Startups and angels: Along the way to success

Golden Angels Announces IRR Results

It’s not very often that angel networks disclose results.  Most of us are ready and willing to discuss our approaches, beliefs or methods, but usually stop well short of providing the proof of our assertions.  

Today, Golden Angels is publishing its internal rate of return calculation (IRR) that has been reviewed by independent accountants.  From 2003 through 2016 year to date, it’s 16.87% on realized investments net of all costs to investors.

That’s 4 successful exits, 5 that returned less than the total investment, and 4 that went to zero.

In 2016, we’ve invested $4MM in 10 companies, averaging $400,000 per investment.  Benchmark reports of venture investing suggest this is in the upper quartile of returns in this category of alternative investments. In total there are 18 companies we have invested in and have not exited.

There’s a lot we’ve learned achieving this result over the last decade, and, thanks to the recently published study by MIT and Harvard Business School on angel investing, we’ve got some benchmark practices to compare to.

This recent study by Josh Lerner of the Harvard Business School and Antoinette Schoar of MIT demonstrates that well structured angel groups not only pick the right companies to invest in, but they also improve the results of those companies disproportionately.

In the case of Golden Angels, its practices since 2003 have evolved to mirror Lerner and Schoar’s findings.  

 

Angel groups have significant advantages over individual angels.  Pooling funds allows angels to share diligence responsibilities.  Acting as a group projects more visibility to entrepreneurs.  And shared expertise makes for better decision making.

• It’s our shared expertise in decision making that has made a significant difference to us.  We bring breadth of industry experience including significant expertise in healthcare; educational technology; finance, tax, accounting and law; software development; data analytics and its application; manufacturing; human resources and services; banking; corporate communications; executive coaching; sales; publishing and performance arts; real estate; water technology; and investment management.

Our 135 members come from corporate backgrounds, entrepreneurial ventures and professional practices.  We expect their involvement on subjects they know and they add invaluable insights.  Their orientation is to provide every entrepreneur with valuable feedback and connections, whether the investment fit is right -- or not.   By building good relationships with every entrepreneur we meet, we think we’ve created a long-term benefit for them and for us.

• When we get to a deal,  we pool our funds and use standard documents that are well accepted and straightforward.  Experience has taught us that complicated provisions with non standard terms invariably create unintended consequences and suboptimal results.  We understand the limited use of non-equity instruments.  We’re pretty good at understanding tax planning and employ it to assist entrepreneurs and investors.   

Firms selected by angel groups get a tremendous boost.  Again, Lerner and Schoar:  Companies selected for funding by angel groups were 20-25% more likely to survive for four years.  In addition these companies were 16-19% more likely to have grown to 75+ employees and achieved a successful exit.  

• In the case of Golden Angels, these successful exits have all been from companies with strong entrepreneurial leaders and significant Golden Angels involvement as board members, connectors and advisors.  

• First and most important is the entrepreneur. This is who we are partnering with.  Our investment means we believe in the entrepreneur and the team for the long haul.  We’ve been fortunate to participate with several serial entrepreneurs and are on company #2 with three of the entrepreneurs from our successful exits.

• We are not a managed fund.  We believe our pooled expertise provides more benefit to us than a fund with one manager and passive investors.

• When asked by entrepreneurs to serve on boards, we take responsibility as directors very seriously.  Golden Angels requires its directors to attend director seminars that outline the appropriate role for directors and their responsibilities to all of the shareholders of the company, not just the investors.  We have also recruited independent outside directors to fill critical slots where our expertise needs to be supplemented.

• We connect resources to companies from our collective rolodex.  That’s lots of people in many roles.

• We’ve successfully introduced Venture Capital firms to these companies  to provide additional capital and connections.  Because we think we understand the goals of venture capital and its interests, this has consistently worked for the companies and the eventual outcomes.
• We coach carefully always with a view to what’s going to be helpful to the entrepreneur. This often means asking a lot of questions, encouraging exploration and offering connections to others with more knowledge.  We try and earn the respect of entrepreneurs by walking the talk.

• At an exit, we try and provide experience to assist the entrepreneur in getting at least a market deal.

We have, over the years, always been biased away from small investments in lots of companies and toward larger investments in fewer companies.  For whatever reason, this has worked well for us. Whether there is any direct correlation to success or not is a matter of discussion.  

• Of course, several investments made in companies did not succeed because of technology changes or outcomes that did not create a sustainable market.

Some Angel Groups actually outperform venture capital.  While this may be true, depending on how you choose to measure what “venture capital” performance means, Golden Angels believes that venture capital often serves a complementary purpose in entrepreneurial investing.  The ability to understand deal terms and structure, to align investor interests, and to be good partners with venture investors, we believe, best serves the interests of the entrepreneurs and all of the stakeholders.   In fact, we are limited partners in two Silicon Valley Venture Capital firms.  In addition to the investment in these funds, they also share deals and have co-invested in several instances.   

Planning For The Future

In response to many requests, we’ve created a program, Golden Angels Advisors, to build a community of early to mid career professionals with an interest in startups and investing that complement and extend the expertise of the network.

This group provides an opportunity for the next generation of investors and advisors to get inside the process and meet other experienced investors and entrepreneurs.  

Members participate in startup company reviews and applications, as well as ongoing involvement.  They’re scouts for good opportunities for both the network and entrepreneurs.

We’re a member owned organization with a board that sets the direction of the organization.  Between the member expertise and board structure, Golden Angels is ready for the next generation of investors and entrepreneurs.

Tim Keane, Director of Golden Angels in Milwaukee, WI was the founder of RTMS, Inc., a retail data analytics company.  Contact him at [email protected]



How should I finance my new venture?

It’s a deceptively simple question:  what is the optimal way to finance a new startup?

And the answer is also devilishly simple: It depends.

Align Everyone’s Interests

This seems like an easy topic – debt where there is appropriate cash flow, equity when there isn’t.  But details in each category vary dramatically.

The overarching idea, of course, is to reduce the cost of capital while maintaining appropriate flexibility for the venture. 

And, while debt is less costly than equity, it can bankrupt a company more quickly than more expensive equity might.

Business success is the ultimate goal. But, what constitutes success for the parties involved – investors, entrepreneurs, employees, and customers – can vary dramatically. Misaligned interests that lead to poor financing choices are often very problematic for first time entrepreneurs in young companies.  And – they can be avoided if both parties – investors and entrepreneurs – are knowledgeable and well-informed about each others’ goals and interests.

Can you bootstrap your way to positive cash flow?

When will the company have positive cash flow?  If the answer is relatively soon, then bootstrapping is a very serious consideration.  Even if it isn’t soon, early bootstrapping can reduce risk and increase chances for success, resulting in more aligned interests for entrepreneurs and investors.

 I’ve written a lot about that topic (http://www.timkeane.org/.services/blog/6a00d834560a4c69e200d83420a4fc53ef/search?filter.q=bootstrap)

 and won’t repeat it all here.

But, this should lead to a thorough, well-planned review of bootstrapping alternatives, since bootstrapping can reduce cash requirements in the pre-cash flow phase.

One common reaction to that statement, though, is the need to accelerate the business, often for competitive reasons in the marketplace. 

However, this need for acceleration necessarily occurs only after thorough, cheap and fast initial testing has been performed – and financed – by the entrepreneur to eliminate or reduce the opportunity for failure based on a faulty hypothesis.

In other words, the need for acceleration isn’t in conflict with bootstrapping – it is step two.  Sometimes, the bonus in bootstrapping is that the venture finds it doesn’t need acceleration financing.  See Greg Gianforte’s story (http://www.timkeane.org/2009/04/bootstrap-your-venture.html)

So, if time to cash flow is well understood, and estimates have been as thoroughly supported by testing as possible, then we consider two broad choices. 

If cash flow is far in the future and not guaranteed, (but early testing has proven we have a viable opportunity) then the entrepreneur probably is not going to have the wherewithal to support a current debt payment[1] structure.  Some form of patient capital will be required.  (Do not mistake the meaning of “patient” capital.  Here it only means that no debt service is required in the near term, or perhaps at all, but an agreed method for repayment will almost certainly be involved in the investment agreements.)

If, on the other hand, there is some near term prospect of cash flow (say within six months or a year) but no ability to repay in the meantime, then the entrepreneur may try and find a way to finance his “pre-revenue period” using friends and family money that accepts a somewhat lower payment in recognition of a relationship beyond just investing.[2] 

Aligning interests in structure: cost and risk

Risk in a given company varies by investor

It’s axiomatic that in a perfectly priced market, a specific level of investor risk in any business should price identically across all companies.  Things don’t work that way in the real world, of course.  One investor who has market knowledge and/or the ability to help affect the outcome may either accept a somewhat lower price since he perceives his risk to be lower, or may take advantage of comparables to obtain a higher price and make a higher return based on his added value.

What are the reasons to choose one financing structure over another?

Example one: Sustainable net operating income with some growth in a stable market. 

John has had ten years of successful experience in cabinet-making and has established a loyal following in his hometown of 750,000 people.  He sells entirely locally and bids his own work and often provides design assistance for cabinets purchased by homebuilders.  His entire income is based on his personal output and he’d like to hire several woodworkers, expand his sales to existing customers, and generate a profit in addition to his contributed labor.  He needs $250,000 of expansion capital.

First question: What are John’s plans to repay this money?  This is a critical alignment of interest question.  If he would like to pay it back out of future cash flow that leads to one set of options; if he would like to sell the business to a competitor within a fixed period of time that may be[3] another set of options.

Second question: Does John have the cash flow to support debt payments?  If he can support partial payments, perhaps some sort of accelerating payment plan might work.

Third question:  Based on the answers to questions one and two, who are the likely lenders/investors?

Possibilities:

1.  If plenty of cash flow regardless of plan for sale/retention of business:

• Senior bank debt based on cash flow coverage and new assets.  Appropriate covenants. Maybe Small Business Administration guaranteed loan.  Least expensive alternative but also least flexible.

2.   If not enough cash flow but with the desire to retain the business --

• Insider junior debt with annual or quarterly payments beginning at the appropriate time - year or so? -  based on available free cash flow up to some sort of limit – i.e., 2x in three years – then a percentage of the cash thereafter, as in 3% of revenue – up to a limit and then a fixed price buyout.  This would imply a recap.  More expensive than #1 but more flexible.

3.  If even less cash flow but with the desire to retain the business:

• Friends and family money on junior debt terms.  About the same cost as #2 but more flexible if repayment terms slip a bit.

4.  Cash flow levels inadequate as in #2 and #3 but desire to sell the business:

• Junior debt with a variable repayment schedule based on available cash (i.e., 85% of all available cash goes to debtholders until they get 2x back, then some percentage of the business proceeds go to them at sale of business within a fixed period of time, (i.e., five years.)

Example two:  Explosive market share growth and revenue in an expanding market with acquisitive players available.

Sarah is a scientist at a national research university focused on water quality.  She has developed a water additive that purifies brown water making it suitable for drinking.  Substantial market testing has proven its scalability in use and early manufacturing tests by a major chemical manufacturer indicate it may be economically feasible from a manufacturing cost point of view.  The marketplace of buyers seems to be expanding worldwide.  The company is pre-revenue and Sarah’s intention is to sell the company within three years.

• This is an equity example, of course.  Depending upon Sarah’s ability to prove the assertions she’s made about scalability and early testing, and convince investors she or her team can deliver, she should be able to get favorable pricing and terms with all of the repayment happening at the sale of the company.
• If Sarah wanted to keep and run the company, she may be able to structure some sort of junior-debt like cash flow repayment as previously discussed.  In most cases sophisticated investors will want a larger guaranteed multiple for this kind of business.
• If in addition to keeping the company Sarah needed less than $200,000 or so, she can probably doe a more favorable terms friends and family financing.

Example three: High growth in a stable market.

John the cabinet maker has decided to expand to several cities within several hundred miles of his location, to develop several standard lines of custom products, and to seek growth at annual double digit rates.  He feels now is an excellent time based on his local experience and believes the high end of the homebuilding and remodeling market is seeking new solutions.

• This is also now an equity situation.  It’s likely the cash required won’t be repayable for several years and the risks of failure are relatively higher.  John’s former track record helps mitigate that risk but an investor perceives this as a new stretch.  Depending upon whether he chooses to retain or sell the business in the future, the same sorts of scenarios as previously discussed – probably apply.

Example four: substantial milestone-based progress that does not generate cash but will attract an acquirer or facilitate an IPO.

Angelina is an orthopedic surgeon with a specialty in hip replacement surgery.  She has designed several new devices that promise to allow arthroscopic hip replacement surgery.  Given the approval cycle required for a radical new innovation, she knows the time to revenue will be long and difficult but feels this is breakthrough technology. She needs $4MM to get the product through the normal approval cycle. 

• Aside from the attractiveness of a particular industry at a given time, this is an equity investment repaid at the sale of the company.  If there are substantial milestones that prove value as Sarah goes along she can consider raising a smaller amount at each milestone thereby increasing the value to her at each stage. She does this by reducing perceived risk for each stage of investment and finding investors at each stage with appropriately matched appetites.

None of this is exhaustive.  And I’ve avoided beginning to describe specific terms in this note.  Specific terms are an additional way that investor and entrepreneur interests get aligned in the investment process.  In addition there are several new intersting methods - royalties is one - that help in term structuring.

Note: Thanks to Bill Stone of Townbank in Delafield, WI for his comments and work in helping me prepare this note.

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[1] From a lender’s point of view, of course, the conditions under which the lender accepts a fixed interest rate in return for the promise of regular payments is based on considerations beyond the ability to repay.

[2] One of the huge mistakes entrepreneurs make at this stage is accepting friends and family money and assigning huge valuations to the company to reduce the size of future payments required.  This practice will do that, but, if other investment is ever required, the inevitability of a reduced valuation leading to a lot of heartburn is highly likely.  Always better to do this with some sort of convertible debt instrument.

 

[3] I say “may be” because if the business will support senior debt then that is less expensive and allows more flexibility whether John intends to keep the business or sell it. 

 

A philosophy of valuations and term-sheets

Several months ago, I'd posted an article about term-sheets.  Based on a lot of feedback, I've added some new comments about put rights and made more explicit my philosophy about working together with entrepreneurs to achieve mutually satisfactory results.  Here's a link to A Philosophy of Valuation and Valuation example the accompanying spreadsheet. 

The overarching theme is that if both groups (not sides!) the entrepreneur and the investor, can get aligned on terms that hold each side responsible for what it says it will do, and this process makes these promises explicit, the relationship begins on a solid footing.  Beware the potential business partner, whether entrepreneur or investor, who says something like "This isn't really important, but our (lawyers, mothers-in-law, or other interested parties) insisted on it." Seems to me it's a poor way to build a relationship.

Bottom Up Market Sizing

A lot has been written about this.  (Google: Bottom up market sizing).  For an example written by a VC, see A Startups Guide to Market Sizing from DocStoc. (OVP Venture Partners)

My own take on this is that a business plan with a bottom up forecast demonstrates an understanding of the potential market that investors love.  It reduces perceived risk and produces assumptions that can be measured and improved. It welcomes feedback from potential customers and experts, reduces the cost and risk of the startup and can potentially drive success quickly.  It can also drive fast cheap failure which is a great second alternative.

(The fast failure allows us to move on to Plan B rapidly and with a lot of learning from the structure, controlled and tested failure in Plan A). 

A bottom up market model goes something like this.

1.  Our product/service will save (audience) a lot of money.  In fact, we estimate $X per year based on current spending for this product/service.  [So this is the general premise for who in particular the early buyers will be and why.]

2.  An average customer will spend $X per year with us because they spend three times that now.  Our solution requires no capital expenditures nor any method change on the customer's part.  It's low risk for them.

3.  Using (example) sales as a proxy (such as copier sales) we think that our average sales rep can make 10 cold calls per day and develop 3 solid leads per week.  Of those, the rep can close 2 per month. 

4.  At a 2 per month closing rate per rep, that's $Z on an annual basis.  Here's a table of the cash flow based on this:  (TABLE)

5.  Using our experience in (market) as an analog, we estimate that customers will stay with our product for 3.5 years.  (Here's a factoid from (example) industry suggesting an average lifespan of 5 years, so we think this number is defensible. 

6.  If we time these cash flows correctly, we can hire 5 new reps per month.  Assuming 90 days to train them and a maximum of 15 reps, here's a table of what we will look like at a full up run rate.

7. Notice that at about 36 months our hit rate drops off and our development $ go back up.  By this time we anticipate competitive pressure and we will use leads acquired per day and time from conversions to sales as an early warning metric.

8.  After we see market #1 begin to slow, we will use the following method to move to market #2 (Etc)

Makes your heart smile, doesn't it?

Here's the assumption list:

1.  Customer premise - who will buy and why.  (Test with a Five Forces Analysis?  Talk directly to potential customers?  Understand who in the organization can make the buying decision?  Is higher up worse or better?  Why?)  What is the competitive environment from the customer's point of view?

2.  Pricing.  How much % of the savings is reasonable?  Are there analogies? What does the customer say?

3.  Rep performance.  At a similar price point in a similar industry, what are the rep comparables?  Do sales rep organizations have this kind of data?  Where can we get it? Let's make sure we aren't premising the best rep performance in the world to date as the base case for our assumption.

4.  Check the math but it's pretty easy.

5.  Again, what is comparable performance?  What is the role of actual or potential competitors? How lucrative is the competitive position vs.us and to whom?

6.  Again, what are the comparables here?  Do recruiters think we can do this?

7.  How do we know this is the right timing and cash reserve for development?  If we can turn on a dime the timing is less important than the cash.  Do we have an ongoing relationship with the customer that can give us very early feedback and product improvement expectations?

8.  Do the same exercise for market #2

Entrepreneurs that can do this build an understandable environment that is friendly to investors and welcomes discussion and feedback from experts.

Term-sheets and Valuations: Thinking about Negotiations

Please see later version of this post on May 16, 2010

Entrepreneurs are often not experts in the area of term-sheet negotiations and all of the surrounding issues.  Investors sometimes “present” the terms they’d like and expect the entrepreneurs to react.  This frequently leads to lots of expense just to get to an understanding of what’s being asked for. A lack of understanding can lead to expensive and difficult negotiations when more clarity earlier in the process may have produced a more efficient and less difficult result.

Now that I’m more often on the other side of the term-sheet, I’ve tried to present term-sheets to entrepreneurs accompanied by a philosophical explanation of what I’m proposing, and why. 

I’ve sat down with entrepreneurs and a copy of a term sheet guide I like [“Term Sheets & Valuations - A Line by Line Look at the Intricacies of Venture Capital Term Sheets & Valuations” by Alex Wilmerding, Aspatore Press.] and walked through each proposed term and why it is or isn’t important.  When accompanied by an “output” spreadsheet that shows the results and implications of terms, this often makes the process work pretty well.

This essay is an attempt to replicate some of that thinking. 

(Here's a copy of the accompanying spreadsheet.)

The Valuation Question

When companies seeking their first round of serious funding are good enough to receive a term-sheet from an investor, the first issue that always arises is valuation.

Good investors use the valuation discussions to gauge the business savvy of the management team and to understand their ability to appreciate and deal with economic market forces that set values.  Most often, investors who are interested in a company raise this issue first to measure the company’s response to a market value offer.

The investors and the entrepreneurs are – or should be – aware that the price of the company’s equity is set by the market – in simplest terms, what an informed buyer is willing to pay.  As a starting point, these become market comparable discussions based on other similar transactions within a recent timeframe and similar business.

Let’s look at how the investor arrives at a value from a philosophical point of view.

Most often, investors have a return target in mind to help them gauge opportunities.  For individual angels and others investing their own money, this may be more fluid than for someone with responsibility for a managed fund. For angel groups, the distinction between groups and VCs on this issue is dwindling, especially as angel groups do bigger rounds of financing.

I’ve attached a spreadsheet to this article to illustrate the issues in numbers.  You can vary both valuation and term-sheet assumptions (in the gray boxes) to assess the impact on the values of the business.  Note that this applies only to earl stage Series A-type equity financings and assumes no cash dividends are paid to investors. It also assumes the entire value of the investment is captured for investors at a sale of the company in the time specified in the term-sheet.

Let’s start at the end.  On the last line on page two of the workbook, you see the resulting returns to the entrepreneur with a variety of terms and valuations and assumptions.  (Originally the sheet showed that selling at $118MM yields a return to the entrepreneur of $73MM).

Now let’s go back to the beginning and begin to understand how one might come to this result.

It starts with the return the investor expects, not normally with what the entrepreneur thinks the company is “worth.”  (Both of these points of view will be tempered by market comparables, i.e., what other willing buyers might pay, but more on that in a moment.)

If you look at the spreadsheet, you will see that the “Required Rate of Return” is expressed as an IRR.  Some people will talk about this as a “multiple,” i.e., “I expect ten times my investment back.”  I find this to be imprecise because it doesn’t encapsulate the element of time.  Internal Rates of Return naturally compound, so a 50% IRR is 7.59 times at 5 years and 11.39 times at six years.  (If you plug in an IRR of 58.5% you’ll arrive at a multiple of 10 for a five year period.)

Let’s work i with a five-year horizon.  That is, the investor assumption is that the company will be sold in 5 years.

The investors believe they have market opportunities that can meet or exceed their desired IRR of 50% p.a.  So, on a $2MM investment, and a five year horizon, they are expecting a minimum return of $15.2MM. (7.59 times the investment.)

Next, they carefully consider the range of multiples being used today to value companies being acquired or doing IPOs in the market that the business is in. 

As an example, I have used an EBIT multiple[1] here of 7.65[2] An EBIT multiple, multiplied by the fifth year EBIT projection, results in an estimate of what the company might sell for in the future given market conditions as they are today. In this example, it’s 7.65 x $15.504MM equals $118.605MM.

Now turn to the company performance projections.  Five-year projections, of course, are never accurate.  And if they are built from the top down, they’re pretty much useless.[3]  However, if they are built bottom up, they demonstrate and make explicit a range of business model assumptions the entrepreneur is using to think about his business and its revenue model.

This is why a bottom up approach is more credible.  In a bottom up approach, the forecast is built from actual user projections.  (“If we can close 35% of all opportunities, and can get an opportunity by making x contacts, and there are 300 opportunities per month, then we should be able to sell 100 customers per month if we have the capital ($35 per contact) to cover the market every month.”  This results in a five-year projection of XYZ.)

So, after having built a working business model with a bottom up projection, let’s assume the five year number in this example is $91MM in revenue.  Let’s also assume that the market EBIT is about 16% and the entrepreneur thinks he can do 17%, a not unreasonable expectation.[4]

Now, the investor asks:

·      What happens if 5 year EBIT drops from the $15MM projection to $5MM?

·      What happens if the EBIT %age erodes from 17% to 12%?

·      What happens if the projected growth rate declines more rapidly than projected?

A simple way to model this is to reduce both EBIT projections and the market multiple to project terminal values. [5]

This results in a range of sale prices; in this example from $118.6MM to $21MM.  Note that the “reductions” in this worksheet are only examples for illustrative purposes and are not necessarily normative.

An average of these ranges results in a pre-money valuation of about $4MM.  ($2mm invested divided by an average % ownership required to me the investor’s target of 33%). 

Next, the investor considers the current M&A market conditions.  If similarly situated companies are seeing $3.5MM pre-money valuations, this might become the target valuation. 

Why, you ask, waste all of your time cranking through all of this only to arrive at a value based on comparable transactions?

 First of all, both parties ought to be mindful of M&A market values.  If the entrepreneur has two competing offers, that’s an excellent way to understand what the market will pay.  Market comparables represent the other way. 

Secondly, if the result of the analysis yielded a valuation that only worked at the top of the range, (i.e., the highest value for the company translated to the M&A market comparable and the other scenarios were less) the investor would have to either really understand why or simply walk away.  So M&A market comparables cannot, in the investors mind, be a substitute for doing the work.[6]

After all of this, in this example, all parties agree on a pre-money valuation of $3.5MM and a $2MM investment, giving the investor a 33.2% stake in the company.

The Consideration of Risk

It is logical to ask why a Term Sheet contains all kinds of complexities if everyone has agreed upon the valuation discussed above.  The answer to that, in a word, is risk, - the uncertainty of outcome. Term-sheets for preferred stock offerings are designed to protect the investor in case things don’t go as well as planned.

Investors want to protect their investment in the company by using tools that help assure that, in a less successful situation, they can still achieve some or all of their goals.  If entrepreneurs believe that they can achieve the projected results, they will generally feel comfortable by accepting terms that reduce the investors perception of risk.

Entrepreneurs should be aware of this and negotiate terms accordingly. 

At the financial level, and assuming a harvest of the investment in the company without the need for further financing, two terms stand out as driving economics: the dividend and the liquidation preference. 

First, dividends.  The risk-protection sense of a dividend is that the invested money makes some interest-like return, which makes it more likely the investor will receive some modest amount of earnings in the event the company doesn’t do well. In some cases, dividends are often paid at the discretion of the board and not required by the terms.

Dividends come in two basic flavors – cumulative and non-cumulative.  A cumulative dividend compounds annually.

In the example on the spreadsheet, a cumulative 8% dividend paid every year for five years pays $938,000 while a non-cumulative dividend pays about $800,000.  A cumulative dividend can get to be very expensive and is not often a feature in early stage terms.  Dividends, finally, are normally not paid in cash; they are accrued and paid at the sale of the company, if they have been declared each year by the board.

Most investors aren’t focused on dividends, and I see very few cumulative dividend term-sheets.  So, let’s assume here we have an 8% non-cumulative dividend.  In most cases, the preferred dividend is paid before any dividend is paid to the common. 

In some rare cases, there may also be a participation provision for dividends which pays the preferred a dividend beyond their own equal to any dividend paid to the common.  It is very expensive if you’re the entrepreneur since it doubles the cost to the company of paying dividends to the entrepreneur.  I’ve never seen it in practice.

Second a liquidation preference and a participation.

A liquidation preference means that the investors receive their investment back (plus dividends) prior to a distribution of the proceeds to stockholders.  

The risk-reduction feature here is that the investor receives all of his money back before the entrepreneur receives anything.  Why is this fair?  Say I invest $1MM in a company and receive 40% of the stock.  After some time, it becomes evident the company is never going to be really successful, and a larger player in the market offers to buy the company for $2MM.  With a preference, I get $1MM back and then the remaining proceeds are divided so I would receive $1.4MM out of $2MM.  If the entrepreneur doesn’t feel this kind of result if feasible because he/she will move mountains to achieve outstanding results, they shouldn’t care about this very much.

The investor may also ask for a participation in which the investors receive some additional multiple of their investment prior to distribution of proceeds to stockholders.  So, for instance, the investor in the above example with a 1x participation (a pretty common term these days) would get $2MM – the original investment back and 1x that investment in addition – before the entrepreneur receives anything.  Again, the feature of this is that it reduces investor risk and requires some level of achievement before the entrepreneur is ultimately rewarded.

On page two of the spreadsheet, you can see the result of dividends, liquidation preferences, and participation terms. 

You can see how these affect the harvest proceeds and investor multiples achieved at various levels.

Non-financial terms affecting Risk

Other major term-sheet provisions, in addition to these economic considerations, also focus on reducing investor risk.

These include:

·      Vesting of Founder Stock. Especially in situations where the founders have a large position and are key employees, it is not uncommon for investors to request that they agree to have some portion of their holdings vest on a schedule.  This is perceived by some investors as a way to assure that the founders are in the game for the long run.

·      Conversion provisions allowing preferred to convert to common if they choose or upon the closing of an IPO at a specified price.  This is most commonly used when a conversion confers superior economic benefits on the preferred stockholder.

·      Anti-dilution provisions that reduce the price of the preferred shares (using a variety of formulas) in the event that the company issues new stock at a lower price.  A full ratchet anti-dilution clause is very unfriendly to entrepreneurs; it requires them to make up the entire difference in price from their own holdings.   Weighted average methods tend to spread the pain of dilution over all of the existing stockholders using a variety of “weighted” methods.  Pay to play provisions are often found here which specify that an investor loses their anti dilution rights if they do not buy their pro-rata share of a new offering.

·      Voting rights.  Preferred vote their shares “as if converted” to common so that they exercise substantial voting control over items requiring stockholder votes.

·      Protective provisions. These confer certain veto rights upon the preferred holders that restrict the company’s ability to take action adverse to the preferred without their consent. 

·      Board composition.  Boards of directors have specific duties and voting rights – things like appointing officers of the company, overseeing financial matters, and so forth.  A savvy investor will look for a company that has an orientation to outside, impartial directors.  This typically indicates a management team that understands the value of outside directors as a way of strengthening the company.  Investors will want to have a seat at the table.  Oftentimes, term-sheets specify provisions under which there is not a majority on the board from either founders or investors.  Sometimes investors will also ask for observation rights so that they may bring expertise to the board without necessarily requiring more voting seats than would be practical.

·      Registration and demand rights are provisions that require a company to file for an IPO under certain circumstances.

·      Right of First Refusal confers on the preferred investor the right to purchase either all of or their pro-rata share of future offerings in the event of a future financing.  The right of first refusal for all of a future financing is a very unfriendly provision to entrepreneurs that can make future financing all but impossible.  It essentially gives the investor the right to take all of a future offering, which means that no new investor will consider spending the time to make a deal knowing that the existing investor can walk away with it. 

·      Conditions Precedent mean that the closing of the proposed offering is subject to the conditions specified here.  This can often include due diligence review of technology and intellectual property; execution of employment and invention agreements; agreement on definitive documents, and so forth.

·      Other items often include the creation of an employee stock option pool prior to closing; restrictions on sales of common stock to third parties; key man insurance, and D&O liability insurance provisions, among others.

Seen from a 35,000-foot vantage point, term-sheets and valuations are a method of assessing risk and making mutual promises about assuming various risk components. 

My own practice, as I mentioned at the beginning of this note, in negotiating term-sheets is to build a real version of the attached theoretical spreadsheet, and sit down with the entrepreneur, the spreadsheet and a copy of “Term Sheets & Valuations - A Line by Line Look at the Intricacies of Venture Capital Term Sheets & Valuations” by Alex Wilmerding, Aspatore Press.

Once we can all agree on the principles of risk and its management, I find it relatively easier to discuss the other terms in the term-sheet.  Wilmerding lays out investor-friendly, entrepreneur-friendly, and neutral terms in an easy to understand way.  I personally find the process of negotiating to be much easier to agree if both parties understand the meaning of the terms at the time they talk about them.

 

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[1] Various multiples are used for various reasons.  Pre-bubble Siliicon Valley deals were popularly valued at multiples of revenue.  For the sake of this discussion it’s the method rather than the specific metric that is important.

[2]  (I don’t like EBITDA multiples very much.  The EBIT concept is to remove the impact of interest and tax on company profits since financing the purchase and paying tax are issues the acquirer may be able to influence.  However, unless you assume that equipment used to run the business will last forever and never need to be replaced, depreciation is a real expense.  So I like multiples of EBIT rather than EBITDA.)

 

[3] Top down projections begin with some assumptions about the size of the total served market and then carve out some, usually small, percentage of the market.  “The total market is 2BB so if we get 5%, it’s $100MM!”.  A bottom up approach has the advantage of logic.

[4] It’s beyond the scope of this short essay to get into the issue of the disruptive nature of the business.  However, I assume that the proposed business solves a real problem that people are willing to pay for and that it may be lest costly, more efficient, and IP-protected.

[5] Reducing EBIT projections is largely an internal discussion while the idea of looking at reduced multiples for smaller EBITs may be available in the marketplace, especially to sophisticated investors.

 

[6] Both parties should be aware that overpaying by investors can be a sign of trouble.  If a company has two or three competing offers and one stands out as being 35% higher than the other(s), it is important for the company to really understand why that is.   One possibility is that the investor has an especially informed view of the market and will be able to actively help the company achieve outstanding results.  This should be relatively simple for the entrepreneur to assess based on the references and prior activities of the investor. (Of course, savvy entrepreneurial teams always check those!)  Another possibility is that the investors is inexperienced and is overly reliant on the entrepreneur’s presentation.  An inexperienced investor, when things don’t go perfectly according to plan, can be very unhappy.  And depending upon how much future control they acquired in the term-sheet, it is possible that they can make a future financing exceedingly difficult.  In my experience, overpayment is most often the second case rather than the first.

 

Lower values, higher risks? Or a paradise for investors?

I'm just reading a post from Wisbusiness.com by Joe Kremer of the Wisconsin Angel Network.  (WAN is a trade group of angel organizations in Wisconsin; I'm on their board.)  Joe, a friend and colleague, is writing about the "great deals" in venture valuations that have been created by economic conditions.  

It's inarguable that valuations are lower.  Relatively late stage pharma ventures, just to cite one example, tend to be doing second and third rounds at depressed values.  

It seems to me there are several reasons for this.  

First, there's less money.  Most obvious, I suppose, is that the investor just has less money to invest.  Thanks to portfolio allocation theory, over-weighted classes get reduced and capital reallocated.  This is a big factor for VC funds.  (They tend to be a lagging indicator of the economy since their investors are allocating resources after they're generally earned,(like wages of workers in pension funds) or in many cases, donated (to the foundation-investor.) So the VC funds have less to invest.

Venture company performance also depresses future new investment as investors use what cash they have to keep worthy portfolio companies alive.

Second, start-ups aren't immune from contextual issues, such as being tied to under-performing sectors of the economy, like housing, or participating in capital intensive high change markets like solar panels or wind turbines.  If the venture with these characteristics is worth investing in, the business is going to take longer and cost more to get to its milestone.

Third, angels in particular have had unpleasant experiences with second rounds that are venture led where down-round terms are painful and expensive.  So one conclusion might be to hold back more than one normally might, creating less money for new ventures.

All of that leads to a tighter money supply which tends to drive down prices.

And, of course, valuation in a start-up is a measure of risk, not a value of the company.  It is the way entrepreneurs and investors agree on what the market value of the risk being assumed actually is. If I'm buying a company, I care about the price relative to the benefit I acquire.  If I invest in a start-up I care about the company's ability to produce a return that covers the risk I assume.

So, while I like and respect Joe, I disagree that "it's a bargain paradise out there."  Risks are higher, exits are slower, (and might be lower) and I have less to invest.  So I pick carefully.  If I am the only one doing that, values won't fall, but if a lot of people pick carefully, then values will come down.  

There's Only a Test if you Sign Up for It

Every business needs cash from someplace.

At RTMS it was from customer revenue.  We had $500,000 in annual sales on the day we opened the door in 1989.  We built the business from there and never had professional investors until ten years later.

We never had to take the "Investor Test," jumping through the hoops of plans and projections, diligent market intelligence, close examinations of our team, and the like.  The closest we came was a personally guaranteed loan from a friendly banker for $75,000.  He asked to see "an outline of the business." 

I did that with six slides.  (Meaning little pieces of film mounted in a paper frame.) 

We grew tenfold in a couple of years and were one of the players in the early CRM business.

By the mid 1990s we were golden.

Great, huh?

I'm teaching undergraduates at Marquette University in a class called "Entrepreneurship for non-business majors" for the first time this year. And I love it.  They are bright, eager, engaged and interested.

But they do ask, constantly, "will this be on the test?"  Somehow they are trying to manage their time and try to remember only those "things" that they will be responsible for.

I think the Investor Test is the same thing.  I assumed in 1989 that since I didn't have to take "the test" since I didn't need any money from investors, I didn't need to study for it or know the answers - or even the questions. 

In the words of Beethoven, dumb de dumb dumb.

We were unprepared for the discipline of rapid growth.  For the complexities of managing a team for success.  The only thing we were really great at was hiring real stars and keeping the target squarely on making money for our customers. 

That was enough for a long time.  Eventually quasi-competition overtook us in the heyday of the late 90s.  We were competing with companies preaching change and talking a good game but delivering...nothing.  A couple went public, and crashed.  One CEO had to return his secondary offering cash - in its entirety - or face the SEC.

While we were smart enough to avoid such lunacy, and stay focused on our customer, I think that if we had taken the investor test in 1989 we would have been a different company - and a better one.

We would have failed, no doubt - and again, and again until we got it right (no failures in life just tests that get repeated until you pass).  But the learning would more than have made up for the work, a thousand times.

BTW the company today is doing great and the exit was fine.

But it could've been "start a foundation great" exit rather than just fine - if we had passed the test.

Not every tester knows what they're doing, of course.  Some ask dumb questions; others ask good questions but have the wrong answers.  But there are those who really do know what to ask, and what the right answers are.

A good deal of this process is well documented.  Bill Sahlman at HBS wrote a great article in HBR ten years ago, "How To Write a Great Business Plan," that is right on.  Critical thinking skills, working from hypotheses rather than assumptions, focusing on the workings of the business model rather than the projections, these are all components of "the test."

Even if you are without need for investment, take the test.  See what you learn. 

Finding "Models That Attract Investment"

Every now and then, a lively discussion coalesces from a group of people with interesting experiences.  I think you'll find this report   by Geoff Bastow fits that description.  (It would be great to find a podcast of the panel; alas, we only have print.) 

While not every example is a pathway, nonetheless these experiences, especially from the vantage point of the Midwest investor, really underline the state of the startup experience in middle America.

Understanding Public Markets

The Kauffman Foundation's eVenturing website has put up an interesting series of articles on raising money in public markets.  If you have heard about the London AIM, PIPEs or other alternative public markets, this is a very good series of articles on these topics.

Due diligence: An Entrepreneur's Perspective

Due diligence by an investor, seen from the entrepreneur's point of view, is all good.  Really.  Here is an opportunity to really learn a lot about your business prospects and gain perspective.

Yes, of course, some investors will use this process to see "how much they can get" and be impolite about it.  Fewer than you might think, tho.  And my advice is always "walk."  Money is only money but business ideas - good ones - are harder to come by. 

So think of this as a process of learning - about your venture from a new perspective - about the investor(s) - and about building trust.

The investor is asking if you are trustworthy.  If you have the capability to run this venture.  If you understand when the venture may need new leadership.  (By the way, this issue will always arise.  Talk about it in an open way.  If the entrepreneur agrees to some sort of leadership strategy it'll probably be in the deal terms.)

She also wants to know if you understand the market dynamics for your proposed business, and if you have thought deeply about eventualities and alternatives.  If the entrepreneur is always selling, beyond a certain point this makes investors uncomfortable.  If they have been around, they have all seen deals that had hidden facts, or that were interpreted rosily without providing the investor the benefit of the information.  Our friends in the VC community, of course, will learn an industry fairly well, and will engage experts as well, so as not to miss something.

It is disarming and refreshing when an entrepreneur explains the risks and the plans to reduce or eliminate them, upfront.  The single most important factor for an investor should always be the people and their quality.  The basics - integrity, fiduciary responsibility, and so forth - go without saying.  Next, I suppose, comes a firm grasp of the facts of the market and the competitive environment.  The willingness to be forthcoming and both seek to present the venture and seek investor advice are next. 

Each question, each discussion, each exploration always has two purposes.  One is the content of the question being discussed; the other is the quality of the entrepreneur in their demeanor and response.

At the same time the entrepreneur has the opportunity to see the investor in action.  And to compare the terms and conditions being offered with what the investor has said.  If the entrepreneur cannot get an equal sense of a straightforward and fair relationship developing, ask more questions.  Have more discussions.  If you don't like what you hear, walk.  (Of course, make sure you've gotten some third party you do trust to make sure you understand all of the terms before you decide they are unfair!)

If you do see a straightforward and fair relationship evolving, work as hard as you can to build mutual trust.  And enjoy the success that will follow.