Clients of mine often ask, “What kind of financing is available for internet startup?” Well, there’s really three areas of financing that are available at the early stages. The first is angel investment. Angel investment is early stage investment, or sometimes called seed round investment, and an angel investor can basically be anyone, it can be family member. A lot of times, it is a high wealth individual and it can also be other entrepreneurs.
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Hello, and welcome to Traverse Legal Radio. My name is John Di Giacomo, and I am an attorney with Traverse Legal, where I practice in the areas of copyright law, trademark law, general internet law, business and corporate law, online defamation and other related areas.
And today, I’d like to talk to you a little bit about financing for internet startups. And I’m going to label this Part 1 of a discussion on things to think about as an internet startup seeks financing.
These investors can possibly be subject to SEC rules concerning accredited investors. The SEC has set up certain rules that limit who can invest in a company because the SEC wants to ensure that investors are not deceived into investing into a terrible company, so prior to seeking angel investment, you should have an attorney take a look at those rules.
The second type of investor is a venture capitalist. A venture capitalist usually provides a larger amount of money than an angel investor. Venture capitalist typically seek high growth companies, and in exchange for their investment, they want equity; they want ownership of your company. Venture capitalist are sort of the traditional type of investor in the internet space, and for that reason, I will focus exclusively within this first Part 1 on venture capital deals.
Now we have, because of the Jobs Act, which was recently signed into law, a new category called crowd funding. Crowd funding is peer-to-peer funding. It is based on the Jobs Act, like I said, and allows small investments in exchange for equity, whereas before investors needed to register with the SEC if they were going to invest in companies in this manner, they no longer have to do so.
But at this stage, it is unclear what this will exactly look like. The SEC is currently in the comment stage and they should have rule making shortly, which will better outline what crowd funding will look like for investors, and at that time, we will certainly inform you of what kind of regulations apply to crowd funding. Until then, let’s focus on venture capital deals.
So, clients often ask, “How do I prepare myself to seek funding?” There are some general principles that you can think about prior to getting ready to make your pitch to a venture capitalist.
The first is create an elevator pitch. And this goes without saying. You need to, within one or two minutes, have a description of your business and your team ready so that you can pitch a person as if you were meeting them within that time period within an elevator. This is very important and many times you’ll see pitch nights where you can test out these elevator pitches, and it’s often a good idea to see how crowds react to your business model. You don’t want this to be to complex. You just want to sell the crowd or sell your potential investor on the business and on the team.
The next thing that you should think about is creating an executive summary. An executive summary is a 3-5 page substantive document explaining your business, the product involved in your business or the service, and explaining why this product or service is innovative. What problem does that product or service solve? It’s a very important piece of material and it’s something that you will send to venture capitalist. It may even serve as the first point of contact with a venture capitalist, so it’s important that you take your time in creating this document.
The next item is what, in Silicon Valley, is called an investor deck. An investor deck is a PowerPoint, or for us Mac users, a Keynote presentation. An investor deck is a10-20 page slideshow that provides an overview of the business, the team and the market. And sometimes, it’ll also discuss the potential for growth. And I want to warn you here that market predictions, growth predictions are not that important here. It’s important that you don’t focus too much on these things because they’re never correct. At the end of the day, you don’t know how the business is going to perform and ultimately it’s more about what the business currently is, and what the team currently is, than it is about what it can be in future.
Additionally, a lot of venture capitalist like to see demos. Demos allow investors to better understand the value of your product. And venture capitalist, like every other group of people in the country or in the world, like to play with things. They want to see what is out there and what they can get their hands into.
So let's talk a little bit about understanding venture capitalists. And understanding venture capitalists is understanding what they want, and what you need to think about as you discuss potential investments with them. So let's talk about what they want. Venture capitalists want equity in your company in exchange for investment. And equity is a share of your company. Specifically, venture capitalists want preferred stock. And preferred stock is a type of stock separate from common stock, the standard kind of stock that you may recognize. Preferred stock gets paid first, that's why it's called preferred.
Secondly, they want participation. Participation is in the happening of a liquidation event, it's a measure of who gets paid out first. So venture capitalists want preferred stock, and then they want participation. They want to know, when am I going to get paid? So a liquidation event which is associated with participation is something that causes, either the sale of the company or an initial public offering or a dissolution. It's something that happens that causes the preferences and the participation shares to kick in. This all relates to control of the company. So when you're thinking about a venture capital investment, you need to think about a couple of different things.
You want to think about what kind of terms you're going to have on this term sheet, and really the most important term is what's the price per share? What is the valuation of your company? The price per share or the valuation is the price that will be paid in exchange for the equity bought by the investor. So it's basically the price that the investor will pay in exchange for a certain number of shares in your company. There are really two types of valuations that are important with regard to price per share. These are the key negotiating terms on the term sheet that you may be handed by a venture capitalist.
The first is the pre-money valuation. A pre-money valuation is what the investor values the company at prior to the investment. A post money valuation is also important. Post money is simply the investment plus the pre-money valuation. So, for example, if you currently have a company that is worth $500,000 at a pre-money valuation and the venture capitalist wants to invest $1 million, the company at post money valuation is worth $1.5 million. It's that simple. And these terms, the pre-money valuation and the post money valuation, set the amount of control that venture capitalists will have over your company. Controlling these valuations allow VCs to get different amounts of equity if, in fact, they ultimately invest in the company. So it's very important to ensure that you're represented by an attorney when you discuss post money and pre-money valuations.
The next item that a venture capitalist will discuss and that relates directly to the control of the company is the liquidation preference. Again, liquidation preference is important because of what are called liquidation events. And those are the sale of the company, the initial public offering of the company and possibly the dissolution of the company. The liquidation preference is simply a statement on how and when the investor gets paid. Preferred stock, like I said before, is paid first. There are different types of preferred stock, however, and different terms that relate to preferred stock. So, for example, there is preferred stock which is, like I said, simply paid back first. There is preferred stock with no participation which is just simply preferred stock. There's preferred stock with full participation and then there's preferred stock with cap participation.
So let's parse these out. Preferred stock with no participation is a subset of simply preferred stock. It simply means that an investor gets paid back the amount that that investor paid for the shares and in some situations an additional amount. It may be interest, it may be a multiplier, but basically speaking, the investor gets paid back what they've invested into the company upon a liquidation event. So, for example, let's think about a private sale of the company. Your company is sold, you receive a significant amount of money for the sale of the company, and the investor has preferred stock. The investor will simply get their investment paid back, plus any multiple that may have been contained within the shareholder agreement at the time of the investment.
Preferred stock with full participation means that the investment is paid off and the investor shares in the liquidation proceeds as if his preferred stock was converted to common stock. So that sounds complex but it really isn't. It just simply means that not only does the investor get paid back first, but he also gets to participate in the remainder of the money that's left over after his investment is paid off, as if his preferred stock was also common stock, so he's basically double dipping. He gets the benefit of recouping the investment and the same benefits as common stock holders. So, an example. If an investor invests $1 million and obtains 20 percent of the company, the investor will be paid back his initial investment, and he will receive the same amount on a liquidation event as a common stock holder that owns 20 percent of the company.
The final type of preferred stock category or subcategory is preferred stock with cap participation. Preferred stock with cap participation is a situation where the investment is paid back, and proceeds are paid to the investor until they reach a multiple of the original share price. Typically, this is going to be two or three times the original purchase price of the shares. So for example, in a situation where an investor owns preferred stock with cap participation on a 2x or two times cap participation, proceeds will go back to pay the investment first, and then the remainder goes to the investor until the original amount paid to the investor is two times the original investment. So, again, the investor is paid back and then the investor gets two times what he originally invested. And after that, the remainder is distributed to common stockholders.
These are just some general overviews of different types of preferred stock and subcategories of preferred stock and considerations to think about when you think about valuation of the company. Obviously, it's a lot more complex than this, and this is a very short kind of tutorial on some of the things that you may expect or may get into as you seek venture capital investments. You should certainly seek the advice of an attorney because these are very complex deals, and there's a lot here that I haven't talked about.
If you have any questions, contact the attorneys at Traverse Legal and we can help you out. Again, my name is John DiGiacomo and this has been a Traverse Legal Radio broadcast concerning financing for Internet startups.
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