On this episode of The Full Ratchet Nick covers part 5 of Best Practices for Seed & Angel Investing including:
- Overview of Seed Investing
- Developing an Angel Investor Strategy
- Identifying startups: Deal-flow
- Evaluation & picking startups
- The Team
- The Product
- The Market
- Deal-Structuring & Terms
- The Art of the Deal
- The Mechanics of the Deal
Sound Cloud: http://bit.ly/1GeHtbF
Deal-Structuring & Terms- “The Art of the Deal”
- Equity Percentage
- Market Price / Valuation
- Deal Types
- Valuation now: Priced-Round (Term Sheet)
- Convertible (The Convertible Note or SAFE)
- Rounds- Before, After and In-between
- The Scorecard
- The Close
- Homework & Docs
This is not a zero-sum game… far from it. Those investors that think the startup has to lose for them to win will not last long in this business. There are predatory investors in this business that will take advantage of startups. There are also many startups that will sell stock at terrible terms to friends and family or early angels. The responsibility is on all of us to educate ourselves If one work with startups to create successful financials outcomes for all, the opportunities for the investor in the present situation and subsequent opportunities will be much better. As David S. Rose has stated in his Angel Investing book, “… what is being negotiated isn’t a one-time deal from which both parties walk away without further interaction, but rather a long-term partnership whose goal is to produce value for both parties.”
2. Equity Amount
An entrepreneur will typically give up between 15-30% equity. Rounds that transfer ownership of more than 30% of company are often considered to be adding unnecessary risks and expectations. Recall that Joanne Wilson advised that a startup shouldn’t sell more than 20% of their company in any round. Downstream problems can occur if the startup doesn’t know a great deal about fund-raising gives away 50%+ of the company to investors. This can cause a successful startup to be led by a de-motivated founder b/c they’ve been diluted down to minimal ownership. And, as Leo Polovets has suggested, a startup should not give away too little equity (ie. less than 15%) or they are probably not raising enough capital to meet or exceed the milestones required for the next round of financing. All said, it looks like the ideal range often falls between 15-25% equity for any fundraise round.
A final note here… Albert Wenger of USV has written about the issue of raising too much capital (ie. the post-money trap). Remember that the true valuation of a startup is the pre-money valuation + the amount raised. If too much is raised and the post-money valuation is pushed too high, it can be a very risky situation for the startup and the investors. Albert has provided the anecdote:
“It reminds me a lot of the problem of getting rockets into space. The simplistic answer would seem to be: just add more fuel. The problem though is that fuel too weighs something which now needs to be lifted into space. Your burn rate is pretty much the same thing. Unless you are super disciplined on how you spend the money you will have a higher burn rate the more you raise which makes subsequent funding harder (instead of easier).”
3. Market Price / Valuation
Many investors will say they need “10x in five” meaning they are targeting an ROI of 10x cash return in five or less years. No one’s going to get that with every investment, but it often is the goal and frames the valuation discussion. Recall the episode on valuation with Jeffrey Carter where we reviewed the links to studies on average valuation by stage. Other resources that can help estimate valuation with current data include AngelList. There’s a pretty neat tool there at angel.co/valuations where you can search on timeframe, geography, market, previous company and university of the founder, etc. Unfortunately, I’ve never been able to get it to show results when I click multiple filters, but it’s still very useful. Other excellent sources for valuation data, not previously mentioned, include Crunchbase, CB Insights, Mattermark, Pitchbook, DataFox and the Angel Resource Institutes Halo Report. While the standard seed valuations have historically hovered between $2 and $3M… recall Dave Berkus’ comments that we are currently in a tech bubble and valuations are inflating… especially on the coasts. In Chicago, I am starting to see many more valuations at an order of magnitude above the historical levels.
Other things to remember are that traction, sector activity, pedigree of the entrepreneur, quality of team, etc. are going to increase valuation. There is a reason for averages and outliers.
We’ve discussed before the difference between Pre-money valuation and post-money.
-For simplicity let’s use some easy numbers….
-If you invest $0.5M @ a $1M pre-money valuation, than the post money is $0.5M +$1M =$1.5M
-So, for your $0.5M, you will get 1/3 of the company
-If you invest $0.5M @ a $1M post-money valuation, then you will get 1/2 of the company
While startups sometimes talk about valuation in terms of pre-money, it’s best practice to think of valuations in terms of post-money. If a startup only tells you the pre-money, make sure you know how much, in total, ,they plan to raise and you may even consider capping the raise to insure that appropriate amounts are being transacted.
And while the convertible note or SAFE is a way to punt on valuation, the agreed upon cap is a proxy for valuation. Both Dave Berkus and Bill Payne do not invest in uncapped convertible notes. To date, I have not either because the likelihood of a startup going out of business is much higher than the 20% discount you are going to get on the note. To compensate for that risk a ceiling should be capped on the equity that the seed investor receives at the series A. Historically, median seed valuations have been a little less than half of median Series A valuations. So, either cap your notes or ask for a 50-60% discount, which I’m sure will elicit some strange looks.
A final note here. Ultimately, if the valuation is too high, it’s okay to pass. For that matter if any of the terms are way outside of ones’ comfort zone, there are always other options out there. There are no sure things at the seed round and dumb money does damage to investors and entrepreneurs alike.
4. Deal Types
3 Main investment instruments used for startup investments:
- The priced-round & term sheet: This is a transfer of cash for equity.
- Convertibles: Transfer of $ for an agreement that is intended to become equity in the future. Includes Convertible Notes (debt structure) and SAFEs (non-debt structure)
- And a reminder for those using convertibles and SAFEs… if you are getting a pro-rata right, I would suggest writing up a side-note, even if the pro-rata is cited in the main doc. Remember that a Convertible Note is a debt instrument, while a pro-rata is a right to maintain an equity percentage. One does not have equity upon executing of a convertible, hence a side doc is a smart way to support your pro-rata long after a your note doc converts and is no longer valid.
- Warrants: The last common instrument to touch on is the warrant. This is typically a supplement to the term sheet or Convertible and is rarely the only transaction used to make a startup investment although it may be in some cases. This is a way for the entrepreneurs to acquire more funding through the sale of options that can be converted to equity at a pre-defined valuation. Recall Jason Heltzer’s comments about the vanity terms of a round. There will be instances, where entrepreneurs are unyielding on the valuation. In these instances, other items can help compensate for an inflated price, such as warrants.
We will not do a full recap of all the other financing sources available as we covered the main ones. If you’d like to learn more about the other sources of funding, please reference Episode 18 w/ Dave Berkus.
5. Rounds: Before After and In-between
I wanted to take a moment to discuss rolling, contingent & stacked closes. Some rounds, particularly before a high-profile demo day are going to fill very quickly and the last thing on your mind will be escrow or an extended rolling close. But these are often the minority at the seed or pre-seed stage. The vast majority of rounds do not close in less than a month. And if a fundraise does not include escrow, what’s the benefit for an investor to be the first check in? If there is early capital risk on top of business risk, think about how incentives should be setup to encourage early capital, or plan for an escrow.
Is there a silver-bullet for evaluating startups? No. But can each investor codify their own process? Absolutely. If you’re like me, there’s way too many good ideas coming your way to keep everything in perspective. Personally, I have a list of 10 items in my pre-filter that helps me make decisions on 90% of deal-flow very quickly. I have another longer list of items in my deeper evaluation set, that helps me focus in on the startups that are very strong and warrant a more significant time commitment. Does a startup need to fulfill every element in my criteria? No. And it’ll be next to impossible to find a startup that is perfect on everything. But those that pass 8 out of 10 are clearly a better fit for me than those that pass 3 out of 10. Now, we don’t all need a long, involved, meticulous process. These items could be as simple as, the idea is disrupting a huge market. The founding team has a wow factor that gets you excited. The makeup of the team includes a builder and a seller. One founder has domain expertise in the target market. The founding team is co-located. Their is some demonstrated traction within the target market. etc. These items don’t have to be high-science, they just need to be consistent with your philosophy on what elements allow for exceptional outcomes and reduce likelihood of startup failure.
7. The Close
As Alec Baldwin so eloquently put it in the film Glengarry Glen Ross, coffee is for closers. While it’s theme is much more cynical, the message rings true. You have to work toward a close. If one treats this like a hobby and does not have a professional lead, it’s probably going to be a big waste of the investor’s and entrepreneur’s time. If we understand what’s important to us and listen to what’s important for the entrepreneur, the negotiation can be much quicker and easier than one would expect.
When I consider the deals that have gone well, here are the critical elements:
- Speed: Many of the good deals move fast. Recall that Leo Polovets advised startups to plan for a 2 month raise. If they can not raise in that time, then either the business or the economics need altering. And investors should be able to gather the necessary information to make a decision and move on it before others do.
- Disposition: It goes without saying that a collaborative, win-win approach will trump an adversarial one any day. Jason Heltzer cited the common pitfalls of negotiation including …those that talk more than they listen, those that are position-oriented instead of principle-oriented, and those that push from a position of power instead of articulating the value.
- Decision-makers: I have made this mistake more than once now. Negotiating with one founder who does not have the ultimate decision authority. And it’s caused pro-tracted, relay negotiations where terms continue to fluctuate long after they are agreed upon. In short, if all decision-makers are not present, everyone is wasting their time.
- Homework & Docs: As much as possible, do your best to have the term sheet and/or purchase agreements ready to go. You may have to adjust items within the docs, like the valuation amount, the liquidation preference, etc… but if you have an understanding of the docs and have them ready, these changes can be made on the fly. I have had numerous negotiations, where agreements were made, only to be revisited and re-worded for many weeks, where nothing material was changed. And, in addition to having my docs ready to go, I have even brought a check to meetings. Something as little as a $50k check can really motivate the parties to get the terms right and move forward. If a deal can be made, get it done.
- In-person: Related to the last item, it’s critical to be in-person w/ the entrepreneur to understand their position and discuss the major negotiation items. It’s another area that will delay and kill deals. Agreements over the phone or over email are less efficient, less clear and ultimately not binding.
Finally, to round out this point on closing, if decision-making is difficult for you, it may be best to partner or co-invest with those that have a process and can move forward decisively. One will never have perfect or exhaustive information. Learn what you need, close the deal and enjoy your coffee.
That’ll wrap up this installment of best practices. I’ll be finishing up the last section and releasing it soon so that the full series on best practices is complete.
I wanted to say a quick thank you to you all for listening and for all the great comments lately, namely on Twitter. I’ve seen a number of audience members tweet about the show, their favorite episodes, quotes from guests and even some who are capturing their own key takeaways from the episodes in a tweet. Special thanks to Ryan Hatch who sent out a number of thoughtful, well-framed comments on a few of the episodes. And to all of you who aren’t big Twitter users, it’s always great to read a new review in iTunes. It’s a big help to me and if you’ve taken the time to listen to a full episode, I suspect you appreciate how much time it takes me to create it… and it would be great if you’d do me the favor of writing a review in iTunes.
Okay, that’s it for this episode… remember to over-prepare, choose carefully and invest confidently.