TODAY’S EARLY-STAGE INVESTMENT VEHICLES
June 7, 2017
Michael Horten
Hello.
THE CHANGING Angel
Financing LANDSCAPE
Emulate the VC community by using Series A
preferred stock
Using NVCA open source documents
Traditional Approach to
Angel Financing
Problems with
Traditional Approach
The traditional approach is too costly and
cumbersome for the smaller angel rounds
• Series SEED
• Series AA
Today`s types of Angel
Financings
• Promissory note
• KISS (Keep it Simple Security) promissory note
• SAFE (Simple Agreement for Future Equity) note
• KISS equity note
Common stock
Un-priced securities
Convertible equity note
Traditional convertible preferred stock
Stripped-down convertible preferred stock
Convertible promissory note
Priced securities
Which Financing Vehicle
Should You Use
Blue-chip legal services to entrepreneurial growth companies
Big firm experience without the marble and mahogany
Fixed fees
Angel investor for over 20 years
Handled over 100 early-stage financings in the last 2 years
Member Angel Capital Association and ATA
Michael Horten
COMMON STOCK
FF&F
CONVERTIBLE
PREFERRED STOCK
How many shares should
the investor receive?
25%
75%
The valuation determines
the investor’s percentage
ownership interest
Pre-Money Valuation
Place a Realistic Value
on your Company
Entrepreneur valuation
Investor valuation
Unlike selling your home, it’s
difficult to lower your valuation
How do you determine
Pre-Money Valuation
Methods for valuing
mature companies
generally do not work
Valuation models for
pre-revenue companies
• Venture Capital Method (VCM)
• Discounted Cash Flow (DCF) or Net Present Value (NPV) Model
• Scorecard Method
• Chicago Method
• Cayenne Consulting Calculator
• Dave Berkus Valuation Model
• Bill Payne’s Model
• Risk Factor Submission Model
• Replacement or “All-In” Method
• Rule of Thirds
• Ratios and Multiples
• Set Ceilings
Venture capital method (VCM)
Assumptions for this Analysis
Venture capital method (VCM)
• Angels should expect an IRR of 25%
• Investment will last for 5 years
• An angel needs a portfolio of at least 10 companies
• 25% IRR in five years = 3X ROI
• Nine deals produce 33% of yield
• 33% of yield = return of capital for portfolio
• One deal must produce 2X ROI on total capital or 20X ROI (82% IRR) on
money invested in the deal
VCM example
Investment $1 million
Exit year 5th year
Projected revenues in 5th year $40 million
Projected net profit in 5th year $4 million
P/E (public companies in sector) 15X
Terminal value (after 5 years) $60 million
Required IRR 82%
Required ROI $20 million
% ownership of company required 33%
Post-money valuation $3 million
Pre-money valuation $2 million
Pre-Revenue Median Value
Scorecard method
• Determine an appropriate median value for pre-revenue
companies in your region
• Assign % weighting for each critical issue
• Calculate the weighted average of issues
• Multiply median value by weighted average
• Determine an appropriate median value for pre-revenue companies
in your region
o National trends in pre-money valuation generally range from $0.5
million to well over 3 million
o National median pre-money valuation is $2.5 million
• Collect valuation data for pre-revenue companies in your region for
the preceding years and calculate the median value
• Track regional and national trends in valuation
Scorecard method
How it works
• Assume that the median local pre-money valuation of pre-
revenue companies is $2,300,000
Scorecard method
Pre-Revenue Median Value
Scorecard method
Calculate Weighted Average Multiple
Issue Analysis Weight Factor Input
Management On board, except sales VP 30% 120% 0.360
Opportunity Enormous 25% 130% 0.325
Product Disruptive, prototype OK 15% 130% 0.195
Sales No channels, all foreign 10% 50% 0.050
Competition No big players, messy 10% 110% 0.110
Other Need partners, selling costs 10% 80% 0.080
Weighted average multiple = 1.12
Scorecard method
Calculate Pre-Money Valuation
Median Value $2,300,000
Weighted Multiple X 1.12
Pre-money Valuation $2,576,000
Agreed Valuation
Example
Company seeks $1M in equity capital
Founders own 2M shares of common
stock
Founders network and pitch to investors
They receive an offer for $1 million at a $2 millionpre-money valuation
The investor will send them a term sheet
Example
Founders are happy with the
$2M pre-money valuation
Founder’s expectations
Pre-Money Cap Table
Common Pre-Money Total %
Founders 2,000,000 2,000,000 100%
Options Granted 0 0%
Options Available 0 0%
Investor 0 0%
Total 2,000,000 2,000,000 100%
Start-Up Capitalization
Founder’s projected post-money
cap table
Pro Forma Cap Table
Series A Series A Post-Money
Common
Pre-Money
Total % Investment Preferred Total %
Founders 2,000,000 2,000,000 100% 2,000,000 66.7%
Options Granted 0 0% - 0.0%
Options Available 0 0% - 0.0%
Investor 0 0% $1,000,000 1,000,000 1,000,000 33.3%
Total 2,000,000 2,000,000 100% $1,000,000 1,000,000 3,000,000 100.0%
Pre-Money Valuation $2,000,000
Price / Share $1
Total $ Invested $1,000,000
Post-Money
Valuation $3,000,000
Start-Up Capitalization Series A Funding
Post Celebration Jolt
Purchase Price: $0.70 (not $1.00)
Founders Own: 46.7% (not 66.7%)
The term sheet pre-money valuation is different from the true pre-money valuation
First culprit: The number of shares received by the investor is computed on a “fully diluted basis”
Second culprit: The investor is receiving preferred stock
Incentive Pool
A pool of unissued shares reserved for
issuance to officers, directors and key
employees (usually as options)
New pre-money cap table
Pro Forma Cap Table
Common Pre-Money Total % New Options Pre-Money Total %
Founders 2,000,000 2,000,000 100% 2,000,000 70.1%
Options Granted 0 0% 0 0.0%
Options Available 0 0% 855,000 855,000 29.9%
Investor 0 0% 0 0.0%
Total 2,000,000 2,000,000 100% 855,000 2,855,000 100.0%
New Option PoolStart-Up Capitalization
New post-money cap table
True Pre-money valuation: $1,750,547
• 2,000,000 common stock held by founders
• 855,000 (20% post financing) common stock incentive pool
• Dilutes founders to 70%
Impact of pre-money
incentive pool
Pre-money cap table
• 2,000,000 common stock held by founders (58.35%)
• 855,000 common stock incentive pool
• 1,427,500 preferred stock held by investors
Post-money cap table
2nd Post Celebration Jolt
The investor is being issued
participating preferred stock
Common stock
Equity financing securities
Convertible preferred stock
• Non-participating
• Participating
Participating vs.
non-participating preferred stock
Investor invests $1M for a 1/3rd interest in the company and
the company sells its business for $2M
Investor gets:
CommonNon-Participating
PreferredParticipating
Preferred
$666,667
(1/3rd of $2M)$1,000,000
(return of investment)
$1,333,333
($1M +1/3rd of $1M)
Participating vs.
non-participating preferred stock
Investor invests $1M for a 1/3rd interest in the company and
the company sells its business for $10M
Investor gets:
CommonNon-Participating
PreferredParticipating
Preferred
$3,333,333
(1/3rd of $10M)
$3,333,333
(1/3rd of $10M)
$4,00,000
($1M +1/3rd of $9M)
Pre-money cap table
Impact of participating
preferred stock
• 2,000,000 common stock held by founders
• 855,000 common stock incentive pool
• 1,427,500 preferred stock held by investor
Company is sold for $3M
• Investors receive $1,832,969 ($1,000,000 + 41.65% of $2,000,000)
• Founders receive $1,167,032
Preferred Stock Valuation Squeezer
Preferred Dividends
The holders of preferred stock receive
dividends before dividends are paid to the
holders of common stock
Cumulative
Non-Cumulative
Participating
Non-Participating
Types of preferred dividends
Governance,
Management & Control
Investors invest in the
management team
Voting rights
Board seat or observer rights
Approval rights
Right to force a sale of the company
Management & Control
Investor Protection
Price anti-dilution
protection
• Time limitation
• Full ratchet
• Weighted average
Price anti-dilution issues
Pre-money cap table
“Full Ratchet” Anti-Dilution
Protection Example
• 2,000,000 common stock
• 1,000,000 preferred stock convertible into common at $1 a share (the
preferred stock issue price) with full ratchet anti-dilution protection
Company raises additional equity capital• Company issues 50,000 shares of common stock at $0.50 a share
because it desperately needs cash
• Conversion price drops to $0.50 a share
Founder dilution
• Founder goes from 66.7% of the equity to 50% and all the company
has gained is $25,000
Pro-rata rights
20%
Right of first refusal
and co-sale
First line of Defense: ROFR
Second line of Defense: Co-sale
Information rights
Proprietary information and use limitation covenants
Ownership of work product & IP
Non-compete covenant
Non-solicitation covenant
Restrictive covenants
agreements
Key holder stock
claw-back
Exit / Liquidity
Redemption rights
Registration rights
Exit / Liquidity
STRIPPED-DOWN
CONVERTIBLE PREFERRED
STOCK
CONVERTIBLE
PROMISSOY NOTES
Company has signed an equity round
term sheet but needs pre-closing
funding (bridge financing)
BRIDGE NOTES
Mandatory conversion into the next equity
round at a 10-20% discount
Bridge Notes
• The investment is in effect disguised equity
Term• The maturity is typically set to allow enough time for the next
equity round to close
Interest rate• Interest rate is typically similar to the preferred dividend in an
equity round
Payment• Balloon payment at maturity
Has gained great popularity
Pier Notes
Usage expanded beyond bridge financing
(the equity round is not yet under way)
Pier note advantages
• Appealing to unsophisticated angels who may not know what
protections and terms to request
• Kicks the “valuation can” down the road
• Faster and cheaper
• Minimal impact on the fair market value of the company’s common
stock, making the company’s equity incentives more attractive
• Flexibility; can provide greater discount to earlier investors
Pier note drawbacks
• Goes against the traditional ranking philosophy of venture investing
• The interest of the founders and the investors are misaligned
• Neither the Company’s founders nor the investors know what
percentage of the company each may eventually own
• Noteholders must wait for the date of conversion to start the clock
running for long-term capital gain treatment
• Notes are much lighter when it comes to rights and protective
provisions for the investors
• Maturity creates a ticking time bomb for the company
The 20-25% discount is not commensurate
with the risk they take as compared to the
Series A investors
Began looking for new solutions
INVESTORS FELT SHORT
CHANGED
Increasing the discount
Adding warrants for common stock
Adding conversion cap
Solutions
Adding warrants
for common stock
Adding Conversion Cap
Price
Your maximum price
Your price
Problems with
conversion cap
• At what time does the cap apply
• Inflates preferred dividend and liquidation preference (the
“liquidation preference overhang”)
• The noteholders get full ratchet anti-dilution protection
When to apply the
conversion cap
• The conversion cap usually is applied at the time of
conversion
• Makes more sense to apply the conversion cap to the cap
table at the time of the issue of the note
The “liquidation preference
overhang”
• Company has 2,500,000 shares of common stock outstanding
• Company issues notes for $500,000 carrying a $2.5M conversion cap
(i.e., $1per share max conversion price)
• Series A has a $10MM pre-money valuation, resulting in a per share
price for the new money of $4.00
• The Series A has a 1x participating liquidation preference and carries
a 6% cumulative preferred dividend
• The $2.5MM conversion cap means the notes convert at $1.00
• The noteholders receive an effective 24% preferred dividend instead
of 6%
• The noteholders receive a $2M liquidation preference instead of
$500,000 -- a whopping 4X liquidation preference – resulting a $1.5M
“liquidation preference overhang”
Issue “discount shares”
in common stock
• Company has 2,500,000 shares of common stock outstanding
• Company issues notes for $500,000 carrying a $2.5M conversion cap
(i.e., $1per share max conversion price)
• Series A has a $10MM pre-money valuation, resulting in a per share
price for the new money of $4.00
• Instead of issuing the noteholders 500,000 shares of Series A
preferred stock, issue them 125,000 Series A preferred stock and
375,000 shares of common stock
• They will still own 500,000 shares, but their liquidation preference is
equal to their purchase price (125,000 x 4 = $500,000)
Convert into “shadow”
preferred stock
• Company has 2,500,000 shares of common stock outstanding
• Company issues notes for $500,000 carrying a $2.5M conversion cap
(i.e., $1per share max conversion price)
• Series A has a $10MM pre-money valuation, resulting in a per share
price for the new money of $4.00
• Instead of issuing the noteholders 500,000 shares of Series A
preferred stock
• Issue them 500,000 Series A-1 preferred stock as shadow preferred
or sub-series preferred
• The Series A-1 preferred stock is exactly the same as the Series A in
all respects, except for the liquidation preference, which would be $1
per share vs. $4 for the Series A
SAFE NOTES
Equity financing
SAFE Notes
• Converts into a “shadow” preferred stock -- some with discount; some
with a conversion cap
Liquidity event• Investor may chose to receive:
• The investment amount
• Common stock priced at the conversion cap
Dissolution event• Investor receives the investment amount prior to any other equity
holder
“Most Favored Nation” provision
&