What is the difference between an Angel investor and a Venture Capital firm?
Angel investors are high net-worth individual investors
A Venture Capital firm is a (group of) professional investor(s) who invest(s) in startups on other people's behalf (i.e. with a "fund")
Many VCs started as successful Angel investors whose friends wanted to start giving them their own money to invest, thereby forcing them to institutionalize into a formal VC fund
What are the usual sizes of investments made by Angel investors vs. Venture Capital firms?
Traditionally, Angel investors have invested in smaller increments (generally $25-500k), while Venture Capital firms have invested in rounds with a minimum size of $2m
However, many "micro VCs" and "super angels" have recently emerged, blurring these lines significantly.
What is a "syndicate" of investors?
A "syndicate" is when one investor (typically a savvy Angel investor or a VC firm) leads a round of several other investors to invest together on the same term sheet.
What does it mean to raise a "Series A" round versus a "Seed" round?
A "Series A" round is the term generally used to describe the first institutional round of equity financing, usually for at least $2m
Small amounts of "friends & family" equity investments (e.g. < $200k), or early investments typically raised in the form of Convertible Debt, are generally thought of as "Seed" rounds
However, the lines are often blurry, and the distinction between what is "Seed" and what is "Series A" really doesn't matter
What are some benefits to raising early rounds of financing from [a syndicate of] Angel investors rather than from a Venture Capital firm?
- You don't give up as much management control
- You don't have to raise as much money (so you get diluted less), since most VCs have a certain minimum investment
- You usually get your cash up front rather than only in tranches when you hit certain milestones (which is how many VCs operate)
- You're probably not ready to raise from a VC anyway
What are some benefits to raising early money from Venture Capital firms rather than angels?
You usually get more money
It shows the market good signaling ("social proof")
VCs have very deep networks of useful connections for you and can help with strategy, hiring, etc
VCs have "deep pockets" and can usually participate in future financing rounds (if you are successful)
Typically, how large is the largest round of convertible debt raised at the seed stage?
Seed rounds of convertible notes are typically under $1m, but they can sometimes be larger if the founders have very strong track records or traction
Financing rounds of $2m and up are usually raised from institutional investors who require equity.
What are generally accepted to be the Top 3 things that early-stage startup investors are looking for?
Great Founding Team
True or False: Investors prefer investing in a company where the entrepreneur has paid his core team in cash, rather than equity, since it is easier to deal with just one main shareholder.
- Investors are investing in the PEOPLE above all, and they like teams where the core members are properly incentivized with equity
- This is especially true for tech startups; it is very important that the technical founders (or early tech employees) be core equity partners, rather than expendable consultants, to ensure long-term commitment
What is the difference between a Share Grant and a Stock Option for employee compensation, and when should each be used?
A Share Grant is equity that is directly given to founders, while Stock Options represent the right to purchase that equity at a discounted price (likely the price at the time of issuance) in the future
Once a company has raised equity at a priced valuation, it generally begins to issue new employees options rather than direct share grants, for tax reasons.
What is Convertible Debt (aka convertible loans or convertible notes), and why is it used?
Convertible Debt is when a company borrows money from an investor or a group of investors with the intention to convert the debt to equity at some later date (usually a later round of financing, once the company is properly valued)
It is a popular financing method for seed-stage startups because (1) It avoids having to set a valuation at such an early, uncertain stage, and (2) It generally involves much less paperwork & legal fees than issuing equity directly.
What is a "cap" on a convertible note?
A "cap" is a provision on a convertible note that limits the valuation at which the note will convert to equity
- This essentially protects the investor from a ridiculously high valuation at the next round of financing
- Ex: If you issue a $500k seed note with a $4m valuation cap, then even if your Series A valuation is $10m, the note converts to equity as if the valuation had been only $4m. So the note-holder gets 12.5% of your company ($500k/$4m).
Is it "normal" to raise money in many small amounts at a time (e.g. $50k), at incrementally higher valuations?
- That said, while many traditional startup advisors caution against a "drip-feed" fundraising model, the advent of Convertible Notes and more standardized financing documents has been making this model more fashionable
- Critics warn that ongoing fundraising may divert a founder's focus and limit decision-making flexibility
Between founders/employees and investors, who usually gets common stock and who gets preferred stock?
Founders & employees receive common stock (or options)
Seed investors sometimes receive common stock (or convertible notes that turn into common stock)
VCs almost always receive preferred stock (at higher prices per share)
What is "crowdfunding", and can it be used to fund startups?
Crowdfunding is the practice of raising money by posting a project publicly and soliciting hundreds - sometimes thousands - of micro-donors or investors
- It is typically used for causes and creative purposes
- Crowdfunding is difficult for startups to use as their sole method of raising finances, as the legal/compliance costs of managing so many investors becomes increasingly prohibitive to a small company
When raising the first round of equity financing for a startup, how do you know how much of the company to give to the investor(s)?
The % of the company awarded to the investor(s) depends on the Valuation of the company
- For example, if the company is valued at $1m, and the investor invests $100k, then he will receive 10% of the company
- A way to avoid the tricky question of determining such an early valuation is to raise the first round of capital as Convertible Debt, rather than giving away explicit equity so early
What is a "down round" of financing?
A "down round" is a round in which the company's valuation is lower than it was in a previous round
This is generally very disadvantageous and dilutive to founders and previous investors.
Why is it important for previous investors to participate in subsequent financing rounds?
It is best for previous investors to participate in subsequent financing rounds for two reasons:
- To protect themselves against dilution; and
- To provide a strong positive signal to incoming investors
What is the purpose of a term sheet?
The purpose of a term sheet is to outline the quantitative and qualitative terms for a financing deal between a company and a qualified investor (e.g. an Angel Investor or a Venture Capital firm).
Is a term sheet binding?
No, a term sheet is not binding
It is more of an honest agreement that guides the subsequent drafting of securities documents resulting from the financing, as well as any necessary modification of bylaws or articles of incorporation.
When, and by whom, is a term sheet usually first drafted?
A term sheet is usually initiated by the lead investor in a round, once it has been determined that the investor(s) would like to move forward in negotiating a deal.
Can an entrepreneur participate in term sheet negotiations with more than one investor at a time?
- Many term sheets include an "exclusivity clause" requiring the company to stop soliciting other term sheets
- Although there is little legal recourse for a company breaking this agreement, simultaneous term sheet negotiations are generally shunned upon as a shady practice
Does a term sheet for a new round of financing create a new class of stock?
Not necessarily, although the usual case is that Founders and Seed Investors have common stock, while incoming Venture Capitalists get preferred stock
Sometimes a new class of stock is created at each round of financing, with the terms varying depending on the stage & strength of the company.
Do owners of previously issued stock have to approve of the creation of new classes of stock with preference over theirs?
Usually, but it depends on provisions in the corporate bylaws or any previous investors' rights
The approval of a new class of preferred stock is generally done either by vote of existing shareholders and/or by vote of the Board of Directors.
What is a Liquidation Preference?
A Liquidation Preference is the right for owners of a particular class of stock (or investors in a particular round) to receive the first proceeds from the potential future sale of the company
Shareholders of preferred stock (typically VCs) tend to demand some degree of liquidation preference, to protect them against a company's failure.
How big is a typical liquidation preference?
The typical liquidation preference awarded to Series A preferred stockholders is 1x
- This means that if the company is sold, the preferred stockholders get their money back and no more
- Founders should be cautious about negotiating liquidity preferences of 2x or higher, since this increases the sale valuation required for the founders to receive any substantial returns on their investment
What is a Redemption clause?
A Redemption clause is a provision that obligates a company to provide investors with liquidity within a specified amount of time
- This can mean that the investor may force the company to either sell to another company, buy back the investor's shares at a premium, or offer the company's shares for sale on a public market
- VCs may request a Redemption clause to prevent them from getting stuck in a "lifestyle company" that simply muddles along with modest growth & dividends but no real exit opportunity
Once investment terms are agreed upon, does the company receive the full sum of cash all at once?
Often, VCs will include a "milestones" section in the term sheet, indicating that the investment will be executed in stages, being doled out only as the company hits key targets (usually revenues, users, or # of contracts).
What are the three ways of determining a Valuation for an early-stage startup?
(Most common) Simply the average of whatever investors are willing to bid, based on market benchmarks and confidence in the team/vision
A multiple of revenues (or expected revenues)
Bottom-up analyses (various calculation methods)
What is the difference between "Pre-Money Valuation" and "Post-Money Valuation"?
A Pre-Money Valuation is the valuation of the company just before a deal is executed. It is determined by multiplying the share price in the term sheet by the number of shares being purchased
The Post-Money Valuation is simply the pre-money value plus the amount of money being invested
Ex: If a startup raises $2m on a $6m pre-money valuation, then the post-money valuation is $8m (2+6), and the investor gets 25% of the company (2/8)
What is a Liquidity Event?
A Liquidity Event is a point at which investors are able to "cash out" and convert their investment into earnings
Typical Liquidity Events are the sale of a company, or the company's "going public" with an Initial Public Offering (IPO).
What is a good number of Directors to have on the Board before entering a Series A round?
Many early-stage investors joke that a Board size of ONE (the founder) is the easiest to deal with and the most attractive as an investment
- But pre-Series A Board sizes of up to 2 or 3 are common, as long as there is strong reasoning for those seats (e.g. Established industry leaders) and/or at least one seat held by an independent outsider
- Founders should avoid pre-stacking the Board with several close insiders, as this can appear threatening to potential new investors, and can also cause much needless paperwork
How is a Board of Directors likely to change as a company progresses through fundraising rounds?
Boards tend to grow over time, as more and more stakeholders demand to have their interests represented
- Each class of stock issued typically has at least one Board seat representing it
- The fact that a Board is bound to grow is another reason why it is convenient to have only a few Board seats occupied in the early stages, when there is only common stock
With convertible debt, what determines the rate at which the debt will convert to equity upon the Series A financing?
The Conversion Discount is what determines the rate of debt/equity conversion
So if the Conversion Discount is set at the typical rate of 25%, then the convertible debt holder may convert his debt to [usually preferred] stock at a price 25% better than the incoming Series A investors.
What is a complementary metric to a Conversion Discount that is often found in seed financing term sheets, to ensure the debt holders will still get a good deal even if the Series A valuation is astronomically high?
Price Caps are often used as a complement to Conversion Discounts to protect early convertible debt holders against high Series A valuations
So if the original convertible debt term sheet is for a $500k loan at a 25% Conversion Discount and a $3m price cap, then even if a future Series A round values the company at $6m, the debt holder may still convert to equity as if the valuation was $3m (rather than just at a 25% discount to $6m).
What is a typical interest rate and maturity date on convertible debt?
Convertible debt is generally set at an interest rate between 6-10%, with a maturity date of around 1 year
- However, investors rarely aggressively push startups to pay them back immediately at the maturity date in the event that they have not yet raised a Series A, since this would likely bankrupt the company
- Instead, the convertible note continues to accrue interest and will thus convert to a higher amount of equity at the next round of financing
What is "fully diluted capitalization"?
Fully diluted capitalization is basically a way to account for all stock that is "spoken for" - i.e. both authorized and issued. It typically includes:
- all outstanding common stock
- all outstanding preferred stock (on a converted to common basis)
- outstanding warrants (on an as exercised and as converted to common basis)
- outstanding options
- options reserved for future grant, and
- any other convertible securities on an as converted to common basis
How can a startup avoid subjecting its founders or employees to a huge tax hit when their stock vests?
Employees can avoid the huge tax hit by filing an 83(B) form with the IRS within 30 days of receiving founders' stock (or exercising options)
- If this window is missed, then when the stock vests (or options are exercised), their value is immediately counted as "income" that will appear on the employee's personal tax return
- This could subject an employee to tens - or hundreds - of thousands of dollars in tax consequences, even though the stock has not been sold and the employee never saw a dime of cash
What is significance of the ratio LTV/CAC?
Lifetime Value (LTV) of a customer / "Customer Acquisition Cost" (CAC)
- It is extremely important for you to understand, optimize, and communicate all the factors that influence this ratio (google them), in order to prepare for rapid scaling
- A VC will likely not invest until you have proven that ratio to be as high as possible (rule of thumb: at least 3/1)