Show Me the Money:  Converible Debt Vs. Preferred Equity for Seed Fundraising
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Show Me the Money: Converible Debt Vs. Preferred Equity for Seed Fundraising



Presentation on the pros/cons of convertible debt vs. preferred equity in seed stage financings of start-ups.

Presentation on the pros/cons of convertible debt vs. preferred equity in seed stage financings of start-ups.



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Show Me the Money: Converible Debt Vs. Preferred Equity for Seed Fundraising Presentation Transcript

  • 1. Thanks to everyone that attended SMT$ 4 on Mon @GA. Here is the document that we used. My contact info is on p.22, and some Bio information is on pp. 4 & 5. “Show Me the $$$$!”…Session 4: Insiders guide to Debt vs. Equity, and Key Deal Terms Cheers, -TW General Assembly / RosePaul Investments Event Tom Wisniewski RosePaul Investments Monday, January 13, 2014
  • 2. Agenda I. Kick-off and Introductions II. Intro to Debt vs. Equity, etc. III. Panel Discussion and Q & A • BREAK: Networking and Beverages IV. Deeper Dive and Best Practices • WRAP-UP: Networking and Beverages 1 confidential
  • 3. Seminar Rationale: Why are we here?  Start-up raising capital soon/now  Founder / Prospective founder: not raising, looking to get up to speed  Investor / prospective investor The Challenge…  Lots of terms and complexity  Lots of noise, lots of conflicting descriptions and advice.  Stakes seem high: mistakes costly • Bad deal…buyers remorse, unpleasant “surprises” later • Scare-off Investors (or founders!) 2 confidential
  • 4. So….. what helps? Invest some time to:  Understand the basics (and the rationale).  Demystify and Prioritize: Not everything is important  Understand the “other guy’s” position: investor perspective. …….learn some best practices from some insiders and your fellow colleagues. 3 confidential
  • 5. Tom Wisniewski: My background  Born in NYC; grew-up in Montclair, NJ  Physics and Philosophy major undergrad (Clark University); MBA at Tuck School (Dartmouth)   1st Job: Programmer at Morgan Stanley then moved to Investment Banking After B-school: joined a start-up management consulting firm Mitchell Madison Group; focus on Strategy/Operations/IT for financial services, tech, outsourcing, private equity/VC clients (1993 to 2000)  Walker Digital: helped set-up and run an early “internet incubator” (2000)  Independent Advisor / Turn-arounds: Advised VC and PE Firms on portfolio company strategy and new investments; joined the management team of two companies  Currently: • Early stage investor and advisor to start-ups • Investor and advisor to VC and PE funds • Member and director at New York Angels confidential
  • 6. Tom Wisniewski: Investor Profile  Direct “Angel” Investor in Companies • $25K-250K investments; Typical valuations: $1-5 Million, • Typical Stage: at least some “product” done, some customer/sales traction • Sector focus: Opportunistic generally within internet/software space; - fair amount of Saas B2B, and consumer “marketplace” models, ecommerce enablers. - NOT (or not much?): hardware, heathcare/pharma, cleantech • NYC based: 50% investments in NYC area companies; total of ~80% NE overall (e.g Boston, DC), 20% West Coast. • Examples: - Sociocast (social/behavioral big data analytics) - LiveLook (Saas, live collaboration sales/service platform) - Anvato (Ad insertion to live video streaming via proprietary machine vision) - Moveline (Uber for the moving industry) - Bizodo (Saas, paperwork automation; “Adobe 2.0” internet document sharing) - Movio (Digital “RedBox”; content delivery via “last 100 ft” of wifi internet) - HeTexted (Relationship advice forum generating content, media opportunities) - Wanderu (Kayak for ground transportation) - DealFlicks (a “Priceline” or “” for movie theater tickets) - iCharts (tool that enables engaging, sharable, embedible chart content)  Investor in Funds • In addition to direct investments in start-ups, invest in VC and PE funds. • Examples: - Social Starts (Seed fund for start-ups leveraging the Social Web) - Brooklyn Bridge Ventures (Charlie O’Donnell’s fund) - Entrepreneurs Roundtable Accelerator (ERA Fund) - Greycroft Partners (Venture Fund) - ff Venture Capital (Fund) 5 confidential
  • 7. What would I like you to walk away with?  Better understanding of subject.  A set of specific insights that will *change* your approach.  A “to-do” list: starting point(s), actions, things to try.  A set of recommended resources to consult and learn more from.  A few new relationships with others in the NYC startup/fundraising ecosystem: fellow entrepreneurs, investors, etc.  Answers to specific questions that you might have. 6 confidential
  • 8. So….what questions do you have about Debt, Equity, Term Sheets, etc.?  xxx 7 confidential
  • 9. II. Intro to Debt vs. Equity 8 confidential
  • 10. Context: Common Sources of Fundraising Capital Earlier Stage “You” aka Bootstrapped Later Stage “Seed” Friends and Family Angel Investment Venture Capital “Seed” VC “Traditional Series A” VC Round Size $: • $10’s of K to $100K • $100’s of K to $1M+ • $500K to $1.5M • $5M-$15M Investment Size $: $5K – $10’s of K • $25K – $75K • $250K-$750K • $3M – $5M Valuation (PreMon): • < $1 M • $1 – 5 M • $5-10 M • $10 – 25 M Who/what are they? • People you already know, that trust you, and (maybe) understand your venture • Experienced early stage investors (individuals or a group) • Accredited Investors. • Angel investing is not their “job”; may not be F/T endeavor • E.g.: NY Angels, GoldenSeeds • Firm with multiple professionals that raises, invests and manages individual funds (other people’s $) • Working F/T (this is their job…) • E.g.: Greycroft, RRE, Union Square 9 confidential
  • 11. Debt, Equity and Deal Terms…..How/When does it fit in? How much does it matter? 1. Iterate on ideas 2. Refine idea; test tech / business case Very, very Little 3. Bootstrap; build/test Prototype 4. Early customer validation 5. Develop “pitch”: gather input/interest Starts to Matter (Maybe!?) 6. Bootstrap more; refine prototype, business case 7. Pitch and receive F&F investment. Terms? 8. Build/validate/refine….Build/validate/refine 9. Pitch Experienced Investors: Angels, Seed VC 10. Term Sheets, negotiation, etc. 10 [ continues on: growth, financings, death/sale of company] confidential Starts to Really Matter (a lot!?)
  • 12. Basic Definitions: Debt  Debt = A loan. You borrow $, owe interest, pay back interest/ principal. E.g. Mortgage on a home; credit cards • Borrower: - Rationale: source of capital, use now pay back over time + plus a fee (e.g. interest) - • Risk: can’t pay back principal/interest; loose assets?, bad credit rating/reputation?, Interests only partially aligned with investors; Loss of flexibility (e.g. Covenants, restrictions) Lender: - Rationale: Believe borrower can definitely repay, Earn fee (e.g. interest); “senior” to equity = paid “first”, before equity; backed by assets or cashflow - Risk: default; partial payback; interests only partially aligned with borrower 11 confidential
  • 13. Basic Definitions: Equity  Equity = Stock; Ownership Interest in a company. You sell a piece of your company, receive capital in return. E.g. shares of “GOOG”, owning 50% of a apartment building • Company/Seller: - Rationale: source of capital, no need to “pay back”, more alignment of interests with investors - • Risk: “Cost” more that alternatives?, less control? Investor/Buyer: - Rationale: “share of the upside”; rights to future profits and sale proceeds ; more alignment of interests with company - Risk: “Share of the downside”; Company has losses, Company is alive but “never” is sold, Company goes out of business 12 confidential
  • 14. More Relevant Definitions: Common Equity  Common Equity: Basic ownership interest in a company.. • Common Equity = founders equity, equity for other employees • Options = rights to buy Common Equity at a price, during a term.  Valuation: in order to “buy/sell” shares of equity, a price per share for the company must be agreed on. • Setting price/share really same as setting “valuation” of company.  Most common form: Stock Delaware C-Corp; • Most of the details are defined by DE law. 13 confidential
  • 15. More Relevant Definitions: Preferred Equity  Preferred Equity (or “Priced Round”): “Same” as Common + a defined set of “preferences” or extra rights, beyond what common has. • Economic rights: - Interest: earn interest on investment - Liquidation preference: in the event of sale, get paid investment (and return) before common is paid • Control rights: - Board Seats - Approval of key company actions: financings, sale, ETC. - Rights to convert to common, right to buy future equity (to maintain % ownership) • Valuation: [Like Common Equity] in order to “buy” shares of equity valuation of the company must be defined. • Most typical form: “Straight” preferred (non-participating preferred), with 4%-9% interest. - Most “preferences” = downside protection (when things go well, everyone converts to common equity 14 confidential
  • 16. More Relevant Definitions: Convertible Debt (Note, etc.)  Convertible Debt: a “loan” …..that converts to equity in predefined ways, circumstances • Loan  Interest rate, defined term (6months – 2 years) • Conversion: Debt converts to Equity when - Qualified Financing - Sale of Company - End of Term • No “Valuation” (or other terms, controls): Defined formula for conversion, e.g. price for buying equity. - Discount to Next Round (Qualified Financing): 5% - 40% discount - Cap: Valuation (and therefore price/share) will be maximum of $2M - $15+. Uncapped Notes are very rare.  Most typical form: • Cumulative interest, rate 4%-8%, • 18 month term, • 20-25% discount • Valuation Cap at $3-5M? (usually set ~ “current” valuation) 15 confidential
  • 17. III. Panel Discussion and Q & A  Introductions: Background on you and your firm  In the last 12 months: convertible debt? Equity?  What like/hate of each and why?  Any interesting stories?  Thoughts on valuation?  Other 1 or 2 Terms that really matter? Why? 16 confidential
  • 18. IV. Deeper Dive and Best Practices 17 confidential
  • 19. D vs. E: Key Pro/Con Convertible Debt Preferred Equity Company/ Pro: Speed/ ease, lower cost, Founders defer valuation (?), rolling close? Pro: Defines valuation/terms(?), advantage for next round, aligned interests Con: Unaligned interests, payback loan (or F*cked?) Investors Con: More time/complexity, higher cost, must define valuation, agree on terms Pro: Speed/ ease, lower cost Pro: Defined price (know what you are buying), preferences compensate for risk, and offer downside protection Con: Uncertain price?, lack of rights (e.g. pro-rata) Con: More time/complexity, higher cost, • Its an Option: want upside • Discount not enough for risk • Works for: round <$1M?, As a Bridge, for F&F round • Is the “Standard” for VC, and most Angels • Round >$1M? 18 confidential
  • 20. Valuation  Regular Business: Based on earnings/ cash flow. • Valuation = 3x – 10x company earnings (EBITDA, etc.) • Valuation = 0.5x – 1x company revenues  Tech Start-ups: • 10-25x? Earnings…but no current earnings • 10x – 100x ?? Revenues? …but no/low revenues • User multiples? (Usually crazy)  Most (experienced) Investors use “Comparables” • Valuation based on other recent “market” prices: valuation of similar companies, deals • Investors (especially active ones) see: - See 3-5 priced deals for every one invested (100’s of pitches for every one invested) - See/hear about 5-10x more deals  Reality Check: • Company only worth what someone is willing to pay. • Supply and Demand: - Company completely unique (limited supply) + Many interested “buyer/investors” (lots of demand) = Higher Price - Many “similar” companies (lots of Supply) + One/No interested “buyers/investors” (limited demand) = Lower Price (or “no” price) • Perception vs. Reality: It all comes down to perception, and belief (very few objective facts, numbers) • It’s a Negotiation. Sales skills matter. 19 confidential
  • 21. Notable Opinions  Paul Graham (Y-Combinator): “All financings for companies coming our to YC are Convertible Notes” (2010/2011) • Easy, founder friendly, and now the standard • Its all about the “optionality”: if its worth $ Billions, valuation unimportant  Fred Wilson (Union Square Ventures). Doesn’t like Notes. “Won’t do them for my investments.” • Conflict of interest, “need to know the price of what I am buying”, cost of preferred is declining  Chris Dixon (Founder Collective). Likes Notes, but will never to uncapped notes. • Investing in founders; no amount of legal will help if you chose wrong; • Reputation: if you screw someone then no one will do business with you. 20 confidential
  • 22. Key Success Factors and Advice….continued  Valuation (and Key Terms). Be realistic. Be Flexible. Realize this is a professional (not personal) discussion ; there will be back and forth. Ultimately the “market” sets the price/terms. • There is more to investment terms than valuation….Important to understand.  Timing. Am I ready for Angel Investment?......A few probing questions: • Have you covered the key success factors mentioned here? Do you have a compiling business opportunity with huge growth potential? • Do you really need the money? Now? The more that you can accomplish on your own, the more compelling your case (and valuation) will be….. • Are you ready to work for a someone else? e.g. the investors, the board of directors • Fund raising is “brain damage”. It wastes valuable time that could be spent growing the business. Avoid it, minimize it, delay it if you can. 21 confidential
  • 23. Thanks! Thomas Wisniewski Contact Info Email: LinkedIn: Twitter: @thomaswis This presentation: New York Angels New York Angels Educational Meetup: 22 confidential
  • 24. Summary Investor Perspective: Notes vs. Equity  History. Preferred Equity is standard for both Angel/Seed and VC (Series A, B, etc.). Convertible Notes were used as a “bridge” to a [reasonably well defined, high probability] upcoming financing. • Now: Convertible Debt much more popular at Angel/Seed round  Preferred Equity. Equity (stock) that has defined “preferences” over common stock. • Establishes a value for the company e.g. [$3.5M] pre-money valuation • Liquidation Preferences. Most commonly used is “non-participating preferred” aka “straight preferred”. E.g. a [1x] liquidation preference. Means investors get their invested money back plus [1x] before common equity holders. In the event of success, everyone converts to common and shares pari passu. Liquidation preference is really downside protection for investors • Investor rights. E.g. approval of key company decisions  Convertible Note. Debt that converts to equity when a next financing round occurs. As Debt, typically: carries interest rate (e.g. 8%); has preference to all equity: gets paid back 1st; secured by assets of company • Converts to equity at “same terms” as next round…..except the Note usually has - Discount [10-30%] to the valuation (in the next round) - Cap on valuation (in the next round); means “valuation not to exceed $__”. • Terms of conversion - Upon “qualified financing”, e.g. financing of a least [$2M] - End of the Note’s term [18 months] - At the option of investors  Other Key Terms. Employee option pool, board composition, dividends, anti-dilution provisions, pro-rata investment rights, capped legal expenses. Source: NY Angels Educational Meetup 23 confidential
  • 25. New York Angels Process: A Monthly Cycle 1. Proposals Reviewed Online (via Gust): 50 – 100 monthly • Sources: • NYA website/Gust (“cold call”: low prob of quality, and success) • Syndicated deal from other group/investor (warm intro: better quality, better success) • Referral from NYA member (warmer intro: even better quality/success) 2. In Person NYA Screening: ~15 companies monthly • Around 15 of the 100 are selected to present at an in person pitch/screening session (1st Wed of the month) • Companies have 10 min to pitch, 5 Q&A (5 minute investor discussion) • Usually ~40 NYA members attend 3. Discovery / Follow-up: 1-3 new companies enter monthly (3-6 in-process total) • Of the 15, 1-3 companies garner enough investor interest to move forward in some fashion • If there is sufficient interest from a core group of investors, and an investor willing to “lead”, then the core NYA process moves forward with follow-up “Discovery” meeting(s) aka deep dives, due diligence. • In some cases individual investors want to follow-up and explore the company further independently 4. Investment Breakfast: 1-3? companies monthly • Those Companies that get to the term-sheet stage with several committed NYA investors, are brought back to present to the NYA Group at the Breakfast • NYA Investment Breakfast meetings: 20 minute presentation + Q&A, 40-60 NYA members attending 5. Final Due Diligence, Legal Docs, Closing. confidential