2017 is poised to be a promising year for venture capital activity. Startup companies — and the venture capital funds that invest in them — enjoyed a blistering 2015 in which investors deployed $60 billion in venture funding, the second highest total since 1995.
2016 included the minor correction that many industry leaders had called for, as funding hit a low during the first quarter of the year. The market for technology IPOs was nearly non-existent. At one point in 2016, only 17 percent of startup companies voiced an ambition to IPO. The obsession with unicorns (companies worth more than $1 billion) has somewhat waned.
As we look ahead, the commercial climate is cause for cautious optimism. Venture funds are largely flush with cash, tech M&A activity is surging (see Microsoft’s $26-billion acquisition of LinkedIn or Symantec’s nearly $5-billion acquisition of Blue Coat Systems as examples) and Snap’s successful public offering has redirected the world’s searchlights onto Silicon Valley.
I caught up with Craig Jacoby, partner in Cooley LLP’s Emerging Companies Group, to discuss the latest strategies involved in financing your company’s growth. Jacoby has a sterling client list (including Yelp and New Relic) that he advises from Cooley’s San Francisco office — and has led hundreds of successful startup financings.
Traditional VC structures: the tried and true
Priced equity rounds
A priced round is defined as a sale of stock in your company at an agreed-upon price per share. Upon the consummation of the transaction, investors become owners in your business. “Priced equity rounds are often the best solution for entrepreneurs,” explains Jacoby. “The terms are set today, and the necessary documents and infrastructure are put in place to ensure that the company can continue to scale effectively in future rounds.”
The upfront cost often pushes founders away from priced equity rounds. “However, for companies and investors that are generally agreeable, a deal can be closed for as little as $10,000-$15,000 on the investor side and not necessarily a whole lot more than that on the company side. When you account for the incremental cost of a note deal, and then also account for the benefits of having clean documents in place, it means that priced equity rounds can actually save significant costs in the long run,” Jacoby says.
Convertible debt consists of “short-term notes, and is commonly used for financing rounds for early-stage companies before or between priced equity rounds,” Jacoby says. “The notes convert to equity when the startup completes its next equity funding round, typically within 12 to 24 months. A crucial distinction between convertible debt and priced equity rounds is that convertible debt allows the company to defer valuation until that next funding round.”
“Convertible debt can include traps for both entrepreneurs and investors,” Jacoby adds. “One widespread change in convertible notes over the last 10 years has been the increasing prevalence of valuation caps on convertible notes, meaning that the investor will convert into equity but at a ‘capped’ valuation.”
Caps aren’t necessarily better for founders. Especially if the cap is set at or around the valuation the company could command in a priced round, it can lead to more dilution and more investor protections than a priced round. “In that situation, a capped note is like an equity round with redemption rights, accruing dividends and full ratchet anti-dilution protection, all of which would be pretty rare in early stage equity financings.”
Newer structures for raising cash
“Silicon Valley has a distinct engineering culture,” Jacoby emphasizes. “Which means that there is constant innovation in search of 1 percent improvements. In the instances of SAFEs and KISSes, I’m not sure that the benefits outweigh the accompanying complications.”
Y Combinator is credited with creation of SAFEs, or a “Simple Agreement for Future Equity.” While the SAFE has appeared in a number of forms, the basic concept is that the investor provides funding to the company in exchange for the right to receive equity upon a future event. The standard SAFE contains no term or repayment date, and no interest accrues. The investor gets the right to receive the company’s equity upon a future equity financing, typically at a discount.
Jacoby emphasizes that many investors have little interest in engaging in SAFE transactions. “For some investors, these instruments suggest a lack of commitment to treating the investors fairly, since they never offer the investors an opportunity to say in the future: ‘This is not going well, what are we going to do about it?’”
500 Startups is largely credited with the creation of the KISS, or “Keep it Simple Security.” Again, KISSes often lack interest payments or a maturity date. Jacoby is similarly reluctant towards embracing any hype around KISSes. “We are often asked by founders what will happen if they are unsuccessful in reaching an equity round by the maturity date of a convertible note — whether the investors will come after the intellectual property or the office chairs as collateral. The reality is that seasoned professional investors aren’t motivated by failed company assets, and will almost never pursue an action against a failing company. However, the KISS essentially grants the investor absolutely no rights until a future financing occurs — even symbolic rights. Many pretty well-known investors shy away from engaging in KISS transactions.”
Most professional investors don’t simply want their money back, they want to convert equity into a fantastically successfully company. They will typically extend the terms of their notes and do whatever it takes to maximize a startup’s runway. “Many of these new structures are designed more to allay founders’ anxieties than to fix problems actually occurring in financings . . . . They’re sort of solutions in search of their own problems.”
Adopting the right mindset when it comes to raising venture capital
Entrepreneurs who have been through the fundraising process multiple times realize that venture funding is more of a marriage than a transaction.
“The founder is bound to a lead investor, especially those who join your board of directors. They are your new business partners working on your ‘baby.’ You want to do your own diligence on how they approach different business problems and the kind of advice that they give. Founders should start to develop relationships months before they plan to ask for money. Investors love proprietary deal flow and will respect your foresight as a founder.”
There is an old adage in Silicon Valley: If you want money, ask for advice — if you want advice, ask for money. When you ask a venture capitalist for funding, they are almost searching for reasons why they shouldn’t invest.
“Instead, when you solicit their advice and update them with your progress every month, they start to gain insight into your willingness to learn and adapt, a vital observation for an investor,” Jacoby emphasizes. “This gives you a whole new way to impress them with your abilities — until at one point you receive a note in your inbox asking, ‘This is a preemptive term sheet, what would you say about us leading a round?’”
Proper fundraising efforts and strategy can make or break an early-stage venture. Make sure you’re as informed as your lawyer and the venture capitalist on the other side of the table as you approach the process – to ensure the best possible outcome for the long-term future of your company.