Innovation at ACC | Alternative Investing 101: Questions Every Investor Should Ask
One of the by-products of running an investment platform like AngelMD is that we get a lot of questions from people looking to make their first foray into alternative investments. Many of these questions are about the terms a potential investor should know, and they lead to a list of questions that every investor should ask.
What are rounds?
Companies typically raise funding through what are referred to as “rounds” of fundraising. Traditionally, this process starts with a “seed round,” which can be best described as planting a small seed of capital in the hopes that it will grow into something larger. Seed rounds are often funded by friends and family, but it’s not uncommon for an angel investor to be the first outside money that a company receives.
Seed rounds are generally under the $2 million level, and often far less than that. They provide the company with money in exchange for a share of ownership (equity) of the company. Sometimes, if the company is very new, the exchange will be for a convertible debt, rather than equity. Proceeds from seed rounds are usually used to get a prototype developed or to convert a prototype into a commercially viable product.
Series A rounds are usually the first rounds in which institutional investors (aka - venture capitalist) will get involved. These rounds usually coincide with a business model that has some proof points and often that includes revenue. Series A round sizes vary, but usually they are in the range of $2 million to $10 million.
What’s the company’s valuation?
Pre-Money Valuation - This is how much a company is worth before money is added by the investor. If a company has a valuation of $1 million, and you plan on adding $500,000 via your group’s investment, the pre-money valuation is $1 million.
Post-Money Valuation - The post-money valuation is how much a company is worth after the investor money has been secured. If the above company has a $1 million pre-money valuation, then an investor (or group of investors) adds another $500,000, the post-money valuation is $1.5 million.
Valuation is a notoriously tricky figure to find, especially with younger companies that lack protected intellectual property, physical prototypes, revenue, profits, or other easily-valued assets. This brings us back to the topic of convertible debt.
What is convertible debt?
Early stage deals are almost half preferred equity and half convertible debt these days. Convertible debt is a way for investors to loan money to a young company with the expectation that the debt will turn into equity at some point in the future. The conversion time is typically between one and two years, once the company has hit some milestones and ready to raise a round with a formal valuation attached.
If you picture a bridge, where you’re standing on one side and your goal is on the other, the bridge loan is what allows you to get from point A to point B.
There is potential risk involved with putting money into a company that has no valuation, but the potential payoff is significant. Convertible debt financiers are often allowed a “discount,” affording them the opportunity to purchase shares at a cheaper price than later investors. The convertible debt notes work like an ordinary note, in that they include an issuance date, interest rate and a date of maturity. But instead of paying off the note in cash, it is settled via shares of ownership. Savvy investors will always require a ceiling to the company valuation at the next stage, which in effect sets a price. This ensures the debt investor doesn’t finance a hefty valuation without participation in that upside.
What’s a term sheet?
The term sheet can be thought of as a negotiation document. It’s an outline of the terms and conditions of an investment, but it isn’t binding and can be changed at any time up until the investment is finalized. The term sheet should strike a balance between the interests of the investor and the company, neither greatly advantaging or disadvantaging either party. Institutional investors will usually present the company with a term sheet if they have interest. There are cases where the startup may circulate their own term sheet to determine if the “market” is amenable.
The Angel Investor Forum has a generic term sheet that can serve as a good indicator of what information will generally be included. A term sheet might be signed by both parties, locking in the valuation while the investor reviews the details of the stock purchase agreement.
What’s a cap table?
The cap (short for capitalization) table is a spreadsheet that shows who owns which type of stock and how many shares of each.
How does dilution factor in?
Dilution is the result of trading ownership in the company for additional investor money. In later funding rounds (B, C, and further) it’s not uncommon to see 50 percent or more of a company diluted to external ownership. Early investors can expect to see greater dilution numbers, but the real key is to focus on the net value of the ownership versus the percentage.
What is a special purpose vehicle (SPV)?
An SPV, also known as a special purpose entity (SPE), is a common way for a group of investors to gather their money into one legal investment vehicle. In most cases, the SPV is formed as an LLC, where each investor buys a membership into the SPV instead of handing over money directly to the startup individually.
For the investor, SPVs allow for an aggregate larger single investment than an individual might find comfortable. Since the total investment by the SPV is larger, it also affords the SPV to bargain for certain rights that an individual may not be able to command. Those rights are then afforded to each member of the SPV.
Startups tend to be fans of SPV investment as well, since the company’s cap table will be simpler. Instead of ten investors, for example, the startup would have one investor, the SPV. The SPV can also simplify the negotiation process for the startup, because all investors in an SPV are granted the same rights.
What is carried interest?
Carried interest is, in short, how the manager of a fund gets paid for their performance. It is a small share of the profit from an investment that is paid directly to the fund’s manager when the fund generates a return. Carried interest is technically not equity, but it acts like equity. Carried interest is only worth something once there is a profitable exit.
What are warrants?
Many investors are offered a derivative called a warrant. The warrant gives them the right to buy or sell a specified amount of equity at a certain price, up until the warrant reaches its expiration date. Warrants are similar to options and are usually offered to those outside the company whereas options are generally given to employees, contractors, etc.
Investopedia has a great example of how warrants can work:
Warren Buffett’s Berkshire Hathaway made a deal in 2011 to invest in Bank of America. In the transaction, Buffet acquired warrants for Bank of America common stock, at an exercise price of $7.14 each, paying roughly $5 billion. In late June, with Bank of America stock at $24.32 per share, the Oracle of Omaha exercised the warrants into a stake worth more than $17 billion, reflecting a $12 billion gain on his original investment.
On both sides of the venture capital/startup relationship, the warrant can be used as a bargaining tool. It is not unusual for a venture capital fund to negotiate a warrant that allows the fund to purchase more shares at a predetermined price. Likewise, it’s not uncommon for a startup to offer a warrant in exchange for securing an initial investment.
What is a bridge loan?
If you picture a bridge, where you’re standing on one side and your goal is on the other, the bridge loan is what allows you to get from point A to point B. A bridge loan, also known as a bridge note, interim financing, or gap financing, is a short-term form of convertible debt that is intended to allow a company to complete a goal of securing long-term funding. In most cases, the money provides immediate, short-term capital, or allows the removal of an obstacle that would prevent long-term funding from being completed. Bridge loans and convertible notes can be used interchangeably in many cases.
What is preferred versus common stock?
There are two types of stock that you’ll typically deal with as an investor. Common stock is a security that represents a share of ownership in a business. It typically affords one vote for each share owned. Common stock is almost always the form of ownership management/employees receive.
Common stock does allow for dividends to be paid, and it does retain cash value in the event that a business must liquidate its assets. However, it is last in line to be paid, behind creditors, bondholders and holders of preferred stock.
Preferred stock, while still a security that shows ownership, will often have a dividend attached that must be paid before the holders of common stock will be paid on their earnings. Most outside investors will receive preferred equity for their investment or upon conversion of convertible debt notes.
This article was authored by Brad McCarty at AngelMD. AngelMD is a health care investment marketplace connecting medical startups around the world with physicians, investors and industry with the goal of creating successful outcomes. ACC and AngelMD have partnered to promote engagement of cardiovascular clinicians in health care innovation and entrepreneurship. For more on Innovation at the ACC, visit the Health Care Innovation Member Section page at ACC.org/Innovation.
Keywords: ACC Publications, Cardiology Magazine, Commerce, Financial Management, Fund Raising, Goals, Intellectual Property, Investments, Negotiating, Ownership, Salaries and Fringe Benefits
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