Angel investors dream of finding and investing early in the next Uber, Airbnb, Waze, or Mobileye. While it’s easy to get seduced by the hype, serial startup investors know it is hard to be successful in this asset class. With the help of members of OurCrowd’s experienced investment team and other industry resources, we have put together a quick, three-part guide to ‘earning your wings’. These articles highlight essential terms and strategies while referencing accepted industry best practices; with these basics in hand, getting started in startup investing can be a lot smoother.
Part I: The Basics
Do Your Homework, Be Highly Selective
A 2007 study on angel investors’ returns found that those who spent more than the median time of 20 hours performing due diligence had an overall portfolio return of 5.9X, while those that spent less than the median only had returns of 1.1X (source).
OurCrowd’s investment team (made up of around 20 investment analysts, principals, advisors, and partners) vets more than 200 startups a month. After analyzing a company’s team, technology, business model, market size, traction, and legal integrity, OurCrowd offers a term sheet or joins an existing round. Historically, we have chosen to invest in less than 1% of the deal flow we’ve seen in our pipeline. Here’s a visualization of OurCrowd’s Startup Vetting Process.
Master the Term Sheet
The devil is in the details and venture investing is no exception. A proper term sheet should include valuation, investment and investor breakdown, form of investment, protective rights, and preferences. Below are definitions of some of the most common rights VCs negotiate. The following rights can be negotiated for Preferred Shares. For an easy to follow, bite-sized breakdown, watch this 3-part video series on Conquering the Term Sheet.
- Pre-money valuation: The valuation of a company prior to an investment. (Read more)
- Post-Money valuation (fully diluted): The valuation of a company at the close of a financing, which includes the new cash, the conversion of outstanding convertible securities, and creation or increase of unallocated ESOP (employee stock option plan).
- Preemptive rights: These right gives existing shareholders priority to invest money in subsequent funding rounds in order to maintain their ownership stake. (Read more)
- Anti-dilution: Generally structured as broad-based weighted average or full-ratchet, this right protects investor’s ownership from dilution when new shares are issued during a follow-on round of financing. With full-ratchet, in a down round, the conversion price is set to be equal to the share valuation at the current down round (note that full ratchet is VERY aggressive against the founders/initial investors – and very uncommon as a result). Weighted Average reduces the conversion price of previous rounds but does not set the conversion price equal to the price of the current down round. For an example of weighted average anti-dilution protection, read this article.
- Liquidation preferences: Investments operate based on LIFO (last in, first out). This feature provides downside protection for investments and are structured as either participating or non-participating.
- Information Rights: Allows investors access to the company’s facilities, employees, as well as the right to receive certain reports detailing the companies’ financials, budgets, revenues, expenses, and cash position. (Read more)
Equity vs. Convertible Debt
Which is better? It depends. Serious investors generally want to know the valuation of a company before they invest so they know exactly what they are paying for. Sometimes, to bridge funding rounds, investors choose a CLA (Convertible Loan Agreement) or a SAFE (Simple Agreement for Future Equity) to make an investment faster without forcing the current financing to set a valuation.
- CLAs are a form of debt intended to be converted into equity, usually at a discount, and/or a capped valuation. The agreement normally includes provisions covering interest, a maturity date, and a liquidation preference.
- SAFE Agreements give the investor rights to preferred stock in the next financing round where the investor can either take the equity or convert it into its cash equivalence.
Alphabet Soup: Funding Rounds Explainer
Over the past 20 years, the definition of funding rounds through capital raises in each round has fluctuated significantly. For example, seed rounds have historically been defined as rounds between $500K-2M. However, recently, startups with little more than an idea or a pitch deck have been raising radically more.With this in mind, below are guideposts for typical funding stages.
- Seed: Initial funding that supports market research, and development of the startup. This includes finding the ideal consumer and supporting early employees. Historical raises range from $500K-$2M, but much larger raises have been trending in the past few years. This round generally has participation from friends, family, and fools. (Learn more)
- Series A: Generally understood as the proof of concept stage, where companies demonstrate a clear product/market fit, user base, and initial revenue growth. The typical company valuation at this stage is between $10-15M. Again, there have been startups recently raising massive, $100M+ rounds in certain areas of the world. (Learn more)
- Series B: Series B can stand for ‘build’. In this stage, businesses are looking to scale, to get past the developmental stage, and expanding in to new market segments, and revenue streams. The typical company valuation at this stage is between $30-60M, raising an average of $25M. (Learn more)
- Series C+: At this point in the company’s growth, it is trying to achieve large-scale expansion by adding a new market, international location, or even a new company through acquisition to fuel growth. The average funding amount at this stage is $50M, with a typical company valuation between $100-120M. (Learn more)
That concludes Part 1 of the series; be sure to check out Part 2 and Part 3. You can also learn more about startup investing terms and how the process works by reading our in-depth guide, How Startups Are Born: An Investor’s Guide for the Perplexed.
Do you have any risk-taking stories of your own to share? Leave your questions and comments below!