Source of Capital for Startups
First of all, there are 2 critical lessons to remember:
- A dollar is not just a dollar, from whom you raise money, can be as important as how much money you raise.
- Investors can be important business leads who can help you.
- The ‘value-added’ services may end up costing more, like ownership.
- Some businesses are not well suited to some types of investors.
- Timing is everything.
- Investors specialize in certain points of the lifecycle of a business.
- It takes time to build relationships that lead to funding outcomes.
- Different capital providers are often complements, not substitutes.
- Raising too much money too early can be deadly
Imagine you’re the entrepreneur, now the question is what is the right source of capital based on the characteristics of your business? The options include:
- Angel investors
- Traditional venture capital
- Corporate venture capital
- Strategic alliances (partnership with an existing firm)
Another way to look at this decision is to think about it in terms of “who” and “what” (debt or equity).
|Who||What (Debt)||What (Equity)|
|Insiders||Friends, Family, Fools||Angels|
|Trade credit||Alliance partners|
Debt is an incredibly important source of capital for most new businesses. About 40% of the total capital being used to launch a business is bank debt. Another 40% is the money that the owner herself is putting into the business. The credit of the business founders really does not make much difference about the percentage of bank debt or owner financing.. The credit only relates to the size of the business, their capital structure is the same.
Take a closer look at the debt. There are two big sources of debt financing:
- Bank loan to the business. ~30% of the total debt that goes into new business.
- Personal loan to the founder. ~40% of the total debt that goes into new business.
The debt works as simple as: you borrow money, you receive cash, you enter into a legal agreement to repay the amount of money that you borrowed plus interest on top of that. The interest is fixed, you (the entrepreneur) keep the upside of the business.
Most bank debt has covenants associated with it. If a covenant violation occurs, the debt technically speaking can be considered to be in default. The debt-holder could potentially seize the firm’s assets and liquidate the firm (contingent ownership). As long as the debt is in good standing, the entrepreneur owns the business.
A major component of most debt is what’s called collateral, which is required (by bank) to provide a loan. Oftentimes, the collateral being used to launch a new business comes from the entrepreneur’s personal assets.
Suppose an entrepreneur takes $10 million for 5% of her company. There’s two key valuation terms that come up all the time in venture capital:
|Post-money valuation||The value of the business after the venture capital investor has invested the money.|
In this example, post value is $10M / 5% = $200M.
|Pre-money valuation||The value of the business before the money goes in.|
In this example, pre value is $190M = $200M – $10M
What’s going to happen is, the venture capital investor and the entrepreneur are going to agree to what’s called a term sheet, which is quite a lengthy, detailed, complicated legal document that specifies all of the rights and privileges that the VC investor has in exchange for providing that capital:
- special corporate governance rights
- special control rights over business decisions
- the amount of equity that the venture capital investor receives
The venture capital investor will provide cash to the firm and then receive a special type of security called Convertible Preferred Equity, which a special type of equity that has special rights and privileges attached to it.
Convertible Preferred Equity
Convertible Preferred Equity is a hybrid of a debt instrument and a standard equity instrument:
- It receives interest payments like a loan (typically accrue unpaid, just increasing the amount of principal balance that’s outstanding.
- VC investor will have an option to convert it to common equity at a conversion price.
This balance between maintaining the security as Convertible Preferred Equity, or converting to Common Equity, gives the venture capital investor downside protection when things go wrong and at the same time allows the venture capital investor to share in the upside of the business.
Convertible preferred equity, sometimes it’s also called participating preferred equity. Initially it is structured as debt with accrued interest. The debt will have liquidation rights associated with it. That means that the holder of the security will get some multiple of their initial investment back before others get anything. A venture investor could abandon the liquidation rights, and convert the equity into common equity and then just own a proportion of the firm. If it’s a participating preferred security, then first the liquidation rights will get paid and then equity is converted. It’s no longer an “either … or …” situation, it is an “… and …” situation.
Convertible Preferred Equity creates incentives for management and it provides downside protection to the VC. If the company is liquidated and ends up not being worth very much, VC investors are better off being a debt holder and getting back as much as possible. That’s where the downside protection is coming in. This encourages management to work hard because management is only going to get paid for large exits.
Venture Capital Investors
If you’re an entrepreneur thinking about getting money from a VC, you’re really getting an investment from a venture capital “fund”, which is distinct from the venture capital “firm”.
|Firm||A venture capital firm is a collection of employees called “general partners” who raise capital from “limited partners”, e.g. big pension systems, university endowments, wealthy families. The general partners, who are using money from limited partners, are the people who were making investment decisions.|
|Fund||The institutional investors enter into partnership agreements with the venture capital firms|
to create a venture capital fund. The fund is the investment vehicle that makes the investments in the portfolio companies. A typical partnership would have about 99% of the capital provided by limited partners and about 1% of the capital provided by the general partners themselves.
These partnership agreements are typically designed to have a 10-year lifespan with possible extension. The 10-year period is kind of broken into three chunks:
- New investments
- A typical venture capital fund might make somewhere between 10 and 15 investments.
- Follow-on investments
- Many of the new investments will fail. Only a small number of those new investments will require follow-on capital
- Exit / Wind down
- Ultimately, hopefully, a few of those investments will be exited. Exits will occur in the form of an IPO, an acquisition by a strategic partner, or a sale to another private equity investor.
The partnership agreement specifies the rules that determine how the general partners (venture investors) are paid. The money comes from two main sources:
|Management fees||Usually 2% of the capital that’s been committed to the partnership. The fees get reduced as fund gets older.|
|Carried interest||A slice (20% – 30%) of the net return that a venture capital investor generates. Usually can not be earned until fund’s whole invested capital is returned to the limited partners.|
It’s important to recognize that a venture capital investor is really investing other people’s money. VC investors need to be able to deliver a solid return to their investors (pensions, universities, etc) in order for them to be able to generate returns for themselves.
The Hurdle Rate
Venture capital is a really expensive form of investing. VC investors having really high hurdle rates. The term sheet calls for the venture capital investor to take a much larger piece of your company’s equity then seems unfair given how much capital they’re providing.
VCs are investing other people’s capital. These limited partners are expecting to earn a return. A venture capital investor is only going to make maybe 10 or 12 investments in any given partnership. Many of those investments will fail. A VC who invests limited partner’s money for T years must earn a return based on the expected payout.
Cash_In × (1+r)T = p × Cash_Out
r is the required return by limited partner,
p represents the probability that this investment is a successful investment. The equation can be used to find the Cash-on-Cash return:
Cash-on-Cash Return = Cash_Out / Cash_In = (1+r)T/p
When we put the cash into the company, we don’t know if this is going to be one of the ones that succeeds and one of the ones that fails. So we’re going to have to write this term sheet in a way that it gives us enough cash coming out of the business if it’s successful, to compensate for all the failures that we’re going to encounter along the way. That means that we’re going to require a very high Cash-on-Cash return, relative to the return you’d be expected if you were a diversified investor.
We can also express the Cash-on-Cash return as a Hurdle Rate:
Hurdle Rate = T√( Cash_Out / Cash_In ) - 1 = T√( (1+r)T/p ) - 1
The VC Method
VC Method is an alternative to the standard Net Present Value calculation. It helps you understand how VCs think about how much equity to take in the investments that they make. Let’s use an example to understand the method, first we need a couple of inputs:
- What is the required investment today? (Let’s call that $100.)
- What is the exit valuation for this company? (Let’s assume $20000, but how to estimate?)
- Actually we could use cashflow forecast / projection to estimate the exit value.
- What is the Cash-on-Cash multiple we have to earn?
- For example: if r = 15%, T = 5, p = 10%, then Hurdle Rate = 82% and Cash-on-Cash multiple is 20.
- Calculate the net present value of the future exit:
NPV = Exit_Valuation / Cash-on-Cash_Multiple. In our example NPV = $20000 / 20 = $1000.
- Calculate how much VC wants to own in order to break-even on required investment?
- In our example: $100 / $1000 = 10%
Bear in mind that the venture capital investor is folding in the fact that your success is not guaranteed. Tney will take a large equity stake and that’s going to compensate the venture capital investor on average for all of the failures that they’ve experienced along the way. Actually the entrepreneur is responsible for compensating limited partners for the high probability of failure in venture investment.
The capital is being injected into the business through a legal document called term sheet, which is lengthy, complex, detailed and spells out exactly the terms under which the venture capital investor is making their investment. The main provisions in a term sheet include:
|Valuation||At the beginning of investment.|
1. What is the pre-money value?
2. How much capital is being injected?
3. How much equity is being taken?
|Governance||Significant latitude decision rights over how the company operates day-to-day.|
1. Board seats on the board of directors.
2. Preferred voting rights or veto rights.
3. Option pool: incentive current and future management.
|Exit||When liquidation occurs.|
1. Anti-dilution protection: protect against future value decrease in later funding.
2. Dividends: seldom cash, but can affect value at liquidation.
3. Liquidation preference and participation.
An option pool is a block of equity that has been reserved for early investors or employees of a start-up. The construction is going to work a little bit differently, depends on whether the options are taken out of the post-money valuation or pre-money valuation.
Consider an example, founders of a start-up own 2M shares, raise an additional $1M for 40% ownership. The total shares after raising money will be 2M / (1-40%) = 3.33M, so 3.33M – 2M = 1.33M new shares are created, if there is no option pool.
The creation of an option pool is causing dilution. The way the term sheet is written, is going to determine who bears the brunt of that dilution that’s going to occur. Suppose new money requires 18% option pool. There are two possible cases:
Options come completely out of the founders pocket, Founders do not own 60% but own (60% – 18%) = 42%. So finally total outstanding shares is 2M / 42% = 4761905 shares. VC investors receive convertible shares 4761905 * 40% = 1904762 shares on a fully diluted basis. The remaining are in option pool 4761905 * 18% = 857143 shares.
60%(founders) + 40%(investors) ⟹ 42%(founders) + 40%(investors) + 18%(option pool)
Because the option pool is being constructed after the VC has invested the million dollars rather than before, that’s going to cause the dilution between the founder and the investor to be borne in proportion to their ownership stakes. So this 18% option pool is going to be split 60-40 between the founder and the new investor.
60%(founders) + 40%(investors) ⟹ 49.2%(founders) + 32.8%(investors) + 18%(option pool)
To round numbers, let’s round that 49.2% ownership to 50%. There are 2M / 50% = 4M total outstanding shares finally. 4M * 18% = 720000 shares is in option pool.
Anti-dilution protection protects the VC investors from the fact that the company may lose value over time. The purpose is to protect the shares of an earlier investor if a later investment occurs in what’s called a down round, which happens when pre-money valuation in a later round is less than the post-money valuation in the previous round, i.e. the firm has lost value over time.
The earlier investor is concerned about that the new shares are going to be issued at a lower price relative to the earlier investment. So the term sheet usually has provisions that give some insulation in case this occurs. Issuing new shares back to the earlier investors will effectively lower the price at which they’re investing.
There are a couple of common different flavors of anti-dilution provisions:
|Full-ratchet||If a single share issues at a lower price, all covered shares change to that price.|
Easy to calculate, but hard to stomach.
|Weighted average||Old price adjusts partially to new price depending on relative amount of capital in each raise.|
The weighted average is calculated as below:
New_price = Old_Price × Factor Factor = (Old_Shares + New_SharesWB) / (Old_Shares + New_Shares) New_SharesWB = New_Money_In / Old_Price
The term ‘Angel’ comes from early financier’s of Broadway shows. They typically refer to high net worth individuals. It’s important to understand that this market is probably pretty large compared to the VC market. Angel investors are allowed to:
- invest in unregistered securities offerings.
- support the pre-seed, seed, and very early stage companies.
- Seed: of size $250K – $750K. Prove a concept, built an Minimal Viable Product (MVP).
- Early-stage: of size $2M – $3M. Pre-revenue.
If you look at the returns to Angel investment, most of the time the return is -100%, in other words a total loss.
Most angel investments are supported by two legal documents:
- Note Purchase Agreement
- Sets rules for who is investing and who is receiving investment
- What constitutes change of control, bankruptcy, default, etc.
- Promissory Note or Convertible Note
- Actually describes the security that the investor is receiving when they make an investment
- Key parameters: investment amount, interest or dividend, conversion.
- Increasingly, Convertible Notes are being replaced by SAFEs (Simple Agreements for Future Equity).
SAFE vs. Convertible Notes
The difference between SAFE vs. convertible notes really gets down to the difference between equity vs debt.
|SAFE||An equity security.|
Technically a warrant that earns accrued dividends.
|Convertible Notes||A debt security.|
It earns accrued interest.
And as a practical matter, the distinction between debt and equity isn’t so important here. Because in most cases, if the company is unable to repay the security or if the company is unable to receive follow-on financing, the company’s probably dead. The security is worthless.
Angel Term Sheets
The Key Investment Terms in a term sheet lay out:
- the amount of principal that’s being invested
- the interest rate that determines the accrual of any dividend or interest.
The start-up may reach a point in the future, where it hasn’t found any follow-on investment and the note is due, and the company has probably used all money. Typically what happens then is that the angel investor and the startup company sit down and renegotiate. They either extend the terms of this loan or they decide that the company has defund.
The term sheet also describes Automatic Conversion. The angel investor is basically lending money to the startup, and instead of being repaid in cash, they’re instead they’re going to be repaid in future convertible preferred shares, that a later investor will invest in the company.
For example, as a note-holder, you will receive:
Shares = Money_Invested / (Discount * Share_Price_Next_Series)
Capped Conversion Prices
In a situation where the startup is raising money at a very, very high valuation, the number of shares that the angel receives is very low. A high share price (next round) effectively dilutes the angel investor. So in order to protect the angel investor against this possible dilution, some angel term sheets will impose evaluation cap. A capped conversion price is a maximum pre-money valuation, it guarantees a minimum number of shares.
For example, as a note-holder, you will receive:
MAX( Shares = Money_Invested / (Discount * Share_Price_Next_Series), Shares = Money_Invested / Capped_Price )
For more on Venture Capital and Angel Investors, please refer to the wonderful course here https://www.coursera.org/learn/startup-valuation-methods
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