Startup Financing

1. Startup Financing Minder Chen, Ph.D. Professor of Management Information Systems Martin V. Smith School of Business and Economics California State University Channel Islands Camarillo, CA 93012 Minder.chen@csuci.edu minderchen@gmail.com

2. “Venture-Scale” Businesses • Create or add value to a customer. • Solve a significant problem/want or need, for which someone is willing to pay a premium. • A good fit with the founder(s) and team at the time. • Can grow large (≥$100 million). • Attractive returns for investor. https://www.slideshare.net/venturehacks/customer-development-methodology-presentation/13-Customer_Development_Big_Ideas_ulliParallel

3. Start-up Funding Sources To give uncle the 5%, you registered the company, either though an online service like LegalZoom ($400), or through a lawyer friend (0$-$2,000). You issued some common stock, gave 5% to uncle and set aside 20% for your future employees – that is the employee stock ‘option pool.’ (ESOP) (You did this because: • Future investors will want an option pool. • That stock is safe from you and your co-founders doing anything with it.) (link)

4. Valuation • The term "valuation" in the context of venture fundraising means the value the investor assigns to the business and negotiates with the company. It doesn't refer to any other type of valuation. • The figure is often "backed into" using two other figures: target ownership by the investor, and amount of capital required by the company to reach the next major milestone/fundraise. (e.g. Investor wants 20% and the company needs $1M; equals a $4M pre-money value.)

5. Example If my company is valued at 1M and an angel wants to invest 100k, how much equity does he/she get? • Valued at $1M post-money, investor gets 10%. • If, however, the valuation is a post-money valuation of 1 M, that means that just before the investment it is worth 900k, therefore the investor will own 100k / 1 M or 10% immediately after the investment. • Valued at $1M pre-money, investor gets 9.09% ($100k/$1.1M post-money). • A pre-money valuation means just before the financing, the company is valued at X.  In this case, if your company's pre-money valuation is 1 million and an angel is investing 100k, then the investor will own 100k / (1 M + 100k) or 9% immediately after the investment (post-money). X (investment) on Y (pre-money valuation) yielding x/(x+y) equity X (investment) on Y (post-money valuation) yielding x/y equity https://www.quora.com/If-my-company-is-valued-at-1M-and-an-angel-wants-to-invest-100k-how-much-equity-does-he-she-get

6. Option Pool • If you have a startup and you are planning on compensating hires with equity, you must create that option pool at some point.  • Larger investments may require the creation of an option pool; but a $100k seed round investment would not typically. • You can create the pool immediately prior to the investment or immediately after the investment.  • If you set aside 30% of the company's stock for an option pool before the investment, you dilute your equity (all existing owners) by essentially giving some of yours to your future employees.  • If you create the pool simultaneously or just after the investment, everyone's equity, including the equity of those that just invested, is diluted.  • So the answer to the question "how much equity does an investor get" depends on whether an option pool is created before or after the financing. 

7. Venture Round Money Raised Funder’s equity% diluted $2.6B * 17%= 442M Funder’s Value Increased , B , C, … http://en.wikipedia.org/wiki/Venture_round & http://themiddlemarketcfo.com/tag/venture-capital-2/

8. IPO 235M Raised at 2.6 B Valuation (link)

9. Dilution Example https://brandalyzer.blog/2014/01/24/how-start-up-equity-dilution-works/

10. Calculation Angel Investor invests seed money: $200,000 at $1M pre-money valuation Post-money valuation = $1,200,000 Friends & Families Angel investor’s ownership % based on post money evaluation: Is 16.7% = 200,000/(1,000,000+200,000) New Option pool % = 20% * (100-16.7)% = 16.7% New Founder 1 % = 37.5% * (100-16.7)% or 37.5%*(1M/1.2M) = 31.25% The founder 1’s ownership is Dilution by about 6.3% The founder 1’s 31.25% is now worth $375,000.

11. Dilution  Taking a Hair Cut If you own 20% of a $2 million company your stake is worth $400,000. If you raise a new round of venture capital (say $2.5 million for 25% equity at a $7.5 million pre-money valuation, which is a $10 million post-money) you get diluted by 25% (=2.5m/10m). 25% is the % of equity for the VC. You now own only 15% (=20% * [100-25]%) of the new company instead of 20%, but that 15% is now worth $1.5 million (10m*15%) or a gain of $1.1 million (1.5m-0.4m). Understanding How Dilution Affects You At A Startup https://techcrunch.com/2011/10/13/understanding-how-dilution-affects-you-at-a-startup/

12. The Equity Equation: Take the Investment Money of Not Value of Ownership after Dilution [multiple of the valuation increase] should be >= 1 / (1 – N) where N = the amount of ownership % giving up For example, suppose Y Combinator offers to fund you in return for 6% of your company. In this case, n is .06 and 1/(1 - n) is 1.064. So you should take the deal if you believe we can improve your average outcome (valuation) by more than 6.4%. If we improve your outcome by 10%, you're net ahead, because the remaining .94 you hold is worth .94 x 1.1 = 1.034. Sequoia takes about 30% of a company. 1/.7 = 1.43, meaning that deal is worth taking if they can improve your outcome by more than 43%. They limit their holdings to leave the founders enough stock to feel the company is still theirs. http://paulgraham.com/equity.html

13. Incubators and Angel Investors Incubators, accelerators, and “excubators” – these places often provide cash, working or co-working space, and advisors. The cash is tight – about $25,000 (for 5 to 10% of the company.) Some advisors from incubators/accelerators are better than cash, like Paul Graham at Y Combinator. The contacts and advice from angel investors can be more important than the money.  http://www.paulgraham.com/startupfunding.html At of 2014, Y Combinator invests $120k for 7% of equity. 120K is for the founders to run their business and pay their living expenses for at least 6 months. Don’t charge any fees to the companies to be part of YC and no anti-dilution terms.   

14. Angel Rounds and Seed Rounds • Angel Rounds and Seed Rounds are Pre-Series-A fundings. They done early in a company's development cycle and they are often very separate events but may be used interchangeably.  • Seed rounds as a round where there is a VC leading/pricing the round (angels may participate) These rounds are typically over $750K, and typically require some level of tangible traction.   Angel Round as being a smaller round of financing, earlier in a company's development cycle led by non-institutional investors (Angel investors are individuals with their own money).  • Most companies have to raise an Angel round (individuals) prior to being able to raise an institutional seed. These rounds are typically up $500K and provide the runway necessary to achieve the tractionmost institutional investors look for when doing a seed financing.  (link)

15. Runway and Burn Rate Runway: The amount of time (#months) until your startup goes out of business, assuming your current income and expenses stay constant. Typically calculated by dividing the current cash position by the current monthlyburn rate. Burn Rate: Burn rate is usually quoted in terms of cash spent per month. Burn rate is normally used to describe the rate at which a new company is spending its venture capital (cash on hand) monthly to finance overhead before generating positive cash flow from operations (self-sustaining) or need future financing; it is a measure of negative cash flow. Example: If a company has $1 million in the bank, and it spends $100,000 a month, its burn rate would be $100,000 and its runway would be 10 months, derived as: ($1,000,000) / ($100,000) = 10. http://www.investopedia.com/terms/b/burnrate.asp

16. A Rounds After getting seed money or using other funding sources and reaching a point where a product or service is scalable and starting to gain momentum with users, an entrepreneur can consider an ‘A’ round of funding, which typically is significantly larger and can be into the million to multi-million range. Investors want to see a very specific strategy for the product-market fit and target audience in terms of timing, revenue streams, future plans and exit strategy in order to make their money back. (link)

17. Fund Raising Types • SEED = SIZZLE. This is the first outside money that you raise. The order of magnitude is $100,000–$250,000. Sources include friends & family as well as angels. At this point, you’re selling on dreams, fantasies, and delusions—in other words, this round is about sizzle. • SERIES A = STEAK. In this round, venture capitalists enter the picture. Their bet on you amounts to $1–3 million dollars. You can’t depend on sizzle anymore because big money is at stake. Now your product has to be generating revenue—in other words, this round is about steak, not sizzle. • SERIES B = STEROIDS. Customers are buying it and eating it. (The dogs are eating the dog food.) Now the company needs an injection of steroids to get to the magical $100 million a year revenue rate. You’re going to use this money to scale your business. • SERIES C = SYCOPHANTS. If you make it to this round, you probably don’t need money anymore. This additional series is just in case the capitalist system collapses or Google/Apple/Amazon decides to enter your business. At this point, investors are buying—you’re not selling—so they are sucking up to you in order to jump on a winner. Source: Guy Kawasaki, The Art of Startup 2.0

18. Exit Strategy Young founders are often surprised that investors expect them either to sell the company or go public. The reason is that investors need to get their capital back. They'll only consider companies that have an exit strategy—meaning companies that could get bought (M&A: Merge & Acquisition) or go public (IPO: Initial Public Offering).

19. Expected Return and Exit Value • Most early stage investors need/want a 10x return.  • If your $100k investor invests in a $1.1 million post-money company, the company needs to exit at $11 million to create that 10x return.  • For the hypothetical $200k post-money, the exit need only be $2 million. • Late stage investors expect a 3x return on average.

20. Crowdfunding Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business venture. Crowdfunding makes use of the easy accessibility of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together. Crowdfunding has the potential to increase entrepreneurship by expanding the pool of investors from whom funds can be raised beyond the traditional circle of owners, relatives and venture capitalists.http://www.investopedia.com/terms/c/crowdfunding.asp The 3 primary types are donation-based, rewards-based, and equity crowdfunding. Crowdfunding gained traction after the launch of ArtistShare, in 2003. More crowdfunding sites started to appear e.g., as IndieGoGo (2008), Kickstarter (2009), and Microventures (2010). https://en.wikipedia.org/wiki/Crowdfunding https://www.fundable.com/learn/resources/guides/crowdfunding-guide/what-is-crowdfunding

21. http://writeonsisters.com/writers-life/6-tips-for-crowdfunding/http://writeonsisters.com/writers-life/6-tips-for-crowdfunding/

22. Startup Funding The Art of Startup 2.0

23. Venture Capital Investment http://xitconsulting.net/us/ http://xitconsulting.net/wp-content/uploads/2014/07/venturecapital.gif

24. Startup 2.0: “Lean Investor” Model Method: Invest in many startups using incremental investment, iterative development. Start with lots of small experiments, filter out failure, and expand investment upon success… (Rinse & Repeat). • Incubator: $0-100K (“Build & Validate Product”) • Seed: $100K-$1M (“Test & Grow Marketing Channels””) • Venture: $1M-$10M (“Maximize Growth & Revenue”) Source: http://www.slideshare.net/dmc500hats/startup-20-a-silicon-valley-story

25. Investment #1: Incubate Product Validation + Customer Usage Source: Link Dave McClure: The Gospel of a Lean VC [Entire Talk] https://www.youtube.com/watch?v=1CcUa3Svh-Y

26. Investment #2: Seed Market Validation + Revenue Testing Source: Link

27. Investment #3: Venture Revenue Validation + Growth Source: Link

28. Investment Readiness Level (IRL) and Lean Startup IRL ties capital-raising to the capital-efficient Lean Startup methodology. It is prescriptive and enables better mentoring. http://www.theinnovativemanager.com/if-we-build-they-will-come-the-story-of-webvan/

29. 4 Powers All Venture-backed Startups Share Ann Miura Koat Floodgate stated that , “thunderlizards” are “roughly 25 companies per year exit for $500 million-plus.” There are 4 required powers that make these companies successful. • Proprietary (Technology) Power • Product Power • Company Power • Category (Market) Power http://trueviralnews.com/floodgates-ann-miura-ko-on-the-four-powers-all-venture-backed-startups-share/ Strategies to gain market power (Geoffrey Moore): Target customer, compelling reason to buy, whole offer, partners allies, sales strategy, pricing strategy, competition, positioning, next target identification. http://www.thegreenabacus.com/category-company-and-market-power/

30. Where You Need the Money https://steveblank.com/2010/04/12/why-startups-are-agile-and-opportunistic-%E2%80%93-pivoting-the-business-model/

31. Innovation and Value Ideas Inventions Innovations $ $$$ $$$$$$$ The Valley of Death “The transition to the marketplace is the Valley of Death” Norm Winarsky, SRI VP of Ventures and Licensing When early stage companies cannot entice investors due to longer time tables and a lot of resources (cash) required for commercialization and lack of an upside in investing early.

32. Valley of Death The name "death valley" refers to the high probability that a startup firm will die off before a steady stream of revenues is established. Valley of Death is used in the venture capital world to refer to the period of time from when a startup firm receives an initial capital contribution to when it begins generating revenue [profit] (from product launch to success as a business). During the death valley curve, additional financing is usually scarce, leaving the firm vulnerable to cash flow requirements [due to negative cash flow]. Death Valley Curve http://www.investopedia.com/terms/d/death-valley-curve.asp http://www.forbes.com/sites/martinzwilling/2013/02/18/10-ways-for-startups-to-survive-the-valley-of-death

33. http://www.greentechmedia.com/articles/read/into-the-valley-of-deathhttp://www.greentechmedia.com/articles/read/into-the-valley-of-death

34. Lean Startup Funding Phases Customer Discovery  Customer Validation  Customer Creation  Company Building Malaysian Ringgit; Currency Symbol: RM Currency Code: MTR http://rightways-tan1.blogspot.com/2014/10/brewing-startup-part-1.html

35. What VC Are Looking for in a Startup Founder? Ron Conway has been investing in startups since 1994, SV Angel and it’s entities have invested in over 700 companies which means they had to physically talk to thousands of entrepreneurs. Here are the questions that go through Ron’s head when he meets an entrepreneur: • Is this person a leader? • Is this person focused and obsessed by the product? • Usually the first question Ron asks is: “What inspired you to invent this product?” hoping it’s based on a personal problem that this founder had and that his product is the solution to this problem. • Does the founder have good communicational skills? If the founder is going to be a leader and hire a team, he’s got to be a really good communicator, a born leader. https://blog.leapfunder.com/how-to-invest-in-startups/

36. VC Success Rate Two general concepts I would share: one is the venture capital business is one hundred percent a game of outliers, it is extreme outliers. So the conventional statistics are in the order of 4000 venture fundable companies a year that want to raise venture capital. About 200 (5%) of those will get funded by what is considered a top tier VC. About 15 of those will, someday, get to $100M in revenue. And those fifteen, for that year, will generate something on the order of 97% of the returns for the entire category of venture capital in that year.  4000  200 [5%]  15 (multi-millions$$$) [ 0.375% ] https://blog.leapfunder.com/how-to-invest-in-startups/

37. Strengths and Weakness • Invest in strength versus lack of weakness: venture capital is to check boxes. So really good founder, really good idea, really good products, really good initial customers.  • We aspire to do is to invest in the startups that have a really extreme strength.  The companies that have the really extreme strengths often have serious flaws. • Along an important dimension, that we would be willing to tolerate certain weaknesses. https://blog.leapfunder.com/how-to-invest-in-startups/

38. 10 Top Ten Mistakes of Entrepreneurs • Multiplying big numbers by 1% • *Scaling too soon • Partnering • Pitching instead of prototyping • Using too many slides and too small a font • Doing things serially • *Believing 51% = control • Believing patents =defensibility • Hiring in your own image • *Befriending your VCs • *Thinking VCs can add value Guy Kawasaki, The Top 10 Mistakes of Entrepreneurs https://www.youtube.com/watch?v=HHjgK6p4nrw

40. How startup valuation works (link)

43. IPO Realists Believers

44. Pitch Deck Example • AirBnB Pitch Deck • http://www.slideshare.net/PitchDeckCoach/airbnb-first-pitch-deck-editable • Buzzfeed Seires A investor deck 2008 • http://www.slideshare.net/ChrisEllis6/buzzfeed-investor-deck-2008-37911918 • Linkedin Series B Pitch Deck (The Key is the Network) • http://www.slideshare.net/webjoe/linkedin-deck-27367069

45. Cases

46. Private Unicorns by Region (via CrunchBase)

47. Scaling • Silicon Valley is special because it enables companies to get very large, very quickly. Not just to start up, but to scale up. • The special sauce is that scaleups here depend greatly on networks (capital, talent, users, etc) that exist outside the startup itself. The network age: speed, global markets, global competition. • Networks • Positive feedback loops • Distribution advantage • Organization Scale, Revenue Scale, Customer scale http://www.slideshare.net/greylockpartners/stanford-cs183c-blitzscaling-lecture-1

48. Scaling

49. AirBnB Case

50. Scaling  http://www.slideshare.net/greylockpartners/the-hierarchy-of-engagement/