The Panel Jeremy Halpern Partner, Nu@er McClennen & Fish jhalpern@[email protected] @startupboston
Yumin Choi Partner, HLM Venture Partners [email protected] @yuminvc
Paul Hartung President and CEO, Cognotpix, Inc PHartung@cognop*x.com
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
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
High Growth Company Characteris*cs • Disrup*ve Innova*on with Strong value proposi*on
– Correla*on between Large Unmet Need : Solu*on • High Margin Product (Ra*o of Revenue : COGS)
– Some*mes Massive Volume Products where innova*on is incremental
• High Rate of Revenue Growth over sustained period • Scalable (Fixed cost is a low percent of Revenue) • No major barriers to con*nued growth (ex. blocking IP; geography;
regulatory) • Repeatable sales and distribu*on model with many credit worthy
customers • Large Total Addressable Market (TAM) • Defensible innova*on able to withstand compe**on and changing
condi*ons • [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 $$
Impact / Tax Write off
NORMAL GROWTH COMPANY
HIGH GROWTH
(COMPANY)
EXTREME HIGH GROWTH (COMPANY)
Risk / Return
SOCIAL VENTURE COMPANY
Match Funding Sources
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NORMAL GROWTH COMPANY
HIGH GROWTH COMPANY
EXTREME HIGH GROWTH COMPANY
SOCIAL VENTURE COMPANY
• Friends family, founders
• Debt Bank and other
• (Future) Crowd funding (portal style)
Early on • Accelerators • Individual Angels • Micro Cap VCs • Seed from VC Later stages • Venture Funds • Strategic VCs • Angel
Syndication
• Friends family, founders
• Charity$$ • 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
Non-‐Equity Sources • Accelerators (some) • Kickstarter type dona5ons
• Pre-‐orders from end-‐customers • Credit from vendors • Strategic VCs • Strategic NREs • Distribu5on Contracts Common Theme: Providing early cash in exchange for a beHer commercial opportunity
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Equity Sources • Accelerators (some) • Friends & Family Common Theme: Suppor5ng success of the entrepreneur; business terms vary
• Portal Funding • Early Angels • Super Angels • Angel Groups • Micro VC • Tradi5onal 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 – Preferen5al treatment on subop5mal 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: indica*ve 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
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
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
So What is Equity Anyway?
• Stock = right to residual economic interests upon sale/liquida*on + stockholder vo*ng rights (usually limited to Board of Directors and Sale of the Company)
• Preferred Stock = right to be paid before Common Stock Par*cipa*ng = original investment PLUS a pro rata share of remainder Non-‐Par*cipa*ng = original investment OR a pro rata share
• Common Stock = whatever is let ater all other creditors and preferred stockholders are paid
• Dividend = a right to an addi*onal amount upon liquida*on measured as a func*on of *me 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
Valua*ons High rela*ve to stage
High rela*ve to stage
Low rela*ve to stage
Low rela*ve 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
Nega*ve Covenants
No Some*mes Yes Yes Yes
Preemp*ve Rights
No Some*mes Yes Yes Yes
Ver*cal Exper*se
Some*mes Rarely Some Usually Always
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+
Structure of an Equity Deal • Company and Investors agree on a “pre-‐money valua*on” (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 • 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 “inflec5on point” – Hopefully at a point where risk is removed – Increased PM = so-‐called “up round”
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Understand the Funding Path, cont.
• 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 anS-‐diluSon provision entrepreneur may carry more burden than the investors
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What about Conver*ble Debt? • Many seed-‐stage companies use an instrument called Conver5ble Debt. Huh?
• Conver5ble debt is not tradi5onal bank debt • Converts exist for two major reasons
– Investors and Entrepreneurs find it hard to agree on a PM valua5on
– Some5mes quicker and cheaper to document than equity deals (but not really)
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Conver*ble Debt provides Op*onality
• ConverSble Debt = unsecured debt obliga*on 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 valua*on in the next round
• ater applica*on of a Discount (oten 5 – 20%) • subject to a maximum valua*on amount (the “Cap”)
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Basic Structure of Conver*ble Debt • Investor loans $ to Company an5cipa5ng 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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Conver*ble Debt – Complica*ons! • 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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Conver*ble Debt – Solu*ons? • Caps and Floors
– May defeat purpose with signaling
• Default conversion price and security at maturity
• Quick sale preferences (ex. 2x) • Governance provisions • Careful agenSon to conversion condiSons
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Conver*ble Debt – Worse than Equity?
• MulSple liquidaSon 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 liquidaSon preference!!
• Without a floor, effecSvely Full Ratchet AnS-‐diluSon
• 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 25
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