Hello. - nsfiipconf.com€¦ · Valuation models for pre-revenue companies • Venture Capital...

TODAY’S EARLY-STAGE INVESTMENT VEHICLES

June 7, 2017

Michael Horten

Hello.

THE CHANGING Angel

Financing LANDSCAPE

Emulate the VC community by using Series A

preferred stock

Using NVCA open source documents

Traditional Approach to

Angel Financing

Problems with

Traditional Approach

The traditional approach is too costly and

cumbersome for the smaller angel rounds

• Series SEED

• Series AA

Today`s types of Angel

Financings

• Promissory note

• KISS (Keep it Simple Security) promissory note

• SAFE (Simple Agreement for Future Equity) note

• KISS equity note

Common stock

Un-priced securities

Convertible equity note

Traditional convertible preferred stock

Stripped-down convertible preferred stock

Convertible promissory note

Priced securities

Which Financing Vehicle

Should You Use

Blue-chip legal services to entrepreneurial growth companies

Big firm experience without the marble and mahogany

Fixed fees

Angel investor for over 20 years

Handled over 100 early-stage financings in the last 2 years

Member Angel Capital Association and ATA

Michael Horten

COMMON STOCK

FF&F

CONVERTIBLE

PREFERRED STOCK

How many shares should

the investor receive?

25%

75%

The valuation determines

the investor’s percentage

ownership interest

Pre-Money Valuation

Place a Realistic Value

on your Company

Entrepreneur valuation

Investor valuation

Unlike selling your home, it’s

difficult to lower your valuation

How do you determine

Pre-Money Valuation

Methods for valuing

mature companies

generally do not work

Valuation models for

pre-revenue companies

• Venture Capital Method (VCM)

• Discounted Cash Flow (DCF) or Net Present Value (NPV) Model

• Scorecard Method

• Chicago Method

• Cayenne Consulting Calculator

• Dave Berkus Valuation Model

• Bill Payne’s Model

• Risk Factor Submission Model

• Replacement or “All-In” Method

• Rule of Thirds

• Ratios and Multiples

• Set Ceilings

Venture capital method (VCM)

Assumptions for this Analysis

Venture capital method (VCM)

• Angels should expect an IRR of 25%

• Investment will last for 5 years

• An angel needs a portfolio of at least 10 companies

• 25% IRR in five years = 3X ROI

• Nine deals produce 33% of yield

• 33% of yield = return of capital for portfolio

• One deal must produce 2X ROI on total capital or 20X ROI (82% IRR) on

money invested in the deal

VCM example

Investment $1 million

Exit year 5th year

Projected revenues in 5th year $40 million

Projected net profit in 5th year $4 million

P/E (public companies in sector) 15X

Terminal value (after 5 years) $60 million

Required IRR 82%

Required ROI $20 million

% ownership of company required 33%

Post-money valuation $3 million

Pre-money valuation $2 million

Pre-Revenue Median Value

Scorecard method

• Determine an appropriate median value for pre-revenue

companies in your region

• Assign % weighting for each critical issue

• Calculate the weighted average of issues

• Multiply median value by weighted average

• Determine an appropriate median value for pre-revenue companies

in your region

o National trends in pre-money valuation generally range from $0.5

million to well over 3 million

o National median pre-money valuation is $2.5 million

• Collect valuation data for pre-revenue companies in your region for

the preceding years and calculate the median value

• Track regional and national trends in valuation

Scorecard method

How it works

• Assume that the median local pre-money valuation of pre-

revenue companies is $2,300,000

Scorecard method

Pre-Revenue Median Value

Scorecard method

Calculate Weighted Average Multiple

Issue Analysis Weight Factor Input

Management On board, except sales VP 30% 120% 0.360

Opportunity Enormous 25% 130% 0.325

Product Disruptive, prototype OK 15% 130% 0.195

Sales No channels, all foreign 10% 50% 0.050

Competition No big players, messy 10% 110% 0.110

Other Need partners, selling costs 10% 80% 0.080

Weighted average multiple = 1.12

Scorecard method

Calculate Pre-Money Valuation

Median Value $2,300,000

Weighted Multiple X 1.12

Pre-money Valuation $2,576,000

Agreed Valuation

Example

Company seeks $1M in equity capital

Founders own 2M shares of common

stock

Founders network and pitch to investors

They receive an offer for $1 million at a $2 millionpre-money valuation

The investor will send them a term sheet

Example

Founders are happy with the

$2M pre-money valuation

Founder’s expectations

Pre-Money Cap Table

Common Pre-Money Total %

Founders 2,000,000 2,000,000 100%

Options Granted 0 0%

Options Available 0 0%

Investor 0 0%

Total 2,000,000 2,000,000 100%

Start-Up Capitalization

Founder’s projected post-money

cap table

Pro Forma Cap Table

Series A Series A Post-Money

Common

Pre-Money

Total % Investment Preferred Total %

Founders 2,000,000 2,000,000 100% 2,000,000 66.7%

Options Granted 0 0% - 0.0%

Options Available 0 0% - 0.0%

Investor 0 0% $1,000,000 1,000,000 1,000,000 33.3%

Total 2,000,000 2,000,000 100% $1,000,000 1,000,000 3,000,000 100.0%

Pre-Money Valuation $2,000,000

Price / Share $1

Total $ Invested $1,000,000

Post-Money

Valuation $3,000,000

Start-Up Capitalization Series A Funding

Post Celebration Jolt

Purchase Price: $0.70 (not $1.00)

Founders Own: 46.7% (not 66.7%)

The term sheet pre-money valuation is different from the true pre-money valuation

First culprit: The number of shares received by the investor is computed on a “fully diluted basis”

Second culprit: The investor is receiving preferred stock

Incentive Pool

A pool of unissued shares reserved for

issuance to officers, directors and key

employees (usually as options)

New pre-money cap table

Pro Forma Cap Table

Common Pre-Money Total % New Options Pre-Money Total %

Founders 2,000,000 2,000,000 100% 2,000,000 70.1%

Options Granted 0 0% 0 0.0%

Options Available 0 0% 855,000 855,000 29.9%

Investor 0 0% 0 0.0%

Total 2,000,000 2,000,000 100% 855,000 2,855,000 100.0%

New Option PoolStart-Up Capitalization

New post-money cap table

True Pre-money valuation: $1,750,547

• 2,000,000 common stock held by founders

• 855,000 (20% post financing) common stock incentive pool

• Dilutes founders to 70%

Impact of pre-money

incentive pool

Pre-money cap table

• 2,000,000 common stock held by founders (58.35%)

• 855,000 common stock incentive pool

• 1,427,500 preferred stock held by investors

Post-money cap table

2nd Post Celebration Jolt

The investor is being issued

participating preferred stock

Common stock

Equity financing securities

Convertible preferred stock

• Non-participating

• Participating

Participating vs.

non-participating preferred stock

Investor invests $1M for a 1/3rd interest in the company and

the company sells its business for $2M

Investor gets:

CommonNon-Participating

PreferredParticipating

Preferred

$666,667

(1/3rd of $2M)$1,000,000

(return of investment)

$1,333,333

($1M +1/3rd of $1M)

Participating vs.

non-participating preferred stock

Investor invests $1M for a 1/3rd interest in the company and

the company sells its business for $10M

Investor gets:

CommonNon-Participating

PreferredParticipating

Preferred

$3,333,333

(1/3rd of $10M)

$3,333,333

(1/3rd of $10M)

$4,00,000

($1M +1/3rd of $9M)

Pre-money cap table

Impact of participating

preferred stock

• 2,000,000 common stock held by founders

• 855,000 common stock incentive pool

• 1,427,500 preferred stock held by investor

Company is sold for $3M

• Investors receive $1,832,969 ($1,000,000 + 41.65% of $2,000,000)

• Founders receive $1,167,032

Preferred Stock Valuation Squeezer

Preferred Dividends

The holders of preferred stock receive

dividends before dividends are paid to the

holders of common stock

Cumulative

Non-Cumulative

Participating

Non-Participating

Types of preferred dividends

Governance,

Management & Control

Investors invest in the

management team

Voting rights

Board seat or observer rights

Approval rights

Right to force a sale of the company

Management & Control

Investor Protection

Price anti-dilution

protection

• Time limitation

• Full ratchet

• Weighted average

Price anti-dilution issues

Pre-money cap table

“Full Ratchet” Anti-Dilution

Protection Example

• 2,000,000 common stock

• 1,000,000 preferred stock convertible into common at $1 a share (the

preferred stock issue price) with full ratchet anti-dilution protection

Company raises additional equity capital• Company issues 50,000 shares of common stock at $0.50 a share

because it desperately needs cash

• Conversion price drops to $0.50 a share

Founder dilution

• Founder goes from 66.7% of the equity to 50% and all the company

has gained is $25,000

Pro-rata rights

20%

Right of first refusal

and co-sale

First line of Defense: ROFR

Second line of Defense: Co-sale

Information rights

Proprietary information and use limitation covenants

Ownership of work product & IP

Non-compete covenant

Non-solicitation covenant

Restrictive covenants

agreements

Key holder stock

claw-back

Exit / Liquidity

Redemption rights

Registration rights

Exit / Liquidity

STRIPPED-DOWN

CONVERTIBLE PREFERRED

STOCK

CONVERTIBLE

PROMISSOY NOTES

Company has signed an equity round

term sheet but needs pre-closing

funding (bridge financing)

BRIDGE NOTES

Mandatory conversion into the next equity

round at a 10-20% discount

Bridge Notes

• The investment is in effect disguised equity

Term• The maturity is typically set to allow enough time for the next

equity round to close

Interest rate• Interest rate is typically similar to the preferred dividend in an

equity round

Payment• Balloon payment at maturity

Has gained great popularity

Pier Notes

Usage expanded beyond bridge financing

(the equity round is not yet under way)

Pier note advantages

• Appealing to unsophisticated angels who may not know what

protections and terms to request

• Kicks the “valuation can” down the road

• Faster and cheaper

• Minimal impact on the fair market value of the company’s common

stock, making the company’s equity incentives more attractive

• Flexibility; can provide greater discount to earlier investors

Pier note drawbacks

• Goes against the traditional ranking philosophy of venture investing

• The interest of the founders and the investors are misaligned

• Neither the Company’s founders nor the investors know what

percentage of the company each may eventually own

• Noteholders must wait for the date of conversion to start the clock

running for long-term capital gain treatment

• Notes are much lighter when it comes to rights and protective

provisions for the investors

• Maturity creates a ticking time bomb for the company

The 20-25% discount is not commensurate

with the risk they take as compared to the

Series A investors

Began looking for new solutions

INVESTORS FELT SHORT

CHANGED

Increasing the discount

Adding warrants for common stock

Adding conversion cap

Solutions

Adding warrants

for common stock

Adding Conversion Cap

Price

Your maximum price

Your price

Problems with

conversion cap

• At what time does the cap apply

• Inflates preferred dividend and liquidation preference (the

“liquidation preference overhang”)

• The noteholders get full ratchet anti-dilution protection

When to apply the

conversion cap

• The conversion cap usually is applied at the time of

conversion

• Makes more sense to apply the conversion cap to the cap

table at the time of the issue of the note

The “liquidation preference

overhang”

• Company has 2,500,000 shares of common stock outstanding

• Company issues notes for $500,000 carrying a $2.5M conversion cap

(i.e., $1per share max conversion price)

• Series A has a $10MM pre-money valuation, resulting in a per share

price for the new money of $4.00

• The Series A has a 1x participating liquidation preference and carries

a 6% cumulative preferred dividend

• The $2.5MM conversion cap means the notes convert at $1.00

• The noteholders receive an effective 24% preferred dividend instead

of 6%

• The noteholders receive a $2M liquidation preference instead of

$500,000 -- a whopping 4X liquidation preference – resulting a $1.5M

“liquidation preference overhang”

Issue “discount shares”

in common stock

• Company has 2,500,000 shares of common stock outstanding

• Company issues notes for $500,000 carrying a $2.5M conversion cap

(i.e., $1per share max conversion price)

• Series A has a $10MM pre-money valuation, resulting in a per share

price for the new money of $4.00

• Instead of issuing the noteholders 500,000 shares of Series A

preferred stock, issue them 125,000 Series A preferred stock and

375,000 shares of common stock

• They will still own 500,000 shares, but their liquidation preference is

equal to their purchase price (125,000 x 4 = $500,000)

Convert into “shadow”

preferred stock

• Company has 2,500,000 shares of common stock outstanding

• Company issues notes for $500,000 carrying a $2.5M conversion cap

(i.e., $1per share max conversion price)

• Series A has a $10MM pre-money valuation, resulting in a per share

price for the new money of $4.00

• Instead of issuing the noteholders 500,000 shares of Series A

preferred stock

• Issue them 500,000 Series A-1 preferred stock as shadow preferred

or sub-series preferred

• The Series A-1 preferred stock is exactly the same as the Series A in

all respects, except for the liquidation preference, which would be $1

per share vs. $4 for the Series A

SAFE NOTES

Equity financing

SAFE Notes

• Converts into a “shadow” preferred stock -- some with discount; some

with a conversion cap

Liquidity event• Investor may chose to receive:

• The investment amount

• Common stock priced at the conversion cap

Dissolution event• Investor receives the investment amount prior to any other equity

holder

“Most Favored Nation” provision

&

Michael Horten

(770) 436-7834

mhorten@hortencc.com

Thank

You.