Presentation on the pros/cons of convertible debt vs. preferred equity in seed stage financings of start-ups.

1. Thanks to everyone that
attended SMT$ 4 on
Mon @GA.
Here is the document
that we used.
My contact info is on
p.22, and some Bio
information is on pp. 4 &
5.
“Show Me the $$$$!”…Session 4:
Insiders guide to Debt vs. Equity, and Key Deal Terms
Cheers,
-TW
General Assembly / RosePaul Investments Event
Tom Wisniewski
RosePaul Investments
Monday, January 13, 2014

2. Agenda
I. Kick-off and Introductions
II. Intro to Debt vs. Equity, etc.
III. Panel Discussion and Q & A
•
BREAK: Networking and Beverages
IV. Deeper Dive and Best Practices
•
WRAP-UP: Networking and Beverages
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3. Seminar Rationale:
Why are we here?
 Start-up raising capital soon/now
 Founder / Prospective founder: not raising, looking to
get up to speed
 Investor / prospective investor
The Challenge…
 Lots of terms and complexity
 Lots of noise, lots of conflicting descriptions and
advice.
 Stakes seem high: mistakes costly
• Bad deal…buyers remorse, unpleasant “surprises”
later
• Scare-off Investors (or founders!)
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4. So….. what helps? Invest some time to:
 Understand the basics (and the rationale).
 Demystify and Prioritize: Not everything is important
 Understand the “other guy’s” position: investor
perspective.
…….learn some best practices from some insiders and
your fellow colleagues.
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5. Tom Wisniewski: My background

Born in NYC; grew-up in Montclair, NJ

Physics and Philosophy major undergrad
(Clark University); MBA at Tuck School
(Dartmouth)


1st Job: Programmer at Morgan Stanley then
moved to Investment Banking
After B-school: joined a start-up management consulting firm Mitchell Madison
Group; focus on Strategy/Operations/IT for financial services, tech, outsourcing,
private equity/VC clients (1993 to 2000)

Walker Digital: helped set-up and run an early “internet incubator” (2000)

Independent Advisor / Turn-arounds: Advised VC and PE Firms on portfolio
company strategy and new investments; joined the management team of two
companies

Currently:
• Early stage investor and advisor to start-ups
• Investor and advisor to VC and PE funds
• Member and director at New York Angels
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6. Tom Wisniewski: Investor Profile

Direct “Angel” Investor in Companies
• $25K-250K investments; Typical valuations: $1-5 Million,
• Typical Stage: at least some “product” done, some customer/sales traction
• Sector focus: Opportunistic generally within internet/software space;
- fair amount of Saas B2B, and consumer “marketplace” models, ecommerce enablers.
- NOT (or not much?): hardware, heathcare/pharma, cleantech
• NYC based: 50% investments in NYC area companies; total of ~80% NE overall (e.g
Boston, DC), 20% West Coast.
• Examples:
- Sociocast (social/behavioral big data analytics)
- LiveLook (Saas, live collaboration sales/service platform)
- Anvato (Ad insertion to live video streaming via proprietary machine vision)
- Moveline (Uber for the moving industry)
- Bizodo (Saas, paperwork automation; “Adobe 2.0” internet document sharing)
- Movio (Digital “RedBox”; content delivery via “last 100 ft” of wifi internet)
- HeTexted (Relationship advice forum generating content, media opportunities)
- Wanderu (Kayak for ground transportation)
- DealFlicks (a “Priceline” or “Hotel.com” for movie theater tickets)
- iCharts (tool that enables engaging, sharable, embedible chart content)

Investor in Funds
• In addition to direct investments in start-ups, invest in VC and PE funds.
• Examples:
- Social Starts (Seed fund for start-ups leveraging the Social Web)
- Brooklyn Bridge Ventures (Charlie O’Donnell’s fund)
- Entrepreneurs Roundtable Accelerator (ERA Fund)
- Greycroft Partners (Venture Fund)
- ff Venture Capital (Fund)
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7. What would I like you to walk away with?
 Better understanding of subject.
 A set of specific insights that will *change* your approach.
 A “to-do” list: starting point(s), actions, things to try.
 A set of recommended resources to consult and learn more
from.
 A few new relationships with others in the NYC startup/fundraising ecosystem: fellow entrepreneurs, investors, etc.
 Answers to specific questions that you might have.
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8. So….what questions do you have about Debt, Equity, Term
Sheets, etc.?
 xxx
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9. II. Intro to Debt vs. Equity
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10. Context: Common Sources of Fundraising Capital
Earlier Stage
“You”
aka Bootstrapped
Later Stage
“Seed”
Friends and
Family
Angel Investment
Venture Capital
“Seed” VC
“Traditional Series A” VC
Round Size $:
• $10’s of K
to $100K
• $100’s of K
to $1M+
• $500K to
$1.5M
• $5M-$15M
Investment Size $:
$5K – $10’s of K
• $25K – $75K
• $250K-$750K
• $3M – $5M
Valuation (PreMon):
• < $1 M
• $1 – 5 M
• $5-10 M
• $10 – 25 M
Who/what are
they?
• People you already
know, that trust
you, and (maybe)
understand your
venture
• Experienced early stage
investors (individuals or a group)
• Accredited Investors.
• Angel investing is not their “job”;
may not be F/T endeavor
• E.g.: NY Angels, GoldenSeeds
• Firm with multiple professionals that
raises, invests and manages
individual funds (other people’s $)
• Working F/T (this is their job…)
• E.g.: Greycroft, RRE, Union Square
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11. Debt, Equity and Deal Terms…..How/When does it fit in?
How much does it
matter?
1. Iterate on ideas
2. Refine idea; test tech / business case
Very, very
Little
3. Bootstrap; build/test Prototype
4. Early customer validation
5. Develop “pitch”: gather input/interest
Starts to
Matter
(Maybe!?)
6. Bootstrap more; refine prototype, business case
7. Pitch and receive F&F investment. Terms?
8. Build/validate/refine….Build/validate/refine
9. Pitch Experienced Investors: Angels, Seed VC
10. Term Sheets, negotiation, etc.
10
[.....life continues on: growth, financings, death/sale of company]
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Starts to
Really
Matter
(a lot!?)

12. Basic Definitions: Debt
 Debt = A loan. You borrow $, owe interest, pay back interest/
principal. E.g. Mortgage on a home; credit cards
•
Borrower:
- Rationale: source of capital, use now pay back over time +
plus a fee (e.g. interest)
-
•
Risk: can’t pay back principal/interest; loose assets?, bad
credit rating/reputation?, Interests only partially aligned with
investors; Loss of flexibility (e.g. Covenants, restrictions)
Lender:
- Rationale: Believe borrower can definitely repay, Earn fee
(e.g. interest); “senior” to equity = paid “first”, before equity;
backed by assets or cashflow
-
Risk: default; partial payback; interests only partially aligned
with borrower
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13. Basic Definitions: Equity
 Equity = Stock; Ownership Interest in a company. You sell a
piece of your company, receive capital in return. E.g. shares of
“GOOG”, owning 50% of a apartment building
•
Company/Seller:
- Rationale: source of capital, no need to “pay back”, more
alignment of interests with investors
-
•
Risk: “Cost” more that alternatives?, less control?
Investor/Buyer:
- Rationale: “share of the upside”; rights to future profits and
sale proceeds ; more alignment of interests with company
-
Risk: “Share of the downside”; Company has losses,
Company is alive but “never” is sold, Company goes out of
business
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14. More Relevant Definitions: Common Equity
 Common Equity: Basic ownership interest in a company..
•
Common Equity = founders equity, equity for other employees
•
Options = rights to buy Common Equity at a price, during a term.
 Valuation: in order to “buy/sell” shares of equity, a price per share
for the company must be agreed on.
•
Setting price/share really same as setting “valuation” of
company.
 Most common form: Stock Delaware C-Corp;
•
Most of the details are defined by DE law.
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15. More Relevant Definitions: Preferred Equity
 Preferred Equity (or “Priced Round”): “Same” as Common + a
defined set of “preferences” or extra rights, beyond what common
has.
• Economic rights:
- Interest: earn interest on investment
- Liquidation preference: in the event of sale, get paid
investment (and return) before common is paid
• Control rights:
- Board Seats
- Approval of key company actions: financings, sale, ETC.
- Rights to convert to common, right to buy future equity (to
maintain % ownership)
• Valuation: [Like Common Equity] in order to “buy” shares of
equity valuation of the company must be defined.
•
Most typical form: “Straight” preferred (non-participating
preferred), with 4%-9% interest.
- Most “preferences” = downside protection (when things go
well, everyone converts to common equity
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16. More Relevant Definitions: Convertible Debt (Note, etc.)
 Convertible Debt: a “loan” …..that converts to equity in predefined ways, circumstances
• Loan  Interest rate, defined term (6months – 2 years)
• Conversion: Debt converts to Equity when
- Qualified Financing
- Sale of Company
- End of Term
• No “Valuation” (or other terms, controls): Defined formula for
conversion, e.g. price for buying equity.
- Discount to Next Round (Qualified Financing): 5% - 40%
discount
- Cap: Valuation (and therefore price/share) will be maximum
of $2M - $15+. Uncapped Notes are very rare.
 Most typical form:
• Cumulative interest, rate 4%-8%,
• 18 month term,
• 20-25% discount
• Valuation Cap at $3-5M? (usually set ~ “current” valuation)
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17. III. Panel Discussion and Q & A
 Introductions: Background on you and your firm
 In the last 12 months: convertible debt? Equity?
 What like/hate of each and why?
 Any interesting stories?
 Thoughts on valuation?
 Other 1 or 2 Terms that really matter? Why?
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18. IV. Deeper Dive and Best Practices
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19. D vs. E: Key Pro/Con
Convertible Debt
Preferred Equity
Company/ Pro: Speed/ ease, lower cost,
Founders defer valuation (?), rolling
close?
Pro: Defines valuation/terms(?),
advantage for next round,
aligned interests
Con: Unaligned interests,
payback loan (or F*cked?)
Investors
Con: More time/complexity,
higher cost, must define
valuation, agree on terms
Pro: Speed/ ease, lower cost
Pro: Defined price (know what
you are buying), preferences
compensate for risk, and offer
downside protection
Con: Uncertain price?, lack of
rights (e.g. pro-rata)
Con: More time/complexity,
higher cost,
• Its an Option: want upside
• Discount not enough for risk
• Works for: round <$1M?, As
a Bridge, for F&F round
• Is the “Standard” for VC, and
most Angels
• Round >$1M?
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20. Valuation

Regular Business: Based on earnings/ cash flow.
• Valuation = 3x – 10x company earnings (EBITDA, etc.)
• Valuation = 0.5x – 1x company revenues

Tech Start-ups:
• 10-25x? Earnings…but no current earnings
• 10x – 100x ?? Revenues? …but no/low revenues
• User multiples? (Usually crazy)

Most (experienced) Investors use “Comparables”
• Valuation based on other recent “market” prices: valuation of similar companies, deals
• Investors (especially active ones) see:
- See 3-5 priced deals for every one invested (100’s of pitches for every one invested)
- See/hear about 5-10x more deals

Reality Check:
• Company only worth what someone is willing to pay.
• Supply and Demand:
- Company completely unique (limited supply) + Many interested “buyer/investors”
(lots of demand) = Higher Price
- Many “similar” companies (lots of Supply) + One/No interested “buyers/investors”
(limited demand) = Lower Price (or “no” price)
• Perception vs. Reality: It all comes down to perception, and belief (very few objective
facts, numbers)
• It’s a Negotiation. Sales skills matter.
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21. Notable Opinions
 Paul Graham (Y-Combinator): “All financings for companies coming
our to YC are Convertible Notes” (2010/2011)
• Easy, founder friendly, and now the standard
• Its all about the “optionality”: if its worth $ Billions, valuation
unimportant
 Fred Wilson (Union Square Ventures). Doesn’t like Notes. “Won’t
do them for my investments.”
• Conflict of interest, “need to know the price of what I am buying”, cost
of preferred is declining
 Chris Dixon (Founder Collective). Likes Notes, but will never to uncapped notes.
• Investing in founders; no amount of legal will help if you chose
wrong;
• Reputation: if you screw someone then no one will do business with
you.
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22. Key Success Factors and Advice….continued
 Valuation (and Key Terms). Be realistic. Be Flexible. Realize this is a
professional (not personal) discussion ; there will be back and forth. Ultimately
the “market” sets the price/terms.
• There is more to investment terms than valuation….Important to understand.
 Timing. Am I ready for Angel Investment?......A few probing questions:
• Have you covered the key success factors mentioned here? Do you have a
compiling business opportunity with huge growth potential?
• Do you really need the money? Now? The more that you can accomplish on
your own, the more compelling your case (and valuation) will be…..
• Are you ready to work for a someone else? e.g. the investors, the board of
directors
• Fund raising is “brain damage”. It wastes valuable time that could be spent
growing the business. Avoid it, minimize it, delay it if you can.
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23. Thanks!
Thomas Wisniewski
Contact Info
Email: thomas@rosepaul.com
LinkedIn: http://www.linkedin.com/in/thomaswis
Twitter: @thomaswis
This presentation: http://www.slideshare.net/Thomaswis/
New York Angels www.newyorkangels.com
New York Angels Educational Meetup: http://www.meetup.com/NY-Angels/
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24. Summary Investor Perspective: Notes vs. Equity

History. Preferred Equity is standard for both Angel/Seed and VC (Series A, B, etc.).
Convertible Notes were used as a “bridge” to a [reasonably well defined, high probability]
upcoming financing.
• Now: Convertible Debt much more popular at Angel/Seed round

Preferred Equity. Equity (stock) that has defined “preferences” over common stock.
• Establishes a value for the company e.g. [$3.5M] pre-money valuation
• Liquidation Preferences. Most commonly used is “non-participating preferred” aka
“straight preferred”. E.g. a [1x] liquidation preference. Means investors get their invested
money back plus [1x] before common equity holders. In the event of success, everyone
converts to common and shares pari passu. Liquidation preference is really downside
protection for investors
• Investor rights. E.g. approval of key company decisions

Convertible Note. Debt that converts to equity when a next financing round occurs. As
Debt, typically: carries interest rate (e.g. 8%); has preference to all equity: gets paid back
1st; secured by assets of company
• Converts to equity at “same terms” as next round…..except the Note usually has
- Discount [10-30%] to the valuation (in the next round)
- Cap on valuation (in the next round); means “valuation not to exceed $__”.
• Terms of conversion
- Upon “qualified financing”, e.g. financing of a least [$2M]
- End of the Note’s term [18 months]
- At the option of investors

Other Key Terms. Employee option pool, board composition, dividends, anti-dilution
provisions, pro-rata investment rights, capped legal expenses.
Source: NY Angels Educational Meetup
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25. New York Angels Process: A Monthly Cycle
1.
Proposals Reviewed Online (via Gust): 50 – 100 monthly
•
Sources:
•
NYA website/Gust (“cold call”: low prob of quality, and success)
•
Syndicated deal from other group/investor (warm intro: better quality, better
success)
•
Referral from NYA member (warmer intro: even better quality/success)
2.
In Person NYA Screening: ~15 companies monthly
•
Around 15 of the 100 are selected to present at an in person pitch/screening session
(1st Wed of the month)
•
Companies have 10 min to pitch, 5 Q&A (5 minute investor discussion)
•
Usually ~40 NYA members attend
3.
Discovery / Follow-up: 1-3 new companies enter monthly (3-6 in-process total)
•
Of the 15, 1-3 companies garner enough investor interest to move forward in some
fashion
•
If there is sufficient interest from a core group of investors, and an investor willing to
“lead”, then the core NYA process moves forward with follow-up “Discovery”
meeting(s) aka deep dives, due diligence.
•
In some cases individual investors want to follow-up and explore the company
further independently
4.
Investment Breakfast: 1-3? companies monthly
•
Those Companies that get to the term-sheet stage with several committed NYA
investors, are brought back to present to the NYA Group at the Breakfast
•
NYA Investment Breakfast meetings: 20 minute presentation + Q&A, 40-60 NYA
members attending
5.
Final Due Diligence, Legal Docs, Closing.
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