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Certainty in Deal Structuring
Thank goodness people know the “correct ways” to structure early-stage investments. Just in our feed today we’ve enjoyed:You have got to be kidding me with participating preferred. Who else has seen it recently? This makes me really angry.There is a special place in VC hell for VCs who demand board seats at pre-seed. Founders, they do not need this.It’s great how confident (some) people are in an asset class filled with such uncertainty and complexity! Perhaps participating preferred equity is abhorrent; or perhaps this is one deal term among many in the overall structuring of an early stage investment – a voluntary deal made by consenting adults – with advantages and disadvantages in different scenarios? Incidentally, between 5% and 20% of early stage (Seed and Series A) deals have some kind of participating preferred (full or capped) right, according to CooleyGo Trends data (the blue lines in the second chart at that link). Perhaps board seats for pre-seed investments ought to condemn you to eternal damnation; or perhaps they are one deal term among many in the overall structuring of an early stage investment – a voluntary deal made by consenting adults – with advantages and disadvantages in different scenarios? Historically, angels (≈ pre-seed investors) have been criticized for not taking board seats as often as later-stage VCs. But perhaps a balanced board is the best way to help investors get good returns while also helping entrepreneurs be successful? The data in Are Angels Different? certainly suggests so.We get it, some VCs drive monetization from Twitter/X and LinkedIn publicity, and others enjoy signaling their virtue to win deals. But if you’re looking to raise capital, or structuring early stage investments yourself, please look beyond the clickbait and anger and consider the merits, issues, and areas for negotiation when navigating the complex world of early stage investing.
October 30, 2023
Venture south fallback
Are startups founders automatically “accredited investors”?
We have debated on the Venture In The South podcast whether startup founders are “accredited investors.”My answer, which might surprise you, is “probably.” Here are some ways founders could be. Number three will shock you, as all good clickbait says.First, obviously if a founder meets one of the “regular” accreditation criteria – net worth, annual income, or holding a Series 7, 65, or 82 license, as outlined by the SEC – the founder is accredited like anyone else.Second, for your own company or investment fund, you are accredited. The SEC says that “Directors, executive officers, or general partners (GP) of the company selling the securities (or of a GP of that company)” are accredited. So, if you are a director or the CEO (or other executive officer) of the company, you are accredited and therefore can buy shares in your own company.That matters for several reasons. One overlooked reason in South Carolina is that your investment could be eligible for the South Carolina Angel Investor Tax Credit. Invest $10,000 in your own startup? If you did it correctly, you might be able to get $3,500 back in a state income tax credit. Follow the rules here. Few people know this.Similarly, for investments in a private fund, “knowledgeable employees” of the fund (even if you are not part of the GP) are accredited. You are “knowledgeable” if, in connection with your regular duties, you participate in the investment activities of the fund, and have (at your company or a similar prior one) for at least a year. So, for example, our head of diligence, Molly Vinkler, and head of portfolio management Alex Biermann, would be “knowledgeable” because they are actively involved in diligence and deal execution. (They also know a lot, of course, but that’s irrelevant here!)This only applies to your company (or fund) – not to others. And it doesn’t apply to regular employees – only to the most senior members of the management team (or general partner), not to everyone.Not accredited yet? There’s a third possible approach. This may come as a surprise but there is a decent chance a founder that has already raised capital is accredited. How? Equity in privately-held companies counts towards the net worth definition in the first section above, because equity is an asset (like cash in your bank account or your car).If you raised even a modest equity round, the implied value of your shares could be enough to make you accredited. Take this example. The CEO and CTO of this company created the company at a 75/25 split, and then raised a $1M pre-seed round at a $3M pre-money valuation. Here’s the math:$1M on $3M pre-money valuation sells 25% of the company. That left the CEO with 56.3% and the CTO with 18.8% of the company worth a $4M post-money valuation.The value of the CEO’s stake is therefore $2.25M and the CTO’s stake is now $750K. Ignoring all their other assets and liabilities – and assuming all these shares are vested – the CEO is accredited on this alone. The CTO is not.Obviously your company’s details and cap tables are different. Convertible notes and SAFEs don’t count; unvested shares don’t count; and different classes of shares have different fair market values. (If our CEO held common stock and investors held preferred stock, the CEO might instead rely on an independent appraisal to determine the fair market value of the common stock – something that most companies already do in connection with their incentive stock option plans and is called a 409A valuation.But hopefully you see there’s a chance the CEO is accredited – for all companies, not just the CEO’s own.Of course, that doesn’t change that early stage investing is risky, and even if you are accredited it is not a great idea to invest money you can’t afford to lose. All the usual warnings (risky, illiquid, diversification required, etc.) apply.Lastly, if the Equal Opportunities for All Investors Act of 2023 becomes law, anyone – including founders – capable of passing the test would be accredited. Hopefully more to come on that! 
August 31, 2023
Venture south fallback
What is an accredited investor?
If you have ever considered making investments outside of public markets (like stocks and bonds) in alternative investments (like private equity, real estate, startups), you may have been asked if you are an “accredited investor.” What is an accredited investor and why does it matter? An accredited investor is someone who the federal government deems capable of taking on the risks associated with private investments. Therefore, companies and institutions raising capital outside the public markets focus on accredited investors. While issuers of publicly traded stocks and bonds are subject to strict regulations requiring detailed reporting and disclosures, private issuers typically seek exemption from those expensive reporting requirements. One of the ways they can be exempt from the disclosure requirements is by selling only to accredited investors. How do I know if I’m an accredited investor? The Securities and Exchange Commission is responsible for setting the accredited investor definition, which we’ve outlined below. An (individual) accredited investor is:Any natural person whose individual net worth, or joint net worth with that person's spouse or spousal equivalent, exceeds $1,000,000 (excluding the equity in the person’s primary residence).Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse or spousal equivalent in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.Any natural person holding in good standing one or more professional certifications or designations or credentials from an accredited educational institution that the Commission has designated as qualifying an individual for accredited investor status. The initial qualifying credentials are for a natural person who holds, in good standing, the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), or the Investment Adviser Representative license (Series 65).In most cases, if you meet the criteria listed above, you can usually self-attest as to your accreditation when completing an investment. However, if you are participating in an equity crowdfunding campaign in which the offering relied on “general solicitation” (meaning it was advertised to the public), you will be required to document and verify your accreditation status. In addition to the qualifications listed above, other “institutional” investors can be accredited – entities like broker dealers, investment companies, RBICs, pension plans, trusts with over $5M in assets, family offices, etc.Also, you are considered accredited for your own business if you are the owner/operator, or if you are the General Partner or a “knowledgeable employee” of your own investment fund. One last note. Even if you are accredited, please remember that investing in alternative assets like startups is highly risky, and you should never invest money that you can’t afford to lose. While the potential returns of a diversified, well-vetted basket of early-stage investments can be quite attractive, the odds of generating a positive return on any individual investment are less than 50%.
February 1, 2023
Venture south fallback
A convertible note learning lesson
From our earlier blog post on convertible notes, you can probably tell that we are not big fans of them, though we concede that as a “bridge” to an imminent “event” (like a new round of financing, or an exit) they are a useful financing tool. (AVC agrees.) VentureSouth members have made several angel investments in this kind of bridge note, including several lucrative “bridges to exit” – one being our investment with our best IRR, over 2800%. Recently, though, we learned a tough lesson about converting convertible notes that we might be instructive to share. It's a complicated one, but we think worth the effort to understand.Compare these two different “change of control” terms:In the event of a Change of Control…the outstanding principal [and interest]… of this Note…plus a premium equal to 10% of the outstanding principal amount of this Note, shall be due and payable upon the closing of such Change of Control.In the event [of]…a Change of Control…then the Balance shall, immediately prior to or contemporaneous with the Change of Control, automatically convert into the number of shares of Common Stock at the time of conversion equal to the quotient obtained by dividing the Balance on the conversion date by…ninety percent (90%) of the price per each Outstanding Equity Security at which each Outstanding Equity Security is valued for purposes of the Change of Control transaction….Modeling these terms, you would get to the same result in either method – a roughly 10% gain for the lender. Most of the time – but not all. Why? In the first scenario, the noteholder never becomes an equity holder. They remain at the top of the “waterfall,” and get their $1 and 10c return without worrying about what happens further down the waterfall. In the second, the noteholder turns into an equity holder, and so loses its place at the top of the waterfall. The “bad stuff” that can happen down a waterfall can therefore happen to them too, which can impact that return. What is the bad stuff? Firstly, the costs associated with the transaction. Let’s say the headline price of the share purchase was $1 per share. Therefore the noteholders convert at a 10% discount, so 90c / share, and would expect to receive the $1 per share in proceeds. Right? Unfortunately, not quite. Transaction fees – like paying investment bankers, attorneys, “banking agents” (our new least-favorite type of transaction expense), and wire fees – plus a near-unending list of other adjustments mean the actual proceeds would be less than the expected $1. Those fees, generally, are irritating (and permanent) but small. But often a transaction includes an “escrow”, where a portion of the proceeds are set aside in an account monitored by an independent third party. If something the seller said turns out to be untrue, those funds can be claimed by the buyer. The bad news here? The converting noteholder’s returns can get caught in that escrow. They might therefore not receive the expected $1 in full for some time. This escrow impact is especially upsetting in this scenario because of math. The 10% of the proceeds put into escrow is larger than the 10% gain we were expecting – so we didn’t even get 100% of our investment back at the closing here! With some figures, let’s say: I invested $1My 10% gain means 10c of gain and total gross proceeds of $1.1010% of the proceeds going into escrow is 10% of $1.10 = 11c into escrowMy net return at closing is therefore $1.10-11c = 99c Gain so far = MINUS 1c ☹We would expect to get those 11c when the escrow period is over – but that could be months later, which isn’t quite such a great rate of return… Were we foolish to invest on a note with the second mechanism? Managing to lose money (so far) on an investment specifically designed to bridge to the exit that actually occurred suggests that…yes. On the other hand, there were process reasons to do it. A silver lining, though, is that in the first scenario the “upside” is limited to 10%. By converting to equity, you share in upside potential. Perhaps enough unexpected “good things” happen before the final payouts are complete – like good operational performance after exit triggering a substantial earnout payment – to make the short-term pain worth the long-term gain? Fingers crossed. Still, the biggest lesson here? Even when you (usually) know what you’re doing, angel investing is hard. This is not a mistake we will make again, and hopefully now you won’t either.  
August 17, 2022