Startup-Investor Negotiations
MohammadReza Farahi About me
MohammadReza Farahi Finance Advisor at Rahnema Ventures
Besides academic education in finance in France and Spain, he has a great experience of valuation and investment affairs with tens of startups in Rahnema ventures.
Notice All rights reserved. This document is an exclusive property of Charkh Academy . No part of it may be reproduced or quoted, in any form or by any means, electronic or mechanical, without the prior written permission of the owner. Copyright © 2018. For a list of references, you can contact the author via [email protected] or [email protected] Investment
• How people manage their wealth?
3 Investment history
• Code of Hammurabi(1700 BC) provided a legal framework for investment by codifying debtor and creditor rights.
• First venture investors: maritime expeditions were first case; navigators were the most adventurous entrepreneurs, and ship owners were first VCs.
• Why investment emerged? Because of specialization; some people have expertise without capital. Some other people have capital, but not enough time or expertise in lucrative fields
4 Traditional Investment vs. VC
• The main difference is between Risk & Reward • Risk factors in ventures are: • Innovation risk • Business model risk • Operation and scale up risk • +90% of Ventures have no earning for investor • VC is a Knowledge-base investor, you need to be expert in some fields. • So, you can help out and control management. • Also, you are doing something unique, so it has social impacts and personal identity
5 Risk in traditional company vs. digital company
Relative weight of technological risk and marketing risk, as company grows 6 Why VC emerged in 20 century • In the past, Information from inside company could not effectively communicate to outside; so investors didn’t know what they are investing in.
• It was very risky to take an equity stake in a company; Limited liability made it possible. So, investors are not liable for company default.
• Before these two, lending money was much safer than buying shares for investment.
7 VC timeline
Georges Doriot (the father of venture capitalism) started First VC: ARDC (American 1946 research and development corporation) after world war II
The first star: 70K$ investment in digital equipment corporation in 1957 valued more 1968 than 355M$ in 1968 (101% annual rate) after IPO
Small business act; licenses private companies to finance other businesses in US and 1958 gave tax breaks to them US labor department removed some restrictions, allowing corporate pension funds to 1978 invest 10% of their funds in venture funds, providing a major source of capital available to VC (the industry became ~40X)
2003 Dot-com bubble have shriveled industry to about its half
8 Venture capital fund raising in the U.S. 1985-2015
9 Upside & downside in investment • Risk means you have the possibility of losing some, or even all of your investment. • In investment, usually risk and return are tradeoffs. (two sides of a coin) • Some people are risk averse, and some others are risk seeker. • The person who refuses a fair bet is risk-averse
Example: Lets Flip a coin; which option do you choose? • You will receive 1MT without flipping coin • Or you will receive 2MT if heads • Which one does VC choose?
10 Salesman case study
An ordinary man with fixed 15K$ salary in a job with no certainty • A proposal comes: a salesman commission-based job with 30K$ (upside) if works well, and 10K$ (downside) if result are not good • probability of good and bad result in salesman mind are same, 50% • So, will you take the proposal? Like any other answer in management, It depends.
11 Salesman solution The utility function is: E (U) = 0.5 U (10,000) + 0.5 U (30,000) • So, the answer depends on each person utility and attitude to risk. • The utility for risk seeker is 60, (more than 43 in 20K$), so he takes job • and for risk averter is 37.5 (less than 65 in 20K$), so he refuses.
12 Liquidation
When you can liquidate your investment? Simply “cash out”
13 Liquidation and Exit • Liquidation: a process by which a company is brought to an end, good or bad • Exit: when an investor gets a return on their investment in a venture-backed startup • Different types of exit: • Acquisition • Acquihire • Merger and acquisition • IPO • Not selling the startup • Investors are looking for a return of 10-100 times on their original investment
14 Acquisition and Acquihire • Acquisition: • Buyer takes over startup using cash or stock as a compensation • Team usually stays at company for a period of time to cash out and vest their stock • One example is: Waze, acquired by Google in 2013. The technology is used in Google maps for estimating traffic .
• Acquihire: acquisition + hire • Buyer usually is more interested in team, than product • Often leads to closure of products, or change the direction of product
15 Linkedin timeline; IPO and acquisition case
2003 Raised 4.7 M$ in first year
2008 Raised 53M$ with valuation 1b$, joining unicorn club.
2008 Raised 22.7m$, more than 100M$ in total funding
2011 Went public, the record market cap was +20b$ in 2015
2016 Acquired by Microsoft with 28B$ valuation
16 Number and value of M&A worldwide
17 IPO • IPO: (initial public offering): When raising more capital from VC or private
equity firm is no longer an option, let’s go for IPO Number Number IPO of in U.S.
18 M&A and Not selling the company • M&A • Merging with similar or a larger company • Often chosen by big companies looking for complimentary products.
• Not selling the company, milking the cow: • When you can establish a solid business model and revenue • You invest your profit in your company • part of those profits can also be distributed amongst investors as a dividend
Further reading: The hard thing about hard things; a real story of ups and downs in IPO and acquisition
19 Liquidation in Iran • Some challenges: • There are not many large IT companies in Iran. So no one acquires your startup • The IPO process is not well-known among startups, because success stories are few • Interest rates are higher, so investors cant wait until you make your own profit
• Some cases of liquidation in Iran • App (*733#): went public on 1395, now market cap is around 3700bT • Zoodfood: acquired by rocket in 2014, merged with bodofood, to accelerate partnership with restaurants • Fidibo: acquired by digikala, to offer customers both physical book and ebook
20 Investment rounds
21 Investment rounds
• Seed investment: a preliminary investment for an idea
• Series A: when you have a strong defined idea
• Series B: when you truly established your business
• Series C and beyond: no technical limit
22 Investment rounds • Seed investment, to achieve: • Product identification • Marketplace orientation • Customer targeting • Team creation
• Series A, to achieve: • Build Distribution channels • Pay for marketing • Develop new markets
23 Investment rounds • Series B, to achieve: • Team expansion • Globalization • Acquisitions (if needed)
• Series C and beyond: • There is no technical limit, mainly it is related to market expansion and growth rate • Be aware of anti-dilution agreements, which prevents founders stake to water down
Further reading: - infographics in funders and founders - Company profiles in crunchbase 24 25 26 Bibliography
• A brief history of venture capital; https://www.financialpoise.com/a-brief-history-of-venture- capital/ • Why venture capital thrives in digital world; https://salon.thefamily.co/low-risk-high-reward-why- venture-capital-thrives-in-the-digital-world-ed56d0b14dc • Utility theory and attitude toward risk; http://www.economicsdiscussion.net/articles/utility-theory- and-attitude-toward-risk-explained-with-diagram/1384 • How can startups exit and investors make money; https://startupxplore.com/en/blog/exit- strategies-for-startups-and-investors/ • Startup Investment 101: Investment Rounds Explained; http://blog.onevest.com/blog/2015/4/23/startup-investment-101-investment-rounds-explained • Intellectual property strategies for startups; https://techcrunch.com/2016/10/31/intellectual- property-strategies-for-startups/ • Silicon valley venture survey; https://www.fenwick.com/publications/Pages/Silicon-Valley-Venture- Survey---Second-Quarter-2014.aspx
27 Shareholder Agreement
How to make a deal Definitions • Letter of intent: It says that we have accepted idea, team and value proposition • Term sheet: a non-binding agreement that sets forth the basic terms and conditions under which an investment will be made • Shareholder agreement: • A shareholding agreement is the final document. • It is definitive and legally binding. • It outlines the shareholders' rights and obligations. • It depicts how company operates. • SHA should be fair, and should be perceived fair, unless, the company will get locked, because founders or investors will not be interested enough to continue this hard journey. • Shareholder agreement has different characteristics.
29 Basic types of investor funding
1 Equity investor will receive a stake in exchange for money
Loan 2 you borrow money now, and pay it back later
Convertible debt 3 a mash-up of debt & equity
Question: Which one is suggested for startups?
30 Equity • Investor will receive a stake in exchange for money • When to do it: • When you need a long runway • When you have zero collateral • When you can’t possibly bootstrap • When you are positioned for astronomical growth • Things to keep in mind • Equity narrows your options: because equity investors are interested in one thing: liquidity • Equity investors are taking big risk for big results • Competition for getting investment is very high • It takes time: about 3-6 month • It is a one-way street: the investor is part of your world, whether like it or not.
31 Loan • you borrow money now, and pay it back later, with an established rate of interest
• Important features: • Interest rate • Repayment schedule • Collateral
• When to do it: • When you don’t need too much • When you need capital quickly • When you need money for a very concrete, tangible reason • Finally, When equity isn’t available
32 Convertible note • You borrow money from investors with the understanding that the loan will either be repaid or turned into a share • How it works: • Discount: investor receive a discount on • Interest rate: for a straight rate • Valuation cap: maximum company valuation at which investors can convert their debt into equity • When to do it: • When you are not ready for valuation • When you believe your company valuation is to skyrocket • Keep in mind: • Investors really like it, because they have exit strategy of debt structure, and they can see how you perform and jump on equity train.
33 Convertible note case • Seed round: • Valuation cap: 4M$ • Discount rate: 20% • Interest rate: 20% • Investment: 100K$
• Series A: • 11M$ pre-money valuation • New investment: 1M$
• How many percent of shares for the convertible note holders?
34 What do investors need in SHA?
• Downside protection: • Liquidation preference: an investor receives its investment back, prior to common investors. • IPO conversion provision: if IPO valuation is below the certain value, the investor gets additional share. • Anti-dilution adjustments: reduce current deal price, if valuation declines in future. • Upside benefits: • Liquidation participation: after an investor receives its money back, the investor then gets to participate with common shareholders in remaining. • Super voting stock
35 Google acquired Slide; case study
• After sale of company, lets see how much different people made: • Max Levchin (founder) – $39M • Scott Banister who also took part in the series A made $5M from the sale. • BlueRun Ventures, who invested $8M in the series B round made $28M. • The Founders Fund and Mayfield Fund, both investors in the series C, each made their money back. • Fidelity Investments, part of the series D: also made their money back. • The reason Fidelity, Founders Fund, and Mayfield got their money back is they had a liquidation preference. Otherwise they would have lost money in a transaction where the founder made $39M • what do you think about this deal? Was it fair?
36 Bibliography
• Convertible notes; examples and how it works; https://www.seedinvest.com/blog/startup-investing/how-convertible-notes- work
• The types of investor funding's; https://www.fundable.com/learn/resources/guides/investor-guide/types-of- investor-funding
• Journey from term sheet to shareholding agreement – Startup Funding; https://yourstory.com/2015/08/termsheet-to-shareholding-agreement/
37 Preferred Stock Preferred stock; terminology
• Preferred stock is a class of stock that provides certain rights, privileges, and preferences to investors
• Compared to common stock, which is normally held by the founders, it is a superior security
• Preferred stock takes its name from a critical feature of preferred stock called liquidation preference • Liquidation preference means that in a sale (or liquidation) of the company, the preferred stock holders will have the option of taking their cost out or sharing in the proceeds with the founders as common stock holders
39 Preferred stock; terminology • Almost all venture capital firms and many angel and seed investors will require the company they are investing in to issue them preferred stock • Common stocks are usually to be issued to founders & Employees through the employee stock option program • Preferred stocks are usually the exclusive offer for investors; but why? • Common stock should be thought of as a vehicle for issuance in exchange for effort, or “sweat equity” • Preferred stock has preferential rights in matters such as liquidation and board representation • These are rights generally reserved for those who have invested cash in the business. (After all, this is a Chicago-wise economic system!)
40 Preferred stock; terminology • Depending on how hard the investors have pushed for more rights and provisions, we have different standardized and non-standardized classes of preferred stocks • It’s not uncommon for the value of preferred-stock shares to be 10 times that of common-stock shares • Ultimately, both types of stock are converted into common shares at the time of the Initial Public Offering • How Frequent? Kaplan & Stromberg of Chicago Booth:
Further reading: An Empirical Analysis of Venture Capital Contracts; Kaplan & Stromberg
41 Rationale motives behind the scene
• As usual, it’s all about “conflict of interests”…
• Founders want to build a company, keep control and earn a fair share of any windfall
• Investors want to profit from your company as much as possible, minimize their financial risk and, often, gain the operating control needed to do so
• Balancing these interests is a delicate process that requires a clear-eyed understanding of the terms involved during negotiations…
42 Ingredients
• Let’s be clear: We, negotiators, are nothing more than a chef!
• In this case, our ingredients are different rights, legal concepts, contingencies, etc.
• Our cooked meal is the particular type of the preferred stock that we manage to achieve, among many classes: Ashe-Sholeh-Ghalamkaar!
43 Many ingredients
• Participating vs. Non-participating • Indemnification
Preferred Stock • IPO Shares Purchase
• Vesting • Pay-to-Play
• Drag Along • Option Pool
• No-Shop-Agreement (Unilateral or • Anti-Dilution Provisions Serial Monogamy)
44 Many ingredients
• Conditions Precedent to Financing • Pro-rata Rights
• Information Rights • Registration Rights
• Board Control • Right of First Refusal
• Dividend Rights • …
• Blocking Rights
45 Bibliography • “Differences Between Common and Preferred Stock”, AllBusiness Networks http://goo.gl/QUuQr8 • “Everything You Ever Wanted To Know About Convertible Note Seed Financings”, Scott Edward Walker, TechCrunch http://goo.gl/GYKlsh • “I Just Heard Some Startling Things About Uber”, Henry Blodget, BusinessInsider http://goo.gl/kKl7QD • “Convertible note agreement templatenths”, PandaDoc https://goo.gl/eFILSx
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