Keith White from Burkland Associates on Startup Fundraisings AngelLaunch 20140130

Early Stage Fundraising

Keith White

© 2013 Burkland Associates. Proprietary

and Confidential

Slides:

Please silence noise-makers.


and Confidential

About the Speaker – Keith White

• Relevant Background

– Burkland Associates

– Part-time CFO for multiple startups

– Modeling, Fundraising, Operations

• Other Background

– General Motors, Bain & Company, Lexmark

– Harvard MBA, Kansas State BS Industrial Engineering

< 3 >

Objectives

• Audience

– Who is out there?

• Stage of company

– What do you want to get out of this discussion?

• Speaker Style

< 4 >

Overview

• Valuation

– Basics

– How to Decide?

• Quantitative Basics

• Common vs. Preferred Stock

• Putting it all together: Two valuation/dilution examples

• Valuation Choice. A real world example

• An alternative: Convertible Debt

• Final Thoughts

• Extra Slides (wordy on purpose so you can review later if desired)

< 5 >

Basics

• Willing buyer meets willing seller

• Valuation is a range

• Valuation is negotiated

• Terms can be as important as the valuation number

• Desired returns are based on expectations of risk – Higher risk; higher required returns

• Stage of development matters

• Angels/VCs will be long-term partners

< 6 >

This is a marriage, not a fling. Choose accordingly.

Stages of Development and Funding

< 7 >

Round Company Stage

Data Risk Value Return

Friends & Family

Incorporation

Early development

Soft data; value proposition; projections

Sky High $500k-$2M

20X +*

Seed Development Tech Validation, time to market, beta rev/traction

Extremely high

$2M-$4M 10X +

Series A Shipping product

Early Revenue/ Traction

Very High $4M-$10M 10X

Series B Shipping product

Predictive Rev

Path to CF+ or Significant Traction

High $10M+ 5X – 10X

Later-Stages Shipping product, profitable

Hard data, EBITDA, net income

Lower - Moderate

$20M+ < 5X

* Friends and Family are not always motivated only for the financial returns, though.

Valuation: How to Decide?

• DCF basics

– Projections

– Discount Rate

– Good Luck!

• Comparables

– Exit scenario discounted back

– Finding comparables

• May be hard to find comparables in narrow spaces. May have to use less-specific but readily available analogous industry.

• Other

– Number of customers (when popular but revenue model not well developed)

– Cost to replicate

• Consider future dilution

• 409A valuations

• Worth repeating: Willing buyer meets willing seller

– Caveat: Angel groups – Momentum!

< 8 >

(…and the perception of momentum!)

Quantitative Basics

• Pre Money

• Post Money

< 9 >

< 10 >

A Real World Example: Which Option Would You

Choose?

Managing to near term valuation is not always the right answer; raising more money sooner bought more runway which led to overall higher valuation. Additional dilution outweighed by greater economic value.

Option A Option B

Series A Pre $3.5 $4.5

$ Raised $4.0 $2.0

Post $7.5 $6.5

Original Owners’ Ownership % 47% 69%

Series B Pre $20.0

$ Raised $15.0

Post $35.0

Original Owners’ Ownership % 40%

Original Owners’ Ownership $ $13.85

Series B Pre $60.0 $20.0

$ Raised $15.0 $15.0

Post $75.0 $35.0

Original Owners’ Ownership % 37% 40%

Original Owners’ Ownership $ $28.0 $13.85

Is Higher Valuation Better?

• Not necessarily…

– Previous numerical example, more money at lower valuation gets you further.

– Preserving your stake. For the business, lower can be better because easier to raise more and avoid down rounds. (Counter: Seeming desperate, retention).

– Finding optimal partners (skills, connections, aligned interests, FORTITUDE!)

– Consider the terms

• Startups have different economics than other investments. Not an issue of 10% vs 12% or even 10x vs 12x. Risk of absolute failure can overshadow modest changes in valuation.

• Valuation is another word for “Expectations.” Harder to live with bubbly valuations.

< 11 >

Pre-Series A Round

< 12 >

Seed/Friends and Family Round already occurred--This is just before the A Round--No additional preferences

A Round Original Derived Per

Pre Money Valuation Shares O/S Share Value

$1,000,000 1,000,000 $1.00

Post Money Post Money

Amount Seed round Seed round

Ownership Shares Invested Ownership % Value

Founder 1 600,000 60.0% $600,000

CEO 100,000 10.0% $100,000

VP Sales 100,000 10.0% $100,000

A Round Investor - $0 0.0% $0

Stock Option Pool 200,000 20.0% $200,000

Total Shares Outstanding 1,000,000 100.0% $1,000,000

A Round Derived Per

Post Money Valuation Share Value

$1,000,000 $1.000

This is what people mean when they talk about a “cap table.”

Series A Round

< 13 >

Seed/Friends and Family Round already occurred--This is the A Round--No additional preferences

A Round Original Derived Per

Pre Money Valuation Shares O/S Share Value

$1,000,000 1,000,000 $1.00

Post Money Post Money

Amount Seed round Seed round

Ownership Shares Invested Ownership % Value

Founder 1 600,000 40.0% $600,000

CEO 100,000 6.7% $100,000

VP Sales 100,000 6.7% $100,000

A Round Investor 500,000 $500,000 33.3% $500,000

Stock Option Pool 200,000 13.3% $200,000

Total Shares Outstanding 1,500,000 100.0% $1,500,000

A Round Derived Per

Post Money Valuation Share Value

$1,500,000 $1.000

B Round Investment

< 14 >

Post B Round Dilution

< 15 >

Common vs Preferred Stock

• Dividends

• Liquidation Preference

– 1X to 3X

• Participation Preference

– Participating: Liquidation pref and prorata participation

– Non participating: Liquidation pref or prorata participation

• Non-economic/control features

• Why have the preferred vs. common distinction?

– Valuation of common/options

– Investor risk mitigation (preferred paid before common)

– Flexibility in negotiating terms of control

< 16 >

Putting it Together: $1m Pre-Money Valuation

< 17 >

Ownership

Common Prfrd Investor %

1,000,000 50%

1,000,000 50% Assume 1X Liquidation, 1X Participations

Upon a liquidation event valued at the following levels, here is how value is allocated across the cap table:

Liquidation Event $10,000,000 Liquidation Event $20,000,000 Liquidation Event $50,000,000

from this total amount, from this total amount, from this total amount,

Preferred Liquidation 1,000,000 Preferred Liquidation 1,000,000 Preferred Liquidation 1,000,000

leaving: 9,000,000 leaving: 19,000,000 leaving: 49,000,000

Participation 50% 4,500,000 Participation 50% 9,500,000 Participation 50% 24,500,000

Common 50% 4,500,000 Common 50% 9,500,000 Common 50% 24,500,000

The ultimate allocation of the value to the two classes of stock

Preferred 55% 5,500,000 Preferred 53% 10,500,000 Preferred 51% 25,500,000


Preferred Investor IRR if the liquidity event happens in year 5

41% 60% 91%

Multiple of Initial Investment

5.50X 10.50X 25.50X

Preferred Round Financing

Putting it Together: $3m Pre-Money Valuation

< 18 >

Ownership

Common Prfrd Investor %

3,000,000 75%

1,000,000 25% Assume 1X Liquidation, 1X Participations

Upon a liquidation event valued at the following levels, here is how value is allocated across the cap table:

Liquidation Event $10,000,000 Liquidation Event $20,000,000 Liquidation Event $50,000,000

from this total amount, from this total amount, from this total amount,

Preferred Liquidation 1,000,000 Preferred Liquidation 1,000,000 Preferred Liquidation 1,000,000

leaving: 9,000,000 leaving: 19,000,000 leaving: 49,000,000

Participation 25% 2,250,000 Participation 25% 4,750,000 Participation 25% 12,250,000


The ultimate allocation of the value to the two classes of stock

Preferred 33% 3,250,000 Preferred 29% 5,750,000 Preferred 27% 13,250,000


Preferred Investor IRR if the liquidity event happens in year 5

27% 42% 68%

Multiple of Initial Investment

3.25X 5.75X 13.25X

Preferred Round Financing

What if You Can’t Agree on Value? – One Alternative

• Punt the Valuation - Use a convertible note as bridge financing

• Term - 1 yr or up to Series A closing

• Interest rate

• “Cap” We’ll do an example on the next slide, but for now know… – The “cap” in “cap table” is short for “capitalization.” In convertible notes,

however, “cap” is the more conventional meaning of a limit. Subtle but important difference.

– Good for the investor. Easy to hear that word and assume it caps their return, but in fact it caps their dilution, which investors like.

• Discount – They get to convert at a lower price

• Security – In a default, debt gets paid before equity

• Conversion – Automatic

– Optional (investor option or company option)

• Increasing popularity

• Some say cheaper too because of simpler contracts.

• Not inherently better or worse than equity. Depends on the risks and terms.

• No equity rights (ex voting, Board) before conversion.

• No liquidation preference.

< 19 >

Example Convertible Note

$500,000 in convertible notes paying 5% interest with a $4 million pre-money cap

and a 20% discount, with $1m raised in a priced round when the note converts.

How much they’re raising.

< 20 >




“Notes” are a loan, or “debt.” “Note” and “Notes” often used interchangeably. NOT equity...

…although they will be allowed to “convert” into equity in some

circumstances, typically next equity round or sale of firm.

< 21 >




Same as interest on a loan, but usually accrued

rather than paid cash because startups low on cash.

Typically paid on acquisition or used in value of

conversion.

< 22 >




• In this case, the founder might think the company

is worth $4-5M while the investor thinks it’s worth

$2-3M. So rather than argue over the value of

equity they negotiate debt with a $4M cap.

• In this case, the cap is expressed as a cap on the

pre-money valuation before the cash from the

investment that causes the conversion.

• Be careful not to call a cap a “valuation.” It’s

something different (that avoids a valuation).

< 23 >




The “and” you usually see is a bit misleading

grammatically. Typically it means the investor can

exercise his/her cap OR discount, whichever leads to

the best results. We’ll walk through an example…

The note investors can convert into equity at 20%

less than the price of the next equity round or a sale

of the firm. In this case, they’d get $500K/80%=625K

in equity for their $500K investment. The 80% is what

remained after the 20% discount.

< 24 >

If the pre-money valuation in the next equity round is $4.5M and $1M of new money is raised, the note investors get (ignoring interest):

• Using the cap,

= Amount purchased via cap reduced by new investor dilution = 10.2% or 10.2%x$5.5M post = $563K

• Using the discount,

= Fixed $ value. % ownership dependent on pre-money and new $ amount = 11.4% or 11.4%x$5.5M post = $625K

In this scenario, the investor would use the discount to get the most value.

Note Value 100%-Discount

( ) $500K 100%-20%

Example


and a 20% discount.

< 25 >

= Note Value Cap

x (100% – New Investor Ownership) = $500K $4M

x (100% - ) $1M $4.5M+$1M

( ) =

Post-Money =

$4.5M+$1M

If the pre-money valuation in the next equity round is $6M and $1M of new money is raised, the note investors get (ignoring interest):

• Using the cap,

= Amount purchased via cap reduced by new investor dilution = 10.7% or 10.7%x$7M post = $750K

• Using the discount,

= Fixed $ value. % ownership dependent on pre-money and new $ amount = 8.9% or 8.9%x$7M post = $625K

In this scenario, the investor would use the cap to get the most value.

Note Value 100%-Discount

( ) 100%-20%

Example


and a 20% discount.

< 26 >

= Note Value Cap

x (100% – New Investor Ownership) = $500K $4M

x (100% - ) $1M $6M+$1M

( ) =

Post-Money =

$500K

$6M+$1M

Additional Convertible Note Info

• No valuation for tax purposes.

• Offer different investors different terms.

But…

• If they convert into the same preferred shares as the next round (typically), they get the liquidation preference too.

• Face value does not decline in down-rounds, so they act like Full Ratchet anti-dilution.

• Cap can act as an indicator for future valuation.

–Too high and they’ll say you failed to meet expectations.

–Too low and they’ll say you didn’t grow that much.

• Maturity of a note can give an investor significant power (default).

• Short maturities mean you may not get much time to start fundraising. If 6 months to raise, 1 year maturity means 6 months before you start.

• Paperwork for interest

< 27 >

Potpourri

• What you realize after raising money and why it always costs more.

• Don’t listen (fully) to friends and family when commiserating about those awful and unwarranted investor demands. Friends and family are your supporters and are not objective! [or be more tuned-in to the hints]

• Momentum matters

• Angels vs. VCs

–VCs might negotiate terms. Angels are more likely to just ignore if they don’t like the terms, especially angel groups.

–Paradoxically, Angels are more conservative than VCs despite being earlier/higher risk.

–Using their own money

–More rounds in the future at the time of investment

–Limited portfolio

• Your sales pitch is different for investors than it is for customers.

–Customers love low prices, investors hate

–Customers hate getting locked-in with a supplier, investors love such “stickiness”

–Customers may know product or service better and be comfortable, investors without industry expertise won’t and may scrutinize things you think are given. Angels have a high variance.

–Customers love building long-term relationships, investors want an exit. Financial investors will worry you’ll never sell your “lifestyle business.”

< 28 >

Potpourri – part 2

• The Myth of Alignment: Investors (esp. VCs) look for one hit out of a portfolio. Founders look for one hit out of one.

• Down Rounds – Valuation lower than previous round

– Beyond the scope of this session, but know they’re out there.

– Can be as bad reputationally as they are financially (momentum killers).

– Anti-dilution clauses become critical.

• Crowdfunding

– New territory. Not all figured out yet. Opportunities, but tread carefully.

– Access larger numbers of investors but with smaller pockets. Their willingness?

– Don’t be tempted to chase just because Angel funding is a grind. The grass is always greener…

– Probably better for consumer products.

– Fame (blogger with audience) or a success in the past that has a following helps.

– Sales tax, non-accredited investor, SEC legal issues. No equity (yet).

• Be prepared for due diligence when pitching. This is not sequential. Start at the beginning of your 6 months.

< 29 >

VCs

• VCs might negotiate terms. Angels are more likely to just ignore if they don’t like the terms.

• VCs typically want 20%+ of the equity and most offerings include more than one. Therefore, VC deals require a good deal of dilution.

– Multiple VCs can mean tapping multiple networks & skills.

– It can also mean a startup has options if one loses interest (see below)

• Prefer $10M+ investments, so better suited to later rounds.

• Be aware of VC incentives and politics.

– Most VCs are determined to make your business work and help as such, BUT….

– Senior partners at Marquee firms might not like to work much but pontificate at your meetings.

– Junior partners at Marquee firms might not have the power in their firms to keep you backed when things get choppy. “Your” partner is your advocate.

– Non-Marquee firms might do great work but their name doesn’t bring momentum.

– VC partner on too many boards can’t add focused value for you.

– Member departs to join another firm/found their own firm and remaining partners neglect your investment for the investments they brought (they are financially incented to).

– VCs have a portfolio. If you’re not a breakout success, they want to ramp you up or close you down. They don’t want a solid but modest business.

– Some too-easily rely on the fallback position of fire-the-CEO.

< 30 >

Control – I need 50% ownership to control, right?

Not that simple…

• Fiduciary Duty typically applies as soon as you sell the first share, even if you keep 99%.

– You are obligated to optimize value or face shareholder lawsuits

– Called “Minority Shareholder Rights.” Generally stronger in the U.S. Ask anyone who’s invested in Russia. Even Western Europe more casual vs U.S.

– Keep you from buying 51% of company then selling assets to yourself for $1. Taking boondoggles with company funds. Etc.

– Therefore, operational control means only that you get greater latitude in determining what is optimal. You can’t do whatever you want, that requires 100.0%.

• Mechanisms to maintain operational control.

– Preferred shares typically don’t have the same voting rights as common, so founders might not face as much pressure from them. In big corporations, preferred shares often have no voting rights, but most startup investors insist on some.

– Other classes of shares can separate economic rights from voting rights. Facebook did this but most tech firms don’t have the sway to pull off. Especially at the VC level, they want the right to fire you.

< 31 >

Some Conventions

• You don’t have to follow the conventions, but the further you get from them, the more scrutiny investors will apply and the more explaining you’ll have to do.

• Some conventions lately have been (Don’t be surprised if they change suddenly as it’s a trend-loving business)…

• Angel rounds typically raise $200-1.5M with most in the mid-to-high six figures. More than a million without a few gorillas is a lot of cats to herd.

• Valuations have crept up this year. Used to be $2-3 for Angel rounds, now we see more $4-5. More (or less) than low-to-mid seven figures will raise eyebrows.

• Angels prefer revenue projections that are ~$100M 5 years out and cash flow positive in 2 years. $50M is about the minimum year 5 revenue to capture their interest.

• Preferred shares typically have 1x liquidation preference. Up to 3x happens, but be cautious. During really lean times it’s been even more!

• Convertible notes typically see 4-10% interest rate, include a cap and a 15-30% discount.

• Warrant coverage from 5-30% is typical, depending on how early they invest.

• Convertible debt is expected to convert because company growing vs the corporate world where it’s often a fallback plan.

• Keiretsu has excellent resources to describe terms.

• Tech people love the internet so there are lots of youtube videos, articles, blogs and templates for startup mechanics.

< 32 >

The “Series A Squeeze”

• VCs have had gross returns of zero over the last decade, historically low.

• This has led investors to have a “flight to quality,” investing in fewer but best performing funds.

• The result is fewer, larger VCs who want to invest MORE per deal.

Meanwhile

• The Cloud and communications has made it cheaper to do a startup.

• Economists say cost down means quantity up -> an explosion of startups needing LESS capital.

Combining these two we see a squeeze where new startups can’t rely on VCs to fund their low seven figure raises anymore.

• Raises the importance of Angels & learning to work with.

• “Capital Efficiency” to an Angel means spending less to get more.

To a VC it means spending more to get much more. A VC might ask why not triple your spend and induce growth.

DON’T ASSUME YOUR SERIES A WILL BE AS EASY AS YOUR SEED < 33 >

< 34 >

Parting Thoughts

• More cash is preferred to less cash

• Cash sooner is preferred to cash later

• Less risky cash is preferred to more risky cash

• Don’t run out of cash

Principles of Financing Strategy*

* William Sahlman, Harvard Business School, January 2007

• Companies with great potential can fail because of inadequate funding.

• Leading companies can fall behind because weaker competitors better-funded.

• Rarely hear a Founder complaining that they raised too much.

Crafting a Pitch

• Less is More. Craft for half the time.

• You stand out with less information, not more.

• Spacial/Visual is better than words but takes longer so we skip.

• Spare slides increase receptivity. Even blank for important messages.

–ABSENCE IS A TOOL

• Draft differently for presenting vs read later.

• Typical form,

–CLASSIC: Problem, Solution, Opportunity Size, Team, Projections, Competition (2x2), The “Ask” (with Use), Exits

–ALTERNATE: Start with “Here’s what we do…”

• AVOIDs “SO WHAT DO YOU DO?” AND “SO HOW DOES THIS WORK?”


and Confidential

Delivering a Pitch

• For investors, a process of elimination not selection

• Unfortunately, style can trump substance. Passion & skill outweighs business.

• You don’t sound like you hear yourself

–Avoid filler words (Um, Er, You Know). They actually DECREASE audience attention.

–SILENCE IS A TOOL.

–Pace yourself. Don’t speak too fast.

–Time yourself. Amazing how many people miss in a pitch.

–“You Play like you Practice”

• Practice on Video. Practice all the way through. Have a bell-ringer for “You Know.”

• Use the mic and learn to use it well. Don’t drift or turn away from.

• Time moves right to left when facing an audience. Upper right is upper left.

• Slides available first. Silence mobiles second.

• Repeat questions for clarity but most importantly for VOLUME. Especially in front, especially if complicated.


and Confidential

Things that Savvy Investors Scrutinize

• Hat tip: Guy Kawasaki & Bill Reichert

• “We are close to a deal with Google.” Their lawyers are reviewing the final contract or I called a guy from my dorm who works their.

• “We have a world class team.” At your stage, your team will be replaced as you gain success.

• “We have the best advisors and lawyers.” Is this really a big deal?

• “Coca-Cola is a client.” The corporation or a middle manager at their midwest distributor who registered your beta.

• “We have no competition.” Really? You misdefined the market.

• “Our projections are conservative.” I mean really.

• “We’re focusing on the X industry.” Is that the industry of the biggest company that called you back?

• “We have multiple revenue streams.” or “…multiple option.” Might mean you don’t understand your business model.

• “Nobody has our X feature.” There are several that just haven’t announced.

• “We are more modular.” Possible, but typically an excuse for me-too.

• “They are too big to react.” Possible, but typically an excuse for no advantage.


and Confidential

Things that Savvy Investors Scrutinize (continued)

• “We’re only losing money because we’re growing (customers, new products)”. Possible, but typically an excuse where we misallocated core cost to expansion.

• “This is a $100 Billion market.” You’ve misdefined the market.

• Winner-take-all businesses. Something they’ll ask and if you will win.

• Funding an idea. You have to have something special now.


and Confidential

Things to Scrutinize from VCs

• Same hat tip.

• They will move slower than they say.

• If they really like to syndicate, they’ll bring their own partners.

• They’ll imply anyone who pays more is incompetent (game the Winner’s Curse).

• “We need to see more traction.” Means “no, but please keep me informed in case things get better.”

• “We invest in teams”…that they’ll continually try to change.


and Confidential

Financial Models

• Analytical, not Predictive

–Answering questions about relationships.

• Watch out for computational errors!

• Don’t miss churn.

• P&L is not Cash Flow.

• Customer acquisition (can) get. Assume you won’t receive a dime in revenue this year from anyone you don’t know today.


and Confidential

< 41 >

Thank you for your participation today

Keith White

Burkland Associates

645 Harrison Street

San Francisco, CA 94107

(702) 420.1044

[email protected]

Please direct questions and feedback to:

Extra Slides

< 42 >

Warrants

Investors for a given round want to be the last money in to make sure you raise

enough to keep going. Yet investors typically expect the same terms. One

“sweetener” you can add are Warrants.

Warrants

• Often tiered based on timing with rewards for being early.

• Based on beating a calendar date

• Based on dollars in (first X dollars gets Y warrants, second X gets Z warrants).

• Basically stock options.

• Often expressed as a percentage “coverage.” Examples…

• For equity, “15% warrant coverage” means for every $100 you buy in you get the option to buy $15 worth of equity in the future at the current price (expected to be a discount since we anticipate the price to be higher later).

• For debt (convertible note) investments, “15% warrant coverage” also means for every $100 in notes you buy, you get the option to purchase $15 worth of equity. But with debt you can set the strike price of the warrant at the last round price, next round price, make it up, etc. It gets complicated.

< 43 >

Discounted Cash Flow Calculation

< 44 >

Negotiation Points

• Think valuation at every milestone

• Your capital plan is as important as your business plan

• Align interests

• Be careful what you trade away early

• Have good counsel

• Be realistic about valuation—other issues are important too

• Power will vary depending on investor interest

• Investor willingness to negotiate varies. Many just won’t bother if they don’t like the initial deal (esp. Angels).

< 45 >

Exit Strategies

• Build a Business!

• Initial Public Offering

• Sale or Merger

– Industry player

• Do you have relationships already?

• Are you building relationships?

– VC/Private Equity

• Management Buy-Out/Recapitalization

• Redemption rights – Investors can insist the firm buy them out

• Tag-along, Drag-along

• Dividends – cash flow (do investors believe you?)

• There has to be an exit for investors to get a return

< 46 >