Overview of angel and venture capital financing for Canadian technology entrepreneurs

1. Things to Know when Raising Angel
and Venture Capital Financing
Contemporary Issues for Technology Entrepreneurs in Canada
Dave Litwiller
Executive-in-Residence
December 17, 2013

2. Introduction
•
•
•
•
•
•
•
Angel Investors
Venture Capital (VC) Investors
Timeline
Investment Structures
Due Diligence
Negotiating Tips
Factors with Greatest Influence Over Outcomes
Copyright, David J. Litwiller 2013
2

3. The Spectrum of Early Stage Funding
Generally:
• First $100K: Friends, Family and Self
• $100K to $1M: Angels
• $3M and up: Venture Capital
Copyright, David J. Litwiller 2013
3

4. Angel Investing
• 95% of returns come from 5% of investments
– Deals need potential to return 10*, not just 5* of later rounds
• Implication: Everything about your deal needs to indicate that it is
one of the few, hottest deals of the year
– Team, technology, market, timing, speed of execution, agility
• Further Implication: If your deal is not one of the stand-outs, even
among investment-worthy opportunities
– Less bargaining power
– Slower funding cycles; more distraction from operations
– Less influence over attaining high performance governance,
appropriate operational involvement and positive networking/referral
impact from investors
Copyright, David J. Litwiller 2013
4

5. Lead Angel
• The critical angel is the lead angel
–
–
–
–
Commits early
Carries ~25% or more of the deal
Refers in other angels
Willing to let his/her name and involvement be used
to attract other investors
– Corrals the input of other angels to present a coherent
set of investment terms so that you can keep
executing on the business
– Added bonus, if you can get it: Domain expertise;
market sector name recognition; and, business
development networking
Copyright, David J. Litwiller 2013
5

6. Lead Angel
• Actively target and recruit your lead angel
• Get introductions to targeted leads or arrange
social encounters
– Do not cold call and do not send batch e-mails
– Best introductions come from past founders with
whom those angels made $
Copyright, David J. Litwiller 2013
6

7. Lead Angel
• Recommendation
– Don’t go out to angel groups to pitch until you’ve lined
up a lead angel
• The likelihood of securing a motivated, high
quality lead angel from an arm’s length group
presentation is very low
– Fallacy of large numbers (surely someone will
emerge…Not)
– Further challenge today with many of the angel
groups being largely tapped out because of longer exit
horizons on past deals than previously expected
Copyright, David J. Litwiller 2013
7

8. Where Angel Investment Works Best
• Capital efficient businesses
–
–
–
–
–
Consumer web
Consumer-like B2B SaaS
Mobile
Software-in-plastic kinds of lower risk hardware
Other low barrier to entry, low regulation businesses
• Other fields require larger funding amounts, more funding rounds, and
have more potential friction points before liquidity to harm the potential
investment returns for early round investors
• Where an early exit is likely
– Angels are generally much happier than VCs to take an early exit
– VCs need to stay in and gamble for the biggest outcomes to make their
business model work
Copyright, David J. Litwiller 2013
8

9. Bimodal Angel Investing Success
Models
• Small number of investments
– In domains where the angel is an expert, and has a current network to make
privileged introductions to substantially lift the success trajectory for each
investee
– Angel has time to dedicate to helping each investee, is supportive, but without
excessive interference
– Typically five or fewer investments at any one time
• Large number of investments
–
–
–
–
–
At least 25, better yet is over 100 investments
Sometimes maligned as “spray and pray”
Little time for value add, but these angels typically don’t interfere much
Sometimes not even much due diligence
Strong statistical and empirical basis favouring this form of angel investing
given the natural volatility of such early stage participation
Copyright, David J. Litwiller 2013
9

10. Amount of Angel Funding To Raise
• Mode #1:
– Enough to fund the next 12-18 months, as the
minimum increment of runway to justify the time
and effort fundraising
• Mode #2:
– Enough to reach the next major milestones or
proof points at which time the business will be
much more valuable and able to attract larger
funding amounts at higher valuation
Copyright, David J. Litwiller 2013
10

11. How Much Funding to Raise
• Know your number, and the use of proceeds
– Nothing says indecision like waffling on the size of
the raise or the critical investments to be made
Copyright, David J. Litwiller 2013
11

12. Angel Due Diligence
• The lead angel will typical spend ten to twenty
hours on due diligence
• Expect you will spend at least twice that
amount of time with preparation, meetings,
and follow-up actions
Copyright, David J. Litwiller 2013
12

13. Targeting VCs
• You need to start with:
– Forty firms
– Well selected as being top quartile in their field over the
past two years for investment returns
– Deep, current domain expertise
– Recent deal flow at the same stage of development
– Several completed first time investments as lead in the
past 18 months, and still in the first four years of their fund
• To get this number of firms requires going south of the
border for some candidate funds
Copyright, David J. Litwiller 2013
13

14. Targeting VCs
• Do as much due diligence on any VC with which
things start heating up as that VC will do on you
– Integrity and communication style of the key people
– In depth discussion with current and past investees
about how the VC behaved, particularly in challenging
conditions
– Understanding from past associates and investees of
how the individual VCs would game their own
accounting and incentive structures and the
implications for investee company deal structures
Copyright, David J. Litwiller 2013
14

15. Pre-Formation VCs
• It is difficult to raise a new VC fund in Canada today
• Manage your time carefully if a pre-formation fund is
interested in you
• The likelihood they will receive funds to commence
investment operations is very low
• Moreover, good VCs do not want to pre-identify their initial
portfolio of investments to their targeted limited partners
– Those limited partners would then (understandably) want to
condition their investment in the VC fund on due diligence
regarding the prospective investees
• If an interested VC has not yet secured their own funding,
you are usually far better to diplomatically defer the
conversation until if and when they have a first closing
Copyright, David J. Litwiller 2013
15

16. Caution about Growth Stage VCs as an
Earlier Stage Company
• One of the few areas of VC strength as an asset class over the past decade
has been growth stage funds
• Growth stage investee thumbnail:
–
–
–
–
$10M in annual sales
Product-market fit
Substantial, proven management team
Looking for growth capital to propel target to $30M sales and beyond
• These funds will spend time with you as an earlier stage company, but
often it is more as a brain pick for ideas for their investment portfolio or to
identify new sectors of interest than with a view to legitimate investment
candidacy in your company
– Don’t expect them to bend their investment parameters for you, despite any
intimations to the contrary
Copyright, David J. Litwiller 2013
16

17. How to Interpret Any VC Answer
Other than Yes
• VCs are approached for 100 to 150 deals to yield each one
that they complete
• One of the core competencies of any VC is knowing how to
say no without having people hate them
• Common forms of a quasi-diplomatic No:
–
–
–
–
–
Buddy pass/referral to another firm
Rock fetch/if you can find someone else to lead…
Not now (but keep giving us information); too early
Exploding term sheet
Early term sheet with no real pace of follow-up activity
Copyright, David J. Litwiller 2013
17

18. How to Interpret Any Answer Other
than Yes
• Takeaway:
– With VCs, listen to the answer to your overture for investment, not the
reason
– Anything other than a clear Yes to proceed to the next step of
investigation and negotiation is a No, no matter the more diminutive
form of the words used
– Maxim for how to think about early VC approaches: Lead, follow, or
get out of the way
– Once there is a high quality lead VC doing the heavy lifting of due
diligence and negotiating, there will usually be many other funds that
would like to jump on and help syndicate the round
Copyright, David J. Litwiller 2013
18

19. The Significance of a First Meeting
• It takes many potential deals to find a few good deals
• VC firm partners and associates are accountable to each other
weekly to review deal pipelines, usually Monday mornings
• Each investment executive is obligated to report that they
have looked at significant number of new deals, to show that
they are broadly aware of interesting companies and ideas
which might be developing, and larger trends which may be
emerging across sectors of interest
Copyright, David J. Litwiller 2013
19

20. The Significance of a First Meeting
• A VC’s willingness to take a first private meeting shouldn’t be
seen as anything more than them fulfilling their internal
metrics for raw deal flow
• Far more significant is a second meeting and beyond when
the VC is clearly investing significant time and opportunity
cost pursuing your deal, and expressing an interest in leading
an investment round, not just joining a syndicate
Copyright, David J. Litwiller 2013
20

21. At The First Meeting and After
• Lay out the roadmap of company objectives
over the next two to four months
• Then,
– Nail all of them (customers, tech, partnerships)
– Hit a couple more you hadn’t promised
Copyright, David J. Litwiller 2013
21

22. At the Second Meeting and After
• Be prepared
• Have answers to all of the open questions
from the first meeting
• Show that you can adapt very quickly based
on events since you last met
Copyright, David J. Litwiller 2013
22

23. The Investor’s Acid Test
• Rising sense of momentum at each successive
meeting
• Otherwise, deal is off
Copyright, David J. Litwiller 2013
23

24. VC Caution
• Stay away from discussing product roadmap specifics
until you have a clear signal of investment likelihood
– Often VCs have other investees to which they can feed this
information
– Sometimes they are even incubating directly competitive
ventures
• Test question: How far into the 100 hours of typical due
diligence for a lead VC is the prospective investor when
precise roadmap questions start coming up?
Copyright, David J. Litwiller 2013
24

25. Time from Start of Fundraising
until Funds Received
• Angel, convertible note:
– 3 months typical
– 6 weeks best case
• Angel, equity:
– 6 months typical
– 3 months best case
• Venture Capital, first round:
– Nine to twelve months typical
– 3 to 6 months best in class
– Up to 2* longer for corporate venture investors (strategic)
Copyright, David J. Litwiller 2013
25

26. To Get Started
• Business overview .ppt
– Business plan for later stage VC rounds
• Historical financials
• Capitalization table
• Pertinent legal documents
– Incorporation
– IP assignments
– etc.
Copyright, David J. Litwiller 2013
26

27. Places Due Diligence Will Often Slow
Down
• Lack of founder vesting/pledge schedules
• Insufficient IP assignment for founders or
early employees
• Lack of understanding of key terms in
agreements (financing, operating, technology)
• Failure to fire unproductive or disruptive
employees
• Failing to put important business relationships
into writing
Copyright, David J. Litwiller 2013
27

28. Negotiating Cautions
• Bait and Switch:
– Angel or VC negotiates all aspects of the investment based on a precash valuation of $X, and then calls up just before the time to execute
and demands that X be lowered substantially, with all other aspects of
the deal remaining the same
• To Counteract:
– Find out from investees who have raised fresh funds from the same
angel or lead VC if (s)he showed tendencies to double negotiate or
otherwise bait and switch
Copyright, David J. Litwiller 2013
28

29. Negotiating Cautions
• Your Price (Sort Of), My Terms
– Scenario: Entrepreneur desires an apparently higher pre-cash
valuation for the business than the Angel or VC initially offers
– Angel or VC comes back with a higher nominal pre-cash valuation term
sheet, but with significant additional preference rights
– The expected value of those preference rights typically lowers the
implied pre-cash valuation to less than the initial pre-cash valuation
– Moreover, the addition of those further preference rights creates a
more complex baseline for subsequent investment rounds
– Downstream investors will typically see the last investment round’s
rights as the starting point for what they will demand
Copyright, David J. Litwiller 2013
29

30. Picking Funding Partners
• Do as much due diligence on your prospective funders as they
do on you
– You will be joined at the hip for many years as the expected case
– Spend the time getting to know who you will be doing business with
before the deal gets signed
– Explore particularly how a candidate investor has reacted in the recent
past when investee companies hit a rough patch and plans needed to
adjust
• For VCs, know how the carry is divided among the partners,
because that allocation shows who really calls the shots
Copyright, David J. Litwiller 2013
30

31. Picking Funding Partners
• Test how actively and precisely the angel or VC
has been able to network on behalf of recent past
investee companies to boost prospects
• Be wary of VC generalists, which invest across
many sectors
– Ex: software, semis, cleantech, biotech…
– Nearly impossible for a generalist to develop enough
expertise or credibility to add much value, especially
at later stages of company development as
contextualization demands increase
Copyright, David J. Litwiller 2013
31

32. Financing Agents
• Preferred practice: Never use them
– Good management teams and good deals find their own investors and
introductions to investors
• Financing agents:
– Signal desperation or lack of business savvy by entrepreneurs
– Garnish the proceeds of the funding, usually 5% to 15%, effectively
taxing the investment returns for a prospective funder, making the
likelihood of securing funding plummet
– Make high quality angels and VCs run away
– Often are people trying to restart failed careers in other sectors of
finance, and taint the business in the eyes of candidate investors
through their association
Copyright, David J. Litwiller 2013
32

33. Investment Structures
• Convertible promissory note/debt
+ Speed, less due diligence
(typically, compared with equity)
+ Limited legal costs for deal structuring
+ No need to haggle over valuation
- Interest rate
(6% to 12% typical)
- Maturity date
(18 month median)
- Acquisition premium
(50% of time and rising, 2* typical)
+/- Cap
(80% of time, $3M to $12M typical)
+/- Discount
(75% of time, 20% discount typical)
+/- No board seat
(About 95% of time)
• Frequently used for seed round deals of <$500K (Canada) or <$1M (US)
• Used in about 50% of angel funding
Copyright, David J. Litwiller 2013
33

34. Investment Structures
• Common shares
+ Investors receive similar class of shares as common shareholders
+ Clean deal terms
+ Diminishes pressure for preference share rights in some subsequent
financing rounds
- Requires all of the customary due diligence to establish valuation
• Typically used for first equity round with angel investors
Copyright, David J. Litwiller 2013
34

35. Investment Structures
• Preferred shares
- Confer significant additional rights to holders of those shares vs.
common or subordinate preferred shares
• Voting rights (veto, issuance of new shares, asset sales, IP licensing, debt issuance,
business plan changes, management hiring and firing,…)
• Dividends
• Participation rights
• Liquidation preference (i.e. 1*, 2* or 3*)
• Redemption rights/puts
• Conversion rights
• Warrants
• Anti-dilution protection
• Typically used in VC financing and some later-stage angel rounds
Copyright, David J. Litwiller 2013
35

36. Warrants
• Sometimes early round investors will require warrants
– A warrant confers the right, but not the obligation, to purchase shares
at a future time at a set price
• Warrants tend to be dilutive to founders
– If the business is successful, the business will later likely be able to
raise funding at a higher valuation than the warrants would be
exercised at
– If the business is not as successful as planned when the warrants were
granted, the warrant holder is unlikely to exercise, and the business
would still have to seek additional funding from elsewhere
Copyright, David J. Litwiller 2013
36

37. Deal Sweeteners
• Know what additional matching and non-dilutive funding is
available, such as IRAP, OCE, FedDev, TecTerra, IDF, OPA, and
SDTC
• Private investors generally like seeing that their investment
will play somewhat bigger through these amplification
instruments than the direct amount they invest
• But, be careful to preserve full access to SR&ED and Digital
Media Tax Credits, as they are the cheapest form of capital
Copyright, David J. Litwiller 2013
37

38. Critical Term Sheet Mistakes to Avoid
• Granting early investors a rights of first refusal on future
financing rounds
– Scares away new downstream investors
– They would face the prospect of doing all of the due diligence, and
then having the deal be scooped by the earlier round investors
– Shows lack of deal savvy by the entrepreneur, and poor start-up
acumen generally
• Veto rights over future fundraising
– Gives early investors de facto exclusivity for supplying future capital, if
they want it
– Similar issues as the RoFR above
Copyright, David J. Litwiller 2013
38

39. Deciding Whether to Pursue VC
• Implicitly, doing so is a strong bet on an exit valuation >> $40 million
• 75% of VC-funded companies fail to achieve this
Copyright, David J. Litwiller 2013
39

40. Your Best Tools
• Competition for the deal
– Multiple, motivated investors, all independently interested in investing
– VC Q: Who else are you talking to? Ans: All the usual culprits. Period.
• A deadline driven by a likely near-term event which will
further drive up valuation or investment interest
• Confidence, tempered by enough humility to learn very
quickly
• High quality, larger in-sector partners with significant bilateral
operational interaction
Copyright, David J. Litwiller 2013
40

41. Your Best Tools
• Salesmanship and negotiating skill
– Leaving no one in doubt that you can do all the other
things needed to build a great business: attract customers,
partners, key future hires, strategic suppliers, future
funders, etc.
• Make investors feel smart, cool and sexy for getting
into your deal
• Execute relentlessly
Copyright, David J. Litwiller 2013
41

42. In Closing
• One thing to remember:
– A funding model is not a business model
– Spend more time with customers and driving
revenue than you do with candidate funders
Copyright, David J. Litwiller 2013
42

43. In Closing
• And a second thing:
– The way to attract the best funders is to show them
that you don’t need them
– One way is through competition for the deal
– Others are through gross margin, working capital,
non-dilutive funding, and resisting premature scaling
to defer the need for equity or venture debt financing
and improve your negotiating position
Copyright, David J. Litwiller 2013
43

44. References
“Cash, Connections and Chemistry”, Litwiller, 2011
http://www.slideshare.net/davidjl/cash-connections-and-chemistry-angel-investment-in-early-stage-technologyventures-feb-2011-dave-litwiller-final
“High Tech Start Up”, Nesheim, Free Press, 2000
http://www.nesheimgroup.com/books
“Renegotiation of Cash Flow Rights in the Sale of VC-backed firms”, Broughman
and Fried, Journal of Financial Economics, Elsevier, 2009
http://leeds-faculty.colorado.edu/bhagat/RenegotiationCashFlowRightsVC.pdf
“Term Sheet Series”, Feld et al, 2005-2008
http://www.feld.com/wp/archives/2008/06/revisiting-the-term-sheet.html
“Venture Capital and the Finance of Innovation”, 2nd Ed., Metrick et al, Wiley, 2010
http://www.stpia.ir/files/Venture%20Capital%20and%20Finance%20of%20Innovatoin.pdf
Copyright, David J. Litwiller 2013
44

45. Questions?
Copyright, David J. Litwiller 2013
45

46. Follow-up Discussion
Contact:
dave [dot] litwiller [at] communitech.ca
© David J. Litwiller, 2013
46