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Deal Structures for Startups

Recently on the nextNY mailing list, an entrepreneur asked if there was “one resource out there which describes all the different types of deal structures, and the advantages and disadvantages for each.”  I replied that this was unfortunately an impossible task, given the unique nature of each individual deal, but that I would at least try for a high-level overview. So this is what I answered:

“Believe me, I empathize with your goal. The problem is that in entrepreneurial startups, as with life in general…there is simply no easy answer, no matter how much we’d like it. To put things in perspective, the country’s leading venture lawyers have gotten together and created an exhaustive set of complete, annotated documentation for venture-funding early stage companies, which the National Venture Capital Association has then put on the web, completely for free.  On top of that, several of the firms have gone even further, and invested many thousands of dollars in creating on-line wizards and expert systems to walk you through the process of creating and structuring early stage debt and equity deals…and THEY have put them on the web for free. And then, not to be outdone, but entrepreneurs like Adeo Ressi of TheFunded have worked with counsel to create an alternative set of documents, and they’ve put their term sheet on the web for free.

With all that spectacular quality, freely-available stuff available online, for funding deal after deal in similar situations, you’d think that it was game-set-match and there shouldn’t be any need for any entrepreneur or investor to ever pay legal fees again to document a simple convertible note or Series A deal, right?

WRONG! I don’t believe that there has been a first round financing deal in the past decade that has not generated five figures of legal fees, in the process of taking these completely standard, completely exhaustive documents and tailoring them for the specific situation at hand. And while there are precious few situations where we can get away with $10K in fees (generally only if it’s a brand new company and the entrepreneur is willing to accept the investor’s standard deal with no negotiation) the typical cost of counsel for a Series A is between $25K and $50K.

Is this insane? In one sense yes, and that’s why everyone keeps working furiously to come up with alternatives. But because of the differences and nuances in each deal, investors and entrepreneurs, if they are smart, ultimately have no choice but to cough up the cash if they want to get a deal done. Believe me, it’s not because we’re stupid, or that the lawyers are holding our children hostage…but simply because we understand that there are no shortcuts.

To answer your question with an almost useless (but at least well-meaning) quick few paragraphs, let’s try this:

A Note (or loan) is where the investor ‘rents’ money to the entrepreneur in exchange for getting it paid back by interest. For the entrepreneur, the advantage is that he keeps any upside, the disadvantage is that he has to pay it back. For the investor, the advantage is that it is the first priority money that comes out of the company, but the disadvantage is that it takes all the risk (if the company fails) and doesn’t get the upside of appreciation if the company is a success.

Selling Common Stock (which is what you, the founder start out with) to an investor means that s/he is taking the risk alongside you. For the entrepreneur, the advantage is that it doesn’t have to be paid back if things go badly, the disadvantage is that you are giving up a piece of the upside in the case of success. For the investor, it’s the reverse: the advantage is that you share in the upside, but the disadvantage is that because you’re on an equal footing with the entrepreneur, if things go south and there’s only a little value at the end of the day, the entrepreneur gets most of it, even though the investor has put in all (or most) of the money.

Preferred Stock is much like a loan, except that it doesn’t have to be repaid if the company fails. It means if the company gets ANY cash at the end of the day, it first goes to fully pay back the investor, usually along with dividends (which is like interest). Only after the investor is taken care of does the entrepreneur get his/her piece of the action. For the entrepreneur, the advantage is that aside from the fixed dividend rate, all the profits are retained by the entrepreneur; the disadvantage is that because it comes out first, there may not be anything left after paying the investor back. For the investor, the advantages are, again, the inverse: it has the security of getting paid back first (after any debts or loan repayments the company owes), but it doesn’t reap any of the upside benefits other than fixed dividends if the company is successful.

The standard “Series A” deal which is almost universally used in venture and serious angel investments, is a combination of the above two, known as “Convertible Preferred Stock”. It starts out with the investor buying Preferred stock, thus ensuring that in a not-good scenario the investor will at least get his or her investment dollars back before the entrepreneur makes any money. But the ‘convertible’ provision means that if good things happen and the company ends up being worth a lot of money, the investor can choose to convert the Preferred stock into Common stock at a pre-negotiated valuation, and therefore benefit from the increased value. In tough markets this is sometimes tweaked into a “participating preferred”, in which the investor has his/her cake AND eats it, too. In a participating deal, the investor first gets back the original investment with dividends (like a regular Preferred), and THEN double-dips by converting the full amount into Common, thus sharing in the upside.  For the entrepreneur, the advantage of all this compared to a note are that it is an equity investment and therefore doesn’t have to be paid back, and there are no specific advantages compared to selling the investor Common (until you realize that investor simply won’t buy Common, so I guess the advantage is that they’ll do the deal at all :-). For the investor, the advantage is that they are covered either way, getting their money back in bad times, and getting the upside in good times. That’s why investors do these deals!

Another variant on this is the Convertible Note, which starts out as a loan, and then automatically converts into Convertible Preferred stock at the time and at the valuation of a future investment. The advantage of this for everyone is that it is easier and cheaper to document. The advantage for the company is that it postpones the valuation discussion until the future found, thus giving the company a ‘free ride’ on the invested dollars during the startup period. This in turn is a disadvantage for the investor who takes the risk but doesn’t get the commensurate reward. For that reason, Convertible Notes typically convert into the next round at a discounted price to what the next investor is paying for the same stock. However, there are a lot of challenges doing this, which is why most professional investors won’t do deals like this, but it is usually the best way to structure a Friends & Family round.

Finally, royalties, which seem to be the preferred alternate structure on SharkTank, are used when the company isn’t really a “company”, but is instead a “product”. In that case, the creator of the product licenses someone else the right to make and sell the product, in exchange for getting a fixed percentage of whatever the product sells for. Advantages to the creator is that someone else does all the work and the creator sits back and gets paid. Disadvantages are that the percentage the creator gets are typically quite small (3-5%) with the bulk of the profits going to the licensee, and there are very big differences between gross and net royalties and all the different terms that can be included.

So, there you have it in a nutshell, but in each case there are more possible variations, tweaks and gotchas than there are hairs on Donald Trump’s head, so that’s why the best early stage lawyers on both sides of the venture table routinely bill—and get paid—more than $400/hour to read these things.

Monday Morning Angel: Shark Tank Episode 2

For a real, early-stage angel investor, watching the new Mark Burnett ‘reality’ series Shark Tank generates quite a few conflicting emotions. On the one hand, it provides the viewing audience with a relatively accurate idea of the range of investment opportunities that flood our inboxes daily. These include everything from companies with millions of dollars in revenues, all the way down to ideas for sticky-note holders (although, to be fair, the show doesn’t deal with the more sophisticated, complicated ventures that make up most of our high-end deal flow).

On the other hand, it presents a very warped view of the way most professional angels (at least in my experience) act, think and invest. I’ve found that my reactions to the Sharks’ decisions seem to fall into one of three categories:

1. “OK, that makes sense, and is probably the reaction I would have had”
2. “Ouch [wincing], that’s not what I would have done, but I can see where they’re coming from”
3. “WHAT!? Are they insane?!”

In particular, there are two unrealistic things that jump out at me on a regular basis: first, the Sharks often demand a majority share of the venture (if not buying it outright). This is counter to the first principles of angel investing, where you are investing in, and incentivizing, the entrepreneur to create a business…not trying to take it over. If an investor starts out with 70% of the company, in a very short time the entrepreneur’s share will be so small as to be insignificant. At that point, he or she is likely to walk away, leaving the remnants in the hands of the greedy investor. Which does no one any good.

The second unrealistic aspect of the show is that, in the interest of making ‘good’ television, some of the Sharks (particularly Kevin O’Leary) behave in such an egregious way that they would immediately be kicked out of any professional angel group of which I am aware. Not only do they denigrate and yell at the entrepreneurs seeking funding (which is NEVER acceptable), but they also try to push deals that are so one-sided that they verge on being both unethical and non-viable. In contrast, some of the other Sharks (particularly Barbara Corcoran) sometimes invest with their emotions rather than their pocketbooks, which is not completely unrealistic…but also not good business. Somewhat to my surprise, the most ‘realistic’ Shark is turning out to be Daymond John, who projects the appropriate blend of business savvy, fair play and entrepreneurial mentoring that I’ve found typical of the best professional angels.

So, let’s get down to a review of Episode 2, and look at the opportunities from the perspective of an experienced, active, US angel investor with 75+ deals under his belt:

_________________________

Craig French
CROOKED JAW
Crooked Jaw is a up and coming action sport/streetwear brand from Long Island, NY. We have worked with many professionals athletes and bands and are looking to be the next big brand in the clothing industry.
http://www.crookedjaw.net

Ask: $200K for 20% ($800K pre-money)
Shark’s Best Offer: Pass

The Angel’s Take: The Sharks were right. Daymond described this quite rationally: these decent, enterprising young men are likable and hard-working, but they’re just like ten thousand other wannabes out there. They have no products worth investing in, nor do they have the business experience that would lead you to take a gamble on backing them. I, too, would like to help them, but this is a non-starter, and I’m afraid they are going to end up losing a lot of their own money in this venture.

_________________________

Robert Allison
LIFEBELT
LifeBelt is a safety device that prevents the car engine from starting unless the drivers seat belt is buckled. It can also control other seat belts within the vehicle.
http://www.nobucklenostart.com

Ask: $500K for 10% ($4.5m pre-money)
Shark’s Best Offer: $1m for outright acquisition
Entrepreneur’s Response: Pass

The Angel’s Take:They are all certifiably insane. I still can’t get my jaw off the floor about this one! The inventor claims to “have a patent” on a seatbelt ignition interlock system. What!?! Does not one person in that studio have any recollection of the 1971 NHTSA regulations REQUIRING passive restraint systems in all new vehicles? Which led to many manufacturers building in seatbelt interlock systems? Before consumers nearly rioted and forced their removal? IF he has a patent on ANYTHING, it would be for a particular implementation of an aftermarket interlock…for which the market would be about…zero. The fact that any investor would offer anything for this is beyond my comprehension. The fact that he would turn down a million bucks for it is perfectly comprehensible (given my familiarity with dogged entrepreneurs) but a crying shame, since it is INFINITELY more money that he will ever see from his ‘invention’. What a cluster muck! (Now, ask me how I really feel :-)

_________________________

Susan Knapp
CLA PERFECT PAIR
Creators of Extraordinary Gourmet Food Products. Their productshelp the home cook prepare delicious healthful meals quickly and make them look like a 5 star chef to family & friends.
http://www.aperfectpear.com

Ask: $500K for 15% ($2.8m pre-money)
Shark’s Best Offer: $500K for 50% ($500K pre-money)
Entrepreneur’s Response: Accept

The Angel’s Take:The Sharks were in the ballpark.I had this one down for a $500-$1m pre money (ie, about 30-50% equity). The fact that she already has $800K invested is too bad, but that’s the reality of startups. She comes across as an impressive entrepreneur with a solid business and a good grasp on what she’s doing. I would probably have looked at putting in less money at the same valuation, leaving her with a majority interest, but that’s not the way this program works.

_________________________

Mary Ellen Simonsen
ATTACH NOTED
AttachNoted is the solution to that irritating problem of loosing those sticky notes while working at your computer. AttachNoted will keep all your sticky notes in place and organized. Also, place your precious pictures or favorite business cards in the 3 slots, that are provided on the front sheet. Now one can securely take all those important sticky notes to their next appointment without having to reposition them.
http://www.attachnoted.com/

Ask: $100K for 20% ($400K pre-money)
Shark’s Best Offer: Pass

The Angel’s Take:The Sharks were right.This is a silly solution in search of a problem that doesn’t exist. It isn’t worth $400K, and, as the Sharks noted, isn’t worth anything at all. But they were harder on her than they needed to be. ‘Nuff said.

_________________________

Mark Furigay
CLASSROOM JAMS
Classroom Jams is an educational record label & publishing house. We produce popular music that turns kids on to school curriculum. Our concept albums and teacher’s guides are the cutting edge in high-interest, high-minded teaching tools.
http://www.classroomjams.com

Ask: $250K for 10% ($2.25m pre-money)
Shark’s Best Offer: They take the company for free, commit to putting in $250K, and he gets 5% royalties with the right to use them to buy into an equal share of the business
Entrepreneur’s Response: Accept

The Angel’s Take:The Sharks were scumbags. A royalty structure might indeed be the appropriate way for this deal to work out, but there were so many problems with this ‘negotiation’ that it left me wanting to wash my hands. The entrepreneur came across as a classy guy with a good product and very decent head for business, and to some extent he got rolled by the Sharks. It will be interesting to see if this deal actually closes (most of these TV show investments, like on Dragon’s Den, don’t actually make it all the way). If I were in his shoes and prepared to accept a royalty, I would have taken the Sharks’ offer as validation of the concept, and then gone off and negotiated with real publishers about how to bring the product to market. Ah well, I wish them all luck on this one.

_________________________

So, there you have it. Stay tuned next week for my review of Episode Three!

The 'Myth' of the Active Investor?!

Recently, Scott Shane, a very smart and decent guy who is a professor of Entrepreneurial Studies at Case Western Reserve, has been highly visible around the web blogging and commentating in support of his recently published book, Fool’s Gold: The Truth Behind Angel Investing in America.

His main thesis is that ‘people’ have a very misleading view of that rare creature known as an “angel investor”, and that angels are far less numerous, generous, and active than ‘everyone’ thinks. In support of this he has extensively research the subject, pulling together all of the available statistics on the field, from the Angel Capital Association, the Center for Venture Research, and even us at Angelsoft (which we’ve been happy to provide.)

As I read his book, and many of his subsequent blog postings and commentaries, I am alternately baffled, bothered and bewildered by his conclusions. First, let me say that his research is legitimate and (as far as anyone, including me, can tell) accurate. So I am not disputing his facts. What I object to, however, is that he sets up straw men to demolish, in order to make lurid points that I believe lead his readers to draw inaccurate conclusions on the state of angel investing.

Take, for example, his contention that angels in America invested “only” as much money last year as venture capital firms. Is the fact of “angel investments = vc investments” accurate? Yes (to the best of our knowledge.) But phrasing it as “only as much” somehow implies that someone is maintaining it is much more. Hunh?

What we and the facts all agree on, is that LAST YEAR ANGELS INVESTED $26 BILLION IN US COMPANIES!! Who on earth is claiming it is anything higher than that??

Meanwhile, in a recent blog post on Small Business Trends, Scott opines that so-called “active investors” are a myth, because even among the cream-of-the-crop angels, the self-reported average time they spend with their portfolios is a miniscule 41.9 minutes a week [gasp!] Once again, I can confirm his facts, but substantively disagree with his conclusions!

I’m one of his “cream of the crop” active angel investors. I’m the Chairman of New York Angels (one of the largest and most active angel groups in the country, with 22 deals this year alone), have 70+ companies in my personal portfolio, and spend my full business time on angel-related activities. That said, it would be absolutely correct to say that there are some (indeed, many) ventures in which I have invested on which I spend less than 41.9 minutes per week. And the problem with that is??

I’m not running the business, the entrepreneur is! The last thing he or she wants is me looking over his or her shoulder and micro-managing the company. If that’s what I need to do, then I shouldn’t have invested in this venture in the first place.

Think about it this way: if, after pulling together an investment round of half a million dollars for a company (including corralling the investors, structuring the deal terms, and doing due diligence analysis, all for no compensation, and then investing $100,000 of my own money), I followed through by serving on the company’s Board of Directors (which would be active involvement indeed), kept updated by asking for and reading weekly management reports (which is way more than most CEOs want to provide), referred the CEO to a dozen high-level sales and business development prospects from my network during the year, and then introduced them to five top-tier venture capital firms for potential participation in a follow-on investment round…would that be the kind of “active” angel investor you’d like to have?

I think the answer from any entrepreneur I’ve ever met would be “yes, in a heartbeat!”

Now, let’s look at my time involvement post closing:

• Bi-monthly, three-hour, in-person, board meetings = 18 hours
• Reading weekly reports for 15 minutes (except Christmas week, at 4 minutes) = 12.8 hours
• A dozen sales/biz-dev referrals, taking me 15 minutes each = 3 hours
• Five VC phone introductions with follow up emails, half an hour each: = 2.5 hours

Total time spent annually = 36.3 hours

Total time spent weekly per venture = 41.9 minutes

And this somehow proves that “active angel investors” are a myth? I’m confused…

How to Pitch an Angel (or VC)

In the early days of New York Angels, we noticed what appeared to be an anomaly in our operations. We had quickly established a good incoming flow of deals, and had followed that up with an effective screening process, but we found that we were actually funding a much smaller percentage of the presenting companies than we had expected. What was particularly puzzling was that we KNEW these were likely fundable companies, because we had spent over half an hour with them around a table during the screening session, and only picked the very best ones (typically the top 10%) to present to our whole group. But after hearing the fifteen minute pitches during our monthly meeting, our full membership just didn’t get excited enough to put their money to work. A puzzlement. We eventually figured out the problem: the companies were great, but the pitches were awful!

That was when we instituted mandatory pitch coaching for every single company that was selected to present to our membership. The result? Our investment rate more than DOUBLED, and we have funded over $35 million into more than 50 companies during the past six years. In that time, I have handled most of the coaching duties on behalf of the group, and have gotten pretty good at helping entrepreneurs refine their Powerpoint presentations to meet the need of their target audience: early stage investors. Word began to spread about these sessions, and soon BusinessWeek came by to do a story about them, giving me the moniker of The Pitch Coach. The next thing I knew, there seemed to be even more demand for presentation training than there was for my investment dollars!

These days, I spend quite a bit of my time teaching entrepreneurs how to clearly and persuasively get their message across. Most of this happens for New York Angels, at business schools like Yale, Columbia or NYU, or for institutions like the National Science Foundation. However a couple of years ago Chris Anderson, the Curator of the renowned TED conference (and a fellow New York Angel member) asked if I would do a session during the “TED University” event before the main conference. I agreed, but wondered how I would be able to compress what is usually an hour long presentation into the allotted 12 minutes. The answer? Talk faster! [grin] So, with the compliments of TED.com, here is The Pitch Coach, in the super-express-version of “How to Pitch an Angel (or VC)”. I hope you find it useful! (The ‘expand’ button in the corner will bring up a full-screen version.)