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Early Stage Capital and Valuation

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A short presentation on early-stage financing with a primer on how angel investors consider risk and reward for equity investments in high-growth companies at their earliest stages.

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Early Stage Capital and Valuation

  1. 1. 1 Early Stage CapitalAN OVERVIEW OF FINANCING OPTIONS FOR EARLY STAGE COMPANIES
  2. 2. 2 82% of Businesses Close Due to Inadequate Cash Management
  3. 3. 3 Your survival as an early stage startup is dependent on your ability to effectively navigate through the “Valley of Death” Image Credit: Kmuehmel, VC20 - https://commons.wikimedia.org/wiki/File:Startup_financing_cycle.svg
  4. 4. 4 Early Stage Company Personal: Founder Funds, Credit Card, Life Insurance, Home Equity Line of Credit Equity: Equity for Services, Love Money, Angel, Venture Capital, Public Market Debt: A/R Financing, Collateral Financing, Trade Credit, Line of Credit Non-Dilutive: AZ Innovation Challenge, Crowdsourcing, Grants, SBIRs, STTRs, Contracts EARLY STAGE FINANCING OPTIONS MULTIPLE FUNDING TYPES DEPENDING ON YOUR BUSINESS
  5. 5. 5 Revenue/Investment (Cash In) •  Services before Product •  Pre-sales •  Upfront Fees •  State/Federal Programs •  Founder, Friends, Family Funds •  Crowdfunding •  Equity Investment •  Loans and Lines of Credit Expenses (Cash Out) •  Salaries •  Product Development Roadmap •  Free/Discounted Resources •  Service Providers •  Payment Schedules •  Equity in Lieu of Cash CROSSING THE CHASM MANAGING THE FLOW OF CASH
  6. 6. 6 Your company life cycle must match the metrics expected by the type of investor you are seeking. Image Credit: Aswath Damodaran, https://seekingalpha.com/article/2689195-twitters-bar-mitzvah-is-social-media-coming-of-age
  7. 7. 7 •  If it looks like a duck, quacks like a duck, it’s a duck, but you better be a duck! •  You must look like the industry average to get the average, no participation credit! •  Round Size: •  Pre-Seed: $50K-$250K •  Seed: $500K-$2M •  Post-Seed: $3-$12M •  Equity Stake: •  20%-33% MATCHING THE INVESTMENT THESIS INVESTORS USE THEIR THESIS TO IDENTIFY AND DISMISS DEALS
  8. 8. 8 Amount Valuation Investors Team Product/ Market Fit Tech MRR Sales/ Marketing Defensibility Market/ Potential Pre-Seed $50-250K $250K-2M Friends/ Family/Angels Smart, committed, relevant experience Market Research indicates strong need for the product Strong tech co-founder with relevant experience --- Understand best practices in market Plan for Funnel --- Believe in $10M+ ARR potential Seed $500K-$2M $2-6M Angels, Micro VCs Founder/ Market Fit Strong indications of PMF from early customers Proven ability to move fast and deliver, starting to think about scalability and process $0-50K Strong indications of demand Established Funnel Tech Product Development Velocity Conviction there is $100M+ ARR potential Post-Seed $3-12M $10-40M VCs Directors No VPs Demonstrated ability to attract good hires Clear PMF and increasing evidence in Market, low churn rate Proven ability to attract great talent, product scales, fast iterations $100-250K Strong organic demand Disciplined Sales Process First Signs of Emerging Brand Expected $300M+ ARR potential EARLY STAGE VENTURE FINANCING INVESTOR METRICS AND EXPECTATIONS
  9. 9. 9 •  Runway •  6-18 months •  Traction •  Achieve “x”% growth •  Validate Experiments •  1-3 depending on complexity •  Achieve Next Valuation Inflection Point HOW MUCH CAPITAL DO YOU NEED? HOW TO COMMUNICATE YOUR USE OF CAPITAL
  10. 10. 10 Our 5 year growth projections show $AA revenue, BB% profit, and we reach a cash flow neutral position in month CC after $DD invested. We intend to do this by offering a solution…. We expect to achieve EE% of our TAM by year 5. Our TAM is calculated by…. The size of our initial target market is FF and we intend to capture GG% of this group who currently spends $HH on the problem we are solving. We expect to meet our revenue projections through our marketing/sales efforts. Our forecasts for year 1 are derived from these campaigns and yield II% conversion on $JJ spent. We are spending $JJ on…. In years 2-5, we made the following assumptions…. We intend to offer the following solution…. We expect to invest $KK on the development of…. Once this is developed, our cost to deliver the solution to the each customer is $LL. Our future development roadmap is…. and will cost $MM Overall, our current spend is $NN in the first year. Based on our forecasts, we will need funding in months OO, PP, QQ…. We plan to get this funding through…. You can see the overall use of funds by category and our overall headcount by year here. A STORY BOARD MODEL TELL A GREAT FINANCIAL STORY
  11. 11. 11 •  Specificity on use of funds during funded period •  Integrity during due diligence •  Enough skin in the company that it hurts, but is not distracting •  Funding connected to milestones EQUITY INVESTOR EXPECTATIONS WHAT HAPPENS AFTER THE PITCH
  12. 12. 12 How Invested are Founders? •  Personal Guaranties •  Personal Loans and Credit Cards •  Mortgages and Home Equity Line of Credit •  Friends and Family •  Retirement Accounts •  Equity Investors •  Bankruptcy How Qualified is Team? •  Friends and Family •  Serial Entrepreneur •  Experience with Market •  Experience with Technology •  Investors from Previous Company involved •  Advisors to Team EVALUATING THE TEAM FUNDING THE BEST JOCKEYS
  13. 13. 13 •  CEO-centric •  Family and Bros •  No hurt money •  Capital provides only short runway •  Hockey Stick Forecast without specifics •  Percent of Market without Milestones •  No competition, no research, no disclosure WARNING SIGNS ON A TEAM GREAT HORSE, WRONG JOCKEY
  14. 14. 14 •  Beta Users is not Traction •  Current Sales •  Sales Pipeline •  Metrics: DAUs, MAUs, Subscribers, Conversion Rate, Churn Rate •  Understand Customer Acquisition Process EVALUATING TRACTION METRICS TO DEMONSTRATE PRODUCT-MARKET FIT
  15. 15. 15 •  Product Components and Architecture •  Scalability and Reproducibility •  Product Development Team Qualifications •  In-Source vs Out-Source Development •  Product Roadmap EVALUATING PRODUCT ROADMAP CAN THEY BUILD IT, SO THEY WILL COME?
  16. 16. 16 •  Identify Comparable Public Companies or Public Acquisitions •  Create Multiples for EV/EBITDA and EV/Revenue •  Understand Competition Tools and Target Customers •  Product Roadmap to Market Segmentation Analysis EVALUATING THE MARKET VALUE BASED ON NICHE MARKET, MONOPOLY, LARGE SIZED MARKET
  17. 17. 17 Management Motivation and Capability 90% Market Demand 90% Customer Acquisition Plan 90% Product-Market-Fit 90% Product Development Plan 90% Capital/Cash Flow Plan 90% Legal and IP Concerns 90% Success Probability (Adjusted Risk) 48% RISK MANAGEMENT RISK DRIVES THE VALUATION DISCUSSION Risk factors are compounding and have multiplicative effects, risk is not an average of all of the potential risks.
  18. 18. 18 Management Motivation and Capability 90% Market Demand 90% Customer Acquisition Plan 90% Product-Market-Fit 90% Product Development Plan 90% Capital/Cash Flow Plan 50% Legal and IP Concerns 90% Success Probability (Adjusted Risk) 27% RISK MANAGEMENT JUST ONE CORE FACTOR CAN DRAMATICALLY INCREASE RISK Risk factors are compounding and have multiplicative effects, risk is not an average of all of the potential risks.
  19. 19. 19 Valuation is not NOT an evaluation how much the company is worth or going to be worth. •  It is the agreement between an investor and company on the price for a share of the company that an investor receives for an investment. •  The enterprise value of the company requires liquidity and market. WHY CREATE A VALUATION? ALLOCATION OF EQUITY FOR INVESTOR RISK
  20. 20. 20 •  Discounting exit valuation or pro forma financials •  Venture Capital Method •  Chicago Method •  Comparing target to typical funded startup •  Scorecard Method •  Dave Berkus Method •  Risk Factor Summation Method •  Online questionnaire •  Cayenne Calculator VALUATION METHODS FOR EARLY STAGE COMPANIES MATCHING RISK WITH VALUATION
  21. 21. 21 VENTURE CAPITAL METHOD INVESTMENT ROI BASED ON STAGE OF COMPANY Exit Year: 5th Year Exit Year Revenues: $6.2M Exit Year Earnings: $4.4M Exit Year Value: $37M (6x Revenues) $66M (15x Earnings) Ownership Requirement: $3M / $37M = 8.1% Ownership Requirement: $3M / $66M = 4.5% Post-Money Valuation: $150K / 8.1% = $1.875M Post-Money Valuation: $150K / 4.5% = $3.3M Expected Rates of Return (5 year multiple) •  Pre-Seed: 100% (20X) •  Startup: 60% (10X) •  Post-Seed: 50% (8X) •  2nd Stage: 40% (5X) •  3rd Stage: 30% (4X) •  Bridge: 25% (3X) Investment: $150K Required ROI (%): 100% (20X) Required ROI ($): $3M
  22. 22. 22 Appraise startups using comps •  Start: •  Median Valuation of similar startups •  Similar stage of development, business sector, location •  Adjustments: •  Use weightings to adjust median Criteria Weighting Entrepreneur, Team, Board 30% Size of Opportunity 25% Product/Technology 15% Competitive Environment 10% Sales/Marketing 10% Need for More Financing 5% Other 5% SCORECARD METHOD EARLY STAGE COMPARATIVE EVALUATION
  23. 23. 23Scorecard Method Example Criteria Weighting Comparison Adjusted Entrepreneur, Team, Board 20% 80% 16% Size of Opportunity 20% 100% 20% Product/Technology 20% 60% 12% Sales/Marketing 20% 40% 8% Competitive Environment 10% 80% 8% Need for More Financing 10% 60% 6% Total 100% 70% $3.5M (HALO Report Median Value) x 70% = $2.45M Pre-Money Valuation
  24. 24. 24Berkus Method Example If Exists: Add to Company Value: Self-Evaluation Value Sound Idea (basic value) $500K 5 $500K Prototype (reducing technology risk) $500K 5 $500K Quality Management Team (reducing execution risk) $500K 3 $300K Strategic Relationships (reducing market risk) $500K 2 $200K Product Rollout or Sales (reducing production risk) $500K 1 $100K Total $1.6M Intended for Companies sub-$2M
  25. 25. 25Bill Payne Method Example Rating Scale Risk Category Allocation Total +2 Very Positive Technology +2 +1 Positive Exit Potential +1 0 Neutral Political, Manufacturing, Competition, International, Reputation, Funding/Capital 0 -1 Negative Litigation, Management -2 -2 Negative Stage of Business, Sales/Marketing -4 Total -3 Regional Pre-Money Valuation Median (HALO Report): $3.8M Multiply $250K by Total: ($750K) Self-Evaluation: $3.05M
  26. 26. 26 If early stage valuation is too high: •  Financial contribution undervalued •  Smart money will walk away •  Time to close extended •  Likelihood of a down round is higher •  Not able to get exit at size needed for risk stage If early stage valuation is too low: •  It always takes 2X times as much and will over-dilute founders •  Entrepreneurs are less motivated •  Founders feel over diluted and exit the company IMPORTANCE OF GETTING A FAIR VALUATION IMPACTS TO INVESTORS AND FOUNDERS
  27. 27. 27 The objective of an angel investor or any private equity investor is to exit! Start planning early, the more fundraising the more difficult it is to exit. Most exits <$30M 0 1 2 3 4 5 6 7 Year 1 Year 2 Year 3 Year 4 Investment Return (X) Inflection point for growth capital $25M exit 6-18 month exit process EXIT PLANNING PRIMARY GOAL FOR AN INVESTOR
  28. 28. 28 Over 80% of exits are through acquisition or buyout
  29. 29. 29 Once you take funding, you are on the clock to get to an exit. Time requires a higher exit multiple to account for the tradeoff in IRR
  30. 30. 30 •  Liquidation Preference •  Option Pool •  Board Representation •  Redemption •  Voting Rights •  Anti-Dilution OTHER FACTORS ON A TERM SHEET BEYOND VALUATION MULTIPLE LEVERS TO MANAGE RISK AND EXPECTATIONS

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