it’s just money: private investing basics craig mccrohon 1 it ’ s just money: legal tips on...

It’s Just Money: Private Investing BasicsCraig McCrohon

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It’s Just Money:Legal Tips on Private Investing

Craig McCrohonBurke [email protected]


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Craig McCrohon specializes in mergers and acquisitions and securities law, including acquisitions and financing transactions in Europe and Asia.

He graduated from Harvard University and received his JD/MBA degrees from the Wharton School of Business and the University of Pennsylvania Law School. As a graduate student, he studied law and economics at the London School of Economics. Prior to entering private practice, he worked with the legal staff of the United States Senate Committee on Banking, Housing, and Urban Affairs.

Speaker Background


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Angel Versus Venture Investing


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The Financing Pyramid

Venture Capital

Strategic Investors

Passive Angels

Active Angels

Family and Friends


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Aligning Objectives – Company and Investor

Be Creative

Make a Living

Change the World/Make a Fortune

Parents

Anon. Investors/

No Investors

Angel

Venture Capital


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Who Is the Personal Private Investor?


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The Angel

Angel Solo Casual review What, me worry My eyes only Take my time No punishment Recreational No steady source of deals Socializing


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Angel Investors – Tight Local Networks


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Typical Private Investment


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Angel Investment Account

$75,000 - $150,000 per investment (initial investment plus one add on)

At least five investments (total $375,000 - $750,000) No more than 10% of liquid portfolio to angel

investments Therefore, need liquid portfolio of at least $3.75 to $7

million Anything less than that, talk with family and friends

(one $25,000 investment requires liquid assets of only $250,000)

Who are the other investors? Do they have a collective liquid net worth of ten times the

amount required


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Angel Investments Are Small


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Institutional Venture Capital


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The VC

VC Staff Intense due diligence Pressure to deliver returns – huge markets, cutting

edge technology, big spending (“go big or go home”) Embarrassment if fail Fiduciary duty 5-7 year exit strategy Fees through investments More micro-managing

Strategy Hiring Compensation and company structure


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Impact of Private Investors versus Institutions


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Total Investments – Angels versus Venture Capital


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Angels as the Source of Start-Up Funding


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Economics of Personal Versus Institutional Investments


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VC Versus Management Returns - Theory

Return to VC

Return to Founder

Time

Money

Super return to VCGood/excellent return to mgt


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Risk-Adjusted VC/Management Returns

Return to VC

Return to Founder

Time

Money

OK return to VCPoor return to Mgt.


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VC Investors BAD for Angels


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Angel Versus Management Returns - Theory

Return to Angel/Strategic

Return to Founder

Time

Money

Good return to AngelGood return to Mgt.


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Investment Size – Personal Versus Institutional


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Angel versus the VC

<$

25

0

$2

50

-50

0

$5

00

-10

00

>$

10

00

% Angels% VC0

10203040506070

% of Invest.

Size of Total Investment

Angels vs. VCs


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Angel Money and Start-Up Milestones

High Fixed Costs (biotech)

Medium Fixed Costs (software)

Low Fixed Costs (services)

VCs ($7,000,000 or more)

Angel/VC ($500,000 - $3,000,000)

Angels – Less than $500,000


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Private/Angel Investment Trends


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The State of Illinois Early-Stage Investing


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VCs Follow Their Own Drummer


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Recession and Private Investing


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Recession and Angel Investing

Deals completed 2004-2007 often over-valued Current deals valued for strong returns In 2009, average deal size down by 31% (Center for

Venture Research) 30%-50% decline in deals (Center for Venture

Research) SBA loans declined, hence less liquidity Fewer IPOs, mergers Like illiquid housing market – BUT small companies

need far more cash than a house


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First Round Investments Suffered Most in this Recession


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IPOs Note as Much of an Option


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Money Invested versus Capital Raised


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Who Gets the Money


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Where the Money Going


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Investments by Industry


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Money Bias for Technology


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Angel Investment Styles


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Angel versus Institutional Due Diligence


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Returns and Industry Expertise of Investors


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VC and Angel Performance


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Angel Returns More Often Negative – Survivor Bias?


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Dollars versus the Number of Investments


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VC Returns


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VC Returns over Time


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Comparative Returns – Survivor Bias in VC Investments?


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Investment Fundamentals


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The Investment Options

Return

Safety

Common Stock

Weak Preferred

Subordinated Debt

Secured Debt

Strong Preferred

Common Stock w/ Sh agmt


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Choice of Entity: Skydiving or Bungee Jumping

Limited Liability Company Corporation Limited Partnership Issues:

o What laws protect investors the mosto Delaware versus Illinoiso Pass-through tax matters


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Exits and Returns

NACV 2010 Yearbook


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Legal Solutions to Investor Problems


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Managing the Initial Investor Group


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Negotiations Difficult, Other Side Demanding

Problem: The parties stake out positions that are unreasonable

Solution: For the investor:

▪ Only provide limited amounts through convertible notes▪ For a liquidity crisis to bring the other side to a reasonable position

For the company:▪ Develop a low-cash burn model if the money is not quickly

forthcoming▪ Aggressively seek alternative investors▪ Seek alternatives to financing altogether


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Crowd Control – Too Many Investors

Problem: too many investors o Divergent investment horizonso Divergent risk toleranceso Divergent investment portfolios


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The Money Pit

Problem – “Willy the One-Check Investor”o Expect several rounds from investors

Solution:o Choose investors for the long-run, not those who will

simply fill-out the roundo Modest valuations to minimize down-roundso Put rightso Punitive dilution of non-contributing investorso For the investor:

▪ Anti-dilution protection▪ Rights to block taking on more investment


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Sloppy Securities Offerings Problem:

o Violations of Federal or State securities laws permits cranky shareholders to demand more than their fair share of the proceeds

o Director and officer liability for breaches of securities laws Solution:

o Limit only to accredited investors (see slide regarding definition of accredited investor)

o Eliminate offerings in states with only one or two minor investors

o Require broad disclosureo Limit correspondence to potential investorso Track mailing of offering materials – Number and password

protecto Remember federal and state filings


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Controlling Management


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Difficult Management

Problems identified by Steve Kaplan, University of Chicago

Distracted and uninterested Private non-monetary benefits Indulging in perks Threaten to leave the project (that is, liquidate the

company)


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Manage the Managers

Problem: o Governance does not align the interests of the management

as an employee with those of the shareholders as investorso Managers invest TOO MUCH of their net worth


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Solution to Control Management/Freedom from Investors

For the manager: Employment agreement to provide protection Clear goals Termination only with the approval of a supermajority Severance provisions for termination without cause

o For the investor: Restricted stock or option plan, with vesting schedule Broad definition of cause Salary subject to approval Reporting to the board of directors Founders stock agreement-vesting schedules and share

buybacks Tie vesting with employment and compliance with non-

competition (repurchase at a punitively low price)


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The Silent Majority – Giving Controlling Investors a Voice Problem:

o Investors lack controlling representation on the board of directors or board of managers

o Management lacks oversight from an active board

Solution:o Classes of directors with veto rightso Information rights for directorso Majority of directorso Supermajorities for voteso Significant actions requiring director approvalo Independent directors often vote with investors

Winston Churchill: "the only thing worse than having allies is not having them"


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Management Bristling at Micro-managing

Problem: Management needs guidance, but the entrepreneurial mindset

is awful for micro-managing Solution:

Use general performance and compensation guides▪ Equity vesting▪ General bonus programs▪ Right of the board to terminate the CEO

Avoid:▪ Specific performance hurdles▪ Detailed reporting requirements common in VC deals


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Controlling the Clock – Getting the Investment Back


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Investors Check In, But They Can’t Check Out

Problem: Company receives cash with no timeline for returning funds to the investors

Solution:o Forced Dividends

▪ Cumulative▪ Specific Rates▪ Preference before payments to others▪ Preference before expenditures

o Mandatory Repurchase on Specified Dateo Put Right for Investors

▪ Partial or complete purchase by the company

o Include in the Articles of Incorporation, Investors Rights Agreement, Limited Liability Company Agreement


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Controlling the Clock

Problem: Investors cannot control the timing of the sale of the company,

IPO or cashing out of investors Solutions:

Investor control to demand IPO (registration rights) Staged investments (refusal to provide is an effective forced

liquidation) Vesting schedule for founders shares Investor right to compel sale of the company


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Getting Out First – Understanding Liquidation Preferences


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Liquidation Preference Basics

Not percentage of the company, but percentage of the company AFTER paying others

First, measure the preferences of the others Double dipping Cumulative dividends

Second, estimate terminal value (such as sales price of the company)

Third, estimate time of sale of company (i.e. liquidation)

Third, measure the proportionate share after preferred parties paid


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Without Anti-dilution, New Investment Crushes Early Investors

% Ownership

New Rounds


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Liquidation Example

Assume: 50% share, $10 million initial value, $50 million end value

Other 50% owners receive 2x investment (initially, $5 million) (participating preferred), 10% cumulative dividends, 5 years to liquidation

Therefore, junior investor receives $50 million - (($5 million x 2) + ($5 million x 1.1^5 (i.e. 1.6)) x .5 OR

.5 x ($50 million – ($10 million + $3.05 million)) OR $13.5 million (NOT $25 million!) If only $20 million sale, then junior holder only

receives $3.5 million, even though in the aggregate a 15% return!)

NOTE: Valuation of preferred should differ from common


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Valuation Problems


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Keeping Icarus Away from the Sun – Realistic Company Valuations Problem: unrealistic valuations Solution:

o Accurate valuations – for IP-oriented companies:▪ NOT liquidation value▪ NOT NPV of expected earnings▪ Market comparables▪ Real Option Method for intellectual property

(assets value, exercise price, time, volatility, risk-free rate, dividends)▪ Strategic value, versus cash-flow value▪ Relief from royalty rates▪ Replacement or Reproduction cost (see milestone analysis above)

o Accurate valuations – real propertyo Accurate valuations – mature businesseso Accurate valuations – retail, small high-risk businesseso No easy valuation – THEN DISCOUNT (the VC 50% discount

approach)


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Risks in Valuation of IP

Superior patent issues Patent declared invalid License/distribution agreement invalid Infringement suits Defective IP agreements:

Inventions assignment Non-disclosures Rights to develop the property

Analogies for retail: Store opens across the street Lose franchise Manager competes across the street


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Convertible Note – Swiss Army Knife of Investments

Problem: Parties cannot agree on a value Parties cannot agree on likely future VC or other financing

events, including the timing Solution:

Shift from equity to debt-like structure Use a convertible promissory note:

▪ Conversion price: • Same price of the next round• Discount from price of the next round• Minimum size of the round

▪ Option to convert:• Automatic conversion• Option of the company• Option of the holder

▪ Security into which convertible:• Same as future round• Common


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In the Eye of the Beholder – Valuation Notes

Depends on the context Strategic use of the assets Pure stand-alone revenue generating assets Asset benefits from large marketing budget, or trapped in

small company How does the portfolio of assets compare with other

companies Internal value (revenue generation/cost savings)

versus fair market value (sale to third party, usually discounted from internal value)

Cost-method results in a lower value, since costs of development usually decline rapidly

For market comparables, how has the market changed since the comparable transaction


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Valuation – Income Model

Elements affecting income model values: Revenue/income measure How much associated with IP Duration of income (e.g. going off patent) Growth rates Risks associated Market impact on revenue

Size of the market Competition/barriers to entry

Computation of discount rate


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Staging Investments


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Money with Their Mouth Is

Problem: Management claims slow growth will precede meteoric growth,

but no way to confirm this Solution:

Match management’s return with rapid growth scenario Liquidation preference, participating preferred for investors Cumulative dividends Staged investments depending on milestone achievement


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Triggers for Staged Investments

EBITDA Revenue Customers Net worth Product development Like a construction project – milestone funding FDA or patent approval Hiring of selected executives Building of new facilities Approval of a business plan


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Knowledge is Power – Information Rights


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No News Is Bad News – Keeping Investors Informed

Problem: Investors lack periodic financial and business information

Solution:o Investor documents require periodic reportso Audited or reviewed financial statementso Pro-active information to shareholders – quarterly, semi-

annual or annual reportso Investors should demand informationo Reports to the board of directors


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Sweetheart Inside Deals – Outside Investor Heartburn

Problem: insider sweetheart deals (consulting contract, hiring friends and relatives, generous compensation, use of funds for other non-business activities)

Solution:o Vigorous due diligenceo Robust representations and warrantieso Significant institutional purchase documents, investor

documentso Staffing with counsel or investment advisorso Approval of inside deals by independent directorso Fairness opinions or other third-party validation of termso Avoid no-bid contracts


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Debates Among Investors and Lawyers

Angel investments should not be documented as thoroughly as institutional VC investments

Kills the deal But: screens bad apples; imposes discipline; prevents disputes In fact, research shows that VCs in non-common law countries

use detailed agreements to manage the investment, though not required under local law

VCs provide services, such as management oversight and introduction to vendors

More than a board, another manager BUT: managers can often hire equally competent service

providers; boards often fly in, stay for a meeting, and fly out (each serves on too many boards)

it’s just money: private investing basics craig mccrohon 1 it ’ s just money: legal tips on...

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