Angel Investing 202: The Mechanics of Investing Stages of Investments Investment instruments Industry Investment Patterns 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 & have liquid stock Equity Investors - Often angels & convertible debt, SAFE, KISS Typically VCs & preferred stock Preferred converts to common Non-equity Investors Angels revenue-based funding

A Key Concept - Valuations Pre-money company valuation ($2M) plus Investment amount ($1M) equals Post-money company valuation ($3M) Result: Investors own 1/3 of the company

Convertible Debt Does not require a pre-money valuation to be defined The loan automatically buys series A preferred stock when A is issued, at better terms than the series A investors receive Debt is unsecured (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 Puts a cap on the series A pre-money valuation used for the debt conversion calculation Protects the percent ownership!! Conversion trigger Typically = series A of a certain size Maturity date Repayment

What is a Typical Convertible Debt Valuation Cap? Depends on every aspect of business plan Team, traction, technology, market size, IP, sales challenges, competition, etc. That said, annualized revenue rate (ARR) is a strong determinate … at least in Texas! Likely valuation caps Pre-revenue ARR < $100k ARR < $500k ARR > $1M $1.5 to $3M $2.5M to $4M $3M TO $6M $5M to $10M

Comparing Early-stage Options – there are variations for each type Structure Number of versions Equity mechanism Has a discount Has valuation cap Earns interest Has Maturity Date Convertible Note (traditional) No standard Conversion  Keep It Simple Securities: KISS 2 varies SAFE - Simple Agreement for Future Equity 4 Warrant to buy X Increasingly Investor friendly More detail and nuance at: https://www.supportscaleup.com/convertible-loan-note-kiss-safe-choose/

Dilution is significant (valuation cap/pre-money) The important question: Can company grow to ~$40,000,000 in revenue and get acquired? Half of angel-funded start-ups will return $0 For these companies: 15% vs 20% interest rate – who cares? Dilution is significant (valuation cap/pre-money)

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 gross 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

Revenue-based Financing can make sense when Company has revenue Revenue is growing Company has positive gross margins Payment amounts are tolerable Uncertain exit potential

A Different Revenue-based 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…. Typically: VC-led and a Delaware C-Corp The marketplace (investors) sets (maybe negotiates?) the price/share Price/share can be higher or lower than in previous round “Down” rounds are terrible for existing investors

Why is it call “Preferred”? Preferred stock holders have rights that common stock holders lack 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 Investment Patterns

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 – Valuation 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

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

2017 ACA Data – CEO Profile

A Brief Look at Cap Table and Valuations

What to Look For in Cap Table - Employees Option pool of 10 to 15% for new hires In pre-investment cap table Vesting schedule for all founders CEO has more shares than co-founders

Valuation, Dilution, Return Example: Angel 7x return. Every round has a higher stock price (up rounds) In this example: Seed round is led by angels ($600k) using convertible debt Angels have no ownership No valuation is set

Valuation, Dilution, Return Example: Angel 7x return. Every round has a higher stock price (up rounds) In this example: Series A equity investment by VCs ($3M and $2/share) Pre-money of $6M and post-money of $9M Option pool increased Debt converts with discount and interest and angels own 13% of $9M, with share valued at $1.18M

Valuation, Dilution, Return Example: Angel 7x return. Every round has a higher stock price (up rounds) Series B and C have higher price per share Series B & C have a pre-valuation which is higher than previous round’s post- valuation Option pool is increased to keep employees engaged After series C, angels own 7% of $60M, valued at $4.2M

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 Goals A wildly successful company Company closes their entire round CEO receives the most-needed assistance Good ongoing two-way communication between company and investors

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)

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