show me the money: converible debt vs. preferred equity for seed fundraising

“Show Me the $$$$!”…Session 4:

Monday, January 13, 2014

General Assembly / RosePaul Investments Event

Insiders guide to Debt vs. Equity, and Key Deal Terms

Tom Wisniewski

RosePaul Investments

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.

Cheers,

-TW

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1

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

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Why are we here?

Start-up raising capital soon/now

Founder / Prospective founder: not raising, looking to

get up to speed

Investor / prospective investor

Seminar Rationale:

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!)

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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.

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4

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

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

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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 “Hotel.com” 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

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6

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 start-

up/fundraising ecosystem: fellow entrepreneurs, investors, etc.

Answers to specific questions that you might have.

What would I like you to walk away with?

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So….what questions do you have about Debt, Equity, Term

Sheets, etc.?

7

xxx

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II. Intro to Debt vs. Equity

8

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9

Context: Common Sources of Fundraising Capital

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

Angel InvestmentFriends and

FamilyVenture Capital

“You”

aka Bootstrapped

Earlier Stage Later Stage

Round Size $: • $10’s of K

to $100K

• $100’s of K

to $1M+

• $500K to

$1.5M

Investment Size $: $5K – $10’s of K • $25K – $75K • $250K-$750K

Valuation (Pre-

Mon):

• < $1 M • $1 – 5 M • $5-10 M

“Seed” VC “Traditional Series A” VC

• $5M-$15M

• $3M – $5M

• $10 – 25 M

“Seed”

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1. Iterate on ideas

2. Refine idea; test tech / business case

3. Bootstrap; build/test Prototype

4. Early customer validation

5. Develop “pitch”: gather input/interest

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.

Debt, Equity and Deal Terms…..How/When does it fit in?

How much does it

matter?

Very, very

Little

Starts to

Matter

(Maybe!?)

Starts to

Really

Matter

(a lot!?)

[.....life continues on: growth, financings, death/sale of company]

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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

Basic Definitions: Debt

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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

Basic Definitions: Equity

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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.

More Relevant Definitions: Common Equity

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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

More Relevant Definitions: Preferred Equity

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Convertible Debt: a “loan” …..that converts to equity in pre-

defined 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)

More Relevant Definitions: Convertible Debt (Note, etc.)

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III. Panel Discussion and Q & A

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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?

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IV. Deeper Dive and Best Practices

17

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D vs. E: Key Pro/Con

Convertible Debt Preferred Equity

Company/

Founders

Pro: Speed/ ease, lower cost,

defer valuation (?), rolling

close?

Pro: Defines valuation/terms(?),

advantage for next round,

aligned interests

Con: Unaligned interests,

payback loan (or F*cked?)

Con: More time/complexity,

higher cost, must define

valuation, agree on terms

Investors 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?

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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.

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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 un-

capped 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.

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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.

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Thanks! Thomas Wisniewski

Contact Info

Email: thomas@rosepaul.com

LinkedIn: http://www.linkedin.com/in/thomaswis

Twitter: @thomaswis

This presentation: http://www.slideshare.net/Thomaswis/

New York Angels www.newyorkangels.com

New York Angels Educational Meetup: http://www.meetup.com/NY-Angels/

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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.

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Source: NY Angels Educational Meetup

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New York Angels Process: A Monthly Cycle1. 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.