A crash course in angel and venture capital funding at SVOD Summer 2013
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Theresia Gouw, Accel Partners, and Iiya Strebulaev, Stanford, offered a crash course in angel and venture capital funding at SVOD Summer 2013. The pair explained the science behind the practice, and what it takes to succeed in the crowded startup community.
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A crash course in angel and venture capital funding at SVOD Summer 2013
- 1. SVOD 2013 Funding Your Start-up 1 Funding Your Start-Up: Successful Contracting Theresia Gouw Accel Partners Ilya Strebulaev Stanford GSB
- 2. SVOD 2013 Funding Your Start-up The Venture Capital Cycle: IPOM&A Failure VC Investment Angels Self-funding by founders “Family and friends” round
- 3. SVOD 2013 Funding Your Start-up • Division of future payoffs • Learning –A/VC about E –E about A/VC • Resolving future problems and agency conflicts The purpose of contracting between E and A/VC p. 3
- 4. SVOD 2013 Funding Your Start-up • Active monitoring • Formal monthly financial reports • Staging of investments • Major reviews of progress/milestones • Stock grants/stock options • Vesting of the stock options over a multiyear period • Dilution of E’s stake in subsequent rounds if the firm does not perform Resolving future problems p. 4
- 5. SVOD 2013 Funding Your Start-up • Example: E owns 7.5M common shares • VC offers $10M of Series A convertible preferred for 25% of the company • Liquidation preference: –Series A Preferred is paid first one times the original purchase price –The balance of any proceeds is distributed to Common Stock • Optional conversion: –Series A Preferred converts 1:1 to Common Stock at any time at option of holder Most commonly used VC contract: Convertible preferred stock p. 5
- 6. SVOD 2013 Funding Your Start-up Convert or do not convert? VC payoff p. 6 No Conversion Conversion Conversion Point 0 5 10 15 20 25 0 10 20 30 40 50 60 70 80 ConvertiblePreferredStockPayoff ($Million) Exit Payoff/Liquidation Payoff ($Million) Common Stock (Converted) Preferred Stock (Unconverted)
- 7. SVOD 2013 Funding Your Start-up Payoff diagrams: Who gets what p. 7 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0 10 20 30 40 50 60 70 80 Payoff(PortionofProceeds) Exit Payoff/Liquidation Payoff ($Million) Venture Capitalist's Payoff Entrepreneur's Payoff Venture Capitalist's Payoff Entrepreneur's Payoff
- 8. SVOD 2013 Funding Your Start-up • Seniority over Common Stocks –Downside protection • Incentives –E get more in better states of the world • Signaling –More optimistic E likely to take the offer • Preventing “Take the money and run” scenario –E do not have incentives to sell too early • Tax reasons Why VCs prefer convertible preferred stocks p. 8
- 9. SVOD 2013 Funding Your Start-up • As minority shareholders, VCs need protection • Anti-dilution provisions • Corporate governance • Vesting of founder and employee stocks • Dividends restrictions • Redemption rights Additional contract features that protect VCs p. 9
- 10. SVOD 2013 Funding Your Start-up • Voting rights –Voting rights vs. cash flow rights –Voting with Common Stock shares on an as-converted basis –Increase or decrease of authorized Common Stock shares shall be approved by majority of Preferred and Common, voting together –Majority of Series A Preferred should consent to: • Liquidation/exit • Amending By-Laws • Issuing any new securities • Paying any dividends • Changing the size of the Board of Directors Corporate governance p. 10
- 11. SVOD 2013 Funding Your Start-up • Board composition –The Board shall consist of five members –Series A Preferred elect two Board members –Founders or their representative elect two Board members –One independent director, who is mutually acceptable to VC and E –Each board committee will have at least one Series A Preferred nominee Corporate governance p. 11
- 12. SVOD 2013 Funding Your Start-up • Vesting: Shares or options are earned over time • Step vesting: –Typically occurs over three to five years at annual/quarterly/monthly increments • Cliff vesting: –Vesting occurs at one time • Example: –30% after one year –Remaining 70% vesting quarterly over next four years Vesting and employee restrictions p. 12
- 13. SVOD 2013 Funding Your Start-up • Vesting is needed to align interests between Es and investors • Ex ante vs. ex post –Getting a better vesting contract for the founders/first employees (e.g. single trigger) seems better for Es –Down the line, other key employees would prefer the same contract • Can affect acquirer’s valuation / exit outcome Economics of vesting p. 13
- 14. SVOD 2013 Funding Your Start-up • Restrictions on founders and investors selling their shares –Transfer restrictions: preventing sales of founders’ stock without permission of investors –Tag-along rights: the right of investors to participate in any of such sales –Right of first refusal: investors can buy first at the price offered to other parties –Right of first offer: Investors will be first to be offered shares • Non-competition, non-solicitation, and non-disclosure for executive officers Vesting and employee restrictions p. 14
- 15. SVOD 2013 Funding Your Start-up • Convertible notes without cap –Angel’s stake in the company is a constant (in good outcomes) –The higher the pre-Series A valuation, the less the angel investor owns post-Series A round –Despite the company doing better –Misalignment of interests between angels and entrepreneurs Contracting with Angels The World of Convertible Notes p. 15
- 16. SVOD 2013 Funding Your Start-up • Cap: Main provision invented to limit the dilution of note holders –They now can benefit from higher valuation in Series A round • Holders of capped convertible note convert at the lower of: –The (discounted) Series-A price or –The capped price • The cap effectively makes seed round (partially) a valuation round Convertible notes: Cap p. 16
- 17. SVOD 2013 Funding Your Start-up Angel’s ownership value after a $10M Series A round p. 17 0 5 10 15 0 5.00 10.00 15.00 20.00 25.00 30.00 35.00 Angel'sOwnershipValueAfterSeriesA ($Million) Pre-Money Valuation Cap of $5 Million Cap of $10 Million Cap of $20 Million No Cap
Notes de l'éditeur
- Intro remarks: what this course is about, for whom this course is intended, discussion of the syllabus, and so on. [Separate file] This course is about how to finance high-potential innovative companies, both for financiers and entrepreneurs.What this course is NOT about. We will not cover: (1) How to prepare a business plan; (2) How to improve your presentation style; (3) only what currently is happening in the VC world (we will talk about it, of course, but the emphasis is on generic mechanisms that will help you when the situation changes).Course logistics, exams [Separate file]Talk about difficulties for this course: (1) so many information, but most irrelevant/weird/confusing; at the same time a lot of useful stuff nobody talks about. Our goal is to put things right and straight. My goal is tell you generic stuff, general rules, that will help you understand issues, ask the right questions, seel answers in the right place, and make efficient decisions.(2) Not a lot of data, especially about angels but also about VCs. It is a secretive industry, no regulation, but frankly just nobody cared to collect data. [THIS IS WHAT I AM DOING – anybody wants to help, let me know]ILYA: Note that the mic synced in and out a bit depending on your head angle. If you were facing left, the sound was much weaker.
- Cold call: Discuss conceptually why VC staged financing works this way: why not give all the money right away and let the start-up exercise the options?Answer: real option, agency costs, information asymmetry, limited resources! [more on this throughout the course]Some firms skip some stagesWILL: This looks great. I like both your versions (perhaps the second one a tiny bit better, can we experiment with the following: (1) I’d like to show graphically the “funnel” – most companies do not get to the next stage; (2) the Exit – is it possible to create three “curvy” arrows [as typically shown on military history maps] of different size: Failure is the thickest, then M&A, and then IPOs an attempt to create a military-chart style diagram. I’m not happy with the result, Excel doesn’t have enough control to create this type of chart.
- Term sheets are not binding, they will become binding in the investment agreementTerm sheets are exploratory, negotiating stageVC/E partnership is often viewed as Marriage – establishing long-term relationship. Term sheet is kind of a marriage agreement. To make future negotiations as predictable as possible. And to learn about each other because when you court before a marriage, you’d better find as much as possible about your prospective partner. [A story about an Indian VC: he always takes prospective entrepreneurs on a ride in his car. In India roads are bad so going from A to B in town will always take at least 2 hours but he takes specific routs to get into traffic and so what would be a ten minute ride in the Bay Area becomes a 5-7 hour journey. He told me there is nothing better to finding about a person than sit with him in one car for 5 hours]Learning: how E reacts to terms. Too tough/too mild (it is used as an indicator of future interactions with VCs and other parties). E.g., if E is naïve/foolish, he will behave in a similarway to suppliers/customers.Important: it is not a contract about current environment, it should take into account future actions and incentives of future players such as future employees and future financiers.Ex ante vs. ex post: renegotiation. Those features of the contract which are easy to renegotiate in the future are less important. [IMPORTANT: this point deserves a separate slide somewhere else]
- Important to resolve as many conflicts as possible ex-ante, this is the idea of the contract/term sheet.Important to emphasize is how investors actually do this:Active monitoring: e.g. informal visits; lead VCs typically visit at least once a month, try to get more information, prevent misbehaviorFormal reports: beautiful story of an Indian VC. He invests in rural entrepreneurs in India. He invested in two doctors who wanted to build rural hospitals and provide cheap healthcare. The Vc wants to make money. He gave them funds, a couple of months later he visited them in a new hospital. He saw several doctors/nurses around, equipment they bought and they led him around to show patients, treatments, and so on. He asked them then for a monthly financial report, how they spent money, and for business plan. They responded why he needed all this, for he could see that patients were happy. That was their measurement of success. Their metric. He is a smart guy so he did not say anything and left. In a couple of months there was a time for him giving them more money (staging!) and they reached a required milestone (built and started operating a hospital). He did not send them money. They phoned and faxed and then came to him. He old them: why do you need money, your patients are happy. This story has a happy ending. These doctors understood and became financially savvy. They now operate more than 20 hospitals and this is one of his most successful investments.Staging: E is on a tight leash because it is obvious that it is not enough money raised initially to get this company successful. Staging gives also an option of not to invest if the milestones are not reached. “If you see a fork on the road, take it.”Stock grants: aligns incentivesVesing: founders can’t just leaveTBD LATER:Look at Kaplan and Stromberg (2002): types of risks – can be incorporatedLook at Hsu (2002): the price to be associated with top VCs (15% discount for top VC firms) – not here really, but when we discuss matching processLook at Hochberg (2002): corporate governance after IPO for VC-backed vs. non-VC backed firms. Somewhere else, not in this lecture.ILYA: Appx 20 minutes
- Non-convertible preferred stock is virtually the same as debt (junior to debt) and differs mostly in tax treatment and seniority.Liquidation preference and optional conversion are crucial. Liquidation preference offers protection of VCs in the bad state or not very good state. Optional Conversion offers protection of the upside in the good state.RED here and later means that specific numbers are points of negotiations
- Payoff for the Series A preferred if it does not convert and if it does.Here is common equity. Now this is preferred stock, which is not convertible. By the way, what does it look like [debt; brief deviation on differences between preferred stock and debt]Finally, here is total payoff. The holders, i.e. VCs, decide on conversion, so they basically choose for each value the maximum between two payoffs. So this is how the payoff structure looks like. Need to emphasize that it is the VCs not E that decide on conversionShow clearly where the liquidation preference bites and where optional conversion bites.ILYA2: QUESTION: (Colin?) Convertible notes?QUESTION: (Jaun?) Clarifying question on when to convert.NOTE: Is this chart clear? I believe Jaun may have been confused about what the common stock value is – IE: it isn’t the E’s common stock value, it is the VC’s common stock value if the VC converts.QUESTION: What is used today?T: E payoff is Exit payoff – E payoffNOTE: We should think about how to present this term sheet section faster.WILL: Slide 21 on Convert/do not convert. I added VC payoff in the title – I think most of them think from the E position and this may cause/have caused confusion. Not really sure what else to add/change – because E do not decide, replicating this chart for E may be even more confusing. May be, we should show E payoff for CPS vs CS and PS using green shaded stuff – i.e. how the payoff changes when VC gets a different security and how conversion affects E’s payoff? Let’s experiment here. Right now, we have slide 23 which is not very telling [I actually quickly went to discussing 24 and 25 exactly because I thought it does not add anything new, but in doing so we omit E payoff’s discussion. What do you think?
- Let’s stop here and think why this security is inherently better in the VC setup than common equity. Note that this diagram of course does not saying anything about voting rights, only about cash flow rights. Basically, when the outcome is bad, Vcs get back all the value and E gets nothing. Is a good idea? Not always, but in the innovative high-potential setup it seems a good idea. It provides more incentives to E to make sure the project works out.What would be an example when this security would not be that great. Consider a large company, say IBM, where you give this security to employees. Any employee is unlikely to benefit much from a great idea because he has a very small amount of securities even if the great event will make IBM worth ten times over. But what if IBM goes bust? He will lose everything still. So in large companies this incentive structure does not work well. Why in the VC world it works? Because E still are large holders of their companies and they benefit greatly from the upside. So if their company becomes next IBM, they will benefit greatly. Related, it is not common for VCs to take a majority stake in a company in the first round. Why? For exactly the same reason. You do not want E to feel herself like an IBM employee.What are the trade-offs here. Between incentives and risk-taking.ILYA2: Question: From the E’s point of view, is the amount of stock negotiable?ILYA2: Question: The value of the VC’s share is higher due to liquidation preference. How is that priced?ILYA2: Question: (Cathy?) What would the term sheet actually say? Conversion at some dollar value? T: It is usually stated as dollars per share or simply “option to convert”.
- Incentives: what is important here is that E get more in the good state of the world than in the bad state of the world. It is RELATIVE compensation of E that matters.Tax reasons – in short, employees are compensated with stock options, issuing VC CP helps employees understate the value of these options which helps for tax reasons. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=301225 has a discussion of this)ILYA2: Minor point, but you referred to E as “it” here, that sounds very grating in English. I’m not sure if a he = VC, she = E style gender assignment would help with clarity in some of these explanations or just sound forced, but it might be worth thinking about. [Ilya’s comment: important; “it” was stupid of course; need to think about. Ask others]
- Majority can be 50% or supermajority (60%, 70%, etc)
- Majority can be 50% or supermajority (60%, 70%, etc)
- The idea of vesting: if the employees leave now, they will get less, so it Is more attractive for them to stay onFrom the website of a law firm: “if the founder leaves the employment of the company before this time period has elapsed, the founder forfeits the unvested portion of the stock.”In the example: 30% is cliff vesting; the rest is step vesting.People talk a lot about difference between cliff and step vesting, not that important. What is important is cumulative vesting over certain period of time. TBD: more on pros and contras of various vesting contractsFUTURE CHART: DO A CHART OF THE EXAMPLE OF CLIFF VESTING[Reality checkpoint: in reality, cliff contracts are often accelerated. For example, in the case of a one-year cliff, if an employee laid off/fired in month 6-12, vesting can be or likely will be accelerated; the same with founders: if for example negotiations ensure to relieve the founder of CEO’s role, etc., then vesting schedule may be negotiated and accelerated]Important: this is just a term sheet. In addition, the founders and employees will get an employment agreement that will specify the terms of their employment precisely.[SEPARATE SLIDE] Acquisitions and so on: vesting is immediately accelerated
- All of this assumes that the pre-series A valuation is above angel’s investment.Cite again Sunrun’s case: angels did not like because they were thinking next round will be $5M, it was $25M, they were diluted.Here is example from Ron Conway on the same issue: “If I invest in a company I open my Rolodex for them. I help them with business development introductions. I introduce employees. I give them credibility in the fund raising process. Let’s say the company was worth $1 million when I met them and I’ve helped them with both my Rolodex and my cash and they can now raise a round of venture capital at a valuation of $6 million. I would be hurting my own interests. A $500,000 investment at a 30% discount to a $6 million round is still priced and more than $4 million and is certainly worth much less than my investing at a $1 million pre-money where I could own 33% of the company.”http://www.bothsidesofthetable.com/2009/07/19/raising-angel-money/Why do angels agree to invest under these terms is very unclear to me. Is it because of lack of knowledge??? Even if the market conditions are such that there is a lot of hype and there is huge supply of angel money, I don’t see how this could be profitable. I suggest this is the lack of knowledge.ILYA: You said that VC’s may want a higher valuation to better align E’s incentives, but this is not correct.
- I’ve seen other examples. For example, I have seen an example where the discount also applies to the capped price. Using the methodology we develop today, you can price any combination and variation, but read the language carefully both as BA and as E. caveats and foundations for future problems lurk everywhere.
- This is what happens as cap varies