Dave Berkus joins Nick on The Full Ratchet to talk fundraise types & structures including:
- Can 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?
1- The Capital Gains Clock
Tip of the Week: What’s your fundraise source & structure?
Dave: Well, I’m really happy, Nick, to be here and anything I can do to help.
Nick: So Dave, can you walk us through your background and how you got into venture investing?
Dave: It’s an interesting story in that I was so early that I didn’t know how to call it anything. I was an angel investor after selling my second Inc. 500 company in 1993, and I called myself a resources capitalist because there was no term to describe me at the time. Angel really haven’t been evolved into a term for investors at that moment, quite, except perhaps in Broadway. So I wrote a book in 1994 called Better than Money. Resource capitalism concepts.
Dave: And we sold some copies and we got some attention, and I started making investments that got bigger and bigger over time. Inc. magazine noticed in 1996 and called me a super angel, and that was the first time that anybody had ever used that term. So they had a picture of Superman in the article and it was kind of nice. But all these terms began to show up around 1995, 1996. And so I continued investing. In 1998 the Tech Coast Angels was created and I became a very early member of the Tech Coast Angels. I’m a former chairman at this point and now I manage the two funds – the ACE Funds for the Tech Coast Angels. So I’m still involved after these 20 years.
Nick: Wow! And can you touch on your portfolio, sort-of how many investments have you done and how is your portfolio structured at this point?
Dave: Yeah. Well, to say that I have seen a few executive summaries, I guess is an understatement. I count that I have seen about 6,300 executive summaries. I have responded to every single one of them, unlike most VC’s that just let it all drop.
Dave: And I’ve invested in 108 of those. I’ve had 16 positive liquidity events, and about 18 negative liquidity events over time. The 16 positive, four of them account for 90% of all of my wealth. And this is, I think, very typical of angel investing. You have to almost call it gambling because there is such a difference between the “I will make a lot of money on one out of every ten” and the reality of it all, which is much more like one out of every 20. So it turns out that the average time to liquidity that everybody said was three to six years or maybe seven at the most, turns out to be 11. And it’s all dependent on the cycles. So as I’ve lived through the cycle of the crash of 2000 and the secondary-, the smaller crash of 2007 – as least as far as the tech industry – I’ve noticed how many survived, how they survived, and in many ways it’s changed the way that I invest.
Nick: Today we’re talking deal structures and types. Previously we’ve discussed the term sheet with Brad Feld and the convertible note will Bill Payne. But today we’re going to take a step back and look at the landscape of deal types and when they should be used. So Dave, can you start us off with a brief history of funding structures in venture capital and how they have evolved to where they’re at today?
Dave: Yeah. First of all, the convertible note, which is often used very early on, is rather new compared to the way that, when I first began, most of these deals were structured. So in the early 90’s the deals were all structured as Series A, and the attorneys would take $10 000 on the average – sometimes more – from the investor and he would pass it on most often to the company, and another $10 000 to the company. And that, of course, was unsupportable. As these documents became much more standardized, the Angel Capital Association and the National Venture Capital Association all created documents that were pretty standard. The attorneys turned more towards negotiation of the special features than they did toward papering the standard features of a document. So through the late 90’s we were still principally using Series A, now called Series Seed documents. And in the late 90’s and the early 2000’s, right after the crash, we began to use convertible notes. And the reason for that was, it put us ahead of all of the capital investors of the company in the case of a liquidation, and they gave us that much more security. There were always problems with the convertible note. We couldn’t start our capital gains clock and that was a big one, especially since back in the Clinton era, we began to get discounts that started at 25% from our income tax, based upon having held something for 5 years. That went in the early Obama years to 100% and back to 50%. So we never know where it’s going to end. But the point is, holding something for Rule 1202, which allows an exemption from some portion of income tax is a motivating force. So we began to use convertible debt, but it could have been more used, had these rules not been in effect. And that convertible debt structure still exist today.
Nick: I want to touch on what you said about the capital gains clock starting. So because it’s a convertible debt instrument and it’s not equity, you would have to wait until the conversion event in order to get that tax benefit clock on the record.
Dave: Yeah, that’s the point. And so therefore, if you hold a convertible debt until the A round – and the A round comes three years later – sure, we’re ahead of the entrepreneur in capital structure. We would have been with a preferred round any way. But either way, we haven’t started that five year clock. And for those few deals that make a lot of money, this is worth something. And so both the federal government and most of the states now have this feature, and have had this for many years since the early Clinton years. And so these states sometimes object when somebody uses it. I’ve been audited because of using it. The federal government is very good at allowing without question, and it’s one that all of us who have been professional investors for lots of years look at as one among several opportunities to put off or sometimes just put out the tax. Another is Rule 1045 which means that within, I think it is six months, you invest in another similar early stage company after receiving your cash from the first, you can roll the cash over just like you can in a real estate transaction. So there are a number of positive ways in which the angel investors and VC’s treat some of their gains when they’re very large.
Nick: Interesting. It sounds like we should do a show specifically on tax and sort-of the government aspect of investing. So you touched on some of the financing types. Can you highlight these major categories of financing and when they are most often used?
Dave: Yeah. In my book, Extending the Runway, I made a list, and I’m looking at the list right now. And it’s 28, 29, and if I add crowd funding, 30 different ways you can look at funding a company.
Dave: And so we really can’t cover them all now, but let me just mention a few of them. First of all, a lot of early entrepreneurs will use credit cards. And that makes some sense. It is a personal liability for sure, but at least it’s one that doesn’t require any kind of additional approvals before you get them. Slowing down the payment of suppliers doesn’t make sense to an early entrepreneur when there are no suppliers. Another home mortgage sure does, but very few, especially those who are married, want to hear their spouses complain about that. But I did it very early on. I might state that I funded two companies, both of which grew to a fairly substantial size, without any outside investment. But yes, I did take another home mortgage on one of the two. Wealthy relatives if you’re born lucky, wealthy friends and partners if you get lucky, but the friends and family and fools is that class we’re talking about. One way that I’ve had entrepreneurs think carefully about funding their companies is by taking on short term consulting work or projects. I know that interferes with the vision and getting the product out, but it’s a form of self-funding that makes a lot of sense to me. And so I’ve seen many of the entrepreneurs do just that and reduce their funding needs from having done that.
Dave: Incubators and accelerators are now becoming something to consider again. The incubators that existed right around the year 2000 before that crash all disappeared. I don’t think any of them survived. And there were no accelerators, or at least the term wasn’t used back then. Today that’s a very acceptable way for these companies to consider getting funded as well as getting coached. Then we get to the area where I specialize – individual angel investors, super angels which are individual angels who spend far less time in looking at due diligence and sometimes write checks immediately upon hearing the pitch. And of course, super angels are nice to get and sometimes have great connections. And then there are the angel groups which certainly are important to all of us, but take a lot longer to get funded. The trade-off for that length of time is that those angel groups will coach you free and do a very good job of honing your presentation. So even if you don’t get funded by an angel group you come out with something positive. And most all angel groups charge nothing for that whole process, and so it becomes to me a very strong way of focusing young companies on getting funded.
Dave: Then there are a lot of advanced sources such as finders and deal package finders and well-connected attorneys and CFO’s and professional CEO’s… I can go on forever. But those are the early stage ones.
Nick: So we hear about equity rounds, price rounds. We hear about convertible debt, safes, hybrid structures, and royalties. Dave, can you walk us through some examples of specific deal structures?
Dave: That’s good. And let me add that safes and crowdfunding are so recent and so new that many of the people now who would like to steer you towards those are a little hesitant to because we’re not quite sure whether, say, Rule 506c, which is the one that allows you to have up to 500 shareholders and crowd-fund your way into funding, whether that will be in the long run sustainable. It certainly is a brand new source for everybody. The safe document which originated in the Silicon Valley just a couple of years ago is being used extensively by some of the super angels and super angel funds up there. But it has not spread widely, at least even to Southern California, let alone to other areas of the country. I’ve signed only one safe document out of hundreds of deals that I’ve done through the Tech Coast Angels, the ACE Fund, and myself. So it really is not yet totally an acceptable method. It really is a document that makes you stand still, waiting for something to happen in the future. A convertible note has more positive terms and much more easily understood at least. So I would think that the best thing to talk about here is the original form of funding for an early stage company, either in a Series Seed – documents being available from the Angel Capital Association or the NCVA – and/or a convertible note – a much more simple document, but again the clock doesn’t start for the investor.
Nick: So 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?
Dave: Yeah. If there is nobody who leads the deals there’s nobody who’s going to negotiate the price. And as Bill Payne so eloquently said in my book, Basic Berkonomics, there ain’t no way that I’ll accept any kind of a PPM – a private placement memorandum.
Dave: That document is one prepared by the company, almost in the dark closet, where there’s an attorney helping and receiving the funds for having the preparation. And in the end, if you’re handing that document to a professional investor or a professional angel, you have turned off the investor thoroughly before even beginning the conversation. So there has to be somebody who leads the deal from the investor side that can negotiate the terms. And that person who leads the deal often has to decide whether or not to kick the can down the road about the valuation of the company or attempt to make a valuation that the investors will accept and the company, of course, will accept. I’m finding that most of the time today in the very early stage companies, nobody wants to put a price on the company. On the West Coast, at this point in time, we’re in a bubble. And the bubble that we’re in is hurting these valuations, at least in the eyes of the investor. We’re seeing valuations that are double, sometimes triple the valuations that we would see if we were in the Midwest. And at the point that makes us want to kick the can further on down the road. So we would kick convertible debt even at the risk of not starting our long term capital gain clock, just to make sure that we don’t get into a Series Seed that are $5 million to $7 million to $10 million dollar pre-money, which is way higher than the $1.6 million to $2 million pre-money that we see in the Midwest and in other areas.
Nick: So the thought there is that valuations will come back down to a more appropriate level in the future, and that’s why you would elect for a convertible?
Dave: I haven’t got the pin, but somebody does. This bubble is going to burst at some time, and it’s going to be thin. It’s not going to be the kind of bubble that burst, that hurt us all in 2000. And the bubble that hit us in 2007 wasn’t a tech bubble at all. It was a financial bubble. So this one is going to hit those very high valuations, particularly coming out of Silicon Valley. And when it does you’re going to see a little bit more reason to pricing for all of those that still need cash.
Nick: Dave, can you walk us through a couple of examples if we assume that the market and the capital flows and the bubble is not impending, how would you choose which vehicle or which funding instrument to use? You can give us an example of a company that you’ll see – let’s say maybe it’s a SAZ company in the financial industry – how would you go about selecting the type of funding structure?
Dave: That’s a very good question. First of all, the SAZ companies are valued much more highly than the premises-based software companies or the standard companies that we see, and therefore we have to be a little careful in two directions. One, this early stage funding. We want to get in early enough when the valuation is low enough, therefore it’s nice for us to think about selling it, at the same time as we worry about if we kick the can down the road, somebody else is going to set the valuation so high at the next round that we won’t be really anxious to participate or happy to see what happens. There are two sides of that coin. If we invested a pre-money of $2 million or we have a noted capped at $3 million and somebody else comes along in the second round at $20 million, it would be good for us to the extent that our investment is worth more money at that point in time, and bad for us to the extent that we probably will be asked to be dragged into a pro-rata at this tier evaluation we never would have accepted. So there are two sides to every coin when you use a convertible debt, but it is one that is simpler to use and does have some opportunities for success.
Nick: So we hear about asset-based financing – royalties, PO financing. I had an entrepreneur that was working on some lease term financing recently. Can you talk a little bit about asset-based financing, what it is and when it is typically used?
Dave: Sure can. Might add to that, getting NIH or other kinds of funding from any kind of agency. But the asset-based funding which I have experienced in one of my companies – remember, I didn’t take outside investment – I chose the asset-based lending method of doing this. It can get very expensive. First of all, there are two principal assets and they are either accounts receivable and/or inventory. And usually the asset-based lenders loan between 70% and 80% of the value of your good receivables, which means those that are 60 days or less and have no government content and there are no receivables that are more than 10% of your total receivables – that is no company that owes you more than 10% of your total receivables. So they can link those kinds of questions to the amount of money that an asset-based loan will grant. Inventory loans typically relate to the size of the inventory, the amount of turns – that is how fresh the inventory is – and they usually run 50% of the acceptable inventory to be loaned. That’s the maximum numbers that can be calculated. The problem is, the very early stage companies don’t have inventory and they don’t have receivables. So it really doesn’t help until you get down the road further, have good revenues, and really need more, typically for growth. The bottom line, though, is that there are extra expenses. And when you do an asset-based loan you have to know that you’ll be paying for documentation, and every year you’ll be paying for an audit. An depending on the lender, you may be paying for transaction fees which means that there may be a float that will be offered, or at least a charge to you, adding three to five days’ worth of interest to the loan for every receivable. You may have transaction reports where you’ll have to actually send copies of invoices. There are, in some of the banks and some of the private lending companies, restrictions that make this a little bit more difficult. Calculate the amount that’s eligible at any one given time. So asset based lending can be more confusing than a straight term loan, more confusing than a lot of other forms of financing. But then again, you’re not giving away any equity. So as I sometimes tell my mid-range companies – those that are beyond the need, beyond break-even sometimes and the need for initial working capital just to cover the overhead – I tell them that if they’re growing at 20% or more and their valuation is therefore growing at at least 20%, then an asset-based loan makes a lot of sense because you’re saving the equity for yourself and for your present investors. And it makes more sense, therefore, to pay out the interest. If you’re not growing that much and you have to have the money, it’s a different question. But there is that question that can be answered based on growth.
Nick: Are there every issues with usury laws which are trying to restrict the total amount of interest that can be paid through a variety of different financing vehicles and the interest rate can escalate north of 20% or 30%?
Dave: So the laws are very careful to differentiate between Beta B – if the lender is a professional with a license to lend and the business is actually in incorporated business, then those usury laws don’t exist. And if it’s Beta C, yes the usury laws exist. They’re typically maximized as some percentage, typically as 10% based upon the libor rate plus some number, but today it’s around 10%. And then you do have to worry whether or not if an individual who has not been incorporated attempts to borrow money from anybody, then that person has to have a lending license. There are disclosure rules. And if it’s a non-lending license lender to an individual then all these usury laws you’re talking about kick in, and they are enforced.
Nick: Do you ever come across early stage companies that have healthy cash flow, healthy business? Maybe they have to purchase some assets or maybe they have to do some hiring. And you don’t see big scale opportunity. You don’t see a big exit. But you think it’s a viable business, you think it’s a healthy business. Have you ever engaged in investments with companies that don’t have the traditional venture scale profile?
Dave: Oh, I have not. But I certainly know some of my friends that prefer these. And they prefer them because they can specify an interest rate. They may specify it at 15% or something of the kind, which sounds a little high, but again, as a trade off against not having to give away equity for a growing company, it makes a lot of sense. So some of these people have specialized in loans and not tried to make investments. And by the way, there’s a hybrid – loans with warrants. So if some of the banks, especially the venture banks – and there are four of them on the West Coast that specialize in this – will make a loan, whether it’s asset-based or not, and ask for some number of warrants so they can participate in the upside when there is an upside.
Nick: You know, I’m glad you brought up warrants. I’m a little confused about when and where to use them and why. So if you’re doing a price round, why not just negotiate on other terms like valuation? Why use these warrants?
Dave: Because the entrepreneur often would never take a valuation of $2 million, thinking his company is worth $4 million. And that $4 million number is stuck in the entrepreneur’s mind at the extent that there is no way of dislodging it. The only way of getting from the point of negotiation where we would have walked to a point where we make a deal is to try and find something in the form of warrants that give the ownership opportunity, at least, to the investor that equals the difference or some portion of the difference. So if you had penny warrants, which are legal, and you were to have bought 20 000 shares and you get 20 000 warrants for common stock, not preferred stock typically, and those warrants are at a penny, the entrepreneur still says the valuation of the company is $4 million, and you say, “I have invested the amount of money I would have invested if this company is successful at the valuation of $2 million.” It has to assume later that the preferred converts to common, and that they are equal. If they aren’t, then of course the investor loses a bit.
Nick: Got it. So assuming you were able to negotiate the appropriate in your mind with the entrepreneur, there would be no reason for using warrants?
Dave: That’s right. Warrants are just one more form of delusion, and when the cap table is presented to a further investor later down the road, the warrants have to be listed. And of course, the new investor looks at fully diluted valuation and therefore reduces the price per shares if the warrants have been exercised. Not good for the entrepreneur.
Nick: When you come across a very promising startup where the fundraise-structure is not appropriate for the business but you’re very interested in investing in the business, how do you proceed?
Dave: It’s the negotiation that we focused on a few moments ago. I had been the deal lead for lots of deals earlier on. I don’t any more. And let me just say it’s because I’m the managing director of the two ACE funds for the Tech Coast Angels, and I feel it would be a conflict of interest for me to lead deals as well as to be able to be the funding source to accept deals, and so I’ve kind-of stepped back during these last two or three years. But that aside, the deal lead gets to decide in many ways how this is handled. And it leads to a discussion between the entrepreneur and the deal lead for all these things. The valuation is the first element of, I would say, discussion that the entrepreneur is emotional about, followed by some way to bridge that gap. We’ve talked about using warrants as one of the ways to do it. Convertible notes are another way to do this as long as there’s a cap on the note, and I know you’ve had a previous interview in which you went into depth on this issue. So there are ways of making that bridge happen, and it’s up to the deal lead to be able to make sure that the investors are happy with the way it finally turns out.
Nick: So Dave, what advice would you have for new angel investors or startups that are in the structuring phase of their fundraise?
Dave: Angel investors have so many resources. Let me list those for those that might not understand what they are.
Dave: The Angel Capital Association is an international organization that actually is centered in the United States and principally about the United States, but its members are all over the world. There are 800 member groups as I think I remember, and 400 of them in the US, and the ACA website has documents for angels that are prototypes for virtually every type of activity that the angel might have – from performing due diligence to term sheets to the final documentation. And that’s a very good first source. I would recommend that any potential angel investor join an angel group, and those angel groups – if there are 400 of them – are pretty close to you no matter where you are in the country. And you will find a mentor in that group, willing to show you how to lead a deal. And it is one of the exciting things to do, is to lead that deal and negotiate with the entrepreneur, and then to begin to be sophisticated in the way in which you look at your funding, make your investments, and document your deals.
Nick: So let’s transition a little bit, Dave. You’re clearly a busy guy based on some of the activities that you’ve mentioned that you’re involved in. But can you talk about what you’re currently most focused on?
Dave: Sure. I have made these 108 investments. I’m on 40… Right now I’m on 14 boards. I’ve been on 40 boards over time. And of those 14 boards, four of them are non-profits. One of them is a college trustee board that takes more time than some of the others do. And then ten are for-profit boards, all of them early stage. I chose about five or six years ago to resign from any public boards, and there were two. And the reasons are because Sarbanes-Oxley just was too much in my face. The liability seemed too great. And I wasn’t ready to assume those kinds of risks. So private only, early stage only for me at this point in time. And I’m chairman of six of those. So I do communicate with the CEO’s of those six corporations fairly commonly, often enough that it becomes a focus for me over time. I speak publicly, as you know, around the world, and I accept about 20 to 25 of those a year. So with travel days that takes a good piece of time.
Dave: I manage these two ACE funds, and then I have the Berkonomics blog and books, and I’ve written 13 books. And the blog, which comes out every week, is right now published to 50 000 by email, about 12 000 by RSS feed, and another – I’m guessing – 40 000 by reposts which have been authorized by me. So that’s over 100 000 a week. The thing to know about that is, I use my regular email address. So you can imagine every Tuesday morning at 8:30, how many people are out of their office. I’d be surprised to say how many are changing jobs or how many email addresses have changed, that I see Tuesday mornings right after sending out these blogs.
Nick: Yeah, I bet. I don’t know how you fit it all in, but at least I can aspire to get a little bit more done with my time. So Dave, if we could cover any topic in venture investing, what topic do you think should be addressed, and who would you like to hear speak on it?
Dave: Well, that’s interesting. The favorite topic I have are stories about companies that have been funded, and how the entrepreneur behaves to make either a success or a failure of that company. And that’s one of the things I do on the road, is tell those kinds of stories, because everybody wants to hear them, especially since each one has a moral if you can dig far enough to find that moral. And then if you begin to understand enough of those morals, that’s what Berkonomics is all about – I’ve written over 300 of those – when you begin to understand them you know which pitfalls to avoid and which opportunities to spend more time on. So that’s what I’d like to hear more about. More stories from more people who have successes and failures to talk about.
Nick: So Dave, what’s the best way for listeners to connect with you?
Dave: Thanks for asking that. I have two websites, and they both lead to essentially the same information, which is… I have a Berkus report on TV and I have 5 minute segments that I’ve put onto my website. That TEDx talk is on the website, lots of other things – clips as well and testimonials – at berkus.com. B E R K US .com. You can look at and order my books at a discount. I’ll sign every book that is ordered through the site as opposed to having it bought from some other site. And you can also get me at Berkonomics – B E R K O nomics.com. And there… either place, you can sign up for these weekly emails. And you’ll get one of these stories every single week. We’re at over 300 of those now, and still working on them.
Nick: All of Dave’s contact information will be included in the show-notes. Dave, thanks so much for the time. It’s been a real pleasure having you on the show.
Dave: Good luck, Nick. I appreciate the opportunity. Thanks again.