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Basics of Investing in Startups

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Are you thinking about investing in a startup company for the first time? If so, such topics as preferred stock, convertible notes, and dilution might sound like startup hocus pocus, but you’ll want to know what they’re all about.

In this post, I provide an introduction to several concepts that you should understand before entrusting your hard-earned cash to the founders of what might — or might not — be the next great thing. This post is a basic introduction to angel investing, which covers concepts common to most angel investments.

 

Startup investments are speculative and illiquid

True to my lawyerly training, I’ll start with the warnings: The first thing to know about investments in startup companies is that they are speculative. Many startup companies fail. This is true of those that gain early traction and successfully raise money from angel investors and venture capital firms, as well as those that don’t. When such enterprises fail, people who’ve invested in them can expect to lose much or all of their investments. So you probably don’t want to invest the kids’ college fund in startups.

Although angel investors can put themselves in a better position by conducting appropriate due diligence before investing, risk is in the very nature of early stage growth companies.

Even if a startup company doesn’t fail, investors might not see their money again for a very long time. Investors typically get money out of companies they invest in through dividends, sale of stock in a public offering, and sale of stock in the private sale of the company. High-growth startups (i.e., the type of companies that tend to attract investments) basically don’t pay dividends. That leaves stock sales as the most common avenue available for investors to see a return on their investments. Even in successful startups, sales of stock via IPOs and private company sales tend to take place only after a lengthy period of growth, and the investors’ money will be tied up in the interim. In the meantime, investors may not be permitted to sell their stock on their own — assuming they can find a willing purchaser.

A number of companies don’t really fail but they don’t really succeed either. This leaves investors’ money tied up indefinitely as the companies soldier on — not doing so badly to cause them to shut down, but not doing well enough to return money to their investors either.

Everyone who has built a business or put a business deal together knows that things generally take longer, are more expensive, and are more complicated than you would expect them to be. This is true of startup business plan execution, also. Even assumptions that seem to be conservative often turn out to be optimistic in retrospect.

High-growth startups are designed to be fed cash. The need for future cash is baked into the business plan of most of them. For example, if execution of a business plan would require $10 million before the company could be sustained by cash from operations, the founders might put in $100,000 of cash from savings, friends, and family; go to angel investors for the next significant infusion of cash; and rely on one or more rounds of venture capital investments to make it to profitability and to roll out the concept on a larger scale. At each round of financing, the investors don’t know whether the company will perform well enough to attract the next round of financing. If there’s a hiccup and the next round can’t be raised, it’s likely that the company will die, the next round of financing will seriously dilute the interests of current investors, or the company will turn into a zombie company that neither succeeds nor fails — nor returns cash to its investors.

 

Is common stock a good investment for angel investors?

Angel investors typically purchase common stock, preferred stock, or convertible notes (which are a bit of a hybrid of debt and preferred stock). The most important aspects of these investments are economic ownership in the company and control in the form of a vote, which allows an investor to protect his or her investment.

Common stock

In a typical corporation, each share of common stock has a right to one vote per director to elect the board of directors. Thus, holders of a majority of the shares of common stock control who sits on the board of directors, and thus who controls the company. In addition to voting for directors, common shareholders also have a right to vote on such things as amending the certificate of incorporation, proposed mergers, and the sale of the corporation’s business in the form of an asset sale. Again, holders of a majority (or in some cases supermajority) of common stock have the final say on whether changes in corporation’s governing documents and significant transactions can take place. (The company’s issuance of preferred stock or granting contractual rights, discussed below, can affect common stockholders’ rights.)

Shareholders also have access rights to certain company information such as stockholder records and other corporate books and records.

Founders usually hold common stock, which gives investors in common stock the protection of owning the same type of stock that the founders own. However, angels usually purchase a minority interest in the corporations they invest in, which means that even though they hold voting stock they can’t vote anyone onto the board of directors, and they usually can’t block mergers, asset sales, or changes to the certificate of incorporation. Thus, once they’ve invested their money, common stock investors won’t have much, if any, say in the success or failure of the company. However, as discussed below, holders of common stock can negotiate such protections through contractual rights.

The other major aspect of common stock is economic: all shares of common stock typically participate equally in any dividends that are paid and in liquidation proceeds after creditors and preferred shareholders have been paid upon liquidation of the company.

Preferred stock

Preferred stock has certain protective features that common stock doesn’t have. Here are some typical features:

  • Liquidation preference. If the corporation liquidates, the preferred shareholders are in line before the common stockholders, but after the corporation’s creditors. A liquidation preference is downside protection in case things don’t go well.
  • Conversion option. Holders of preferred shares typically have the right to convert their shares to common stock under certain circumstances. This allows them to enjoy the upside if things go well.
  • Antidilution protection. Preferred shares typically have antidilution protection which kicks in when the corporation issues shares below the price that the purchaser of preferred stock paid. This is protection against dilution of the preferred shareholder’s ownership interest in a later round of financing or other issuance of stock. Again, this is downside protection.
  • Blocking rights. Preferred shares often have rights to block major activities, such as selling the company, raising additional money, and increasing the number of stock options available to the company’s management.
  • Other rights. Investors in preferred stock sometimes receive rights to have a person on the board of directors, rights to more detailed information about the company on an on-going basis, and a right to participate in future rounds to protect their ownership percentage.

It’s important to note that, although the protections that are typical of preferred stock aren’t built into shares of common stock, common-stock investors can obtain some of the protections via a voting agreement or other contractual document. Angel investors should also understand that startups are wary of giving blocking rights and board seats to inexperienced angel investors.

When things go well, each round of financing fuels company growth such that the company is worth more each time it sells equity to new investors. Thus, although the early investors’ percentage ownership in the company decreases over time, the investors have a smaller slice of a larger pie and the value of their investment grows. In this scenario, many of the protections of preferred stock often aren’t necessary.

When things go poorly, however, preferred stock protections can be valuable. Antidilution features protect against dilution if the startup has to price a round of financing relatively low due to company struggles or a downturn in the economy. Joe Wallin’s Startup Law Blog post How Dilution Works is a good introduction to how dilution works. Liquidation preferences make it more likely that investors will get some of their money back if the company fails completely or has to be sold at a loss, since holders of preferred stock are ahead of holders of common stock when a company liquidates.

Convertible note

A convertible note is a promissory note that can be converted into common or preferred stock at the option of the noteholder or upon certain triggering events, such as a later financing round or meeting of developmental milestones. There are a number of potential features of convertible notes. The various features and their pros and cons are discussed in detail in this three-part article about convertible notes.

A note about authorized and issued shares

A corporation’s certificate of incorporation provides how many authorized shares — both common and preferred — the corporation can issue. A corporation can issue shares up to the number authorized. Issuance of additional shares requires an amendment to the certificate of incorporation. Thus, if a corporation has 10 million authorized shares of common stock and 1 million authorized shares of preferred stock, it can issue 10 million shares of common and 1 million shares of preferred before having to amend the certificate of incorporation to increase the number of authorized shares. If when you invest, 1 million shares of common stock have already been issued, that leaves another 9 million shares available for issuance to you, later investors, and management via stock options.

The specific features of preferred shares are generally not initially contained in the certificate of incorporation. Those features are set forth in a certificate of designations, which becomes part of the certificate of incorporation by amending the certificate when shares of a series of preferred stock are first sold.

 

Which type of security should an angel investor invest in?

There’s no set answer to which type of security is best for angel investors. Each situation is different, so the type of security that is appropriate in one situation might be different than the type that is appropriate in another. However, here are some things to consider:

Negotiating leverage is important

As in most transactions, the relative negotiating leverage between the investor and the startup is important. If the startup has several financing options and plenty of runway before it needs the capital, the startup will be less likely to agree to additional investor protections. The converse is true, also.

Later investors tend to receive more protection

As the company matures, the valuation tends to increase, the amount of money raised in each successive round of financing tends to increase, and the sophistication of the investors tends to increase. Thus, investor-protective features are more common in later rounds of financing than in earlier rounds. Formal angel groups, super angels, and venture capitalists all tend to invest in preferred stock, and the preferred stock issued in later rounds tends to have more investor protections than early-round preferred stock.

Early rounds set the floor for later rounds

Whatever concessions a startup gives to investors in a round of financing will be the starting point for negotiations with later investors.

Complexity costs money in legal and advisor fees

The simpler the investment, the more quickly it can be concluded and the lower the professional fees. Although it’s important to push for appropriate protections in light of such factors as how early in the process you’re investing, how much money you’re investing, and the relative valuation you’re being given, the transaction costs of purchasing preferred stock (for both the investor and the startup) tend to be higher than the transaction costs of purchasing common stock. And the transaction costs of purchasing preferred stock with a lot of investor protections tend to be higher than the transaction costs of purchasing simpler preferred stock.

 

Due diligence

Almost every investor will perform due diligence on the company he or she is investing in before closing the investment. The extent of due diligence that is appropriate depends on a number of factors, but the single over-arching consideration is that the due diligence you conduct must be sufficient to give you reasonable comfort to invest in the company given the nature of the business opportunity, the amount of money you’re investing, and how important that money is to you. That said, here are a few considerations:

The earlier the stage of the investment, the less due diligence there will be. This is partly due to the fact that early-stage companies don’t have much operating history or complexity, as well as the fact that you’re probably investing more in the idea and the management team than in past performance.
Negotiating leverage is important. If the startup has a number of potential investors eager to invest, it’ll be less willing to undergo a protracted due diligence ordeal. On the other hand, if it desperately needs your money, it’ll be more willing to let you look under the hood.
The more committed you are to making the investment, the more receptive the startup will be to providing information to you. Startup founders tend to be wary of giving tire kickers access to the inner workings of the company.
Some of the areas to investigate in the due diligence process include:

  • The company’s corporate documents (articles, bylaws, list of shareholders);
  • Capitalization table;
  • Authorized and outstanding securities;
  • Business plan and presentation slides;
  • Market and customer attributes;
  • Analysis of the competition;
  • Financial projections and financial statements;
  • Tax returns;
  • Cash on hand and monthly burn rate;
  • Intellectual property and protection (e.g., patents and trademarks);
  • Material contracts;
  • Use of the proceeds of the offering;
  • Reference and background checks of the members of the management team; and
  • Information about employees and employee benefits.

written by Brian Rogers of theContractsGuy. see more.

Entrepreneurship

The Brittle vs. Ductile Strategy for Business

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Companies and startups often pursue a path of “brittle strategy” and in it’s execution, it can be translated, in layman terms, into something like this:
Heard about the guy who fell off a skyscraper? On his way down past each floor, he kept saying to reassure himself: “So far so good… so far so good… so far so good.” How you fall doesn’t matter. It’s how you land!
– Movie : La Haine (1995)

Brittle strategy :

A brittle strategy is based on a number of conditions and assumptions, once violated, collapses almost instantly or fails badly in some way. That does not mean a brittle strategy is weak, as the condition can either be verified true in some cases and the payoff from using this strategy tends to be higher. However the danger is that such a strategy provides a false sense of security in which everything seems to work perfectly well, until everything suddenly collapses, catastrophically and in a flash, just like a stack of cards falling. Employing such approach, enforces a binary resolution: your strategy will break rather than be compromising, simply because there is no plan B.
From observation, the medium to large corporate company strategies’ landscape is often dominated by brittle “control” strategies as opposed to robust or ductile strategies. Both approach have their strong parts and applicability to corporate win the corporate competition game. The key to most brittle strategy, especially the control one, is to learn every opponent option precisely and allocate minimum resources into neutralizing them while in the meantime, accumulating a decisive advantage at critical time and spot. Often, for larger corporations, this approach is driven by the tendency to feed the beast within the company that is to say the tendency is to allocate resources to the most successful and productive department / core product / etc.. within the company. While this seems to make sense, the perverse effect is that it is quite hard to shift the resources in order to be able to handle market evolution correctly. As a result of this tendency, the company gets blindsided by a smaller player which in turn uses a similar brittle strategy to take over the market.The startup and small company ecosystem sometimes/often opts for brittle strategy out of necessity due to economic constraints and ecosystem limitations because they do not have the financial firepower to compete with larger players over a long stretch of time, they need to approach things from a different angle. These entities are forced to select an approach that allows them to abuse the inertia and risk averse behavior of the larger corporations. They count on the tendency of the larger enterprise to avoid leveraging brittle strategies, made to counter other brittle strategies. These counter strategies often fail within bigger market ecosystem as they are guaranteed to fail against the more generic ones. Hence, small and nimble company try to leverage the opportunity to gain enough market share before the competition is able to react.

Ductile strategy :

The other pendant of the brittle strategy is the ductile strategy. This type of strategy is designed to have fewer critical points of failure, while allowing to survive if some of the assumptions are violated. This does not mean the strategy is generally stronger, as the payoff is often lower than a brittle one – it’s just a perceived safer one at the outset. This type of approach, will fail slowly under attack while making alarming noises. To use an analogy, this is similar to the the approach employed with a suspension bridge using stranded cables. When such a bridge is on the brink of collapse, will make loud noises allowing people to escape danger. A Company can leverage, if the correct tools and processes are correctly put in place, similar warning signs to correct and adapt in time, mitigating and avoiding catastrophic failure.
To a certain extend, the pivot strategy for startups offer a robust option to identify the viability of a different hypothesis about the product, business model, and engine of growth. It basically allows the Company to iterate quickly fast over the brittle strategy until a successful one is discovered. Once found, the Company can spring out and try to take over the market using this asymmetrical approach. For a bigger structure, using the PST model combined with Mapping provides an excellent starting point. As long as you have engineered within your company and marketed the correct monitoring system to understand where you stand at anytime. Effectively, you need to build a layered, strategic approach via core, strategic and venture efforts combined with a constant monitoring of your surroundings. This allow you to take risks with calculated exposure. By having the correct understanding of your situation (situational awareness), you will be able to mitigate threats and react quickly via built-in agility. However, we cannot rely solely on techniques that allow your strategy to take risk while being able to fail gracefully. We need techniques that do so without insignificant added cost. The cost differential between stranded and solid cables in a bridge is small, and like bridges, the operational cost between ductile and brittle strategy should be low. However, this topic is beyond the scope of this blog post but I will endeavor to expand on the subject in a subsequent post.
Ductile vs Brittle :
The defining question between the two type of strategies is rather simple: which strategy approach will guarantee a greater chance of success? From a market point of view this question often turns into : is there a brittle strategy that defeats the robust strategy?
By estimating the percentage of success a brittle strategy has against the other strategies in use, weighted by how often each strategy is used by each competitor you can determinate the chances of success.Doing this analysis is a question of understanding the overall market meta competition. There will be brittle strategies that are optimal at defeating other brittle strategies but will fail versus robust. However, the robust one will succeed against certain brittle categories but will be wiped out with other. Worse still, there is often the recipe for a degenerate competitive ecosystem if any one strategy is too good or counter strategies are too weak overall. Identifying the right strategy is an extremely difficult exercise. Companies do not openly expose their strategy/ies and/or often they do not have a clear one in the first place. As a result, if there is a perception that the brittle strategy defeats the ductile one, therefore the brittle strategy approach ends up dominating the landscape. Often strategy consulting companies rely on this perception in order to sell the “prêt a porter” strategy of the season. Furthermore, ductile strategies tend to be often dismissed as not only do they require a certain amount of discipline, but also the effort required in its success can be daunting. It requires a real time understanding of the external and internal environment. It relies on the deployment of a fractal organisation that enables fast and risky moves, while maintaining a robust back end. And finally, it requires the capability and stomach to take risk beyond maintaining the status quo. As a result, the brittle strategy often ends up more attractive because of its simplicity, more so that it’s benefit from an unconscious bias.

The Brittle strategy bias:

Brittle strategies have problems “in the real world”. They are often unpredictable due to unforeseen events occurring. The problem is we react and try to fix things going forward based on previous experience. But the next thing is always a little different. Economists and businessmen have names for the strategy of assuming the best and bailing out if the worst happens, like “picking pennies in front of steamrollers” and “capital decimation partners”.
It is a very profitable strategy for those who are lucky and the “bad outcome” does not happen. Indeed, a number of “successful” companies have survived the competitive market using these strategies and because the (hi)story is often only told by the winner’s side only, we inadvertently overlook those that didn’t succeed, which in turn means a lot of executives suffer from the siren of the survival bias, dragging more and more corporations into similar strategy alongside them.
In the end all this lot ends up suffering from a more generalized red queen effect whereby they spend a large amount of effort standing still (or copying their neighbors approach). This is why when a new successful startup emerges, you see a plethora of similar companies claiming to apply a similar business model. At the moment it’s all about UBER for X and most of these variants. If they are lucky, they will end up mildly successful. But for most of them, they will fail as the larger corporations have been exposed and probably bought into the hype of the approach.
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About the Author
This article was written by Benoit Hudzia of Reflections of the Void, a blog about life, Engineering, Business, Research, and everything else (especially everything else). see more.
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Entrepreneurship

What Kills A Startup

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1 – Being inflexible and not actively seeking or using customer feedback

Ignoring your users is a tried and true way to fail. Yes that sounds obvious but this was the #1 reason given for failure amongst the 32 startup failure post-mortems we analyzed. Tunnel vision and not gathering user feedback are fatal flaws for most startups. For instance, ecrowds, a web content management system company, said that “ We spent way too much time building it for ourselves and not getting feedback from prospects — it’s easy to get tunnel vision. I’d recommend not going more than two or three months from the initial start to getting in the hands of prospects that are truly objective.”

2 – Building a solution looking for a problem, i.e., not targeting a “market need”

Choosing to tackle problems that are interesting to solve rather than those that serve a market need was often cited as a reason for failure. Sure, you can build an app and see if it will stick, but knowing there is a market need upfront is a good thing. “Companies should tackle market problems not technical problems” according to the BricaBox founder. One of the main reasons BricaBox failed was because it was solving a technical problem. The founder states that, “While it’s good to scratch itches, it’s best to scratch those you share with the greater market. If you want to solve a technical problem, get a group together and do it as open source.”

3 – Not the right team

A diverse team with different skill sets was often cited as being critical to the success of a starti[ company. Failure post-mortems often lamented that “I wish we had a CTO from the start, or wished that the startup had “a founder that loved the business aspect of things”. In some cases, the founding team wished they had more checks and balances. As Nouncers founder stated, “This brings me back to the underlying problem I didn’t have a partner to balance me out and provide sanity checks for business and technology decisions made.” Wesabe founder also stated that he was the sole and quite stubborn decision maker for much of the enterprises life, and therefore he can blame no one but himself for the failures of Wesabe. Team deficiencies were given as a reason for startup failure almost 1/3 of the time.

4 – Poor Marketing

Knowing your target audience and knowing how to get their attention and convert them to leads and ultimately customers is one of the most important skills of a successful business. Yet, in almost 30% of failures, ineffective marketing was a primary cause of failure. Oftentimes, the inability to market was a function of founders who liked to code or build product but who didn’t relish the idea of promoting the product. The folks at Devver highlighted the need to find someone who enjoys creating and finding distribution channels and developing business relationship for the company as a key need that startups should ensure they fill.

5 – Ran out of cash

Money and time are finite and need to be allocated judiciously. The question of how should you spend your money was a frequent conundrum and reason for failure cited by failed startups. The decision on whether to spend significantly upfront to get the product off the group or develop gradually over time is a tough act to balance. The team at YouCastr cited money problems as the reason for failure but went on to highlight other reasons for shutting down vs. trying to raise more money writing:

The single biggest reason we are closing down (a common one) is running out of cash. Despite putting the company in an EXTREMELY lean position, generating revenue, and holding out as long as we could, we didn’t have the cash to keep going. The next few reasons shed more light as to why we chose to shut down instead of finding more cash.

The old saw was that more companies were killed by poor cashflow than anything else, but factors 1, 2 and 4 probably are the main contributing factors to that problem. No cash, no flow. The issue No 3 – the team – is interesting, as if I take that comment ” I didn’t have a partner to balance me out and provide sanity checks for business and technology decisions made” and think about some of the founders and startup CEOs I know, I can safely say that the main way that any decision was made was by agreeing with them – it was “my way or the highway”. I don’t therefore “buy” the team argument, I more buy the willingness of the key decision makers to change when things are not working (aka “pivoting” – point 9).

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About the Author

This article was produced by Broadsight. Broadsight is an attempt to build a business not just to consult to the emerging Broadband Media / Quadruple Play / Web 2.0 world, but to be structured according to its open principles. see more.

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