2013 12-04 early stage venture investing

MIMPerpestr- estr-MPA 120927-V1.0
Early Stage Venture Financing
March 11, 2014
Jean-Jacques Degroof, jjdegroof@alum.mit.edu
http://alum.mit.edu/www/jjdegroof
http://mit.academia.edu/JeanJacquesDegroof
1

MIMPerpestr- estr-MPA 120927-V1.0 2
INTRODUCTION
Non-dilutive Dilutive
Bootstrapping x
Family and friends ~
Crowdfunding ~
Incubators X
Public sources x ~
Bank loans x
Franchising X
Strategic alliances Depends
Business Angels X
Venture capital X
(*)

WHAT IS A BUSINESS ANGEL?
3
• What is a business angel?
• What kind of ventures are BAs looking for?
• What kind of return do BAs require?
• How do BAs negotiate an investment?

WHAT IS A BUSINESS ANGEL?
5
“A business angel investor is an affluent individual who provides
capital for a business startup, usually in exchange for convertible
debt or ownership equity.” (Source: Wikipedia)
How do business angels operate?
• Individually.
• In a networks.
• In groups.
• As a fund.

WHAT KIND OF VENTURES ARE BAs LOOKING
FOR?
6

WHAT KIND OF VENTURES ARE BAs LOOKING
FOR?
7
• Evidence of “sweat equity” (bootstrapping).
• Financial commitment of the founders.
• Complementary team.
• Evidence of focus – Deep knowledge of the industry.
• Proprietary position (patent, copyright, trademark, tacit
knowledge), or barriers to entry.
• Growth potential - potential of scaling.
• Clear idea about distribution.
• Execution capacity (including in sales).

WHAT KIND OF VENTURES ARE BAs
LOOKING FOR?
8
• Growth potential
• “Exit” potential.

WHAT KIND OF VENTURES ARE BAs
LOOKING FOR?
9
• What turns angel investors off?
• Service orientation and custom application (do not scale well).
• Product orientation instead of market orientation.
• What problem do you solve?
• Excessively optimistic financial projections.

WHAT KIND OF RETURN DO BAs REQUIRE?
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• 35%-65% compounded.
• 50% compounded over 5 years = 7x initial investment.
• Are there evidence you can provide such kinds of returns?

12
• Why do investors require such high returns?
• Risk premium, “small cap” premium, illiquidity premium.
• Because they manage a portfolio of which 1-2/10 will be
winners.Winners needs to offer very high return to
compensate for the “losers.”

HOW DO BAs NEGOTIATE AN INVESTMENT?
13

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• Valuation of the venture.
• Terms of the deal.

15
• What calculations do angel investors do?
• Assuming a venture will have Eur 20m in sales in 5 years.
• Assuming a multiple for acquisition of 2x sales, the venture
would be worth Eur 40m in 5 years.
• Assuming that the company is seeking 1 million of funding, this
amount should be worth 5 million in 5 years to satisfy investors
( if he requires a return of 5x his initial capital).
• To realize Eur 5 million from a company worth Eur 40m, the
investor must need to own 12.5% of the company.
• In other words, the company would be valued today at Eur 8m
by the investor.

16
• In practice, contextual factors determining valuation.
• “The market” – valuation of recent similar transactions.
• Bargaining power (e.g. case of cash-strapped venture)
(*)
• Past track record of founders (e.g. “serial
entrepreneurs”)
(*) Fundraising is time consuming!

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• Reinvestment
• BAs keep “dry powder” to re-invest in the venture in the
future.
• Either because the company doesn’t meet its
objectives and needs more cash (“downround”)
• Or to fund growth.

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• Terms of the deal.
• Why? To compensate for assymetry of information.
• To build assymetry of incentives for the entrepreneur.
• If he succeeds: he fully participates in the capital
gain.
• If he fails: he looses everything.

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• Important terms.
• Information rights.
• Board representation.
• Protective provisions (veto right) in case of…
• Sale of the company
• Change of the bylaws.
• Change of the size of the board of directors.
• Pay of a dividend.
• Borrow money

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• Important terms
• Liquidation preference.
• Impacts how the proceeds are shared in a
liquidity event.
• Anti-dilution preference.
• Protects investors in the event a company
issues equity at a lower valuation than in
previous financing rooms.
• Right of first refusal
• Defines of the rights that an investor has to buy
shares in the future financing.

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• Note
• Terms can impact valuation at the exit.

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Alternative to equity investing: convertible note (loan)
• Mecanism
• Investors loan money to the venture with the option to
convert the loan to equity at the valuation of the next
“institutional” equity financing, with a discount to reflect the
additional risk they took by investing earlier.
• Advantages
• Postpones the negotiation about valuation.
• Requires less time to raise funds.

CONCLUSION
Non-dilutive Dilutive
Bootstrapping x
Family and friends ~
Crowdfunding ~
Incubators X
Public sources x ~
Bank loans x
Franchising X
Strategic alliances Depends
Business Angels X
Venture capital X
(*)

2013 12-04 early stage venture investing

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