(Newsletter: tsCFO.006 v3 2023.12.12)
(complete rewrite of original May30'23 posting)
Introduction
Tech startups develop financing momentum through predictable stages. There are parallel stages in the human journey: crawling, first baby steps, walking, and perhaps one ambitious day, an Olympic medal in track and field (Unicorn exit!). First baby steps for a tech startup involve early Founder, Friends & Family financing with priced common shares (Pre-Seed love money). This is usually straightforward logistically, but can be socially awkward in putting future turkey dinners at risk. This early high-risk financing from Founders, Friends & Family is used to develop a Minimum Viable Product (MVP), and gather feedback from beta testing and early customers. The Founders are developing an innovative product / service in search of a viable (read profitable) business model. Following progress past the MVP / early revenue stage, a tech startup can credibly pitch to Angel investors who are motivated by earning a highly uncertain but potentially rewarding >10x return on investment. Angel investors are often also motivated by wanting to contribute back to the tech community that nurtured their success.
Serial entrepreneurs who have had successful exits in their past may have enough personal financial resources to “prime the financial pump” with little or no reliance on external investors. Another possible shortcut to Founder success is to introduce a product / service innovation with such perfect timing that it generates strong customer demand out of the gate. In either case, Founders may be able to graduate directly to an exit through sweat equity, with little or no dilution of their equity pie. However, bootstrapping successfully without relying on external investor financing is quite rare.
In the context of the table above, the focus of this tsCFO.006 Newsletter is on the yellow shaded areas called “2. Seed” stage, “3a. Founder controlled exit”, and “3b. VC Elephant exit”. Those investment stages need to be understood in the context of what comes before and after.
Stage “1. Pre-Seed” (grey shade) is straightforward logistically, but tough emotionally. Love money can be uncomfortable, but it is the job of the Founder team to find a path forward, and it’s hard to deny the leverage you get from unconditional love. Honesty is important here – most tech startups fail, so disclosing the high-risk nature of tech startup investing by family and friends has to be made clear to avoid complicating relationships. Setting a valuation to price the common shares is a bit of a “thumb in the air” guess at this stage. The best advice I can give is to imagine the steps remaining to achieve a classic $3-$4M valuation needed for the “2. Early Seed” stage, and discount back to a current valuation with those steps in mind. If that sounds confusing, throw your thumb in the air. Ultimately the value of a tech startup share can only be determined in an informed negotiation between investors who understand what they are buying (after full and fair tech startup disclosure), and Founders who accept the negotiated dilution from new investor shares, in exchange for the cash proceeds.
At the “2. Early Seed” and “3. Late Seed / Venture Capital (VC) Series A” stages, the tech startup has developed its business model sufficiently to pitch to 3rd party investors who are primarily “in it for the money”. As seasoned Angel / Seed investor Mike Volker puts it, Angels may enjoy engaging with the tech startup community, but we also expect our >10x investment returns here on earth. Without a Minimum Viable Product (MVP), and some early beta testing feedback, it is very hard for a tech startup to attract Angel / Seed investors. Ideas are a dime a dozen – the real work is in the 10,000 steps it takes to transform that idea into a profitable product that future customers are both aware of, and eager to purchase.
VC (Venture Capital) financing is a natural fit for tech startups with strong teams, a significant product / service innovation, and a very large market opportunity. This kind of growth potential often involves market disruption, and a series of R&D and S&M (Sales & Marketing) milestones to be achieved before revenue can be scaled-up. Biotechs and advanced material pioneers are examples of tech startups that need the kind of >$5M scale milestone financing which VC’s enable. “Elephant sized” tech startup investment opportunities require an understanding of the advanced technology window (which VC’s should have), and a long-term investment horizon. However, a VC’s patience is not unlimited. Generally VC’s have a bias to see a tech startup “go big, or die quickly in trying”. The “die quickly” part can help a VC avoid throwing good money after bad.
Angel / Seed financings can feed “baby Elephants” to set the stage for a follow-on >$5M VC financing. Angel / Seed financings can also represent the last stages of a smaller <$2M financing for tech startups with less revenue potential, but a more direct bootstrap path to a profitable “Moose sized” exit. I have coined the term “Moose sized” for bootstrap business models to give the reader a sense that, while smaller than a VC Elephant, there can still be a lot of meat on the bones – especially if there are fewer seats around the table.
Stage “4. VC Expansion” (grey shade) happens in the land of Venture Capital Elephants and future Unicorns, which is beyond the scope of my tech startup / Fractional CFO world (yellow shade areas above). VC Expansion with Series B,C,D rounds involves scaling a relatively proven business model, with reduced financial risk and corresponding reduced VC expectations for return on investment. Follow-on preferred share terms generally follow the pattern set by Series A preferred share terms. Speaking personally, where is the tech startup risk and excitement? (yawn)
Equity Preparation - Finance and Administration
There is a natural tendency for the Founder team to treat the Finance and Administrative function like a neglected poor 3rd cousin. A tech startup clearly needs one or more Founders with a strong Product / Service Development background out of the gate. It is also common for at least one Founder with a Sales & Marketing background to lead the effort in understanding the pain points of potential customers. Finance and Administration can feel like a necessary evil, something the Founder CEO takes on as a side activity. If the CEO develops a “fix it later” habit, any poorly understood Finance and Administrative issues can become expensive to fix, and sometimes even fatal. For example, serious flaws in the cap table can become unfixable, and enough to force investors to pass on the investment opportunity for that reason alone.
The most cost effective way for a tech startup to manage its financial and legal affairs is to get its foundation in order from inception (date of incorporation), and invest in modest amounts of timely expert advice to maintain that foundation as the tech startup matures. Serial tech startup entrepreneurs understand this instinctively, having learned from past battles with lawyers and accountants. Growing a solid Finance and Administrative foundation is cheaper than cleaning up a long ignored financial or legal mess. It is a logistical exercise, best supervised by a tech startup expert (like a Fractional CFO or tech startup Advisor) who understands how the pieces fit together. It takes attention to detail. One simple example – someone has to ensure ALL signatures are collected on the “master” Data Room copy of each legal document. Missing signatures can lead to frustrating headaches in the closing hours of a financing deal, especially if an unethical person involved with the “missing signature” senses an opportunity for financial gain.
In the early days Founders must maintain their focus on product development and early customer traction, while nurturing a supporting finance and administrative foundation on the side. Founders must strike a balance between keeping things as simple as possible, and responding to forces nudging a tech startup to develop more complex processes as it matures. This balance is summed up in one of my favorite expressions – “keep processes as simple as possible, but no simpler”. A healthy bias towards legal and administrative simplicity must be managed within a checklist of “essential basics” to be covered off. If all this sounds like balancing on a tightrope, there is a good reason. Nobody said the Founder CEO’s journey was easy.
If Founders take too many shortcuts with Finance and Administration, as reflected in an attitude of “we know about that dead body under the rug, but we choose to plug our nose and throw money at the problem later”, they may be in for a shock. The “later fix” can be disruptive, especially if festering issues become a sudden and urgent priority blocking the close of a financing deal. Panic spending on Finance and Administration (especially if professional accounting or legal fees are involved in a cleanup situation) can be very expensive, and the situation is completely avoidable.
To put this in perspective, at the Angel / Seed financing stage, the Founders can generally get away with a moderate investment in their Finance and Administrative foundation, and save a few loose ends for later. The level of Angel / Seed investor due diligence will vary widely depending on the financial sophistication of the investor(s), and the amount being invested. In many cases, a lead Angel / Seed investor with financial experience will do most of the due diligence analysis on behalf of a group of investors, with some delegation of tasks in areas where they lack expertise. The total absence of any Finance and Administrative foundation is a deal breaker for an informed investor, and represents an existential risk for the Founders.
The Founder CEO is responsible for getting advice to cover off holes in their organization, and maintain functional balance. This can be done cost-effectively by soliciting tech startup expertise from Mentor / Advisor relationships, or Consultant / Contractor relationships (such as a Fractional CFO). Reliance on professional law and accounting firms that specialize in tech startups is also an important resource, but professional firms have little or no experience on the operations side of the business where many of the hidden pitfalls lie.
Unfortunately, it is not uncommon for a less experienced Founder CEO to imagine they are saving money by “winging it” on accounting decisions. If there are a limited number of transactions since inception, the size of the problem may also be limited, but it is always wiser to avoid making a mess, than to hire a specialist to clean it up. If there has been significant Angel investment and past spending, scrubbing historic actuals can be painful. The part some Founder CEO’s don’t get is that you can’t just ignore a historic mess of a material nature and hope it fades away over time. Accounting rules and tax compliance are both sensitive to historic issues. You have no choice but to remove the dead body from under the rug. Aside from issues with corporate tax authorities, it’s lingering smell will attract unwanted attention from any competent investor Due Diligence effort.
A solid Finance and Administrative foundation from an accounting perspective means selecting cost effective and appropriate accounting software (generally Xero or Quickbooks, as discussed in tsCFO.002), and designing a logical General Ledger (GL) structure organized around departmental expenses (normally Development, Sales & Marketing, Administration), with GL placeholders for segmented future revenue. Actuals from the accounting software are based on this GL foundation, and must sync perfectly with the same GL lines in the 3 year forecast model. If you don’t want your house leaning over as the 3rd story gets built, don’t start construction before you establish a GL foundation that anticipates future growth.
Strategic planning decisions for product development and marketing must be costed out in a comprehensive 36 month forecast model that is organized around the General Ledger (GL) account structure, and includes monthly prior actuals history. Forecast assumptions must include monthly details of revenue growth, headcount growth, functional expenses, cashflow, and use of investment proceeds. A full description of a recommended Forecast model structure is a deep topic covered in future Newsletter tsCFO.011.
Any VC financing at >$5M will trigger a “sophisticated investor” Due Diligence review of the Finance and Administrative function. The tech startup must respond with a complete, accurate, and well organized virtual Data Room with a wide range of investor grade documentation covering IP (Intellectual Property) strategy, PMF (Product Market Fit) strategy, GTM (Go To Market) strategy, legal agreements for all functional areas (Development, Sales & Marketing, Administration), HR documents, historic actuals and forward projections. A full description of Data Room contents is a deep topic covered in future Newsletter tsCFO.009.
Founders of tech startups need to recognize their Finance and Administrative function is a core component of their future success. If the Founder team makes an honest assessment of organizational holes, the next step is to plug them by seeking missing expertise through network connections. This can mean the cost-effective hourly use of Mentors / Advisors (like a serial tech startup entrepreneur) and Consultants / Contractors (like a Fractional CFO). The goal is to maintain overall health of the tech startup by having a balance of competence in all 3 key core functional areas: Product Development, Sales & Marketing and Finance and Administration.
Equity Preparation - Legal
From a legal perspective, a solid tech startup foundation is most cost effectively implemented through a legal template package from a law firm specializing in tech startups. These discounted packages start as low as $3k for qualifying clients, and are offered as a loss-leader investment in a relationship that can becomes financially rewarding for the law firm only if the tech startup is successful. The tech startup can help support the law firm’s relationship investment by keeping its legal agreements as simple and vanilla as possible. Customizing legal templates for unusual circumstances imposed by the Founders starts to drive up billable legal fees.
Every successful tech unicorn started out as a newly incorporated startup taking baby steps. The range of legal agreements a tech startup has to navigate through is significant, and they present a challenging learning curve for a less experienced Founder CEO. The standard list includes incorporation documents (including detailed Articles), shareholder documents (including share certificates, a shareholder agreement between Founders, employee option plan, share subscription agreements), employee related agreements (covering employment terms, IP ownership, confidentiality, termination, option compensation), IP ownership (patents, trademarks), 3rd party agreements (non-disclosure, contractors), corporate maintenance (AGM, annual registration filing, Board minutes / resolutions, Board member appointments / terminations, shareholder register), and more. A more complete list of legal documents will be documented in future tsCFO.009 under the topic “Data Room”.
For expediency, there are normally a few legal shortcuts taken in the early days. For example, the Founders generally form a fully internal Board of Directors (often supported by “Board Advisors” with no formal legal status or obligation) until a significantly large Angel / Seed or VC investment triggers the appointment of one or more external Directors, which in turn triggers the beginning of more formal corporate governance procedures. Another early shortcut is conducting the Annual General Meeting (AGM) process through a shareholder resolution, rather than a physical annual shareholder meeting.
Key early legal themes for a tech startup include documenting and protecting exclusive corporate ownership of IP, protecting confidential information, protecting the company and other shareholders against a disgruntled former employee or Founder, and accurately capturing share register and option agreement details.
To deal with important control and fairness issues arising from unplanned situations where there is a premature Founder exit, consideration should be given to restricted Founder shares which reverse-vest over time in a similar manner to option vesting. In the case of a premature Founder exit before full vesting, the tech startup has a right to repurchase any unvested shares at cost (which for a Founder, is usually $.01 per share or less). This arrangement assumes all Founders have fully earned their founder shares by the end of the vesting period, which isn’t a perfect assumption, but it’s far better than having no mechanism to deal with a premature Founder exit.
A key strategy for the capitalization table (“cap table”, aka share register) in the early days is to restrict the share structure to a single class of vanilla common shares at the pre-seed (love money) stage, and for as long as possible thereafter. There should be no premature indulgence in unnecessary classes of shares that are preferred, non-voting, or have a par value. VC’s want a clean and simple vanilla common share cap table under their preferred shares, and they will force a tech startup to jump through legal hoops and internal shareholder negotiations (read squabbles) to clean up a cap table mess as a pre-condition for VC financing. Founders who want to raise ongoing financing rounds must not frustrate future investors with a prematurely complicated share structure.
If a tech startup is ready for a >$5M Venture Capital (VC) Series A round, the deal will involve some variation of preferred share terms based on standard US National Venture Capital Association (NVCA) legal paperwork, because these widely accepted US preferred share terms also work in Canada, and similar legal paperwork facilitates cross-border tech deals. Canada is sometimes referred to (in a good way) as the “51st state” when it comes to US investors financing tech deals. This relatively recent easing of cross-border friction for US investors helps increase competition for Canadian tech investment opportunities, and that is an important factor in Canadian Founders getting a fairly valued exit for their hard work. The specifics of preferred share terms are influenced not only by the tech startup investment opportunity itself, but also by the latest VC preferred share deal trends, which fluctuate with general economic conditions and other factors. VC’s will tolerate a thoughtfully structured in-between stage of “Lite Preferred” shares which may be demanded by investors providing >$1M in financing at the Angel / Seed stage. These “Lite Preferred” share terms have to be carefully structured to avoid interfering with follow-on standard VC Preferred share terms for a >$5M investment.
Founders should be cautious about issuing fully vested shares or options to early contributors based on future expectations. Equity should always be considered long term compensation, and vest accordingly over a period of time – typically 3 or 4 years with a 1 year cliff (nothing vests until the first anniversary). There is a natural tension with tech startups in the early days, where cash is hard to come by and shares look cheap (the Founders typically paid little for their “sweat equity” shares). Ten years down the road, a successful tech startup will generate plenty of cash and the fair value per share will have increased dramatically. Many Founders have regretted premature option grants with below FMV strike prices that did not vest over a sufficiently long time period.
A related issue can occur when sophisticated Angel / Seed / VC investors require Founders, who have paid very little cash for their “sweat equity” shares, to carve out a portion (say 50% of Founder shares) into a restricted pool that vests over time starting with the new money investment. This is a way of ensuring the Founders retain “skin in the game” following an Angel / Seed / VC investment, without asking the Founders to come up with personal cash to purchase more shares at the same price accepted by the new investors. Sophisticated investors want the Founders highly motivated to stay lean and continue growing the business opportunity after they receive the investment proceeds (vs. the Founders abusing the new investor relationship by paying themselves a nice salary raise, not putting any Founder shares at risk, and letting the new investors take on the financial risk going forward). The new money wants the Founders to continue growing value for all shareholders, and get rewarded for doing so by “earning back” the vesting portion of their Founder shares over time.
Fork in the Road - VC "Elephant" Exit
VCs are only interested in Elephant and Unicorn hunting. A 10x return for VC investors who are buying 25% of your tech startup for $5M means you have a current pre-money valuation of $20M, a post-money valuation of $25M, and you have just signed up to deliver a $250M exit to satisfy your VC’s requirement for a 10x return in 7-10 years. Unicorns with a >$1B exit provide higher VC returns, though they also likely consumed more VC funding.
Not surprisingly, both Elephants and Unicorns are rare, but VCs are committed to a big win to the extent that they can be expected to use their “change in control” veto to sabotage an early “Moose-sized” exit opportunity that the Founders might otherwise be happy with. This can leave Founders with no option but to take on more VC money as they “swing for the fence”. In the process of targeting a bigger win, the VCs can cause the Founders to take on increased operational risk (eg. solve how to scale up production, or expand global distribution channels). “Swinging for the fence” with one or more >$5M VC financings involves a longer journey. During this longer journey, promising startups can fail for many reasons beyond their control, such as a well-financed competitor duplicating their best ideas, a new technology making their product / service obsolete, a shift in customer preferences, or the impact of a fresh global crisis (like a passenger jet flying into a New York skyscraper, the COVID pandemic, or an earthquake under San Francisco).
Founders must carefully consider their personal values and determine how well they align with VC values. Following the VC path often can mean accepting ongoing syndicated VC financing over time, which will cause control of the Board to gradually shift from the Founders to a VC controlled group. The CEO Founder may find themselves shifted to a lesser role within the company (not always easy on the ego), to make way for “professional management” chosen by the VC control group. In fairness, nobody has a monopoly on the full set of skills required to manage growth from tech startup inception to an Elephant exit, and open-minded Founders should recognize it can be in the best interests of all shareholders (including themselves) to ensure the CEO has the right skills and experience to manage the next stage of growth. In rare cases dynamic Founders (such as Steve Jobs or Bill Gates) learn quickly enough on the fly to demonstrate the personal skills needed to manage the next stage of development, so the interests of the VC control group and the Founders remain in alignment.
A natural source of tension between VC’s and Founders is the maturing of a VC Fund. Roughly 8-12 years after receiving funding from its institutional investors (pension funds, etc) a VC will be hungry for exit transactions which allow it to close out the fund. If the resulting investment track record is compelling, the VC will be able to attract institutional investors back to its next fund, and keep the cycle going for another 8-12 years. Founders with a longer-term perspective may not welcome Board pressure from VC’s to exit before the tech startup works the bugs out of its promising business model. On the other hand, a VC with a fresh new fund can be keen to get the money working, which makes it receptive to well-timed pitches from tech startups. A VC will also likely be more responsive after completing a Due Diligence exercise, and less responsive in the middle of it. Most VC’s only commit to a few investments each year after reviewing hundreds of pitches, so being sensitive to their availability can help. It is important for the Founder CEO to focus their limited time on developing relationships with senior management in the VC organization. Time spent with analyst level staff in the VC organization can mean the tech startup gets lost in a spreadsheet statistic, and never gets serious consideration.
Neither Elon Musk nor Bill Gates would have taken their respective turns at becoming the world’s richest human by following a bootstrap path, so if you’re heading for the moon, you’ll be wanting that VC grade rocket fuel to help put your “little dent in the universe”. Shortly after the champagne bubbles have died down following the celebration of a VC financed Series A round, the Founders will begin to feel a loss control, and new layers of complexity in Board reporting and Corporate Governance. There is a natural tension here. In theory, the Founders benefit from increased oversight by one or more new VC’s on their Board. VC’s can bring a fresh perspective to the management team, particularly in the areas of strategic thinking and a broad understanding of the tech startup landscape. In practice, it is not unusual to hear Founders grumble about poor VC led Board decisions that show a lack of operational understanding. It is not always clear which side is right when VC’s and Founders disagree, but it is clear the tech startup will suffer from internal conflict when it needs to focus all resources and energy on its competitive battle for survival in the real world.
When VC money is readily flowing into new tech startup deals, the valuation tide will be rising according to the reliable laws of supply (limited number of high quality tech startup investment opportunities) and demand (investors with available cash). Most VCs are motivated by FOMO (Fear of Missing Out) on the next big deal. Tech startup CEO’s should be watching for signs of a rising valuation tide and consider whether the timing is right to set their sights on a new financing, or perhaps even a full exit to a Strategic Investor. This is especially true if the startup is performing well against industry standard metrics, such as the B2B SaaS “Rule of 40” (which compares annual SaaS revenue growth% + EBITDA% against a minimum sustainability standard of 40%).
When seeking a VC financing, the Founder CEO should be doing their homework to make sure they are knocking on the right doors, but only after they have rehearsed with their pitch deck many times, and have battle tested it for critical questions from sophisticated “practice investors”. The VC fundraising process can take over 50% of a Founder CEO’s time for several weeks, so setting priorities, and successfully delegating less critical CEO tasks to subordinates, can become very important.
If a tech startup goes for VC funding and fails, they are still faced with meeting future payroll deadlines while the business may have suffered from a lack of CEO attention during the unsuccessful fundraising effort. The tech startup needed a realistic Plan B going into the financing effort if an anticipated VC financing goes off the rails before cash hits the tech startup’s bank account, sometimes for reasons beyond anyone’s control. A tech startup should never spend anticipated financing proceeds before the cash is in the bank.
Fork in the Road - Bootstrap "Moose" Exit
It is quite common for VC’s to present their investment selection criteria and filtering process to tech startup audiences at seminars and webinars. VC’s cast a wide net, seeking out the small fraction of tech startups with “baby elephant” potential. What is generally not made clear to the audiences at those seminars is that VC deals are not the only, or even the most common, path to exit success for a tech startup. In fact the VC path is relatively rare if you consider that ~1% of tech startup business plans submitted to a VC will survive through their filtering process to a Series A financing, and statistically most of those VC investments will fail before a successful exit.
The vast majority of successful tech startup exits (generating millions for Founders) occur without VC investment. There is a little-discussed fork in the road that Founders come to when deciding what they want their tech startup to become when it grows up. One option is a Founder controlled “boostrap Moose exit”, running lean in a focused search for early profitability, and eventually an M&A exit to a NASDAQ strategic acquiror.
Moose sized exits for Founder controlled tech startups can be enabled by an Investment Banker who “shops” the exit deal to targeted Strategic Investors (SI’s). The goal of an Investment Banker is to create a competitive bid situation. They are seeking NASDAQ companies searching for complimentary product / service innovation from a tech startup acquisition to sustain their revenue growth. A reasonable median value for a Moose sized tech startup exit is $20-$30M, but each negotiation is unique. Tech startups can exit from a bootstrap business model in any range from a “fire-sale IP” deal for $1M (where the tech startup’s search for a viable business has failed, but some valuable IP can still be sold for a bit of cash), to a huge Founder win at $80M+.
Aiming for a Moose sized bootstrap exit supported by a modest <$2M level of Angel / Seed financing to “prime the pump”, normally leaves the Founders in control and lets them stay focused on their core mission – which must always be innovative product /service delivery directed at creating great customer experiences. Success in a bootstrap is measured by both customer traction and progress towards profitability. With this disciplined customer focus, the Founders improve their odds of finding a path through the competitive landscape to early profitability. Profitability enables operating cashflow and bank financing, rather than dilutive equity financing. This path to tech startup success can provide comfortable multi-million dollar exits for Founders who execute well. In a Founder controlled bootstrapping model, the exit pie is smaller, but the Founders have a wider pie slice, so they can still end up with a big personal win.
Former Founders with a successful exit behind them often become local Angel investors, or launch their next tech startup as serial entrepreneurs. Any tech startup journey (even a failure) increases the valuable pool of experience the local tech sector can draw on. While most tech startups fail, not all tech startup failure is negative. Aspiring mountaineers aiming for a distant peak will not all make it on their first serious attempt, but they will all gain valuable experience.
Tech startup Founders can choose to manage a “lifestyle business” for years as long as they are nimble enough to keep their “window of opportunity” open. That is not guaranteed. Many large corporations with professional management and deep pockets have lost their way. Nortel failed to react quickly enough when improvements in the quality of VoIP packet switching rendered circuit switched telephone networks obsolete, and Kodak (and Polaroid) failed to respond adequately to instant digital pictures rendering their chemical film technology obsolete. In fact, most of 1972’s “Nifty-Fifty US large-cap set and forget” stocks no longer exist. A few (notably IBM, General Electric, Proctor & Gamble, J&J) have adapted, or have been lucky enough to be in more stable markets. Other huge brands (Sears, Xerox) have either passed or are limping along as shadows of their former 1972 selves. Long term stability is no easier for today’s tech startups, where the pace of change and disruptive technologies continually create new opportunities while eroding the market share of incumbents.
For a tech startup targeting a Moose-sized exit, long-term survival can involve several course corrections (if not a full pivot) from the original vision, influenced by emerging technologies, an evolving competitive landscape, and insights into product improvements that reduce customer pain. Each course correction involves risk – so it is a challenging journey to remain profitable in a “lifestyle business” while growing or at least maintaining revenue over many years. If tech Founders wanted a predictable long term profitable business, a few well located Tim Hortons franchise outlets would have been a better option (yawn).
Founders on the bootstrap path may have a lifestyle option to “exit early” after 3-5 years for a smaller / faster return (say 3x in 3 years) with lower risk. If the Founder's can't find a lean path to profitability on <$2M in Angel financing, and they aren’t a fit with a long-term VC "swing for the fence" commitment to an Elephant exit, then an early exit may be their best alternative. One advantage of an early exit is that Founders avoid the consequences of execution errors and unforeseen risks during the growth phase, where the devil is in operational details. Nothing is unsolvable, but managing infrastructure growth and scaling problems can be painful for a technical Founder who would rather tinker with technology, than fuss with supply chain logistics and impatient customers. Some specialized Investment Bankers (eg. Strategic Exits Partners in BC) have the experience to help with an early exit, as discussed in tsCFO.005.
SAFE (Simple Agreement for Future Equity)
In a typical situation, a tech startup leverages Founders, Friends & Family to finance a Minimum Viable Product (MVP) or service, and uses the resulting prototype to generate feedback from early adopter customers. At this point there may be enough positive signals in terms of product / service innovation and early adopter interest to attract Angel financing with priced common shares set within a classic $2-$4M valuation range. Progress beyond this stage gets harder for “thumb in the air” valuation metrics to cope with. When it starts small, a tech startup doubling in size is barely perceptible. When it becomes large, doubling in size looks dramatic.
Following the first common share priced Angel financing in the $2-$4M valuation range, proceeds are consumed by the next steps in R&D and S&M milestones, and generally everything takes longer than expected. In the absence of clear financial signals like revenue growth and profitability, it is very difficult for investors to value the incremental progress. This is an “in between” stage of financing where an extensive Due Diligence process by a sophisticated investor is the best way to set a new valuation from the last investment round. Angel / Seed investors are generally not motivated to go through an extensive Due Diligence exercise, either because they don’t have sufficient financial / legal / engineering / marketing experience to do a comprehensive job of evaluating a tech startup’s Data Room, or because they don’t have the time. In the absence of an updated valuation, Founders are reluctant to continuing to issue common shares at the last priced common share valuation, because if fails to recognize any milestone progress since that last common share valuation. How do Founder’s continue to attract ongoing Angel / Seed investment at a fair price without being roadblocked by this valuation hurdle?
There are two investment vehicles that allow new Angel / Seed shareholders to invest without fixing a current valuation. 1) SAFE’s (Simple Agreement for Future Equity) and 2) Convertible Debt (aka Convertible Note). They are close cousins – SAFE’s have been loosely described as “little more than Convertible Notes without the interest”, though that is an oversimplification. The key feature of both investment vehicles is that they enable current smaller “bridge” investments pegged to (or discounted from) a valuation set in the future by a large qualifying 3rd party equity financing involving a full Due Diligence exercise by a sophisticated investor.
The qualified 3rd party investor doing this Due Diligence valuation is typically a VC leading a Series A preferred share financing round of >$5M. Note that for this strategy to work, Angel / Seed investors are taking a leap of faith that the tech startup will make sufficient ongoing progress to attract a qualifying future 3rd party VC investment. To put this in context, all tech startup shareholders are taking a leap of faith that their investment will be worth more than nothing some day. It’s a high-risk environment where failure is more common than success, so SAFE investors aren’t really taking on much more risk than Angel investors buying common shares.
The SAFE investment vehicle came out of a Silicon Valley Accelerator called Y Combinator in late 2013 as an alternative to Convertible Debt. It has become popular in the US and Canada due to its simple legal structure and low transaction cost. SAFE investors push the valuation exercise into the future by accepting a discount on the valuation set by a future priced equity round of minimum size (generally a Series A preferred share round from a VC which involves a full-on Due Diligence exercise). Founders may have concerns about unexpected dilution / premature erosion of voting control from SAFE investments, especially if there are stacked SAFE investment rounds required before the tech startup is sufficiently mature to attract the anticipated VC Series A preferred shared financing that fixes the pre-money valuation and resulting share price. Multiple stacked SAFE investment rounds can cause complicated circular share discount calculations – so while the legal language in a SAFE is simple, the math behind it might become a headache.
With no shares being issued at the time of a SAFE investment, it is effectively an unsecured and unpriced equity investment waiting for a future conversion to shares. If the tech startup is not able to close a qualifying 3rd party priced financing round before the SAFE expiry date (eg. within 3yrs of the SAFE investment), the SAFE will sometimes convert to common shares at a deeply discounted price to the last common share financing round. From a GAAP (Generally Accepted Accounting Principles) perspective, SAFE and Convertible Debt investments are both treated as quasi-equity.
Since March 2019, BC residents making SAFE investments may be eligible for a 30% EBC tax credit if the tech startup successfully applies for an EBC allocation. This generous incentive refunds 30% of a qualifying Angel / Seed investment (either SAFE or share purchase) in a BC tech startup. The EBC tax credit is claimed when filing a personal T1 tax return for the year of the tech startup investment. SAFE investments qualifying for the 30% EBC tax credit still have to be held for a minimum of 5 years, or the 30% tax credit can be clawed back by the BC government. There is some wiggle room for a tech startup to negotiate with the BC government on behalf of its EBC shareholders in some circumstances. For example, if the tech startup goes bankrupt within the 5 year EBC hold period, and the shareholder has a complete write-off of their investment, in the past the BC government has agreed to waive repayment of the 30% tax credit. In another example, if the tech startup has an exit close to the minimum 5 year hold period, the BC government may agree to claw back only a portion of the 30% tax credit it paid out.
Several other provinces have their own version of Labour Sponsored Investment Funds (LSIFs) that work in a similar manner to BC’s 30% EBC tax credit program. A quick Google search will reveal their provincial rules around SAFE investments qualifying for a tax credit. US resident SAFE investors may benefit from a US federal Qualified Small Business Stock tax exemption from the IRS that applies as long as the SAFE investment converts to shares within a specified time limit.
Here is the English version of how a SAFE works: SAFE investors negotiate for a low valuation cap, which puts a ceiling price per share on their SAFE conversion. If the tech startup achieves a strong valuation at the future priced equity round (typically a Series A financing), SAFE investors convert at that low ceiling price – giving them upside for contributing early to a tech startup that blossomed into an attractive investment opportunity for a successful priced VC financing round. If the tech startup ends up struggling, SAFE investors convert at a negotiated discount (typically 10-20%) below the future priced equity round.
Here is a representation of the concise (but demonically confusing) legal language in an actual SAFE agreement: this SAFE investment converts at the LOWER of a 10-20% discount to the next qualifying priced round, or the capped per share price (= valuation cap / issued shares).
If the tech startup struggles following a SAFE1 investment, the negotiated valuation cap can be lowered for follow-on SAFE2 and SAFE3 financing rounds. The lower valuation cap can be retroactively applied to the SAFE1 round as well, setting up complex circular calculations of 10-20% conversion discounts to the next qualifying priced round. If that logic makes your head spin, you are starting to understand. The unanticipated Founder dilution from these kind of calculations are a risk in taking the SAFE route, vs. the Convertible Debt alternative.
Convertible Debt
Convertible Debt (aka Convertible Note) has many characteristics in common with a SAFE investment. It lets a tech startup raise Angel money without a detailed Due Diligence (DD) exercise required to set a priced equity financing. Convertible Debt involves a more complex legal agreement than a SAFE. In addition to an accrued interest component, it provides more conversion options for both sides.
Convertible Debt terms can include:
1) Accrued interest - (say 6-12%) from the investment date added to the investment principal up to the conversion date or repayment date
2) Maturity date - typically 18-36 months after the investment date (by which time a future priced equity round is anticipated)
3) Optional Conversion Discount / Valuation Cap – set in anticipation of a future priced equity round, similar to the mechanism discussed for the SAFE conversion above which sets a ceiling price per share if the tech startup valuation does well, and a 10-20% discount to the negotiated financing round if they are struggling more than anticipated. To keep the math simple and avoid circular calculation logic from multiple investment rounds, Convertible Debt may be structured to convert to shares at a fixed discount to a future priced equity round (no valuation cap option offered).
4) Exit Option1 – a key difference between Convertible Debt and a SAFE, is that Convertible Debt investors can often demand their money back if the Convertible Debt matures (typically in 18-36 months) without a priced future priced equity round in place.
5) Exit Option2 – from the tech startup perspective, closing a priced future equity round on or before the maturity date forces the conversion of Debt into shares.
6) Exit Option3 - the tech startup may have a right to repay the debt plus accrued interest to the investor, with no conversion to shares. Normally the tech startup desperately needs cash to fuel growth, so this would be an unexpected outcome for both parties.
7) Warrants - Convertible Debt holders can be motivated to voluntarily convert to shares before a priced future equity round with a warrant incentive, which (just like employee options) gives the warrant holder a right to purchase shares at a fixed strike price up to a warrant expiry date.
Convertible Debt investors are unsecured creditors at risk of losing all their money. This may sound dramatic to the ears of a bank loan officer with low risk tolerance, but Convertible Debt is really quasi-equity. SAFE and Convertible Debt holders expect the higher risks (and potential higher rewards) borne by other tech startup investors. There is no BC EBC 30% tax credit for Convertible Debt investors until the debt is converted into shares, but it is possible for BC residents to qualify for the EBC 30% tax credit at the time of conversion. This delay in eligibility for the 30% EBC tax credit implies additional risk for BC resident investors. There is no guarantee the EBC 30% tax credit program will still be available when the future share conversion occurs, the EBC criteria may arbitrarily change making the tech startup ineligible, or the government’s EBC allocation limit for the year may be used up before the tech startup submits its EBC application.
Generally Accepted Accounting Principles (GAAP) require Convertible Debt to be treated as equity for accounting purposes.
Lite Preferred Shares
Once a tech startup is well past the Minimum Viable Product (MVP) stage working towards a whole product solution, and is beginning to scale customer revenue in a meaningful way, they can attract a larger 3rd party (in it for the money) Angel / Seed financing of $1-$2M. With the larger amount raised, the Angel / Seed group may have enough leverage to negotiate “Lite Preferred” share terms (a step above vanilla common shares). This can be on a lower risk path to a Moose-sized exit, assuming the tech startup can demonstrate revenue growth and sustained profitability with little or no further investment.
VCs participating in a "Lite Preferred" Seed round are anticipating the next financing step will be a conventional VC >$5M Series A Preferred Share investment, with standard “full on” VC preferred share terms.
A "Light Preferred" round is only possible if a sophisticated lead Angel / Seed / VC investor goes through a Due Diligence exercise and negotiates a valuation that sets the “Lite Preferred” share price. Determining which conventional Series A preferred share terms get removed in a “Lite Preferred” share negotiation is part of the process. This negotiation is generally influenced by the latest deal terms trending in the current investment climate. Founders are well advised to have an experienced tech startup lawyer with “deal flow” exposure helping to defend their negotiating position.
Conclusion
Founders logically focus on product / service development in the early days, followed by customer feedback from beta testing, followed by more iterations of product / service development. Tech startups know they’re on the right track for Product Market Fit (PMF) when new customers start being referred by existing customers. While juggling between the development of innovative products / services and finding cost effective distribution channels to “cross the chasm” (from tolerant early adopter customers into fussy mainstream markets), Founders must also support their tech startup with balanced investments in a Financial and Administrative foundation that supports the tech startup’s journey.
Sources of financing evolve as the tech startup matures, and the efforts required to raise the financing also increase over time. This follows a consistent pattern for a tech startup, where simple processes evolve to become increasingly complex with growth and maturity.
Preparing for a financing beyond the early “Friends, Family and Founder” stage involves investing in a Financial and Administration foundation though a deep scrub of IP, legal, financial, tax, supplier, employee, contractor, and customer documentation, which is organized in a Virtual Data room. It means strategic plans for Product Market Fit (PMF) / Go To Market (GTM) and the Product Roadmap have been worked out, with those costs and the anticipated revenue growth reflected in a detailed 3year forecast model which will then calculate the amount of financing required. The more money raised, the deeper the due diligence exercise by the investor, and the higher the expectations for the virtual Data Room. Founders can minimize their effort through attention to detail, and taking the time to “get it right the first time”. For example all legal documents in the Data Room should be followed-up until fully executed. Missing signatures can become a source of future grief. It is the responsibility of the Founder CEO to manage the financing process, ensure they have sufficient cashflow runway at all times, and seek cost-effective support in areas where the tech startup has organizational holes.
Venture Capitalists (VC’s) cast a wide net in their search for baby elephants. Their business model rejects tech startups that don’t have the potential for spectacular “Elephant exit” home runs. If your tech startup qualifies as a “baby Elephant” and the Founders are bursting with enthusiasm to change the world, you should pursue a Series A >$5M preferred share financing. Keep in mind that a 10x return for VC investors who are buying 25% of your tech startup for $5M means you have a current pre-money valuation of $20M, a post-money valuation of $25M, and you have just signed up to deliver a $250M exit to satisfy your VC’s targeted 10x return in 7-10 years.
Most tech startups that generate successful exits for their Founders don’t fit the >$250M exit “home run” Elephant profile that VC’s require. Most tech startup exit wins result from triples and doubles, which are easier to hit (and have lower strike-out risk) than home runs. These smaller exit opportunities (either fully bootstrapped, or with limited Angel / Seed level financing up to $2M) swim through gaps in the VC net. You won’t find much discussion of them in VC sponsored “baby elephant hunting” presentations at tech seminars. I call these smaller exits “Moose sized” to give the reader a sense that, while smaller than an Elephant, there is still a lot of meat on the bones – especially if there are fewer seats around the table. Smaller exits range widely in size, starting at a $1M “IP fire-sale” loss exit for a tech startup that has lost its struggle for a viable business model, but still has some valuable Intellectual Property to sell. On the higher end, stunningly successful tech startup exits of $80M+ are possible without VC funding. In an extreme case, the $800M exit for PlentyofFish Founder Markus Frind in 2015 remains Vancouver’s poster child for how well a tech startup can do from a bootstrap business model (no VC investor involved). Kelowna based Club Penguin’s $350M exit to Disney in 2007 is another example of a massively successful bootstrap (no VC investor involved).
Founders can choose to continue a profitable tech startup operation as a lifestyle business as long as they remain nimble enough to course correct, so their Product-Market-Fit (PMF) window of opportunity remains open. They can also choose to steer towards a financial exit, which can set the stage for a serial entrepreneur Founder to launch their next tech startup after some deep thinking on a sunny beach.
The natural purchaser of a tech startup is a Strategic Investor (SI), which is normally a large US NASDAQ company which can leverage its existing sales distribution channel to dramatically grow revenue using the tech startup’s innovative product / service. Large tech companies are often forced into M&A activity to ensure their long-term survival, because their internal politics and budget processes limit the effectiveness of new product innovation developed in-house. Most big tech companies are good at incremental product innovation, but few are capable of truly innovative leaps. Steve Jobs was able to establish a remarkable pace of new product innovation during his tenure at Apple, but he was an extraordinary leader. Legacy sources of big tech revenue tend to fall prey to declining product life cycles as innovative new products emerge. That didn’t seem likely to the makers of Palm Pilot and Blackberry back in the day, but their once dominant market share positions crumbled. Surprisingly, IBM with its “big iron” mainframe computer dominance in the 1980’s did manage a dramatic pivot to becoming a leading provider of enterprise information services, which demonstrates that the largest ships can still change course over time with a rare combination of self-awareness and inspired leadership.
Founders of tech startups can get the same or better personal financial returns from a “Moose sized bootstrap” exit, because there are less investors sharing the exit pie. A bootstrap business model allows Founders to stay in control of the Board. If forces a discipline on Founders to listen carefully to what customers are willing to pay for, as they struggle for an early path to positive cashflow.
Tech startups should issue priced vanilla common shares to Friends, Family and early Angel investors for as long as possible to keep their cap table clean and simple, which is what VC’s will demand as a precondition to investing. Angel / Seed investors approaching the $1-$2M range may have enough leverage to negotiate “Lite Preferred” share terms, which are a normally a modest subset of standard VC Series A preferred share terms. VC’s will tolerate this simple layer of complexity in the cap table if it is done properly. At the Angel / Seed investment stage, Founders may still have a “fork in the road” choice between a “Moose sized bootstrap” exit where they retain control and drive towards early profitability; or choose a higher-risk “Elephant sized” revenue growth path leveraging one or more >$5M VC Series A Preferred share rounds. Sometimes the nature of the tech startup’s product / service innovation can’t support a bootstrap business model. For example, tech startups leaning heavily on IP (eg. university spin-off biotechs and advanced materials) will likely have a long R&D milestone journey prior to revenue, and naturally fit on a VC “Elephant exit” investment path. B2B SaaS companies can have a relatively shorter path to profitability, which gives those Founders a choice.
Full on Series A preferred share terms are generally based on tech industry standard US legal templates also adopted in Canada to facilitate cross-border investment. If the Founders are committed to a >$5M VC Series A financing, there are two “in-between” investment vehicles that can bridge the “uncertain valuation gap” between priced vanilla common shares and a future priced Series A preferred share round. These “in-between” quasi-equity investment vehicles are called SAFEs (Simple Agreement for Future Equity) and Convertible Debt. They both delay conversion of a quasi-equity investment into shares until a sophisticated investor does the Due Diligence exercise required to set a valuation for a qualifying future Preferred Share Series A financing. SAFE agreements have simple legal wording (a good thing), and can allow BC resident investors to qualify for a 30% EBC tax credit. On the negative side, SAFEs can dilute the Founders unpredictably if there are multiple SAFE rounds required before a Preferred share financing. Convertible Debt has a nominal interest rate kicker for the investor, and provides a simpler yet more flexible path for debt conversion, but it involves more complicated legal paperwork, and can’t qualify for the BC EBC 30% tax credit until the future share conversion takes place.
Multiple >$5M financing rounds will leave VC syndicates with Board control. One likely outcome is that the Founder CEO will be replaced by a VC chosen “professional management” candidate. The Founder CEO is well advised to swallow a little humble pie, and find a lower executive position within the organization where they can best leverage their skills, and perhaps regain a bit of lifestyle. Not all bad.
Raising a tech startup financing is a complex area with a lot of moving parts. The Founder CEO is responsible for managing the financing process to ensure sufficient cashflow runway is maintained for all contingencies. Where they lack Financial skills and experience, the Founder CEO should engage hourly paid tech startup experts to cover organizational holes. In the early years of a tech startup, this can involve the cost-effective use of Mentors / Advisors (like a serial tech startup entrepreneur), and Consultants / Contractors (like a Fractional CFO). Legal and accounting firms specializing in tech startups also play a supporting role in filling gaps, but their high hourly rates (unavoidable due to overhead), and lack of direct tech startup operating experience limit their contributions to niche professional areas. It is a mistake to assume a professional accounting firm can provide a temporary hourly resource to cover off the full range of operational tech startup responsibilities a Fractional CFO deals with.
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