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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.

Callum Connects

Malcolm Tan, Founder of Gravitas Holdings

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Malcolm Tan is an ICO/ITO and Cryptocurrency advisor. He sees this new era as similar to when the internet launched.

What’s your story?
I’m a lawyer entrepreneur who owns multiple businesses, and who is now stepping into the Initial Coin Offering/Initial Token Offering/Cryptocurrency space to be a thought leader, writer (How to ICO/ITO in Singapore – A Regulatory and Compliance Viewpoint on Initial Coin Offering and Initial Token Offering in Singapore), and advisor through Gravitas Holdings – an ICO Advisory company. We are also running our own ICO campaign called AEXON, and advising 2 other ICO’s on their projects.

What excites you most about your industry?
It is the start of a whole new paradigm, and it is like being at the start of the internet era all over again. We have a chance to influence and shape the industry over the next decade and beyond and lead the paradigm shift.

What’s your connection to Asia?
I’m Singaporean and most of my business revolves around the ASEAN region. Our new ICO advisory company specialises in Singaporean ICO’s and we are now building partnerships around the region as well. One of the core business offerings of our AEXON ICO/ITO is to open up co-working spaces around the region, with a target to open 25 outlets, and perhaps more thereafter.

Favourite city in Asia for business and why?
Singapore, since it is my hometown and most of my business contacts originate from or are located in Singapore. It is also a very open and easy place to do business.

What’s the best piece of advice you ever received?
Be careful of your clients – sometimes they can be your worst enemies. This is very true and you have to always be careful about whom you deal with. The closest people are the ones that you trust and sometimes they have other agendas or simply don’t tell you the truth or whole story and that can easily put one in a very disadvantageous position.

Who inspires you?
Leonardo Da Vinci as a polymath and genius and leader in many fields, and in today’s world, Elon Musk for being a polymath and risk taker and energetic business leader.

What have you just learnt recently that blew you away?
Early stage bitcoin investors would have made 1,000,000 times profit if they had held onto their bitcoins from the start to today – in the short space of 7 years.

If you had your time again, what would you do differently?
Seek out good partnerships and networks from day one, and use the power of the group to grow and do things together, instead of being bogged down by operations and going it alone from start.

How do you unwind?
I hardly have any time for relaxation right now. I used to have very intense hobbies, chess when I was younger, bridge, bowling, some online real time strategy games and poker. All mentally stimulating games and requiring focus – I did all these at competitive levels and participated in national and international tournaments, winning multiple trophies, medals and awards in most of these fields.

Favourite Asian destination for relaxation? Why?
Phuket – nature, resort life, beaches, good food and a vibrant crowd.

Everyone in business should read this book:
Rich Dad Poor Dad by Richard Kiyosaki

Shameless plug for your business:
Gravitas Holdings (Pte) Limited is the premier ICO Advisory company and we can do a full service for entrepreneurs, including legal and compliance, smart contracts and token creation, marketing and PR, and business advisory and white paper writing/planning.

How can people connect with you?
Write emails to [email protected], or [email protected]

Twitter handle?
@malcolmABM

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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Entrepreneurship

Women on Top in Tech – Pam Weber, Chief Marketing Officer at 99Designs

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(Women on Top in Tech is a series about Women Founders, CEOs, and Leaders in technology. It aims to amplify and bring to the fore diversity in leadership in technology.)

Pam Webber is Chief Marketing Officer at 99designs, where she heads up the global marketing team responsible for acquisition, through growth marketing and traditional marketing levers, and increasing lifetime value of customers. She is passionate about using data to derive customer insights and finding “aha moments” that impact strategic direction. Pam brings a host of first-hand startup marketing experiences as an e-commerce entrepreneur herself and as the first marketing leader for many fast-growing startups. Prior to joining 99designs, she founded weeDECOR, an e-commerce company selling custom wall decals for kids’ rooms. She also worked as an executive marketing consultant at notable startups including True&Co, an e-commerce startup specializing in women’s lingerie. Earlier in her career, Pam served in various business and marketing positions with eBay and its subsidiary, PayPal, Inc. A resident of San Francisco, Pam received her BA from the University of Pennsylvania and MBA from Harvard Business School. Pam is a notable guest speaker for Venture Beat, The Next Web, Lean Startup, and Growth Hacking Forum, as well as an industry expert regularly quoted in Inc., CIO, Business News Daily, CMSwire, Smart Hustle, DIY Marketer, and various podcast and radio shows. You can follow her on Twitter at @pamwebber_sf.

What makes you do what you do?
My dad always told me make sure you choose a job you like because you’ll be doing it for a long time. I took that advice to heart and as I explored various roles over my career, I always stopped to check whether I was happy going to work every day – or at least most days :). That has guided me to the career I have in marketing today. I’m genuinely excited to go to work every day. I get to create, to analyze, to see the impact of my work. It’s very fulfilling.

How did you rise in the industry you are in?
I had a penchant for numbers and it helped me stand out in my field. This penchant became even more powerful when the Internet and digital marketing started to explode. There was a great need for marketers whose skills could span both the creative and the analytic aspects of marketing. I capitalized on that growth by bringing unique insight to the companies I worked with, well-supported with thoughtful analysis.

Why did you take on this role/start this startup?
I’m not sure this is relevant to my situation as I had been a marketing leader in various start-ups and companies. I took on the role at 99designs because I was excited by the global reach of the brand and the opportunity the company had to own the online design space. I especially liked the team as I felt they were good at heart.

The challenge I’ve faced in my time at 99designs is how do I evolve the team quickly and nimbly to address new challenges. The work we do now, is very different than the work we did a year ago and even the year before that. There is a fine line between staying focused on the goal ahead and being able to move quickly should that goal shift.

Do you have a mentor that you look up to in your industry or did you look for one or how did that work?
There is no one I’ve sought out or worked with over my entire career as my “mentee” needs have changed so much over the years. There are many people who have helped me along the way. For example, one of my peers at eBay, who was quite experienced and skilled in marketing strategy and creative execution, taught me what was in a marketing plan and how to evaluate marketing assets. As I have risen to leadership positions over the years, I often reach out to similarly experienced colleagues for advice on how they handle situations.

How did you make a match if you and how did you end up being mentored by him?
I learned early in my career that it rarely hurts to ask for advice. So that is what I have done. Additionally, there are people that are known to be quite helpful and build a reputation for giving back to others in advisory work. Michael Dearing, of Harrison Metal and ex-eBay, is one of those people. I, as well as countless others, have asked him for advice and guidance through the years and he does his best to oblige. Finding mentorship is about intuiting who in your universe might be willing and whether you are up for asking for help.

That being said, generally, I have found, if you are eager to learn and be guided, people will respond to the outreach.

Now as a leader how do you spot, develop, keep, grow and support your talent?
I generally look for a good attitude and inherent “smarts”. A good attitude can encompass anything from being willing to take on many different types of challenges to working well amongst differing personalities and perspectives. Smarts can be seen through how well someone’s done in their “passion areas” (i.e. areas where they have a keen interest in pursuing).

I try to hire those types of people because in smaller, fast-growing companies like many of the ones I’ve worked in, it’s more often than not about hiring flexible people as things move and change fast.

Once those people are on my team, I try to keep them challenged and engaged by making sure they have varying responsibilities. If I can’t give them growth in their current job or in the current company, I encourage them to seek growth opportunities elsewhere. I’d rather have one of my stars leave for a better growth opportunity than keep them in a role where they might grow stale.

Do you consciously or unconsciously support diversity and why?
I consciously support diversity. When I am hiring, I am constantly thinking about how to balance the team with as broad a range as possible of skill sets, perspectives, etc. to ensure we can take on whatever is thrown at us, or whatever we want to go after.

What is your take on what it takes to be a great leader in your industry and as a general rule of thumb?
I’m going to assume a great leader in my industry to mean a marketing leader in a technology company. I think a great leader in this industry is not afraid to learn new tricks no matter their age – it’s the growth mindset you may have heard about. I have a friend who inspires me to do this – she purchased the Apple Watch as soon as it was available, and was one of the first people I knew to use the Nest heating/cooling system. She’s not an early adopter by most definitions, but she adopts the growth mindset. This is the mindset I, too, have sought to adopt. In my field of marketing, it most recently has meant learning about Growth Marketing and how to apply this methodology to enhance growth. Independent of your industry, I think a growth mindset serves you well.

Advice for others?
I have been at 99designs for 3.5 years. During that time we’ve invested in elevating the skills and quality of our designer community, we’ve rebranded to reflect this higher level of quality, and have improved the satisfaction of our customers. Our next phase of growth will come from better matching clients to the right designer and expanding the ability to work with a designer one-on-one. We have the best platform to find, collaborate, and pay professional designers who deliver high quality design at an affordable price, and it’s only going to get better. I’m excited to deliver on that vision.

Pam Webber
Chief Marketing Officer of 99designs
Twitter: @pamwebber_sf

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