Angel Investing 202: The Mechanics of Investing Stages of Investments Investment instruments Industry Data Valuation examples Post-investment activities Tax considerations

Not all companies use all these stages. Stages of Investing Amounts raised $0 $x0,000 $x00,000 $xx,000,000 $xx0,000,000 Exits Bootstrap Friends and Family Angels Venture Capital IPO Crowd Funding Strategic Investors M&A Kickstarter Private Equity Grants Time Not all companies use all these stages.

Type of Investment by Stage Bootstrap Pre-Seed/Seed A > B > C ... IPO or M&A Founders Common stock Typically few additional shares Shares become liquid Employees Common stock option grants. Option pool may increase over time. Can exercise options & then have liquid common stock Investors - Often convertible debt, SAFE, KISS or revenue based funding Typically preferred stock Preferred converts to common

Convertible Debt Does not require a pre-funding valuation to be defined for the company The loan automatically buys series A preferred stock when A is issued, at better terms than the series A investors receive Is basically unrecoverable if the company fails

Convertible Debt – Key Terms Interest rate Earns interest which is used to buy stock at Series A conversion Typically 3% to 8% annually Discount rate The discount from the Series A preferred price Typically a 20% discount Valuation cap More on pre- and post- investment valuations later, but Protects the percent ownership position at conversion time Conversion trigger Typically = series A of a certain size Can also be a set date

Comparing Early-stage Options Structure Equity mechanism Has a discount Has valuation cap Earns interest Has Maturity Date Convertible Note Conversion at date or TBD equity round  Keep It Simple Securities: KISS/debt Conversion at 18 months or $1M equity round KISS/equity X SAFE - Simple Agreement for Future Equity Warrant Increasingly Investor friendly

Half of angel-funded start-ups will return $0 Dilution concerns and SAFE vs. Debt don’t matter The important question: Can company grow to ~$40,000,000 in revenue and get acquired? If that growth happens, Debt vs. SAFE and detailed terms don’t matter very much. Dilution is significant (valuation cap/pre-money) For a struggling but surviving company Debt vs. SAFE and detailed terms can make some difference, but the absolute value of any financial return will likely be small

Revenue-based Funding Investors loan money to company Company repays investors with interest by sharing a percentage of revenue Benefits to company Company does not give up equity [non-dilutive] No M&A pressure from investors [no exit required] Repayment amounts scale with revenue [no fixed monthly payment]

Typical Mechanics Amount raised 25% to 33% of annualized revenue Repayment rate 4% to 8% of revenue Total repaid 1.5x to 2x the amount raised Typical repayment period 3 to 5 years Examples: Monthly revenue $20k $100k Annualized revenue $240k $1.2M Amount raised $80K $400k Amount repaid $160k $800k

Can Work Well When Company has revenue Revenue is growing Company has positive gross margins Payment amounts are tolerable

An Alternative Revenue-based Financing Model Hybrid of Loan and Equity Investment dollars initially buy equity Company buys back half of the equity from investors over time by paying investors 5% of gross income

Preferred Stock Successive priced rounds: Series A/B/C…. Often a VC-led round where VCs typically expect Delaware C-Corp The marketplace (investors) sets the price/share Don’t bother with net-present-value calculations If investor wants 25% ownership for $1M investment: The pre-money valuation is set at $3M Assuming 750,000 shares/options were previously issued, then with $1M investor buys 250,000 shares at $4/share Price/share can be higher or lower than in previous round “Down” rounds are terrible for existing investors

Preferred Stock Preferred stock holders have rights that common stock does not have. Most notably, upon acquisition investors have the option to get 1 to 2 times their investment back before common gets anything If a company raise $3M and get acquired for $2M than common stockholders may get nothing The preferences are why investors pay more per share than stock option strike prices CEO

Preferred typically get to approve: Change the primary business of the company Annual budgets, business plans, and financial plans Hiring of all officers Compensation for officers A merger or acquisition Liquidation, wind-up or dissolution; Increase or decrease the number of directors Standard company employment agreements Equity incentive programs as well as issuance of all stock and stock options Paying of dividends An increase in the authorized number of shares Real estate transactions Capital equipment purchases greater than $500,000 Debt in excess of $500,000

Industry Data

2017 ACA Data - Round Size and Median Overall Valuation Total Amount Raised Per Round Pre-Money Valuation or Cap on Note Nearly 60% of the total investment rounds were $1M or less, with a median size of $1M.  The dataset includes some larger investments, however, with 9 deals of $10M or more (all follow-on rounds), and 16 deals between $5M to $10M. The median pre-money valuation or cap on a convertible note was $5M, with a wide distribution of valuations.   Median Round Size = $1M Median Valuation = $5M

2017 ACA Data - Valuations Change by Round Stage Pre-Money Valuation - Angel Round Pre-Money Valuation – Series A Round The median pre-money valuation or cap on a convertible note was $5M, with a wide distribution of valuations. The valuation levels change depending on which series the investment is made in.  In the Seed/Angel Round, the median pre-money valuation was $4M, with 46% of groups reporting valuation between $2.5 and $4.5M.  Many angel groups invest beyond the Seed Round.  In the case of Series A deals, the median pre-money valuation was $8.5M.   Median Valuation = $4M Median Valuation = $8.5M

Median pre-money valuations ($M) for rounds less than $1M

2017 ACA Data – Company Status Revenue at Time of Funding Number of Employees at Time of Funding Company Detail: The initial data provides insights into the sizes of angel group portfolio companies, which are typically smaller companies based on revenue and number of employees.  At the time of investment, nearly half of the companies were pre-revenue, although about 6% of the companies had revenues of more than $3M.  The companies had small staffs, with a median of 7 employees, but some companies had revenues above $10M and 100+ employees.  In terms of tax structure, the bulk of the startups were C Corporations, followed by Limited Liability Companies and S Corporations.   Tax Structure

Valuation, Dilution, Return Example: Angel 7x return. Every round has a higher stock price (up rounds) Download spreadsheet at http://swanimpact.org/due-diligence-workflow/

Angel 0.5x return example. Company survives but struggles during A and B. Series B is a down round. Employee option pool increased to retain employees. Angels dramatically impacted

Post-investment Activities Receive quarterly reports for company Involvement opportunities Board of Directors seat If we led the deal and invested significant amount. Has some legal risks. BoD Observer Attend board meeting but don’t vote on board resolutions. No legal risk Formal Advisory Board seat May include stock options Mentor / informal advisor Not compensated Paid Consultant Unusual

Tax considerations: Laws can change yearly. Consult a tax attorney!!!! QSBS: A Qualified Small Business Stock. is a domestic C Corporation in which the aggregate gross assets of the corporation at all times up to the time of issuance do not exceed $50M Section 1202 Can exclude 100% of QSBS capital gains from taxes if stock (not convertible debt) is held for five years Section 1045 Capital gains can be avoided if you put all of the gains from a QSBS in a new QSBS investment within 60 days Section 1244 If your investment is part of the initial $1M invested in a QSBS company, the loss can be used to reduce your earned income (vs. reducing capital gains)

A Good Resource

Consider taking the Angel Investing 201 class

Angel 202 Feedback What was most helpful? What was less interesting? What would you like to learn more about?