Funding Options for High Growth Companies

September 5, 2012

Today’s  Experts  •  Jeremy  Halpern    

–  Partner,  Nu8er  McClennen  &  Fish  LLP  –  Director,  MassVentures    

–  Director,  The  Capital  Network  –  Angel  Investor  –  Former  entrepreneur  

–  Geek  

•  Ben  Li8auer    –  Member,  Launchpad  Ventures  –  Advisory  Board,  The  Capital  Network  –  Member,  Walnut  Ventures  –  Member,  Boston  Harbor  Angels  –  Director,  Lots  of  Startups  –  Former  Entrepreneur  –  Geek   2  

Funding  the  Company  

Jeremy  Halpern  Nu8er  McClennen  &  Fish  LLP  

jhalpern@nu8er.com  @startupboston  

Ben  Li8auer  li8auer@blkk.com  

vizibility.com/li8auer  @li8web  

Funding  the  Company  

Assuming  you  plan  to  be    a  “high  growth”  company…  

What  are  your  funding  opXons?  

Entrepreneurship  comes  in  many  types      

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NORMAL  GROWTH  COMPANY  

HIGH  GROWTH  COMPANY  

EXTREME  HIGH  GROWTH  COMPANY  

SOCIAL  VENTURE  COMPANY  

•  Includes all service businesses

•  Exploiting a local market need

•  Team has ‘great jobs’

•  Growth by adding resources one by one

•  Exit will be based on value of cash flow (mature biz.)

•  Growth profile ultra-scalable

•  Team focus is exit •  Revenue $40M+

with lots of room for growth (5 yr.)

•  Based on $20M+ investment

•  Exit targeted to IPO or by ‘large’ M&A event

•  Goal is to fulfill a social need

•  Has mission orientation

•  Team needs to support mission

•  Growth profile often one resource at a time

•  Exit …much harder to find fit

•  Company can grow fast (on-line) or has a scalable system

•  Team often motivated by exit

•  $10m revenue in 5 yrs & market size allows significant additional growth

•  Capital efficient total investment$2-4M

•  Exit by M&A

Close  Up:  Extreme  High  Growth  vs  High  Growth  

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Capital Needs

Time

High Risk

Low Risk

Formal Venture Capital

M&A or IPO

Crystallize Ideas

Demonstrate Product

Early Scaling Growth

Sustained Growth

Angel Group (or Micro-cap) Syndication

Angels or Accelerators or Micro-cap

funds Angels or Accelerators or Micro-cap

funds Business Angels

Market Entry

M&A

Later VC Rounds

Extreme High

Growth High Growth

Friends, Family & Founders

Friends, Family & Founders

High  Growth  Company  CharacterisXcs  

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•  DisrupXve  InnovaXon  with  Strong  value  proposiXon  –  CorrelaXon  between  Large  Unmet  Need  :  SoluXon  

•  High  Margin  Product  (RaXo  of  Revenue  :  COGS)    –  SomeXmes  Massive  Volume  Products  where  innovaXon  is  incremental  

•  High  Rate  of  Revenue  Growth  over  sustained  period    •  Scalable  (Fixed  cost  is  a  low  percent  of  Revenue)    

•  No  major  barriers  to  conXnued  growth  (ex.  blocking  IP;  geography;  regulatory)    

•  Repeatable  sales  and  distribuXon  model  with  many  credit  worthy  customers    

•  Large  Total  Addressable  Market  (TAM)    

•  Defensible  innovaXon  able  to  withstand  compeXXon  and  changing  condiXons    

•  [Capital  efficient]  

Return  on  Equity  Return  on  Debt  Income   High  Return  

NON  PROFIT  ORGANIZATION  

Capital  Source  View  

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Debt- Pay it back Fixed Amounts

Equity – Ownership stake % of Future Value

Charity  $$  

Impact  /  Tax  Write  off  

NORMAL  GROWTH  COMPANY  

HIGH  GROWTH  

(COMPANY)  

EXTREME  HIGH  GROWTH  (COMPANY)  

Risk / Return

SOCIAL  VENTURE  COMPANY  

Match  Funding  Sources  

9  

NORMAL  GROWTH  COMPANY  

HIGH  GROWTH  COMPANY  

EXTREME  HIGH  GROWTH  COMPANY  

SOCIAL  VENTURE  COMPANY  

•  Friends family, founders

•  Debt Bank and other

•  (Future) Crowd funding (portal style)

Early on •  Accelerators •  Individual Angels •  Micro Cap VCs •  Seed from VC Later stages •  Venture Funds •  Strategic VCs •  Angel

Syndication

•  Friends family, founders

•  Charity$$ •  Crowds (Kick-

starter) •  Impact Angels •  (Future)

Crowd funding (portal style)

•  Angels •  Angel Groups •  Angel Group

Syndication •  Angel List •  Micro-cap Funds •  (Future) Crowd

funding (portal style)

•  Increasingly Strategic Corporate VCs

Non-­‐Equity  Sources  

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•  Accelerators  (some)  

•  Kickstarter  type  donaXons  

•  Pre-­‐orders  from  end-­‐customers  •  Credit  from  vendors  

•  Strategic  VCs  •  Strategic  NREs  •  DistribuXon  Contracts  

Common  Theme:    Providing  early  cash  in  exchange  for  a  be8er  commercial  opportunity    

Equity  Sources  

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•  Accelerators  (some)  

•  Friends  &  Family  

Common  Theme:  SupporXng  success  of  the  entrepreneur;  business  terms  vary  

•  Portal  Funding  

•  Early  Angels  •  Super  Angels  

•  Angel  Groups  

•  Micro  VC  

•  TradiXonal  VC  (1st  Round)  

Common  Theme:  All  are  looking  for  

–  sale  (or  IPO)  of  the  Company  at  4-­‐10  x  original  investment  

–  Capital  gains  treatment  on  all  sale  proceeds  –  PreferenXal  treatment  on  subopXmal  exit  versus  the  founders  

Sources  of  Equity  Capital  

Must  have  exits  for  equity  model  to  work!!  –  2011  US  IPOs  -­‐  $36B  –  2011  US  M&A  -­‐  $57B    –  2011  US  Private  Equity  -­‐$35B  

•  Exit  sources  extremely  variable  …  health  of  economy  •  All  exits:  indicaXve  of  future  cash  flow  or  market  control    

Idea  Stage    • Friends    family,  founders  

• Grants  • Crowds  (Kick-­‐  starter)  

Demonstrate  Product  &  Market  Interest    • Accelerators  • Individual  Angels  • Angel  Groups  • Accelerators  • Micro  Cap  VCs  

Market  Entry  &  Early  Growth  •   Crowdfunding  (portal  style)  •   Angel  Groups  •   Angel  Group  SyndicaSon  •   Angel  List  •   Micro-­‐cap  Funds  

Early  Scaling  Growth  •  Most  Venture  Funds  

•  Angel  SyndicaSon  

Repeatable  Growth  • Most  Venture  Funds  

• Strategic  VCs  • Angel  SyndicaSon  

• Private  Equity    

High  Growth  Capital  by  Stage  &Amount  

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Venture Stage

Investment Size

Friends & Family

Vendors

Angels

Traditional VC

Angel Groups

Corporate Venturing

Grants

Customers

Crowdfunding

Portal Funding

AngelList

Micro VC

Equipment Financing

Founder

Capital  Sources:  Size  &  Cost  

Investment Size

Investment “Cost”

Traditional VC

Micro VC

Equipment Financing

Angel Groups Angels

AngelList

Corporate / Strategic Venture

Customers

Portal Funding

Vendors

Founder Friends & Family

Crowdfunding

Grants

Venture Debt Bank

Loans

Personal Loans

Private Equity

So  What  is  Equity  Anyway?  

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•  Stock  =  right  to  residual  economic  interests  upon  sale/liquidaXon  +  stockholder  voXng  rights  (usually  limited  to  Board  of  Directors  and  Sale  of  the  Company)  

•  Preferred  Stock  =  right  to  be  paid  before  Common  Stock  ParXcipaXng  =  original  investment  PLUS  a  pro  rata  share  of  remainder  Non-­‐ParXcipaXng  =  original  investment  OR  a  pro  rata  share  

•  Common  Stock  =  whatever  is  lev  aver  all  other  creditors  and  preferred  stockholders  are  paid  

•  Dividend  =  a  right  to  an  addiXonal  amount  upon  liquidaXon  measured  as  a  funcXon  of  Xme  x  percentage  of  original  investment  .  Ex.  6.0%  per  annum  

•  OpSons  /  Warrants  =  Contracts  allowing  holder  to  purchase  an  amount  of  stock  in  the  future  at  a  pre-­‐determined  price  

•  Control  Rights  =  Statutory  and  Contractual  

Equity  Type  Comparisons  

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Solo  Angel   Super  Angel   Angel  Group   MicroVC   VC  

ValuaXons   High  relaXve  to  stage  

High  relaXve  to  stage  

Low  relaXve  to  stage  

Low  relaXve  to  stage  

Medium  

Type  -­‐  Likely  (less  likely)  

Common  (Warrants)  

Conv  Note  (Preferred)  

Preferred  (Conv  Note)  

Preferred  (Conv  Note)  

Preferred  

Board  Seat   Maybe   1  or  none   1-­‐2  of  5  +/-­‐  Observer  

1  of  5  +/-­‐  Observer  

1-­‐2  of  5  +/-­‐  Observer  

Audited  Financials  

No   No   No  (reviewed)   Yes   Yes  

NegaXve  Covenants  

No   SomeXmes   Yes   Yes   Yes  

PreempXve  Rights  

No   SomeXmes   Yes   Yes   Yes  

VerXcal  ExperXse  

SomeXmes   Rarely   Some   Usually   Always  

Equity  Type  Comparisons  

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Solo  Angel   Super  Angel   Angel  Group   MicroVC   VC  

Exit  Horizon  (from  $  in)  

7  years   5  years   4  years   5  -­‐7  years   4-­‐5  years  

Exit  Range   $20m+   $40m+   $50m+   $100m+   $250m+  

Structure  of  an  Equity  Deal  

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•  Company  and  Investors  agree  on  a  “pre-­‐money  valuaXon”  (PM)  which  leads  to  a  price  per  share  

•  Investors  put  in  $X  •  Investors  then  own:  X  /  (X  +  PM)  of  the  company  

Example:  PM  =  $1M  X  =  $0.5M  Investors  own  0.5/1.5  =  33%  

Remember:  New  issuance  NOT  transfer  

Understand  the  Funding  Path  

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•  We’re  talking  about  1st  funding  here  •  What  is  the  probable  complete  funding  picture?  

– This  is  only  funding  – Another  small  round  then  probable  small  exit  – Big  money  needed  before  exit  

•  Each  funding  event  should  occur  at  an  “inflecXon  point”  – Hopefully  at  a  point  where  risk  is  removed  –  Increased  PM  =  so-­‐called  “up  round”  

Understand  the  Funding  Path,  cont.  

20  

•  What  if  things  aren’t  going  so  well?  – Flat  or  decreased  PM  =  so-­‐called  “down  round”  

•  More  money  coming  in  without  increased  PM  means  everyone  gets  diluted,  but…  

•  Depending  on  anX-­‐diluXon  provision  entrepreneur  may  carry  more  burden  than  the  investors  

What  about  ConverXble  Debt?  

21  

•  Many  seed-­‐stage  companies  use  an  instrument  called  ConverXble  Debt.  Huh?  

•  ConverXble  debt  is  not  tradiXonal  bank  debt  •  Converts  exist  for  two  major  reasons  

–  Investors  and  Entrepreneurs  find  it  hard  to  agree  on  a  PM  valuaXon  

– SomeXmes  quicker  and  cheaper  to  document  than  equity  deals  (but  not  really)  

ConverXble  Debt  provides  OpXonality  

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•  ConverSble  Debt  =  unsecured  debt  obligaXon  of  the  Company  that  may  be  converted  into  equity  of  the  Company.    

•  Conversion  Trigger  =  Qualified  Financing  usually  at  some  minimum  amount  of  funds  (ex.  $500,000)  

•  If  Notes  stays  as  Debt  =  Get  back  principal  and  interest  ahead  of  other  equity  (behind  other  creditors  typically)  

•  If  Notes  Convert    =  Convert  amount  of  debt  and  interest  into  equity  at  the  valuaXon  in  the  next  round  

•    aver  applicaXon  of  a  Discount  (oven  5  –  20%)  •    subject  to  a  maximum  valuaXon  amount  (the  “Cap”)  

Basic  Structure  of  ConverXble  Debt  

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•  Investor  loans  $  to  Company  an#cipa#ng  another  round  of  funding  •  Investment  accrues  small  interest    •  When  the  funding  occurs,  investment  +  interest  convert  to  equity,  

usually  at  a  discount  (5-­‐20%  typically)  

Example:  •  Investors  loan  $200K  to  Company    •  20%  discount  •  As  of  conversion,  interest  of  $10k  has  accrued  •  Next  Round  PM  =  $2m  •  Conversion  Amount  =  1/(1  -­‐  0.2)*  $210k    =  $262,500  

At  Conversion,  Noteholders  receive  262.5K  /  (PM  +  262.5K  +  New  Money)  

ConverXble  Debt  –  ComplicaXons!  

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•  What  if  only  a  li8le  money  comes  in?  •  When  does  the  debt  convert?  

•  What  happens  if  PM  of  next  round  is  huge?  

•  Does  the  investor  have  any  say  in  things?  •  What  if  there  is  an  equity  investment  that  doesn’t  trigger  conversion?  

•  What  happens  if  it  never  converts?  

•  What  happens  if  Company  gets  bought?  

ConverXble  Debt  –  SoluXons?  

25  

•  Caps  and  Floors  – May  defeat  purpose  with  signaling  

•  Default  conversion  price  and  security  at  maturity  

•  Open  round,  minimum  close  

•  Quick  sale  preferences  (ex.  2x)  •  Governance  provisions  •  Careful  a8enXon  to  conversion  condiXons  

ConverXble  Debt  –  Worse  than  Equity?  

26  

•  MulXple  liquidaXon  preference  (circa  2008)  –  Ex.  $500k  of  Notes  with  cap  at  $2m  PM  –  Next  Round  at  $6m  PM  –  Issue  Noteholders  3x  number  of  shares  –  3x  shares  equals  3x  liquidaXon  preference!!  

•  Without  a  floor,  effecXvely  Full  Ratchet  AnX-­‐diluXon  

•  Preference  Overhang  –  In  prior  example  Noteholders  bought  $262,500  of  preference  for  

$200,000.      –  All  other  Series  A  Holders  bought  1:1  preference  

•  Not  Just  a  Price  Adjustment  

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