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


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

Published in: Economy & Finance, Business
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Show Me the Money: Converible Debt Vs. Preferred Equity for Seed Fundraising

  1. 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. 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. 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. 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. 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. 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. 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. 8. So….what questions do you have about Debt, Equity, Term Sheets, etc.?  xxx 7 confidential
  9. 9. II. Intro to Debt vs. Equity 8 confidential
  10. 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. 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. 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. 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. 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. 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. 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. 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. 18. IV. Deeper Dive and Best Practices 17 confidential
  19. 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. 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. 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. 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. 23. Thanks! Thomas Wisniewski Contact Info Email: LinkedIn: Twitter: @thomaswis This presentation: New York Angels New York Angels Educational Meetup: 22 confidential
  24. 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. 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