18. Fundraise Types, Sources & Structures (Dave Berkus)

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Dave Berkus joins Nick on The Full Ratchet to talk fundraise types & structures including:

  • 3c9ac79Can you start us off with a history of funding structures in venture capital and how they have evolved to where we are at today?
  • Can you highlight the major categories of financing and when they are most often used?
  • For each major type of financing, can you walk us through examples of specific deal structures within each?
  • For investors and startups that are structuring their financing vehicle… what questions or decision-process should they walk-through to determine the most appropriate structure?
  • When you come across a very promising startup where the fundraise structure is not appropriate for the business, how do you proceed?
  • What advice do you have for angel investors or startups structuring a fundraise?

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Key Takeaways:

1- The Capital Gains Clock

One challenge of the non-equity based financing, including convertible debt is that you can not start your capital gains clock.  This is important b/c many investors get a discount on capital gains tax paid for equity investments that are held for five years.  In some cases both at the state and federal level.  As Dave mentioned, this can be a significant reduction that has fluctuated between 50% and 100% over the years with various administrations in office.  Probably goes without saying that the positive exits that have this tax exclusion may have a much healthier IRR or Internal Rate of Return.
2- Frothy Valuations
We’ve briefly touched on this in the past, but while convertibles are typically not preferred by investors, in the case of a tech bubble, they could be the better structure… Certainly for investors and maybe even for startups.  The reason for this that we are seeing very frothy, inflated valuations right now, Sept 2014, especially on the coasts.  When the tech bubble bursts, valuations will come down and make it difficult for startups to raise with high valuations from a previous raise.  This is where the full-ratchet + a discount, comes into play for investors with a convertible.  While the company may have done well, capital markets could retract, causing valuations to correct-down.  IF that happens then the convertible note investors will get their discount on the post-bubble valuation.  Of course the big variable here is time and no one can predict when the bubble will burst and if their note term will convert before or after this event.
3- Warrants
Recall that a warrant is an option to purchase a certain number of shares at a pre-determined price.  As Dave articulated, these are typically necessary when an investor and an entrepreneur are too far apart on valuation, so they use warrants as a negotiating tool.  They are also used for non-equity structured deals to provide some upside opportunity.  And finally, you’ll find entrepreneurs using warrants as a way to try and generate more fundraise dollars in the future, but as Dave mentioned these will be dilutive to the cap table.  In a way a pro-rata right, assuming no drag-along, is an option, similar to a warrant, although it doesn’t often cost anything and there will be no discount on the price at the future fundraise.  But, they do provide the investor the option to maintain their equity %.



Tip of the Week:   What’s your fundraise source & structure?