There is Much to Consider When Raising Outside Capital for Your Startup Across Different Funding Stages
Patrick Henry, Founder CEO of QuestFusion, and Rod Turner, Chairman and Founder of Manhattan Street Capital, Reg A+ Funding platform will discuss the key considerations when you are raising outside capital for your startup, and when and how to do it. Key topic including:
- Bootstrapping and Friends & Family Financing
- Raising Early Stage Financing, Including Seed and Series A Rounds
- Fuding Your Startup from Revenue
- The Use of Pre-Sales Crowdfunding and Equity Crowdfunding, Including Reg CF and Reg A+
- The use of ICOs, Initial Coin Offerings
- Raising Growth Stage Capital in a Series B and Series C Round
- Considerations Around an Initial Public Offering (IPO) and Regulation A+ Offerings
- M&A Versus IPO as an Exit
Rod Turner is the Founder of Manhattan Street Capital, the #1 Growth Capital marketplace for the best mid sized US and Canadian companies. He has been the Senior Executive for two IPOs to NASDAQ (Ashton-Tate, Symantec). Rod was an Angel Investor in Ask Jeeves, INFN, AMRS, eASIC, Bloom Energy. He is a high energy strategic thinker with an engineering background and skills in all areas of business. He is also an experienced M&A expert. Rod is a contributing writer for Forbes. You can contact Rod at [email protected].
Patrick: This is Patrick Henry, the CEO of Question Fusion, with the Real Deal…What Matters. I’m here with Rod Turner who is the Chairman of Manhattan Street Capital. Rod and I have known each other a long time. He started Manhattan Street Capital almost three years ago to focus on companies that want to use Regulation A+ to raise capital.
We were having a side discussion around ICOs. This means using a form of cryptocurrency called Blockchain to raise capital for companies, which is fascinating. Cryptocurrencies like Litecoin are a major topic so you should check this link out if you don’t know anything about Litecoin to find out more. This is an emerging area within the last year.
Rod: Yes. This last 12 months is where ICOs have taken off.
Patrick: We’ve done other webinars focusing on Regulation A+. Rod and I thought it would be interesting, based on conversations we’ve had with our clients, that range from early-stage startups to growth-stage companies. These are discussions around the whole process or raising money and what it’s all about. There seems to be a considerable amount of mystery around this.
We’re going to try to clear that up as much as possible. If you are going to raise capital and form a company, get a good legal counsel. Get a good attorney that really knows what they’re doing. A lot of people use LegalZoom. I think that’s risky. There are great package deals from a number of attorneys in highly respectable firms, including Mintz Levin, Cooley and Procopio.
They work with startups and have programs specifically for startups on a fixed-fee basis. You’re going to spend more than you would on LegalZoom but you’re going to have things done right if you’re building the company to eventually raise capital. Rod, there were some questions you thought we could discuss.
Rod: What’s the best source of funding for a startup? That’s an interesting one.
Patrick: I think the best source of funding for a startup is revenue. The vast majority of companies don’t need to raise outside capital. It’s a mistake to do that. There are various different sources to generate it through revenue, especially with the internet. You can do pre-sales crowdfunding. There are companies that I know that have a product idea. They build a landing page and run Facebook ads to see if there’s any interest around that product idea before they’ll spend $1 on developing products.
There are so many sophisticated and creative ways to do test marketing, where you get real data from real people who are willing to spend real money. Those are great ways to do smart ideation. That’s what I call it in my book, Plan, Commit, Win. You’re getting that feedback. If you want a more robust platform for doing pre-sales crowdfunding, Indiegogo is great.
I did a Kickstarter for my book. Those are great ways to do it. Be frugal. Rod and I are both entrepreneurs. He’s been involved with multiple companies. Now he’s running his own company. I’m running my own company. We were talking earlier that you have to think about it every day. What am I going to spend money on? What am I going to invest in? What am I not going to do? Making those decisions and not having to raise outside capital is hugely beneficial for multiple reasons.
Rod: I want to add one thing in terms of donation crowdfunding, like Kickstarter and Indiegogo. Quite often, I’ll refer companies to them with a neat idea that’s engaging. They don’t have any money on hand in order to spend money to raise money. That is generally what you need. The advantage of donation crowdfunding is that, because it’s donations, this is not as much a regulated space. It is regulated, but there are very few restrictions.
The marketing agencies that are promoting the companies in that environment are allowed to charge a percentage fee. That makes it possible to have a company with no money and a product that you want to capitalize. If you can get on the radar of the right marketing agencies, they like it enough and almost all of their fees will be on a percentage basis. That’s a beautiful thing. This is not to say that it’s easy to get on their radar. That becomes a qualifying process.
Patrick: I did a lot of research around this before doing the Kickstarter on my book, specifically on doing Kickstarter for publications. I didn’t even think about that as a possibility. I was interviewed by John Lee Dumas, who runs a famous podcast. He had done that for his book. If it’s good enough for John, I thought I would try it as well. I did a lot of research around it.
A key part, if you do this type of pre-sales crowdfunding, is that you do a significant amount of promotion and momentum build-up prior to the launch of the campaign. If these campaigns don’t get a lot of momentum in the first day or two, they fall flat. In the cycle that I did mine, I ended up raising three or four times my goal.
It was a very successful campaign. About 75% to 80% of the campaigns didn’t reach their funding threshold. On Kickstarter, you have to reach that funding threshold for it to fund. Indiegogo has a little bit more flexibility. Whether it’s hiring a marketing agency or doing the research yourself and understanding how to build that momentum within your network, getting that initial momentum is very important.
Rod: Rapid success breeds more success. Before much time has gone by, it’s too late. At 10 to 14 days in, if there’s not much activity, it’s gone.
Patrick: It’s the same way in equity-based funding processes, in terms of traditional as well as the more novel approaches with crowdfunding. If you don’t get that early buzz, momentum and excitement, you typically won’t get the deal done.
Rod: What about using Reg CF?
Patrick: You’re more of an expert than I am on Reg CF. Rod and I were on a panel for Funded San Diego. There was a guy who, like Rod, does equity crowdfunding but focused on Reg CF compared to Reg A+. Reg CF, as I understand it, they don’t have to be accredited investors. It’s very similar to pre-sales crowdfunding where you can market to the masses. You can raise less money. You can raise up to $1 million.
That’s the range for a seed or seed plus financing round. It is an alternative to raising money from angel investors and accredited investors in a Reg D offering. One of the things that came up in that panel was that, a lot of times, a founder or CEO of a small company is focused on a primary deal term of valuation in raising capital. They want to maximize valuation at every single step.
Because you’re dealing with less sophisticated investors in a Reg CF equity crowdfunding environment, you might be able to get a very high valuation. But that’s not the valuation where you will exit. That’s the valuation that you’re going to try to raise for your next round of financing. If it’s overly inflated, when you get more sophisticated, traditional, institutional investors, whether they’re experienced angel investors or venture capitalists, you might have a lot of problems raising that next funding round. Be careful in how you’re using it.
Rod: You get a lower valuation. That’s a big upset.
Patrick: Instead of upsetting five people who might have been your friends and family, or a couple of angels, if you’ve sold securities to thousands of people, it can be a big issue.
Rod: There are two things that I want to touch on. I was on the phone yesterday with a very seasoned, successful entrepreneur. He called me about Reg A+. We had a great conversation. He wants to do an IPO using Reg A+. Based on his company make-up, it’s going to be a good one. He is raising money, not to raise the money. He has his own money.
He wants to get the company listed. He wants the IPO to be very successful. He’s going to sell a limited amount of equity, a smaller IPO, at a low enough valuation. This way, the things that he has planned for after the IPO lists will cause a significant uptake in the share price. That’s a win-win. It’s one thing to go public, which feels great.
But you could also be in a win-lose scenario when you go public, but your shares tumble after the IPO because they were overvalued at the listing time, or for other reasons. The first is the example of the right way to do it. That applies at every level. As you said, a great CF sets the valuation low enough that he’s going to go up higher over time rather than having a big upset where everyone’s pissed off with you, the CEO. That’s not a good thing. Even if you can explain it to them, it’s still not a good thing. It’s a waste of time.
The second point is more delicate. Like you, I’m dealing with so many companies now. I’m helping qualify them as to if they should use Reg D or Reg A+. Should they do an initial coin offering? There’s a lot of up front qualification. When I hear too much emphasis on, “I don’t want dilution,” in the early stages, that’s a bad sign.
It’s an indicator of a risk factor. In my view, the entrepreneur mindset needs to be, “I want to have a small, sensible ownership position in a gigantic company that shoots the lights out,” versus, “I own 100% of the corner store, which is barely able to make any profit.”
Patrick: That gets back to my point earlier. The vast majority of companies shouldn’t raise outside capital. When you start a company, the thought often is, “How am I going to get angel investment? How am I going to get venture capital investment?” In order to start that thought process, you need to believe that you’re addressing a massive market opportunity that hasn’t been identified yet but it’s on the horizon.
Your timing is good. You’re intersecting at the right time. You have a massively differentiated solution with incredible value to customers that you can sustain over a period of time. That’s very few companies. We’re talking about companies that have the potential to be worth $1 billion. Everyone thinks, “My company is going to be worth $1 billion.”
There aren’t that many. I did some research around this for a blog post, which later became part of the introduction for my book. It’s around why companies succeed, and why most companies fail. There is a variety of different reasons. One of the big things is that companies get over their skis. They raise too much money for the opportunity that’s available for them.
The vast majority of companies that create jobs and wealth in the United States are small to medium-sized businesses. I know a number of small business owners here who do pretty well. They can make six figures and sometimes seven-figure incomes. I knew a guy in Los Angeles several years ago. He had an engineering services firm. He was taking about $1 million in salary a year over a 15-year period of time.
At the end, when he was ready to retire, he sold the company for $20 million. He never raised outside capital. There are definitely companies that are suitable for raising outside capital. But you have to think. When you get into Series A financing, an average-sized Series A is about $4 million. Let’s say the typical dilution on a Series A is somewhere between 15% to 25%. Let’s call it 20%.
That means that you have to have created enough value that your company, pre-money, is worth $16 million. Then, the expectation is that, $20 million is going to become $200 million. That will eventually become a half-billion to $1 billion. That’s the only reason why a venture capitalist would be interested in investing in companies. You have to get to those numbers.
Rod: I talk mostly with companies that are a little further along. They do need to raise capital in larger quantities. I’m not having the conversation that you are. It is so rare, and hard, to satisfy yourself. It’s so hard to have the concept that will take off like that. It has to justify the funding.
Even more difficult is that it can generate the revenue. Especially in my case, I don’t like asking people for money. I’m on their side of the table, too. I’m thinking, “That’s a lot of money. They can’t afford to pay that. They’re here to raise money. They don’t have money.” I get caught up in that and I end up being too cheap for my own company’s good. In that case, it’s an example of how we need people to fill out our team that complement our skills.
I need people on my team who are great at sales and understand the value of what we’re offering. They’re not shy about asking to be paid. That’s an interesting balance. You can bring in revenue sometimes when you’re a little too humble to ask for it.
Patrick: I recently wrote an article about this topic. It was based on a discussion I had with Amanda around giving free stuff away. If you’re building an online business like I am, you need to do a lot of things for free. You need to prime the pump. You need to put some water in the pump before you can get water out of the pump. You’re building a brand. That’s why we do these webinars. That’s why I do pro bono advisory services. That’s why I write my blog. The book isn’t free, but it’s $15. Anyone can afford it.
When you say, “I want to work with you, have you be my guide and spend huge amounts of project time together,” we do this for a living. That’s where we have to capture the value. Don’t be offended if we don’t pick up the phone. There are guys that I can’t get to pick up the phone. They have huge online businesses, podcasts and online presences. They have to make money. They’re booked. I think it’s important to understand how to assess value.
Way too many people get caught up in this. This is advice for you whether you’re running a product company or a service business. Understand the value of your service. Understand the value of your product to the customer. If you are able to articulate that in a way that the customer can understand, then they should be willing to pay whatever price is necessary to capture that value.
There are too many people that get caught up in the cost of something as opposed to the value that it can potentially deliver. Working with Manhattan Street Capital, you’re going to have a much better chance of a successful outcome than you would otherwise. With the Entropic IPO, we had a great attorney. We had a great accounting firm. We had great bankers. Those are the people who really know what they’re doing. They’re expensive, but the results were better because of that.
Rod: Seed round structure and convertible notes is a good topic.
Patrick: In the area of seed financing, there have been a lot of changes over the last several years. In my era when I was raising capital, I never did a seed round. The earliest round I’ve ever done as a CEO was a Series A. I’ve worked with a lot of companies back then that were raising seed capital.
Frequently, if a venture capitalist liked a company, they would do seed rounds. As a venture partner, you would have one company that you would do a seed round with. Then you would do your Series A and Series B rounds as well. That money is dried up, as far as I can tell. There might be companies still getting that.
What’s filled the gap is angel investors and super angels in cases where you’re raising a larger seed round. A typical seed round is between $250,000 and $1 million. A venture capitalist can’t get involved in companies like that unless it’s someone with a proven track record that they’ve worked with before or they’re a known entity before they started the company. You need to focus primarily on friends and family. Bootstrap as much as you can. Put your own money in. Then find the right angel investors that have domain expertise and technical product knowledge in your area.
Fortunately, the resources available for that with the internet are better than they used to be. You have AngelList. You have Propel(x). You have various different ways to do these consortiums of investors that come around a deal. There are the traditional angel groups, like Tech Coast Angels and Keiretsu Forum. You have LinkedIn.
If you do Reg D scrubbing, there are great sources for finding appropriate investors, like CrunchBase, Mattermark and CB Insights. There is a variety of different sources where you can get that information. You have to do real work to identify the right potential investors.
Then it gets deal structure. Historically, seed financing was almost exclusively done with convertible notes. There are three basic deal terms. You have the interest rate, which most people don’t care about. It’s relatively small. You have the discount to the Series A, where it gets priced. You have some type of a cap associated with it. There’s a newer instrument being used, especially in Silicon Valley, but it’s starting to spread call the SAFE agreement. It is a soft guarantee for future equities. It is an investment that will be converted but it doesn’t have an interest rate. This is something that Y Combinator came up with.
It’s more favorable for the companies and a little less favorable for investors. It’s being used widespread now for seed financing. If you’re raising on the higher end of a seed round and you get some more sophisticated angel investors involved, a seed round can end up being a priced round and look more like a Series A, which would be a preferred stock offering. There are a lot more deal terms associated with a preferred stock offering than a SAFE or a note.
Rod: I want to digress back to initial coin offerings because they’re so relevant to this discussion. There’s a thing called an SAFT, which is a derivative of SAFE. The delivery at the end isn’t equity. The delivery at the end is a token. In some ways, people are confusing the issue in the initial coin offering space. For US companies that want to do an initial coin offering, in most cases, their offering will end up being considered a security by the SEC.
They have to toe the line and follow one or another of the regulations to do that. The two best ones are Reg D and Reg A+. The SAFT confuses people. I hear people say, “I’m doing an SAFT, so I don’t need to do Reg D or Reg A+.” That’s completely wrong. That’s important if you’re interested in a coin offering. I’m talking about this because more $2 billion has been raised today in initial coin offerings.
It is currently a seller’s market, which is saying that it’s too easy to raise money in that space. That’s going to change. There are flaky companies raising money through coin offerings and there are some great ones. There is breakthrough technology occurring. I believe that the blockchain as a technology and its application will be a large step forward in growth for the industry beyond the internet. It’s the next wave past the internet.
It’s easy to raise money in an ICO if you do it properly. You can do it as an early-stage company or as a later-stage company, depending on which vehicle you use.
Patrick: It’s an important point as it relates to seed financing as well. When you do a seed round, even in the form of a SAFE or a convertible note, it’s in the context of Reg D. Eventually, it gets converted into a preferred stock in either one of those cases. I had an entrepreneur recently talk to me about raising a financing round. She got some bad legal advice. She was told she could not raise money from non-accredited investors in the seed round, which is wrong.
In a Reg D offering, you can raise from up to 35 people who are not accredited investors. It could be friends and family who do not have that super-high net worth of an angel investor. There are ways that you can exceed that number if you do a Reg CF offering, if a regulation is around that. Even in a Reg D offering, you can raise money from your friends and family. You do need to make sure that, if you’re raising money from accredited investors, you follow the rules. There are a number of rules that you need to follow.
Amanda: Someone wants to know more about the SAFE.
Patrick: It can be found on the Y Combinator website. It looks a lot like a convertible note, except it doesn’t have an interest rate because it’s not debt. It’s an agreement that you use to raise outside capital. This is typically in a seed round of financing. It’s the legal document that outlines what you’re going to get, in that they’re able to raise a Series A financing.
I’ve done both. I’ve invested through a SAFE and through convertible notes. As a debtholder, you have certain rights from a governmental standpoint, in the event that there’s a default of the company. With a SAFE agreement, those rights go away. There’s a slight disadvantage as an investor for a SAFE agreement, and a slight advantage for the company.
For the details of the SAFE agreement, I would look at the Y Combinator website. There are probably some good blog posts that Y Combinator has written about it as well.
Rod: If you look at Reg CF offerings, a lot of them are going that way. There is a lot of neat stuff going on there, as you touched on earlier, in the Reg CF space. Up to $1 million is pretty good if you have a company that is appealing to consumer investors. Generally speaking, in Reg CF, as in Reg A+, we’re getting more attraction. The behavior of investors is similar.
You’re engaging with consumer investors that love what you do. You need to have that level of appeal. An offering that would appeal in a Kickstarter environment can appeal in a Reg CF environment to consumer investors. If you have that going, then it’s a great way to go.
Patrick: I think that’s an important distinction and differentiation. AngelList is a much better platform for companies that aren’t consumer facing, but you can still do consumer facing stuff. With Reg CF, you really need to have fans that are excited about what you’re offering. They can relate to it on some kind of consumer level.
Rod: My experience with referring companies to AngelList is that it’s a complicated process. AngelList is phenomenal. They’re in a class by themselves in terms of their ability to raise money for good companies. There is no question about that. For companies to get into AngelList and succeed through their system, it’s complicated. It helps if you’re in Silicon Valley. It helps if you have a network of the right people, which is a pain. That’s the restriction I see there. They’ve built a superb system.
Patrick: Even in an IPO, you need an anchor tenant. When we took Entropic public, it was essential that we had one or two big funds. Fidelity was one of the big funds that decided to make an investment in Entropic’s IPO. Without having that anchor tenant, at any round of financing in a seed round, Series A or IPO, you want to have someone like that. I think AngelList is the same way. You want to identify someone who is a super angel or does a lot of these consortiums around a particular deal. They’re putting their stamp of approval on it. They raise these mini funds within the platform. There is a lead guy or gal. If you identify that and they have influence within that community, then your chances of success are much higher versus just throwing it out there.
Rod: One of the characteristics of equity crowdfunding is that you have platforms like OurCrowd. That is very good. It has a good footprint in many countries around the world. They’re very selective. If they get involved with your company, they’ll put their muscle behind it. They’ll invest in it and it’s very likely to succeed. It’s like getting into Harvard. Once you’re in, you’re likely to graduate. That’s one side.
The other group tends to be lists. They are listing services where you pay a fee. You have the platinum program where you get a little bit more attention. They don’t do it for you. They aren’t driving it and they’re much less selective. In that case, you’re in a crowd of companies raising money. You need to pull yourself out from that. You have to do the marketing.
Patrick: It’s very similar to Kickstarter and Indiegogo from that standpoint.
Rod: Yes. The fact that it’s giant and vibrant isn’t enough. It’s giant and vibrant for everyone. How do you get seen in that environment? In that case, you’re paying for the marketing. This is a transaction where you’re selling shares. That is a regulated transaction. Agencies are not allowed to charge a percentage fee. That’s a key distinguishing factor.
If it’s the selective type, you have to start it early. AngelList is a process. If it’s with the other kind, where it’s a listing service, recognize what you’re doing. You’re taking your own responsibility for making it all happen and driving it. That’s okay, too. You have to know that and have the right agency, programs and effort.
When does a company know it’s ready for a Series A round?
Patrick: The typical size of a Series A is $4 million. It could be $3 million or $10 million. You need to be able to explain why you need that much capital. You need to have enough of a track record so that a venture capitalist or super angel can look at the deal and say, “All I have to do is add gasoline to an already functioning engine, and it’s going to skyrocket.” What are some of those things?
Let’s look at traditional software deals. This is for software as a service, but it also applies to other companies. What is your customer acquisition cost? What is the long-term value of a customer? What is your churn? You need to have a critical mass of customers that can demonstrate at some minimum scale.
You have to say, “I’ve validated the market opportunity. I’ve validated that the product or service works at a certain level. I have customer feedback. I have testimonials. I have people saying this is a good company.” What’s the monthly recurring revenue? Then you can model it and say, “If I put this much more money in, I can add these additional features to this product, execute on this product roadmap or put more weight behind the sales effort.”
It costs something to get something. What is the cost of your customer acquisition?
Rod: You’re talking about scaling up.
Patrick: How can you scale it? It has to be a certain size to attract those types of investors, and you need the metrics. They need to be able to look at it and say, “I can scale it just by adding money.”
Amanda: Do blockchain-based companies that can raise ICO financing have restricted scalability due to existing on the blockchain?
Rod: There’s no such thing as a complete no, just like there’s no such thing as a blanket yes. There will be exceptions. Right now, there is speed of processing the transaction issues in Bitcoin in the blockchain. This has to do with the way that it was architected. That will be overcome, in my view. Eventually, they’ll figure that out. Even if it means that there’s going to be a different cryptocurrency than Bitcoin that takes the lead, it will get solved. There is no inherent reason. It would be foolish not to recognize cryptocurrency as the future of all currency. What makes it so great is literally anyone can join the bitcoin revolution. All you have to do is look at the history of its development to see how much it has changed and how much the bitcoin historical statistics resembles a premature version of the early stock market.
Patrick: There’s no inherent technical issue around the underlying technology. The underlying technology doesn’t have that restriction.
Rod: Some of the companies that I’m seeing are doing exciting, impressive, revolutionary things. We say, “Why didn’t I think of that?” It’s those ideas where you say, “It’s obvious now.” It’s the sort of thing where we wish we had done it. I’m seeing some of those. These are things that are revolutionary and were impossible. You have this token that’s intelligent. It does what it’s supposed to do and nothing else. It does that really efficiently.
You have this small contract, which governs the way in which it pays out money and earns money as well as ways that it can be sold and purchased. It knows its history. It knows who bought it initially. It knows who owns it now. It knows through which exchange it was purchased. The inherent intelligence and information is there. When you have that kind of functionality built into the token itself, there’s so much that you can do with it. It’s an intelligent, stand-alone entity that’s doing its thing.
Amanda: Are there mainstream applications that you can download from the Google Play or IOS Store based on blockchain networks?
Rod: Not that I’m aware of yet. One of the things that I’m seeing is a company that is pioneering the use of cryptocurrency for buying and selling electricity from wholesalers through resellers and purchasers.
Patrick: You see agricultural applications and big power applications. From everything that I’ve read, those applications have vastly more opportunities than just cryptocurrencies. It makes sense when you think through it. There are so many applications of blockchain that are so valuable.
Rod: You have the financial things, which are streamlining and making banking more secure over time. The things that I do in cryptocurrency are drastically more secure than regular banks. Regular banks are awful. There are also things like micropayments. When you move away from the money transaction side, then you have proving identity.
Patrick: Only providing the information that’s necessary for the transaction. That’s a huge problem with security. Here’s an example. You give a bartender your driver’s license to show that you’re 21. There is all sorts of information on there that they don’t really need to know.
Rod: Yes, selective exposure.
Patrick: Exactly. That’s a key part of the security elements of blockchain and cryptocurrencies.
Rod: They’re providing security services. One of the interesting dilemmas is that there are companies that we’re dealing with that are established, successful companies in a space. They want to do a token but they’re considering doing it as a utility token where no money changes hands.
This is a dilemma we don’t know the answer to yet. If it’s just a token that does that neat stuff, you have to work hard to get the word out. Whereas, if you do an initial coin offering to sell those tokens, there’s a process that exists to promote them, get them known and get people engaged. That’s an advantage. It’s a way in which to get the usage established rapidly versus knocking on everyone’s door and saying, “You should use these tokens because they’re so cool.” There isn’t a process for that. That’s an interesting dilemma that goes along with it.
Amanda: Can you raise ICO financing without having blockchain based features?
Rod: It isn’t really an ICO then. The way that the initial coin offering universe operates, there are a bunch of excited people around the world that are engaged in these companies and investments. If it doesn’t have a token with really interesting functionality, then it’s just a company raising money. That’s okay. It has its place, but that doesn’t excite the ICO crowd. It’s like taking your Harley to a dirt bike event. You’re not going to go in the dirt with your Harley.
Patrick: We were talking about Series A. Typically, the Series A is going to be your first institutional round of financing and your first true equity offering. A seed round, if it’s done in a SAFE or convertible note, you negotiate the terms around valuation, and the preferences here versus the preferred stock in the seed round. There is antidilution.
There is a variety of different deal terms you need to consider. This is where having a good CFO or attorney that understands these things becomes very important. There are many people, such as CEOs and company founders, that don’t understand some of the basics between common stock and preferred stock. As an owner of the company, when you form the company, that’s common stock.
Let’s say that you and a co-founder start a company. You decide to split the company 50/50. You also put an option pool in place for hiring employees. Maybe that’s at 20%. You own 40%. Your partner owns 40%. The option pool is 20%. In terms of the preference stack within a balance sheet, you have receivables and payroll at the top. Then you have some dead offerings. Then you have long-term debt. Then you have preferred stock, and then common stock.
If there is an event where the company is sold for less than the preferred stock offering, you get zero. You could have an exit of $40 million or $50 million and still make zero because of the way that the terms work in a preferred stock offering. I call them perverse elements of offerings. Look at a lot of the deals that were done the last few years around unicorns. Everyone was focused on valuation and getting to that billion-dollar valuation as a private company.
But with the claw-back features, preferences and everything associated with those offerings, you might in theory have 30% of the company, but it’s in common stock. The preferred stockholders are going to wipe you out. There won’t be anything left for you. Understanding deal terms becomes very important, and not just the deal term evaluation.
Rod: This is a preference of mine. I don’t like convertible notes. I don’t like SAFEs. As an investor, I hate them. As an entrepreneur, I don’t like them. Now you have debt on the books. It surprised me that the credit card authorizer says, “What’s this debt on the books?” You’re behind the line already.
Now you have to earn your way out of that and prove to them that it’s legitimate debt, not debt you have to pay back next Thursday. I also don’t like the overhang. I don’t like accruing the interest rate on a convertible note. There are terms in these things. If you don’t properly note exactly when you must convert the convertibles, sometimes the note can be called by the note holder.
You have to structure it properly in the first place, and you have to know what it is, so you don’t get called out. Someone gets pissy and they’ve read it better than you. Now they call you out and they bankrupt your company out of animosity. They think they can get a better deal.
Patrick: They might feel like they can get your products and IP on pennies for the dollar.
Rod: Unfortunately, there are people who will do that. You have to protect yourself. I don’t like that complication. It’s okay, but you have to provide for that so that you don’t get called out. For example, there is a company now called Pandora. I almost invested in them when they were called Savage Beast in 2001. They were a lovely company. They had the potential then.
It was a kickass company. It was a convertible note with no future. They were ethereal about what would happen in the future. What happens if there is no venture funding and you do great without venture funding? What’s my valuation? Stuff like that doesn’t cover the investor well. They wouldn’t negotiate it, so I walked away. I haven’t calculated how much money I lost in that case. I don’t like convertible notes. I like to know where I stand. Twenty percent isn’t enough of a discount. I’m taking all the risk. I’m here now.
Patrick: Many times, if you’re raising a large amount of money from more sophisticated angel investors, there will be so many deal terms around the convertible note. You might as well do a preferred stock offering. It becomes ridiculous. That’s something that you have to gage based on the interest level that you’re getting from prospective investors. Some companies are great. I’ve invested in a SAFE agreement because I believed in the entrepreneur and the idea. In those cases, I typically have an advisor agreement. They’re not paying me, but I have equity. It’s a different gig in those situations.
Rod: Here is our next question. My company needs expansion capital beyond the Series A. What’s next?
Patrick: This is a company that has raised a Series A. They’ve been successful with the money that they’ve raised. You have people excited around the table. Depending upon what you did with valuation in the Series A, you can still raise Series B or Series C money in a down round if people say, “I’d rather take a little less than flush the whole thing.” It’s always better if, on each successive financing round, you have enough valuation.
In Entropic’s Series C, we had a slight uptick, but not a huge uptick. Everyone was still happy because there wasn’t some type of cram down. The investors that were very excited about it and continued to invest in the A and B round invested in the C round. They were able to keep hold. Expansion capital is when you have a company on a tear. You’re moving from single product, single market segment type of dynamics.
You’re starting to penetrate other vertical markets or launch new products. You need expansion and growth capital for that. The way that Series A rounds have evolved, I would characterize a Series A as being a growth capital round. With traditional Series A rounds 10 or 15 years ago, you may not have had a product. It was an earlier stage.
You might have said, “I’m going to add money so that you can complete your product development.” Maybe you have a prototype. Maybe you have some initial customer feedback. I don’t see those deals happening as much anymore. Maybe if there is deep science involved in something, like a pharma company or a biotech company with leading-edge technology that everyone is excited about. That’s not the vast majority of companies. With the vast majority of companies, a Series A is growth capital.
Rod: I agree. One of the things that I find amusing when dealing with venture capital firms is that you will often see on their website, “It’s never too early. Approach us now. We invest in very early stage deals.” What that really means is, they’re open to everything. If you have a great idea, like another Facebook, then they will engage. You’ll get very early stage money. For 95% to 99% of the companies that they look at, they’re not going to submit. They’re only seriously looking at companies that have taken the lion’s share of front risk out of the equation.
Patrick: They list the technology risks and most of the product risks. Some of the customer and market risk has been mitigated. That’s when a Series A typically happens in today’s world. Let’s say that you’re doing a seed round. Your seed round is half-million to $1 million and you’re expecting to raise a Series A.
About 12 to 18 months after the seed round, there is no harm in talking to venture capitalists that have domain expertise, technical knowledge and an investment track record and experience in your space. They may come in even if their fund is not ready to put money into the deal. Maybe they are ready to put money into the deal as a personal angel investor.
Rod: They will ask great questions.
Patrick: If they’re willing to have an audience with you, there’s no harm in doing that as long as you don’t damage or trash that relationship so that they can’t go back in the future. If you’re planting seeds, over the next six to twelve months, drop them an email here or there. Maybe you get on a phone call and say, “We’ve reached a key milestone. We’re gaining momentum.” Then you’re establishing a track record in advance of the formal process of raising the Series A.
Rod: Then you’re on the same side of the table.
Patrick: There has been some discussion around this from a famous angel investor in Los Angeles. It’s about this so-called funding gap between the seed round and the Series A. You see this very often now. If you’re only raising $250,000 to $500,000 over here, and you’re going to try to raise $4 million-plus over here, you have to make a lot of progress. Most deals don’t get done that way. Most deals are done with a C or B round before you get to a Series A.
Amanda: Here is another comment. “My co-founder and I are similar to the Winkelvoss twins in the case of Facebook. Would you recommend searching for technical and coding resources by looking to find more co-founders or seek investment from tech connected angels?”
Patrick: Two co-founders is good enough if you have very complementary skill sets, one on the business side, one on the technical product side. That’s typically the model that you see that works. There are companies that have had more founders. Qualcomm had seven founders. Entropic had four founders.
Rod: The question sounds like they don’t have the technology bit covered.
Patrick: If they were to go to Y Combinator, like the guy who started Dropbox, and they came with this story, Y Combinator would say, “Come back when you have your technical founder.”
Rod: Then you’ll have the bases covered. That’s a reasonable thing to do. I want to add something to this. There is a funding gap there. For a smaller transaction, like $1 million or $2 million, that doesn’t really fit Reg A+. The up-front costs are too high for that.
There is something that we are now doing in select cases at Manhattan Street Capital, the fact that cryptocurrency exists and it’s in the hands of so many investors as they can just buy cryptocurrency around the world means that we have a convenient way for the Chinese middle class of 300 million people to invest in quality US companies. We’re doing that now.
Patrick: You’re expanding your platform to tap into that potential source of capital.
Rod: Yes. We’re doing it for all of our offerings with initial coin offerings as we start launching them next year. That’s a no brainer. That’s the normal way of funding them. For our Reg A+ offerings and our Reg D offerings, we are expanding them to make it convenient for international investors, wherever they may be, to invest. It’s critically important and valuable.
Patrick: How does that work from a federal government standpoint in terms of saying that someone from outside the US isn’t an accredited investor?
Rod: They have to prove that they are. Reg D 506C is the only way in which you can generally promote a Reg D transaction. Reg S is a derivative of that. We can promote these Reg Ds worldwide, whether it’s a share offering, convertible or coin offering. Then the issue is, what do you do to make sure that you verify that the investors are accredited if they say they are? That’s an obligation in 506C on the issuer. We help the issuer with that. There are service providers that do that. It can’t be a mystery. Otherwise, we couldn’t take the money.
Patrick: There are check-the-box certifications.
Rod: Yes. There is verification of identity and accreditation status. You have to do that. With Reg A+, it isn’t required to verify. They don’t have to be an accredited investor. They can come from anywhere in the world.
Patrick: Unlike in the US, you can self-certify.
Rod: That’s where 506B comes into play. This is not for a 506C.
Patrick: On your platform, you’re focused on the 506C.
Rod: Yes, because they’re open. People can parachute straight in and go straight to the offering and see it without first having to sign up and prove anything. It’s a pain. They don’t want that. 506C lends itself to open access.
Patrick: That’s interesting. Typically, in this funding gap period, you have to have had angel investors in your Seed A round who still have dry powder to support the Seed B. So many companies fail because they die during the funding round.
Rod: I see it on a regular basis. They have a great company. The existing investors don’t have anymore willingness or capital to deploy. What do you do now?
Patrick: If you can’t find a corporate strategic investor or you don’t have dry powder left with your initial investor group, it doesn’t mean they have to fully fill the gap. If no one who has been involved with the company is willing to step up and say, “I’m putting more money into this deal,” the likelihood of getting outside people to come in is very slim. The guys who know this the best aren’t willing to fund it. They’re not excited anymore, so why should I get excited?
Rod: It’s a difficult situation. This makes it more cost effective to raise money. There are so many people outside the US who want to deploy their money into quality US companies. This is a way to do that. I’m looking forward to this. We’ll be putting up some Reg D offerings fairly soon in this method. We’re accepting all regular payments but they’re more US-centric. We’re adding cryptocurrency. We’ve built that into the platform. We’ll find out how it goes. It will reduce the cost of promoting these offerings.
Patrick: It’s significantly less than a Reg A+ offering.
Rod: Yes, that’s true. Reg D deals are generally more expensive to bring in the investors because US accredited investors have so many choices. There are so many emails and promotional things. Breaking through that is expensive. It’s about double the cost of marketing for investors in a Reg A+. Now we bring it down again by going outside the US.
The accreditation line is much less significant. If you were an Italian or English investor, they have their own limits there. They have to qualify the same over here, but they’re not overwhelmed like they are here. That’s going to be interesting. Using Reg D for ICOs is also interesting. You have the limitation of accreditation requirement, but there is no cap on the amount of money that you can raise.
Patrick: We should have a follow-up conversation about ICOs and cryptocurrency. Do you have other webinars coming up on these topics?
Rod: Next week on Thursday at 11:00 Pacific, we’re having a webinar for companies doing ICOs that want to know how to make them security compliant.
Patrick: The information about that is on the Manhattan Street Capital website?
Rod: Yes, it is there and on social media posts.
What was the decision process in taking Entropic public in an IPO versus selling the company in an M&A?
Patrick: This was in late 2006. The company was founded in 2001. I came in 2003. We had our first customer deployment with Verizon. We had raised a Series A, B and C round. We were making tremendous progress. We were on the initial start of hypergrowth. We were in Fast Company for one of the fastest growing companies.
We worked with our bankers to get an idea of valuation. The valuation that we felt we could get in an initial public offering was about two-and-a-half X what we could sell the company for in an M&A transaction with the most likely buyers of the company. It was primarily based on doing the best thing for the stockholders.
It wasn’t that the other company didn’t feel that we were a good company. They weren’t in a position to pay the amount that we felt we could get in an initial public offering. Then I worked with my board. I still felt like Entropic was subscale for being a public company. It’s one thing to take a company public, it’s a totally different thing to run a public company.
There was another emerging growth technology company that had complementary products to what Entropic had. They were called RF Magic. They were also a San Diego based company. There were a lot of common friendships, employees and founders. I started working with their CEO and CFO around the idea of putting the two companies together as a private company, and then taking it public.
It was challenging because it was a stock-based transaction. The RF Magic shareholders ended up owning about one third of the company. The historical Entropic shareholders had about two thirds of the company. We completed that transaction around June of 2007. We were the last tech IPO for the next two years.
Do you want to cover some highlights of Reg A+ versus an IPO?
Rod: Reg A+ is very versatile. From the investor side, the advantages are that the SEC considers every investor to have liquid stock post offering, even when the company doesn’t list. It doesn’t have to list on the NASDAQ, New York Stock Exchange or on the OTC markets. The shares are liquid by the SEC unless the company locks them. Genuine liquidity is a good thing. It is followed by liquidity for all of the owners of the company.
Patrick: Is it hypothetical liquidity or is it real liquidity? Is there an aftermarket for trading the shares?
Rod: It’s hypothetical and there’s no trading volume. That’s the bad news. The good news is that there are now secondary markets evolving where you can buy and sell these non-listed Reg A+ stocks or bonds. Some of the companies are defining the liquidity that they will provide direct so that they can lock the shares.
That’s only reasonable if they lock the shares and provide a defined redemption or liquidity method. That’s happening, where a third party conducts an evaluation at the point of redemption. It might be once a quarter. That’s reasonable. It provides a good way for companies to get liquid for their insiders over time. There’s not too much to do in the raise.
Patrick: That’s the case with an IPO as well.
Rod: In the secondary market, the investors get liquid and the insiders get liquid after they’ve reported results, as in a regular public company situation, depending on liquidity. There are the good reasons to provide that liquidity. There are other interesting things about it.
If you do not use Reg A+ for a full IPO, and you list on one of the OTC markets, you can automatically qualify for the OTCQB and pay $2500 to get a fresh, new ticker symbol. The reporting obligation is the same as if you had done the normal Reg A+, which requires an audit once a year, but not PC A or B, and six-monthly revenue and profit reporting.
Then you’re public and you have some degree of liquidity depending on how much excitement you build and how good of a job you do at delivering over time. For the companies, it’s very versatile as a system. One can raise money all the way around the world. There’s a process to verify that every investor is legitimate, which is true for ICOs as well as regular Reg A+.
The opportunity to go as high as an IPO to the NASDAQ or the New York Stock Exchange is there. There have been six so far this year. We posted Arcimoto, which is a very innovative electric-driven three-wheeled car. They were the fifth of six so far this year. They raised $19.5 million in four weeks, of which $4 million came in online. That is pretty good.
They are a very interesting company with good management and a low-cost philosophy. They are in Eugene, Oregon. At the high end, you can use it to list a company with a relatively small or maximum of $50 million. If you do list on the major exchanges, then you do a secondary in the conventional manner.
Now you have a full reporting public company. If you don’t list, or if you do an OTC listing, you do another raise every year up to $50 million. That way, it will last for up to a year. You don’t have to rush it all in three to eight weeks. You are allowed to combine promotion of your shared investment with your product offering or service.
Patrick: It’s almost like a shelf-type of offering.
Rod: Yes, in a way. You can pause it when you choose. You can raise the share price, within reason. You have to file with the SEC for that. If you are promoting a club that’s really exciting, you charge a membership. It might be a 20% discount for anyone who invests more than $1,000. Deliver it. Half off your first X shipments of our special pet food product.
Then you’re combining merchandising your product with selling your shares. Doing it over a year makes more sense. It’s more cost effective. The versatility is there. The downside would be upfront costs and time. The minimum all-in expense would be $100,000 for a small raise before you can go live to investors.
Patrick: That’s legal and marketing for your services?
Rod: Yes, that’s legal and marketing. Depending on the nature of the raise, we may charge a monthly fee for consulting to help companies through their entire journey.
Patrick: That’s really inexpensive, relative to an IPO.
Rod: Yes, it’s massively less. For a full IPO, then it costs a little bit more up front. It’s not a massive amount up front. The advantage is relative to a regular IPO.
Patrick: This is the lower exchanges, like the NASDAQ?
Rod: It could be either. That’s a function of how much you raise and how many shareholders you get. It’s not a problem to get enough investors and raise enough money to go to the major exchanges, like NASDAQ or New York.
Patrick: Are the bigger banks starting to get on board with this?
Rod: Not yet. Bigger as in Morgan Stanley and Goldman Sachs, not a chance. We get inquiries from more established underwriters. There is a set of underwriters and broker dealers that are active.
Patrick: This is like the Red Fin of the financial markets. It’s like a discount type of process where you can still get public.
Rod: Yes, and it’s newsworthy and interesting, which helps. The cost of the audit fees and legal fees are dramatically lower.
Patrick: The ongoing costs?
Rod: The upfront costs. It is a private placement as far as the SEC is concerned, unless and until it completes. If you list, now it’s a public company.
Patrick: You have the same reporting requirements as any public company once that happens.
Rod: Yes.
This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.