Hello. TODAY S EARLY-STAGE INVESTMENT VEHICLES Michael Horten June 7, 2017
THE CHANGING Angel Financing LANDSCAPE
Traditional Approach to Angel Financing Emulate the VC community by using Series A preferred stock Using NVCA open source documents
Problems with Traditional Approach The traditional approach is too costly and cumbersome for the smaller angel rounds
Today`s types of Angel Financings Priced securities Common stock Traditional convertible preferred stock Stripped-down convertible preferred stock Series SEED Series AA Un-priced securities Convertible promissory note Promissory note KISS (Keep it Simple Security) promissory note Convertible equity note SAFE (Simple Agreement for Future Equity) note KISS equity note
Which Financing Vehicle Should You Use
Michael Horten Blue-chip legal services to entrepreneurial growth companies Big firm experience without the marble and mahogany Fixed fees Angel investor for over 20 years Handled over 100 early-stage financings in the last 2 years Member Angel Capital Association and ATA
COMMON STOCK
FF&F
CONVERTIBLE PREFERRED STOCK
How many shares should the investor receive?
The valuation determines the investor s percentage ownership interest 25% 75%
Pre-Money Valuation
Place a Realistic Value on your Company
Entrepreneur valuation
Investor valuation
Unlike selling your home, it s difficult to lower your valuation
How do you determine Pre-Money Valuation
Methods for valuing mature companies generally do not work
Valuation models for pre-revenue companies Venture Capital Method (VCM) Discounted Cash Flow (DCF) or Net Present Value (NPV) Model Scorecard Method Chicago Method Cayenne Consulting Calculator Dave Berkus Valuation Model Bill Payne s Model Risk Factor Submission Model Replacement or All-In Method Rule of Thirds Ratios and Multiples Set Ceilings
Venture capital method (VCM)
Venture capital method (VCM) Assumptions for this Analysis Angels should expect an IRR of 25% Investment will last for 5 years An angel needs a portfolio of at least 10 companies 25% IRR in five years = 3X ROI Nine deals produce 33% of yield 33% of yield = return of capital for portfolio One deal must produce 2X ROI on total capital or 20X ROI (82% IRR) on money invested in the deal
VCM example Investment $1 million Exit year 5 th year Projected revenues in 5 th year $40 million Projected net profit in 5 th year $4 million P/E (public companies in sector) 15X Terminal value (after 5 years) $60 million Required IRR 82% Required ROI $20 million % ownership of company required 33% Post-money valuation $3 million Pre-money valuation $2 million
Scorecard method Pre-Revenue Median Value Determine an appropriate median value for pre-revenue companies in your region Assign % weighting for each critical issue Calculate the weighted average of issues Multiply median value by weighted average
Scorecard method How it works Collect valuation data for pre-revenue companies in your region for the preceding years and calculate the median value Track regional and national trends in valuation o National trends in pre-money valuation generally range from $0.5 million to well over 3 million o National median pre-money valuation is $2.5 million Determine an appropriate median value for pre-revenue companies in your region
Scorecard method Pre-Revenue Median Value Assume that the median local pre-money valuation of prerevenue companies is $2,300,000
Scorecard method Calculate Weighted Average Multiple Issue Analysis Weight Factor Input Management On board, except sales VP 30% 120% 0.360 Opportunity Enormous 25% 130% 0.325 Product Disruptive, prototype OK 15% 130% 0.195 Sales No channels, all foreign 10% 50% 0.050 Competition No big players, messy 10% 110% 0.110 Other Need partners, selling costs 10% 80% 0.080 Weighted average multiple = 1.12
Scorecard method Calculate Pre-Money Valuation Median Value $2,300,000 Weighted Multiple X 1.12 Pre-money Valuation $2,576,000
Agreed Valuation
Example Company seeks $1M in equity capital Founders own 2M shares of common stock
Example Founders network and pitch to investors They receive an offer for $1 million at a $2 million pre-money valuation The investor will send them a term sheet
Founders are happy with the $2M pre-money valuation
Founder s expectations Pre-Money Cap Table Start-Up Capitalization Common Pre-Money Total % Founders 2,000,000 2,000,000 100% Options Granted 0 0% Options Available 0 0% Investor 0 0% Total 2,000,000 2,000,000 100%
Founder s projected post-money cap table Pro Forma Cap Table Start-Up Capitalization Series A Funding Series A Series A Post-Money Common Pre-Money Total % Investment Preferred Total % Founders 2,000,000 2,000,000 100% 2,000,000 66.7% Options Granted 0 0% - 0.0% Options Available 0 0% - 0.0% Investor 0 0% $1,000,000 1,000,000 1,000,000 33.3% Total 2,000,000 2,000,000 100% $1,000,000 1,000,000 3,000,000 100.0% Pre-Money Valuation $2,000,000 Price / Share $1 Total $ Invested $1,000,000 Post-Money Valuation $3,000,000
Post Celebration Jolt Purchase Price: $0.70 (not $1.00) Founders Own: 46.7% (not 66.7%)
The term sheet pre-money valuation is different from the true pre-money valuation First culprit: The number of shares received by the investor is computed on a fully diluted basis Second culprit: The investor is receiving preferred stock
Incentive Pool A pool of unissued shares reserved for issuance to officers, directors and key employees (usually as options)
New pre-money cap table Pro Forma Cap Table Start-Up Capitalization New Option Pool Common Pre-Money Total % New Options Pre-Money Total % Founders 2,000,000 2,000,000 100% 2,000,000 70.1% Options Granted 0 0% 0 0.0% Options Available 0 0% 855,000 855,000 29.9% Investor 0 0% 0 0.0% Total 2,000,000 2,000,000 100% 855,000 2,855,000 100.0%
New post-money cap table
Impact of pre-money incentive pool Pre-money cap table 2,000,000 common stock held by founders 855,000 (20% post financing) common stock incentive pool Dilutes founders to 70% Post-money cap table 2,000,000 common stock held by founders (58.35%) 855,000 common stock incentive pool 1,427,500 preferred stock held by investors True Pre-money valuation: $1,750,547
2nd Post Celebration Jolt The investor is being issued participating preferred stock
Equity financing securities Common stock Convertible preferred stock Non-participating Participating
Participating vs. non-participating preferred stock Investor invests $1M for a 1/3rd interest in the company and the company sells its business for $2M Investor gets: Common $666,667 (1/3 rd of $2M) Non-Participating Preferred $1,000,000 (return of investment) Participating Preferred $1,333,333 ($1M +1/3 rd of $1M)
Participating vs. non-participating preferred stock Investor invests $1M for a 1/3rd interest in the company and the company sells its business for $10M Investor gets: Common $3,333,333 (1/3 rd of $10M) Non-Participating Preferred $3,333,333 (1/3 rd of $10M) Participating Preferred $4,00,000 ($1M +1/3 rd of $9M)
Impact of participating preferred stock Preferred Stock Valuation Squeezer Pre-money cap table 2,000,000 common stock held by founders 855,000 common stock incentive pool 1,427,500 preferred stock held by investor Company is sold for $3M Investors receive $1,832,969 ($1,000,000 + 41.65% of $2,000,000) Founders receive $1,167,032
Preferred Dividends The holders of preferred stock receive dividends before dividends are paid to the holders of common stock
Types of preferred dividends Cumulative Non-Cumulative Participating Non-Participating
Governance, Management & Control
Investors invest in the management team
Management & Control Voting rights Board seat or observer rights Approval rights Right to force a sale of the company
Investor Protection
Price anti-dilution protection Price anti-dilution issues Time limitation Full ratchet Weighted average
Full Ratchet Anti-Dilution Protection Example Pre-money cap table 2,000,000 common stock 1,000,000 preferred stock convertible into common at $1 a share (the preferred stock issue price) with full ratchet anti-dilution protection Company raises additional equity capital Company issues 50,000 shares of common stock at $0.50 a share because it desperately needs cash Conversion price drops to $0.50 a share Founder dilution Founder goes from 66.7% of the equity to 50% and all the company has gained is $25,000
Pro-rata rights 20%
Right of first refusal and co-sale First line of Defense: ROFR Second line of Defense: Co-sale
Information rights
Restrictive covenants agreements Proprietary information and use limitation covenants Ownership of work product & IP Non-compete covenant Non-solicitation covenant
Key holder stock claw-back
Exit / Liquidity
Exit / Liquidity Redemption rights Registration rights
STRIPPED-DOWN CONVERTIBLE PREFERRED STOCK
CONVERTIBLE PROMISSOY NOTES
BRIDGE NOTES Company has signed an equity round term sheet but needs pre-closing funding (bridge financing)
Bridge Notes Mandatory conversion into the next equity round at a 10-20% discount The investment is in effect disguised equity Term The maturity is typically set to allow enough time for the next equity round to close Interest rate Interest rate is typically similar to the preferred dividend in an equity round Payment Balloon payment at maturity
Pier Notes Usage expanded beyond bridge financing (the equity round is not yet under way) Has gained great popularity
Pier note advantages Appealing to unsophisticated angels who may not know what protections and terms to request Kicks the valuation can down the road Faster and cheaper Minimal impact on the fair market value of the company s common stock, making the company s equity incentives more attractive Flexibility; can provide greater discount to earlier investors
Pier note drawbacks Goes against the traditional ranking philosophy of venture investing The interest of the founders and the investors are misaligned Neither the Company s founders nor the investors know what percentage of the company each may eventually own Noteholders must wait for the date of conversion to start the clock running for long-term capital gain treatment Notes are much lighter when it comes to rights and protective provisions for the investors Maturity creates a ticking time bomb for the company
INVESTORS FELT SHORT CHANGED The 20-25% discount is not commensurate with the risk they take as compared to the Series A investors Began looking for new solutions
Solutions Increasing the discount Adding warrants for common stock Adding conversion cap
Adding warrants for common stock
Adding Conversion Cap Price Your maximum price Your price
Problems with conversion cap At what time does the cap apply Inflates preferred dividend and liquidation preference (the liquidation preference overhang ) The noteholders get full ratchet anti-dilution protection
When to apply the conversion cap The conversion cap usually is applied at the time of conversion Makes more sense to apply the conversion cap to the cap table at the time of the issue of the note
The liquidation preference overhang Company has 2,500,000 shares of common stock outstanding Company issues notes for $500,000 carrying a $2.5M conversion cap (i.e., $1per share max conversion price) Series A has a $10MM pre-money valuation, resulting in a per share price for the new money of $4.00 The Series A has a 1x participating liquidation preference and carries a 6% cumulative preferred dividend The $2.5MM conversion cap means the notes convert at $1.00 The noteholders receive an effective 24% preferred dividend instead of 6% The noteholders receive a $2M liquidation preference instead of $500,000 -- a whopping 4X liquidation preference resulting a $1.5M liquidation preference overhang
Issue discount shares in common stock Company has 2,500,000 shares of common stock outstanding Company issues notes for $500,000 carrying a $2.5M conversion cap (i.e., $1per share max conversion price) Series A has a $10MM pre-money valuation, resulting in a per share price for the new money of $4.00 Instead of issuing the noteholders 500,000 shares of Series A preferred stock, issue them 125,000 Series A preferred stock and 375,000 shares of common stock They will still own 500,000 shares, but their liquidation preference is equal to their purchase price (125,000 x 4 = $500,000)
Convert into shadow preferred stock Company has 2,500,000 shares of common stock outstanding Company issues notes for $500,000 carrying a $2.5M conversion cap (i.e., $1per share max conversion price) Series A has a $10MM pre-money valuation, resulting in a per share price for the new money of $4.00 Instead of issuing the noteholders 500,000 shares of Series A preferred stock Issue them 500,000 Series A-1 preferred stock as shadow preferred or sub-series preferred The Series A-1 preferred stock is exactly the same as the Series A in all respects, except for the liquidation preference, which would be $1 per share vs. $4 for the Series A
SAFE NOTES
SAFE Notes Equity financing Converts into a shadow preferred stock -- some with discount; some with a conversion cap Liquidity event Investor may chose to receive: The investment amount Common stock priced at the conversion cap Dissolution event Investor receives the investment amount prior to any other equity holder Most Favored Nation provision
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Thank You. Michael Horten (770) 436-7834 mhorten@hortencc.com