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Context Shows the Value Beneath the Counter-Intuitive Surface

I was shared a lesson about context through a story of the fabled NASA rockets that helped NASA reach space, orbit the earth, and reach the moon.
Paraphrasing, the rockets evolved a great deal, especially captured in their sizes with the Saturn rocket (took the astronauts to the moon) greater than 35 stories tall. The earlier iterations propelled the rockets only so far. To reach the moon, the rockets had to be bigger. Common wisdom would suggest that bigger rockets added heft. Heft is counter to the goal of going farther and faster. Except, size hid the real need for “bigger” – more fuel.
Greater context can reveal the real value of an investment. What looks on the surface to be counter-intuitive can actually be a catalyst for a desired outcome.
A few examples where this plays out:
  • Instead of working, taking an hour off. That one hour may seem counter to the need for greater productivity. However, context of that hour may reveal an hour of exercise which has shown time and time again massive benefits mentally, emotionally, physically, etc.
  • Regular coaching of employees. Everyone’s working hard, right? There’s a lot to do and things seem to be working fine. Why coach or have periodic touch-points? Because there’s context happening that aren’t visible on the surface. Because being a B-player works, but being an A-player works better.
  • Slowing down a sale to learn more about the challenges a prospect faces. The more we close, the more money we make, right? Glengarry tells us to Always Be Closing. However, always aiming for the close can scare off prospects without understanding and value creation. It’s not just the one-time sale. It’s the consistent selling of a vendor-customer relationship. (Well, for complex sales anyways.)

It turns out we’re pretty smart, but we are also quick to jump to conclusions. What seems counter to a goal or objective can actually be a catalyst. All it takes is context for understanding.

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De-Risk for Investments

I was talking to a Producer and Director recently who is starting out his business. He’s got his business set up, and is seeking investors for a film. He’s got the script. He’s ready to go. Except, the investors want him to slow down. The investors wanted to “de-risk” the investment. New to being an entrepreneur, the Producer shared the nuances he wasn’t quite prepared for.
  • Expected Returns – SaaStr states that a 10% return on the totalventure capital (VC) fund is good while aiming to earn its total VC fund in profits is the goal. Understand what the goals of the investor(s) are, and have the model to illustrate goals can be met with even conservative achievement.
  • Legal Collateral– The Producer was shocked to learn how much he had to spend to validate the authenticity and originality of the script. Investors are looking at legal terms and insurance to not only cover risks of copyright infringement, but also the leveragability for greater valuation.
  • Long-Term Strategy – Are you a one-hit wonder? Do you have the creativity to be adaptable? Are you thinking big? Focusing on the now is good, but investors are looking for big returns. Long-term value creation enables bigger returns.
  • Traction– One of the “shticks” about Atlanta investment is how stingy investors can be. In the Valley, ideas can be funded pre-revenue. In Atlanta, the companies that garner investment are largely post-revenue. For the Producer, he had to collect and display written interest from film festivals. On “Shark Tank”, entrepreneurs can show letters of intent or purchase orders (POs).
  • Business Plan – The Producer lamented the pain of creating a business plan. Having never done one before and without a business degree, he sought help from others. However, many could not show him “good” plans. Business plans can be rare outside of startups seeking investment. However, they can be immensely helpful in thinking about the business holistically, not just about this “great app idea”. The business plan forces the entrepreneur to think of the risks and the opportunities – sometimes, it can show the opportunity isn’t as big as he might think.

I share these, too, because I’ve heard a lot of ideas from wantrepreneurs. Then, there are others who start out, and then fold up shop only months later. They weren’t prepared. Most investors are savvy as they should be with their money. So, it’s no surprise what some common de-risk factors included, and how important wantrepreneurs and new entrepreneurs should consider when starting out.

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Investing In Things Like Conferences, Bring the Energy

Last week, my company sponsored a conference for sales force productivity. As I went into it, I remembered running booths with Body Boss…

I forgot how much fun (and tiring) it was to work a conference, and how important it was for those working the booths and sessions to actively participate. Walking around many of the booths, many people sat behind their booths. Some, even, working on their laptops. Not very engaging.
Perhaps because my company is a startup that I was determined to get as many conversations and leads as possible. Sinking the investment that we did meant we needed a strong return. I felt that my company’s investment was myinvestment.
As attendees entered and exited sessions, and walked by our booth, I was right there in the middle of everyone engaging with just about everyone. One piece of schwag we gave out at the conference was a green “squishy” stress ball. I must’ve put these balls directly in the hands of 75 people while casually giving my 5-second pitch to see if they’d stop by. I even up put one ball directly in the chest coat pockets calling them “pocket spheres” – new fashion accessories. Hey, I got laughs, and I got serious interest from them.
Okay, maybe I had too much energy – ha! But you know what? I have a stack of qualified leads and ongoing conversations with 20 or so contacts, while no doubt raising a lot of awareness. If a few of these convert, our investment and our enthusiasm will have paid off well. Isn’t that the most important thing? To drive a return on an investment knowing you did all that you could? I made the experience more personal for attendees while adding some ridiculous humor into it. Like making cold calls – you need something to get the receiver hooked and engaged for that initial conversation.
If you’re going to work, enjoy it. If you want a conversation, start it. If you’re going to make an investment, give yourself every chance to succeed and the highest returns.
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The Finance of Startups: For Dummies (Part 4)

I’ve somehow managed to keep this going for four months (including today) researching finance concepts, and blogging about them. Wow, it’s been a great exercise learning and sharing.
I admit my recent blog posts haven’t gotten me THAT excited where I’m openly sharing, but when I started researching and writing this post, I felt that excitement again.
So, anyways… moving on for today’s post – PART 4! The following topics will be covered:
  • Convertible Note
  • Discount (as part of Convertible Note)
  • Cap (as part of Convertible Note)
  • Dividend
  • Pro-Rata Rights

Convertible Note.

A convertible note is kinda, sorta, like-a hybrid of debt and equity financing. Here, the company and the investor delays setting a valuation for the company till a time when the company may raise another round with a valuation. Convertibles are a popular vehicle for early stage startups as it’s hard to discern the value of an extremely young company with little to no earnings.
So instead, the capital at the beginning is treated like a loan upfront. When the company raises another (or official) round, then the outstanding convertible note is converted to equity as a ratio of the valuation. However, to sweeten the deal for the inherent risk of investing early on, there are a couple levers that impact the conversion of the convertible:
  •  Discount – a percentage reduction the convertible note holders can convert to the principal loan amount relative to the purchase price of the next round. The discounts typically range from 0-35% with 20% being the most common. So if Series B round investors are paying $10 per share, the original investors who had a 20% discount on a principal amount of $100,000 can convert this loan amount at a per-share-price of $8 ($10 less 20%)… they’d get 12,500 shares at $8 each but valued at $10 per share.
Seed Round: You invest in a convertible note of…
Principal of $100,000 with a discount of 20% (convertible to Preferred Stock)
Series A: Awesome Venture Capital Firm invests…
$10 per share at a valuation of $10M (pre-money)
Your conversion price-per-share
$10 * (1 – (20%)) = $8 per share
Shares of stock
$100,000 / $8 = 12,500 shares of Preferred Stock
Book Value of stock (unrealized)
12,500 * $10 per share from round = $125,000 (25% unrealized return)
Series A investors would’ve gotten…
10,000 shares for $100,000 investment due to $10-per-share price
  • Cap – a maximum limit of the valuation that can be converted into equity at a later priced round. The investors will typically be priced at the lower of the cap or the valuation of the round. How this works…

Seed Round: You invest in a convertible note of…
Principal of $100,000 with a cap of $5M (convertible to Preferred Stock)
Series A: Awesome Venture Capital Firm invests…
$10 per share at a valuation of $10M (pre-money)
Your conversion price-per-share
$10 * ($5M / $10M) = $5 per share
Shares of stock
$100,000 / $5 = 20,000 shares of Preferred Stock
Book Value of stock (unrealized)
20,000 * $10 per share from round = $200,000 (100% unrealized return)
Series A investors would’ve gotten…
10,000 shares for $100,000 investment due to $10-per-share price

Dividend.

Dividends are disbursements of profits from a company to its shareholders. Dividends are post-tax, and typically abide by a dividends schedule. Though, companies can issues dividends at any time as “special dividends”.
On the opposite end of dividends, companies can also choose to reinvest its net profit into the business as retained earnings rather than issue dividends.
Dividends are more commonly issued as cash to its shareholders. Each dividend is fixed per share, but the total amount will vary depending on the percentage of the shareholder’s shareholding (ownership).

Pro-Rata Rights.

In PART 1, I talked about dilution – the outcome where ownership percentage may decrease when a company raises a round of capital at a higher valuation. Pro-rata rights enables investors from earlier investing rounds to maintain their shareholding percentage and avoid dilution by investing additional capital.
So if an investor invests $500,000 in Amazing Hair Gel Company with a post-money valuation of $2M, the investor has a 25% equity stake in the company ($500,000 / $2,000,000). If the company raises additional capital in a Series B with a post-money valuation of $40M, the investor has pro-rata rights to invest an additional $9.5M to maintain a 25% stake in the company (25% of $40M = $10M with an initial investment of $500,000 already).

Need Your Help Moving Forward!

All of this research has been making me so much more adept and savvy when reading posts about investments and valuations, and also much more knowledgeable talking to others about them. This has been a great exercise, but I think I can do better, but I need your help.
I’ve heard positive feedback so far, and I’m always looking for ways to explain things better. This stuff makes sense in my head as I’m writing it, but it’s largely been one-way communication. That is, I write and “teach” without the student-interaction that makes good teachers GREAT teacher. That is, in 1-to-1 teaching, the teacher (or presenter) and student (or audience) interact with thought-provoking questions. Heck, I oftentimes learn more through these interactions.
Short story – interactions help me learn and explain things even better. So if you have feedback, feel free to shoot me a message on Twitter (@TheDLu) or email so I can explain things better.
Till next month… Cheers!
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The Finance of Startups: For Dummies (Part 3)

Onwards and upwards with more finance learnings! Part 3… yes, that means I’ve effectively kept this learning thing going for three months already. I’ve learned a ton about finance itself, and some of its roles in startups.
At the end of Part 2, I noted a few points I wanted to dive into with more detail. So today, I’ll cover a handful of them including:
  • Pre-money and post-money valuation
  • Earnings-per-Share
  • Equity Financing
  • Debt Financing

Pre-money and post-money valuation.

In Part 2, I touched on a lot of stocks and investments by VCs. Simplistically, the equity a VC receives in exchange for funding is:
Except, valuation can also be parsed into pre vs. post-money valuation. You can probably guess what these terms mean, but they can have a big difference in equity. Pre-money refers to the valuation of the company BEFORE the injection of capital; whereas, post-money refers to the valuation of the company INCLUSIVE of the investment round. For example…
Pre-Money Valuation
Post-Money Valuation
Hugh Invests
$10M
$10M
Valuation of Company at Investment
$50M
$50M
Valuation After Investment
$60M
$50M
Hugh’s Equity %
16.7%
25.0%

What’s happening? As you can see, if Hugh invests $10M at a pre-money valuation, the company is then valued at $60M after the investment. Hugh’s equity stake is 16.7% because the company is valued at $60M ($10M + $50M) à$10M/$60M = 16.7%.
With a post-money valuation, Hugh is investing his $10M into a company valued at $50M which is already including his investment. Thus, Hugh has a 25.0% equity stake in the company.
8.3% can mean a lot of money on the table for either side – the investor or the company when going public or some other liquidation event.

Earnings-per-Share.

Ah, another pretty “straight-forward” financing metric. Straight-forward in that its name is exactly what it is… “earnings” per share; where share is the number outstanding shares. Note: outstanding shares is the number of shares issued to company officials, stock holders, etc.
Earnings is the net earnings less taxes and dividends paid out to preferred stock owners (recall from Part 1 that preferred stockholders receive dividends before any other common stockholders).
EPS is a metric used as a gauge for how well a company is performing, and evaluate the performance of a company to its shareholders.

Equity Financing.

Mostly up to now, I’ve shed more light on equity financing. In the startup world, equity financing makes the headlines like Yik Yak raising $61M or BitPay raising $30M back in May 2014.
As a recap, with equity financing, companies are exchanging ownership in the company for capital (and partnership). As equity investors are investing on the potential upside of future success, they may be more lenient on recent financials with an eye on the future. Further, there usually isn’t a fixed return to investors which frees up working capital for the company. However, investors, as owners of the company, do usually get a share in the profits and have a say in the direction of the company.

Debt Financing.

Debt financing is very common place in everyday life ranging from homes, cars, and of course, businesses. In debt financing, loaner and loanee (the company) agree on a principal amount + interest to be returned on a period basis for some time (or when the note (another word for loan) is paid up).
The principal and interest can be marked as a fixed cost which raises the break-even point of a company (costs + revenues = 0; costs = revenues). As you can imagine, this can be a significant burden on a company’s cash flow, and thus, loaners typically require strong financials in addition to credit.
On the upside of debt, the company does not give up ownership in the company, and thus, the company maintains all profits (present and future) as well as the direction of the company. Also, interest on the loan can be tax-deductible for the company.
There’s obvious upsides and downsides to both equity and debt financing. Making that decision is hugely dependent on a myriad of factors for the company.

Onwards to Next Month

Here’s the open list of topics for me to research and share starting next month. Happy I knocked a few off the list from last month.
  • Convertible
  • Dividend
  • Pro-rata
  • Leveraged
  • Term Sheet
  • Etc.

What questions, thoughts do you have about the above? Any other topics from a startup’s finance point-of-view you’d be interested in learning more about, and having me research for you?
Resources: http://www.investopedia.com/ask/answers/114.asp,  http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/earnings-share-eps-1003, http://www.investinganswers.com/financial-dictionary/stock-market/shares-outstanding-3594
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The Finance of Startups: For Dummies (Part 2)

Finance lessons part 2! Excited to share this, but also hoping I can transcribe what I’ve recently learned in a clear, concise way.
I was reading Bufferapp’s somewhat recent blog post about raising $3.5M at a $56.5M pre-money valuation – “We’re Raising $3.5m in Funding: Here is the Valuation, Term Sheet and Why We’re Doing It”. The startup is a “fully distributed team” meaning that they (the employees) operate anywhere and everywhere; though, they’re headquartered in San Francisco. Interesting company in how they operate in being highly values-first and built on “full transparency”. Like, everyone’s emails are open to one another, salaries are out in the open, etc. I wonder if they have unisex bathrooms, too. (That’s my attempt at a joke.)
Anyways, they’re looking to raise $3.5M and in the spirit of full transparency, they share with the digital world everything including why they’re raising, what they’re going to do with the money (including reserving $1M each to the two founders to put away), valuation, etc. Very unheard of to be that open, but very cool to read about and learn from.
It’s through Joel and Leo’s (the two founders) blog post where I realized I needed to expound on my Finance Lessons Part 1 post, especially around the concept of preferred vs. common stock. I’ll focus here since these types of details can really complicate VC deals.

Liquidation.

The first and fundamental concept today is Liquidation, and what I’ll build on beyond. This isn’t really a tough one, but liquidation happens largely in two ways – through acquisition or through bankruptcy.
  • Bad Company LLC goes bankrupt and is sold for parts at $10MM
  • Great Company LLC sells for $60M to Bigger Company Inc.

Liquidation can mean the sell-off of assets, acquisition by another company, etc.

Liquidation Preference.

Recall from Part 1 that preferred stock ensures shareholders the allocation of funds before common stock shareholders. Liquidation preference is a mechanism used to help protect investors on their initial investments while also being a means to “line up” in queue for claims to money.
Investors usually will have set a multiplier on their initial investments written into the contracts, too.
Let’s say Hugh invested $10M in each of Good But Not Great LLC and Great Company LLC initially at 40% equity each (each company had a value of $25M). The companies’ founders and employees owned the other 60%.
Scenario 1: Hugh had a 1X Liquidation Preference.
Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
1X
1X
Company Sold For
$30M
$60M
Hugh Guaranteed
$10M (1 x $10M initial investment)
$10M (1 x $10M initial investment)
Founders and Employees Distribute (what’s left)
$20M
$50M
Scenario 2: Hugh had a 2X Liquidation Preference.
Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
2X
2X
Company Sold For
$30M
$60M
Hugh Guaranteed
$20M (2 x $10M initial investment)
$20M (2 x $10M initial investment)
Founders and Employees Distribute (what’s left)
$10M
$30M

Participating vs. Non-Participating Preferred Stock.

Note in the scenarios above I didn’t say, “Hugh Receives”. I said, “Hugh Guaranteed”. That’s because there’s also this notion of participating vs. non-participating preferred stock. This part gets tricky so perk up!
Investors (namely VCs here) can negotiate for participating vs. non-participating preferred stock. Participating preferred stock allows the investors to participate in converting their preferred stock for common stock to realize gains. These gains can be added ON TOP OF the liquidation preference. Note that the conversion of preferred stock to common stock is dependent on some conversion ratio of preferred stock-to-common. The participating vs. non-participating election in addition to the Liquidation Preference give the investors a function to maximize returns. So let’s do a couple scenarios.
Scenario 3: Hugh negotiated for nonparticipating preferred stock with a 1X liquidation preference.
Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
1X
1X
Company Sold For
$30M
$60M
Hugh Guaranteed
$10M (1 x $10M initial investment)
$10M (1 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion
$12M (40% equity x $30M liquidation)
$24M (40% equity x $60M liquidation)
Founders and Employees Distribute (what’s left)
$8M
$36M

What’s happening? Hugh would obviously choose to convert his stock in both options as he would be +$2M in the Good But Not Great sale (return of 20%) and +$14M (return of 140%) in the Great Company sale.

Scenario 4: Hugh negotiated for participating preferred stock with a 1X liquidation preference.
Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
1X
1X
Company Sold For
$30M
$60M
Hugh Guaranteed
$10M (1 x $10M initial investment)
$10M (1 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion after Guarantee
$8M (40% equity x $20M liquidation ($20M = $30M less the $10M guarantee))
$20M (40% equity x $50M liquidation ($50M = $60M less the $10M guarantee))
Hugh Receives Total
$18M ($10M guarantee + $8M from conversion)
$30M ($10M guarantee + $20M from conversion)
Founders and Employees Distribute (what’s left)
$12M
$30M

What’s happening? Hugh’s making out like a bandit with 80% returns in the Good But Not Great sale with 60% of the total sale amount even though he owns only 40% of the company!

In the Great Company sale, Hugh takes home $30M representing 50% of the sale amount with the same 40% equity share.
As you can see, there are some BIG ramifications depending on how Hugh and the companies structured their investment contracts. Now, let’s take those same scenarios, and see what happens when there’s 2X liquidation preference.
Scenario 5: Hugh negotiated for nonparticipating preferred stock with a 2X liquidation preference.
Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
2X
2X
Company Sold For
$30M
$60M
Hugh Guaranteed
$20M (2 x $10M initial investment)
$20M (2 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion
$12M (40% equity x $30M liquidation)
$24M (40% equity x $60M liquidation)
Founders and Employees Distribute (what’s left)
$10M
$6M

What’s happening? Hugh has a bit of a choice here in converting or take the liquidation preference for the two sales. In the Good But Not Great sale, Hugh would obviously choose the liquidation preference option which is +$8M over the conversion scenario.

In the Great Company sale, Hugh would likely choose to convert his preferred stock so he can realize the gains with a +$4M value over the liquidation preference.
Scenario 6: Hugh negotiated for participating preferred stock with a 2X liquidation preference.
Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
2X
2X
Company Sold For
$30M
$60M
Hugh Guaranteed
$20M (2 x $10M initial investment)
$20M (2 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion after Guarantee
$4M (40% equity x $10M liquidation ($10M = $30M less the $20M guarantee))
$16M (40% equity x $40M liquidation ($40M = $60M less the $20M guarantee))
Hugh Receives Total
$24M ($20M guarantee + $4M from conversion)
$36M ($10M guarantee + $20M from conversion)
Founders and Employees Distribute (what’s left)
$6M
$24M

What’s happening? Seriously, Hugh’s killin’ it. In the Good But Not Great Sale, Hugh has a 140% return with 80% of the sale price with only 40% of the equity.

In the Great Company sale, Hugh gets to look at buying a plane and a helicopter to avoid Atlanta traffic as he receives a disbursement of $36M – a 360% return on his initial investment! This represents 60% of the sale of the company despite only 40% equity.
Notice what’s happening to the money left over to be disbursed to the rest of the shareholders to both companies in each of the scenarios. The liquidation preference and the participating vs. non-participating mechanisms can have DRAMATIC effects to the money left for the founders and employees. What happens if Good But Not Great has a sale of $20M when Hugh has a 2X liquidation preference on his initial $10M investment?
Good But Not Great LLC
Initial Investment by Hugh
$10M for 40% equity
Liquidation Preference
2X
Company Sold For
$20M
Hugh Guaranteed
$20M (2 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion
$8M (40% equity x $20M liquidation)
Founders and Employees Distribute (what’s left)
$0 ($20M sale – $20M to Hugh)

What’s happening? Hugh will likely take the liquidation preference at $20M as it maximizes his return. Though, maybe he’s nice, and will give some of it back.

It’s clear it’s important to consider the preferred stock options of investors in a startup whether you’re looking to raise or you’re joining a company. Depending on the terms, that hope of an exit to pay for a new life may not pan out.

Caps.

Okay, so some of the scenarios above look incredibly dismal. Is there anything that can be done outside of negotiating or anything to put in the investment terms to protect the startup? After all, the liquidation preference and participating vs. non-participating stock help protect and maximize value to the investor. There are a few mechanisms, but one of the more common ways is via a cap that limits the returns of what investors can achieve.
With caps, companies can protect their equity stakes and that of other shareholders including the employees. I’m not going to illustrate this, but if you want to investigate, check out the sources below. When you do, also look up “Zone of Indifference”. The zone of indifference is the region between acquisition values where the returns to the investor won’t change due to structures of the liquidation preferences, participatory vs. non, and caps.

Conclusion.

When I ended Part 1, I listed several finance terms and subjects I would talk about… whoops. I started reading about Buffer, and I had so many questions. After doing my research, this stuff was just too good to not share. Okay, so let’s repost the list from last month add a few subjects, and then I’ll shoot to research them and share in January.
  • Types of financing including equity vs. debt
  • Convertible
  • Earnings per share (EPS)
  • Pre-money vs. post-money
  • Dividend
  • Pro-rata
  • Etc.

Umm, I’ll also perhaps start the S-1 IPO filing reviews beginning next year… maybe. We’ll see how all this goes in addition to the technical posts having launched Dee Duper a couple weeks ago.
What are your thoughts about the concepts introduced and talked about here? What questions/ concepts are you wondering about that I can help do some research for you? What questions do you have about what I’ve shared above, or comments?

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