called “up round”
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Understand the Funding Path, cont.
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• What if things aren’t going so well? – Flat or decreased PM = so-‐called “down round”
• More money coming in without increased PM means everyone gets diluted, but…
• Depending on anX-‐diluXon provision entrepreneur may carry more burden than the investors
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What about ConverXble Debt?
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• Many seed-‐stage companies use an instrument called ConverXble Debt. Huh?
• ConverXble debt is not tradiXonal bank debt • Converts exist for two major reasons
– Investors and Entrepreneurs find it hard to agree on a PM valuaXon
– SomeXmes quicker and cheaper to document than equity deals (but not really)
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ConverXble Debt provides OpXonality
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• ConverSble Debt = unsecured debt obligaXon of the Company that may be converted into equity of the Company.
• Conversion Trigger = Qualified Financing usually at some minimum amount of funds (ex. $500,000)
• If Notes stays as Debt = Get back principal and interest ahead of other equity (behind other creditors typically)
• If Notes Convert = Convert amount of debt and interest into equity at the valuaXon in the next round
• aver applicaXon of a Discount (oven 5 – 20%) • subject to a maximum valuaXon amount (the “Cap”)
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Basic Structure of ConverXble Debt
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• Investor loans $ to Company an#cipa#ng another round of funding • Investment accrues small interest • When the funding occurs, investment + interest convert to equity,
usually at a discount (5-‐20% typically)
Example: • Investors loan $200K to Company • 20% discount • As of conversion, interest of $10k has accrued • Next Round PM = $2m • Conversion Amount = 1/(1 -‐ 0.2)* $210k = $262,500
At Conversion, Noteholders receive 262.5K / (PM + 262.5K + New Money)
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ConverXble Debt – ComplicaXons!
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• What if only a li8le money comes in? • When does the debt convert?
• What happens if PM of next round is huge?
• Does the investor have any say in things? • What if there is an equity investment that doesn’t trigger conversion?
• What happens if it never converts?
• What happens if Company gets bought?
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ConverXble Debt – SoluXons?
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• Caps and Floors – May defeat purpose with signaling
• Default conversion price and security at maturity
• Open round, minimum close
• Quick sale preferences (ex. 2x) • Governance provisions • Careful a8enXon to conversion condiXons
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ConverXble Debt – Worse than Equity?
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• MulXple liquidaXon preference (circa 2008) – Ex. $500k of Notes with cap at $2m PM – Next Round at $6m PM – Issue Noteholders 3x number of shares – 3x shares equals 3x liquidaXon preference!!
• Without a floor, effecXvely Full Ratchet AnX-‐diluXon
• Preference Overhang – In prior example Noteholders bought $262,500 of preference for
$200,000. – All other Series A Holders bought 1:1 preference
• Not Just a Price Adjustment
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www.TheCapitalNetwork.org
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Upcoming Programs
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Sep 13 Funding OpXons Deep Dive: Consumer Products Companies
Sep 18 Financial ProjecXons for PresentaXons
Oct 16 Building a High Growth Business for Angel and Venture Capital
Oct 24 Structuring Founder RelaXonships: Stockholder Agreements & Choice of EnXty
Nov 5 Mobile Fast Track