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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

Science is the Next Big Thing in Startups

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From pharmaceuticals to petrochemical processes: Newcomer companies and investors and investors alike are setting their sights on science. How the start-up scene moves beyond the mobile apps bubble…

For the last two years Silicon Valley analysts and venture capitalists are anticipating the burst of yet another bubble. This time, under the risk are the mobile start-ups which constitute the biggest share of the market. Out of 50 companies listed in Forbes’ “the hottest startup of 2015” (by valuation) only six companies are based on innovations in other-than-mobile area, one company provide cleaning services, while the rest are diverse mobile apps.

Meanwhile many products listed can be barely called innovative. A significant proportion of the listed start-ups are texting apps, apps for people search (starting from business partners to life partners) or delivery services. While those services can definitely facilitate one’s life, in general they differ from their predecessors by only a narrower audience.

Many venture investors expect stagnation if not decrease on the markets, which is why they start to transfer their capitals from start-ups offering customers software to start-ups offering specific solutions for existing businesses. Such companies are expected to demonstrate more stability in the near future.

The Market for Mobile Apps Might be Saturated

Back in 2012 a talented entrepreneur could walk into a venture capitalist’s office, say his startup was a mobile-first solution for pretty much any problem (payments! photos! blogging!), and walk out with a good-size seed investment. “That pitch was enough to get going,” says Roelof Botha, a partner with VC firm Sequoia Capital. “It’s not enough anymore.”

“I think investors are bored with investing in another messaging app. And our idea is crazy enough that it might just work. ”, has declared in 2014 Nadir Bagaveyev a founder of a start-up using 3-D printers to make rocket engines. By 2016 the company attracted investors funding sufficient to launch its first rocket.

Pharma and Biotech Start-Ups in High Demand

Currently the most successful science-based start-ups are the companies offering innovative solutions in the field of pharmaceuticals and biotechnologies. It’s noteworthy that despite the previous revelations and even judicial proceedings the list of the most expensive start-ups still includes Theranos, blood analyzing laboratory, whose story did not descend from the main pages of the global leading media from 2014.

It first amazed the audience with its fantastic take-off and then with its collapse. One of the crucial parts of the success story of this start-up is its fundamental difference from the majority of the services produced in the Silicon Valley. Unlike the others, it was not a story of yet another beautiful gadget for communication or mobile app, but the story of the scientific idea which intended to conquer the world.

The great success stories in other scientific areas are now happening on occasional basis. However certain facts allow to predict that the situation is to change soon. One of such factors is growing interest among the big corporations to attract innovative solutions from outside to develop their businesses.

Given the accelerating pace of scientific and technological development of the world, the activities of internal R & D departments are often turn to be insufficient to ensure stable development of innovative business. Outsourcing of the R&D may become the efficient mechanism to stimulate the growth of the company. And high-tech start-up can certainly benefit from it.

Start-Up Technology for the Petro-Business

In December, 2016 world leading companies in the field of gas processing, petrochemicals and chemicals announced their intentions to enforce their R&D capacities by attracting start-ups. 3M, AkzoNobel, BASF, The Dow Chemical Company, DuPont, Henkel, Honeywell UOP, LG Chem, Linde, Sibur, Solvay and Technip together created a global stage for startups and investors.

“The petrochemicals industry can and must rely on the potential of open innovations to facilitate further inventions and implementation of new solutions in all major application areas, from construction and medicine to packaging and 3D printing. Thanks to the participation of international partners, IQ-CHem is now the largest global project within the industry which attracts innovative solutions and provides for their implementation into practice,” said Vasily Nomokonov, Executive Director of Sibur, a company which coordinates the project.

Positive Experience in Chemicals and Beyond

Some of the listed companies have already gained positive experience in working with start-ups which may have driven them to elaborate a systemic approach to attract innovative companies.

At the beginning of 2016, SIBUR and RRT Global start-up reached an agreement to build a pilot plant for isomerization based on RRT Global technologies in Sibur’s Industrial Park SIBUR “Tolyattisintez”. According to Oleg Giyazov, co-founder and CEO of RRT Global cooperation with a large corporation bring significant advantages to his company.

“By cooperation with Sibur we get a huge industrial experience that enables us to develop technologies and solutions better fitted to the market demand. This advantage is often not given due attention, but we, on the contrary, see significant opportunities in it. Currently, RRT Global cooperates with several companies around the world” he said.

Another petrochemical leader BASF enjoys successful cooperation with Genomatica start-up. In 2013 BASF started the production of 1,4-butanediol based on renewable feedstock (renewable BDO) using Genomatica’s patented process and in 2015 the license was expanded to the Asian market.

Unlike traditional forms of cooperation between a start-up and a venture capitalist, a cooperation between start-up and a relevant corporation allows to minimize the risks associated with investing in a potentially promising idea where the key word is “potential” (but not “guaranteed”). While delivering services in the same field as the start-up the corporation gets an opportunity to more effectively and accurately estimate the market value of an innovative idea and to support its implementation.

Structural Changes Ahead: Outlines of A Coming Market

In the short term prospective, possibly in 2017, the global start-up market will face structural changes – both in terms of start-ups professional orientation and of funding mechanism. In the future science-based start-ups will dominate the market and will change our lives at a deeper level than the way of sending a text message or searching the restaurant for an evening meal. To be more concise this is already happening in the pharmaceutical industry, and the other scientific areas are to follow.

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About the Author

This article was written by Dominik Stephan of Process Worldwide. See more.

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Callum Connects

Norman Tien, Founder of Neuromath and Early Math Matters

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From a young age, Norman Tien, found his passion helping students as a math tutor and went on to translate that into a successful business.

What’s your story?
From the age of 14, I knew I would be in business for myself and started designing my company logo.

Growing up in a poor family, I worked part time while I was in school. That’s when I started tutoring and realised I had a gift to help students “see” mathematics. I delivered good results, and my students started to love math as well.

A turning point was when I was down with dengue fever and I realised I had to grow my business to the next level. I started a learning centre and that was the beginning of Neuromath. The initial years were tough as costs went up while my personal income took a dive. I almost gave up, but I pushed through.

Today, we have 3 specialty math enrichment centres managed and delivered by my dedicated team of teachers.

What excites you most about your industry?
“How to win” has always influenced how I position myself in the industry. I researched the psychology of learning, why some students are so naturally good at math, while others struggled. I managed to find the connection, and have always sought out niches to position myself so I can win.

In the beginning, I fused academic delivery with psychology to differentiate my services. Now I have a good team of teachers fully equipped with a psychological skillset.

In the next evolution of our business, we will incorporate technology into education in order to customise each student’s learning experience based on his or her needs.

What’s your connection to Asia?
I was born and educated in Singapore. One key driver why I started a business was, as a youth, I witnessed how my dad struggled daily as a taxi driver trying to make ends meet.

That said, I am very blessed to be in Singapore and to be given the right education. I see this as a very important factor to my success today.

Favourite city in Asia for business and why?
Singapore – well, for one, most of my businesses are here. Singapore is convenient for business and is very well governed. There are rules and systems that make the entire entrepreneurial journey more secure here. One big plus is the location: Singapore is a hub that allows us to connect to the world.

What’s the best piece of advice you ever received?
船到桥头自然直 –
There is a Chinese saying that when a boat goes near the pier, it will automatically align itself (with the current). It means we don’t have to worry too much, that things will take care of themselves.

A mentor once challenged me: “But who can guarantee you can even reach the pier?”

It is such a highly competitive world we are in, who can guarantee success? This is the ONE question that has been etched in my mind for decades. The Chinese saying always comes to mind when I am positioning, designing and strategizing for my business.

Who inspires you?
Mr. Lee Kuan Yew – The fact that he started ruling the country just like a startup. With limited resources, he was able to find a strong positioning to differentiate his country from the rest of the of Asia. With hardwork and proper planning, he transformed Singapore from a fishing village to a prominent financial hub in Asia.

Because Mr. Lee Kuan Yew positioned Singapore so well, government owned companies, such as Singapore Airlines, have emerged as the best in the world.

His story inspires me, spurs me to understand that success is not by chance but by design – every little step, all the strategies are all planned out. Not at all by chance.

What have you just learnt recently that blew you away?
My business coach, Marshall Thurber, shared with me the power of the “Trim Tab” – a small part of the rudder system in a ship. This Trim Tab, despite its small size, is able to influence the entire ship’s direction by turning it.

This metaphor helped me see that a man can influence the entire world if the right effort is applied. We are now living in an entirely new world, the way we commute with an app on the phone – that’s the power of the Trim Tab at work.

If you had your time again, what would you do differently?
I would embark on the same journey but I would seek a mentor at a very early age.

I have been through many hard knocks along the way, and I definitely could have shortened the learning curve if I had a mentor to advise me on the many aspects of entrepreneurship.

How do you unwind?
Driving down long highways helps me unwind, that’s when I let my mind relax and wander.

I love long distance driving and riding. My wife gave me a Harley Davidson Tourer for my 50th birthday and we intend to embark on riding holidays together in Asia.

Favourite Asian destination for relaxation? Why?
Hong Kong – I love the fast pace and the vibrance of the city. I love the cars there and it’s a very unique and exciting experience for me. And of course, I love the food there too!

Everyone in business should read this book:
One Minute Millionaire – this book highlights the mindset of an individual that is the key determinant for success in whatever we embark on. As long as we know we have a very strong reason why we need to do it, we can do it!

Shameless plug for your business:
I am the CEO and Founder of 2 Math enrichment brands:
Neuromath is a Specialist Math Learning Centre that helps students from Primary 1 to Junior College, empowering them with strategies, skills and a strong desire to learn and problem solve. We use technology to train students to avoid careless mistakes reclaiming 30 marks or more in Math exams and achieve their full potential in math.
www.neuromath.com.sg

Early Math Matters is a premier Mathematics and Cognitive Development enrichment centre for preschool children aged 3-6 years old. Through purposeful play and our renowned EMM approach, we help learners build a strong foundation for problem solving at an early age, and instil in them a passion & love for math that will stay with them for life.
www.earlymathmatters.com

We are actively seeking passionate teachers, entrepreneurs and investors who are keen to grow the education business with us.

How can people connect with you?
I speak regularly at workshops for schools, parents and platforms demonstrating the use of technology for peak performance in education.

Do contact me at
www.NormanTien.com

Alternatively, you can connect with me:
www.NormanTien.com/facebook
www.NormanTien.com/linkedin

This interview is part of the ‘Callum Connect’ series of more than 500 interviews

Callum Laing is an entrepreneur and investor based in Singapore. He has previously started,
built and sold half a dozen businesses and is now a Partner at Unity-Group Private Equity and Co-Founder of The Marketing Group PLC. He is the author two best selling books ‘Progressive Partnerships’ and ‘Agglomerate’.

Connect with Callum here:
twitter.com/laingcallum
linkedin.com/in/callumlaing
Download free copies of his books here: www.callumlaing.com

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