Friday, June 16, 2017

Structuring An Early Round Investment

The actual structure created for a life science startup will not be substantially different from any other startup investment. Thus the following information is not specifically customized to the needs of the life scientist-entrepreneur.

Structuring an early stage investment can be seen from two perspectives. The first perspective focuses on the complexity of the structure. In general, this requires a simple yet understandable agreement and an agreement which is based on trust and mutual respect of both parties. The Simplicity of the agreement is important because in most cases funding from the angel will not be the last funding. For both the founder and the investor it is important that the structure created at the outset is acceptable to venture capitalist in later rounds without significant modification.

The secondary component is the actual agreement terms. Structure includes more than ownership stake however since that component is often the most important the most contentious is it make sense to address it first.

The primary decision is between offering the investor of common shares and various rights that would likely accompany the common shares versus some type of preferred shares as well as the many possible rights that would be conferred alongside preferred shares.

Arguments for either can be made but basically, common shares will not confer many of the special rights available to preferred shares yet will be simpler arrange. For a small stake in a company common shares made be the easiest and most logical path to follow. The potential upside can be added through additional rights to invest in additional rounds as well as to sell when anyone else sells shares.

Preferred shares may provide additional rights related to board selection, obtaining dividends, obtaining internal information, making decisions regarding liquidation, or conversion or redemption of shares.

The final type of investment would be a convertible note which is more attractive currently. This avoids actual negotiation on the price and sets the share offering tied to a future event. The note is likely to be convertible into preferred stock and discounted to the rate of the actual sale of preferred stock as compensation for the additional risk that the angel endured. The advantage is that neither party must agree on a valuation at this time. At a later time, the financials will be more clear and the VC will likely be more skilled at valuation. The convertible note provides an incentive to gather additional funds via venture capital had a later time, and because of changes in the discount rate, the incentive is to obtain those funds earlier rather than later. Thus if additional funding is not expected this is not a logical path to follow.

The note includes the possibility that the investor would be repaid if additional funding is not received. However, in such a case it's more likely that the company is not viable and all the funds would have been lost. If additional funds are not received then the angel has likely taken on a large risk and received a fairly meager rate of return on the note. Again in such a situation a not is the optimal structure.

Additional important parts of the structure beyond the capital structure discussed above would be the expected involvement of the investor regarding participation in the board, or acting an advisor. The structure should also include the expected time that the entrepreneur will be involved as well as the salary and expected time the entrepreneur will stay with the company. Finally reporting as with any contract is essential and should offer financial information for the company as on a monthly and quarterly basis as well as significant expenses.

The entrepreneur should consider that a request for preferred shares will require a more complicated legal agreement to clarify the details and the investor rights. This also increases the time for the negotiation as well as the legal costs involved. However to avoid confusion and disagreements later it's logical to invest wisely regarding time and energy and ensure that the agreement is both sound and clear to both parties.

The Startup ProcessSourcing - Evaluating - Valuing - Structuring - Negotiating - Supporting - Harvesting

Reference: David Amis-Howard Stevenson (2001). Winning angels: the seven fundamentals of early-stage investing. Pearson Education.

12 comments:

  1. Brad,
    Nice explanation of all the ways to structure a deal. The key for both entrepreneurs and new angel investors is to become educated about these different components around the deal structure. As you mentioned above, down the line problems may arise from the lack of understanding of the terms.
    Cece

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    1. Agreed. Since the goal is to "impress" the investors with your skills and talents, I think having the vocabulary is key. If they propose a structure or a right and you say "what's that?" I think you shoot yourself in the foot. For that reason this book and this aspect of the course is really useful. Hopefully when the time comes I will have have the time to quickly hit the Internet and remind myself what all these rights and structures are...

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  2. I feel as a startup; a convertible note could be the simplest and best option for the entrepreneur and investor. There is no negotiation on price in the beginning and leaves it for future events. In the end, it is important that both the entrepreneur and investor understand the different components of the deal.

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    1. My understanding is you don't know exactly how much stock you are getting. If the valuation is high then even with a discount you may not get as many shares as if you spent your money when the value was low. I guess it is a risk/reward thing. You take less risk but the upside is probably less.

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  3. I consider the convertible note attractive as a start-up. It gives the angel investor(s) confidence in getting some return on their money and leaves room for future investment. I'm curious, what type of structure would you consider or enter into for your startup/company?
    Nicole

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    1. I'm kind of an "in for a penny in for a pound" person, so I think offering the convertible preferred stock makes the most sense. That makes it clear that if doesn't work out they lose everything but I consider them a key part of the team and they should get their money before everyone else

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  4. I mentioned in another post that the convertible note is a frightening way of raising, or giving, money to me. I know the point of investing is risk, but this just seems like a really big risk. If you invest too much money and the business goes south, you don't get your money back. If you wait to get a valuation later, the business may take off and you've missed out on your chance of a larger share. I'm not sure I would take this route as an entrepreneur or an investor...but it definitely is for some folks out there.

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    1. I agree. It seems to give you minimally less risk (there is the slight chance you get paid back) for less reward. And it is hassle to arrange. I'd skip it on both ends. Yet for some reason it is becoming more and more attractive. I don't understand...

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  5. Brad,
    Great information...
    I think I would be more attractive to the preferred method. I believe that investing in the beginning will save you a lot of headaches - as you mentioned in the end. At least everything will be well written out; so that no one can say-they do not understand what can happen and what is expected. Also, the preferred - seem to offer a little more comfort - than common stock. lol

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    1. I agree. If you are really invested in seeing the idea succeed and since so few succeed why not give it the best chance and with the most thorough structure.

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  6. Brad,

    Great writing, it seems like each of these investment types could easily be dictated by the individual peculiarities of each opportunity. I know that as humans we like to choose favorites and say "this is my favorite, and it's what I will use", but I think it would be wise to keep each one of these structuring methods in our bag of entrepreneurial tricks so that we can adapt to varying deals.

    Austin

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    1. You comment was indeed my take home message. Be flexible. If the investor has a strong opinion then perhaps there is a good reason. I don't see a downside of starting off the relationship trying to learn from the investor.

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