Welcome to the Innovator

Welcome to the January 2020 issue of The Innovator, a monthly newsletter for iiM, LLC. What is iiM? We are a funding platform for early-stage companies in the animal health, agriculture and human health verticals. In this newsletter, we intend to share educational information, ideas and a perspective on the investments we are making. If you do not want to receive this publication, please let us know and we’ll remove you from the list of recipients. Please enjoy this issue of The Innovator.

 

Lydia Kinkade, iiM Managing Director

 

Take Care of Investors, Before They Invest

 

When I lecture on negotiating principles, my recommended “ground rules” always include two points (among others):

 

Make sure you know what the other side really wants out of the deal, and find a way to make sure they get it. A bad deal for either side is . . . well . . . a bad deal. Click here for information on negotiating principles.

 

When I represent a company seeking to raise investor capital, I advise the company to propose investment terms we know in advance will be attractive to the investors and meet their anticipated needs.  To do otherwise is a recipe for a slow or unsuccessful funding effort.

 

I am frequently on the investor side of transactions, reviewing and negotiating term sheets or transaction documents proposed by the company and its legal counsel.  I am amazed by how often they miss the mark on these simple principles.  Here are examples of some errors I see sometimes see in terms proposed by companies seeking investor capital:

 
Pre-money valuation is way too high, unsupported by any clear rationale.

• Exit transaction is not mentioned or is too speculative to be realistic.
• Too much control retained by founding owner, significantly disproportionate to ownership percentage.
• Refusing to provide the investor frequent access to basic business and corporate information, including inspection rights.
• Lack of accountability for performance promised in the pitch, such as milestone deliverables or other deadlines.
• Not providing contact information for investors to communicate directly with each other on company matters, including negotiating deal terms.
• Structuring different classes of investors whose interests are in conflict rather than synergistic, particularly where earlier investors are disproportionately disadvantaged.
• Retaining rights for future events that would not protect the earlier investors’ rights.

The key question the company should ask, before proposing terms to a prospective investor, is “do we understand what the investor is seeking by investing in our company.”  If the investor cannot get that, then the investor simply will not write the check the company needs.

Philip Krause, iiM Legal Counsel

Venture Investing Terminology

There are many terms in the venture capital world that can be confusing. As we look at various companies and meet with their founders, you may hear us use some of this terminology. Here are a few such terms and what they mean.

 

 

Acqui-hire – Acqui-hire is a talent acquisition in which a company is acquired primarily to recruit its employees, rather than its products or services. Acqui-hires are common in hot industries (such as AI or autonomous vehicles) in which large companies may have a hard time otherwise finding enough talent or complete teams for their own development efforts.

Bridge Loan – bridge Loans are short term loans to fund the operations until a more comprehensive longer-term financing is available. In Venture Capital, the need for a bridge loan typically arises when a company runs out of cash before it has enough new track record to close a new funding round with reasonable terms; bridge loan creates more runway for negotiating the next funding round.

Cliff – employee stock agreements have often a cliff, usually one year before the employee stock options start vesting. Option holders may only exercise an option after it has vested but before the specified expiry date. Other possible vesting requirements typically give the employee an incentive to perform well and remain with the company for a longer period.

Direct Listing – Direct listings (or Direct Public Offerings or DPOs) are an alternative to Initial Public Offerings (IPOs) in which a company does not work with an investment bank to underwrite the issuing of stock. While forgoing the safety net of an underwriter provides a company with a quicker, less expensive way to raise capital, the opening stock price will be completely subject to market demand and potential market swings.

Triple-Triple-Double-Double-Double – a company that is on its way to becoming a Unicorn (valued at $1 billion or more) starts with annual recurring revenue (ARR) of $2 million. Then ARR is tripled to $6 million the next year; tripled again to $18 million the next year; doubled the next year to $36 million; doubled the next year to $72 million; and doubled the following year to $144 million. Based upon today’s multiples, ARR at that level should produce a valuation of more than $1 billion.

 

To Follow-On or Not to Follow-On . . .

This article was written by Ham Lord, Chairman of Launchpad Venture Group and Co-Founder of Seraf-invstor.com and Christopher Mirabile, Angel Capital Association Chair Emeritus, Managing Director at Launchpad Venture Group and Co-Found of Seraf-investor.com. iiM utilizes the Seraf platform for investor reporting.

 

As your angel career develops, and you start to build a larger portfolio of companies, you are increasingly asked to make follow-on investments. Not only do companies need investment to get off the ground, the faster they grow, the more cash they need. Whether to follow-on, and how-to follow-on, are questions which have long given rise to angel debate.

 

Christopher and I are both believers that follow on investments are essential to achieving good returns. We firmly defend and negotiate for pro-rata rights to participate in future financings. Our overall perspective is that with your earlier checks you are basically buying options on a front row seat which comes with the right to add more “smart money” into the winners as they begin to show promise.

 Our bias is backed up by observational data. During the first couple years, most of an angel’s checks go into shiny new companies, but after a couple years, there tend to be more and more follow-on checks in the mix. Based on the behaviors we have seen in our own portfolios, observing many serious angels first hand, as well as the aggregate data we have seen from professional investor behavior in Seraf, we've observed experienced angels tend to have only about 30% to, at most, 50% of their aggregate investment dollars in “first checks” into a company and about 50% to as much as 80% of their money has gone into second, third and even later checks. We’ll tackle that topic in depth here, but I’ll start out by confessing to bias right up front.

 

We feel that, over time, a successful investor should be able to look at the average amount of money into each failed investment and compare it to the average amount of money into each successful investment and see a ratio of at least 2:1 to 4:1 of dollars into winners over losers. In cases where an angel has really significant amounts of money to put to work, it might approach 7:1 to 10:1.

 

So if the hypothesis is that an angel should be biased towards follow-on investments, that still does not answer the question of how an angel actually decides which ones are “winners” and merit follow-on investment. What is the process of actually deciding to follow on or not? What should you look at and how should you decide?

 

Christopher has personally invested in a ton of startups, and as the Managing Director of Launchpad he organized and facilitated countless follow-on rounds for his investing colleagues. Let’s see if he has any perspective to share on the follow-on decision-making process.

 

Q: Christopher, how do you decide whether to follow-on? Do you have a framework you use?

 

I should start out by saying that this decision is almost never cut-and-dried. Companies typically come back for money long before it is truly clear that they out of the woods.  This is particularly true of that crucial “second check.”

Companies looking for a second check from you usually present a thorough mix of positive accomplishments and negative surprises. So, unless you are just going to follow your gut instincts, some kind of decision-making process is needed to make sense of the mix of plusses and minuses.

 

The process I use, and recommend, is probably best analogized to a decision-tree. The first question is whether you are in an offensive or defensive mode. 

• Offense is where a company is doing well and you are looking to maintain or  increase your ownership position. 
• Defense is where a company has clear potential, but is struggling to bring in needed money; the terms for the new money are intentionally or unintentionally dilutive, or even punitive, to existing investors who do not put  in  additional money.

 

In defensive situations like that, where you believe the company really has potential, an investment might be justified because it could protect (or even enhance) the value of your existing investment. For example, I have seen deals where early investors who put in their full pro-rata were rewarded by having all of their stock elevated to a pari pasu position with the top of the preference stack, whereas investors who didn't were left at the bottom of a now even more top-heavy stack. If you are feeling good about the company's prospects, that is an opportunity to potentially enhance the value of your holdings.

 

Fortunately really defensive “pay to play” situations are not common and each one tends to have a pretty unique fact pattern you are probably going to need to weigh on a stand-alone basis. So I will focus mostly on offense situations. Many of the analyses and concepts applicable to the offense situation can actually help in defense situations too.

 

Offense situations typically present the classic follow-on conundrum. The company is doing reasonably well (it’s pretty rare for a company to nail or exceed their forecasts - those cases are pretty clear cut green lights), and you need to decide whether to put additional money in. My decision framework really has three main elements, each of which has its own analysis:

•  Reconfirming there is still sufficient upside potential forward from this round.
•  Reconfirming the downside risk at this point is still acceptable.
•  Reexamining the opportunity cost of this investment given current climate.

 In the next issue of this newsletter, we’ll continue the article.