A better seed investment structure
There has been a fair amount of discussion on seed / angel investment structures recently in the blogosphere. Below are two great postings that cover most of the discussion to-date:
- Brad Feld - discusses the two main structures currently used, preferred equity and convertible debt with a warrant
- Josh Kopelman - discusses the positives and negatives of each and when to use one over the other
I think Josh’s analysis is exactly right. I’ll illustrate a main reason why from a perspective of an angel. However, the added complication comes when you want to use the preferred equity structure. Most companies at this stage do not want to go through the hassle or cost of structuring a preferred equity instrument. Josh offers the NCVA standard documents, which is certainly an option.
After speaking with several angels I came across a structure used by a successful angel investor in the Austin area. The structure is a Debt Note and a Warrant. It goes as follows:
- Debt Note is for a term of 2 or 3 years at simple annual interest, and is payable in full plus interest at the earlier of term of a financing event
- Warrant is good for a fixed percentage of the company in its most senior equity security on a fully-diluted basis at a fixed price (which is the amount of the Debt Note); warrant has a term as well, maybe the same as the note maybe longer.
An example will illustrate how this works.
Say the seed round is for $200k and the postmoney valuation is $2MM (MM = Million). In this case, the debt note would be for $200k and the warrant would be for 10% of the company ($200k/$2MM) with an exercise price of $200k. If the company raises a Series A round for $10MM postmoney valuation, the angel is paid his debt note back and can exercise his warrant for 10% of the company by paying $200k. The reality is this can be a swap of the note for the warrant so that no cash need change hands again (i.e. the company simply keeps the angel cash and the angel gets 10% of preferred equity).
This effectively puts a valuation on the Seed round, but Josh addresses that issue well in his post. There is no need to structure the preferred equity terms here, since the angel simply assumes the most senior security at the time of conversion.
The angel with whom I spoke allows the exercise of the warrant to happen any time during its term (which may be up to 5 years). So, in this event, the exercise isn’t forced at the next financing event, but it could be 1 or even more financing events later than that (e.g a Series C or D round) and still be good for the fixed percentage ownership fully-diluted then. This is likely to be viewed as extreme, as it survives dilution through multiple capital rounds and gives the angel a free option since his note is paid back. I have not grappled with that yet, but the right solution may be an exercise of the warrant at the first financing event.
In addition to the misalignment of interests between the angel investor and the entrepreneur, the other problem I have with the convertible note with warrant coverage structure is the implied valuation. This is probably why one of Josh’s cases for using this structure is "when a venture round is imminent or already underway" and a timing of "60 days or less to close." If it falls outside of these parameters, the valuation of the company on this structure is way too rich.
Let me illustrate. Again assume the company can raise a venture round at $10MM postmoney valuation. Let’s also assume $200k is invested in the seed structure of convertible debt with 40% warrant coverage (the high end of Josh’s range). I’m ignoring the interest since it’s negligible. In this case, the angel will own 2.8% of the company ($200k plus $80k warrants divided by $10MM). The implied postmoney valuation is $7.1MM (take $200k in actual cash invested divided by 2.8% ownership, which includes the warrants).
$7.1MM is pretty expensive for an angel to be paying for equity in a startup that isn’t on the doorstep of venture funding. You can run whatever numbers you would like in this structure and it’s hard to realistically get below $5MM. These are VC valuation levels and can be handled since the VC typically has enough money to carry the company to profitability and has a distributed portfolio to diversify risk. Angels typically have neither and thus play early to get better valuations. Seed investments typically are in the $1MM to $3MM range of valuation (except for those that are bridges to Series A as Josh illustrates). For $200k this get an angel 6.7% to 20% of the company depending on the valuation. A far cry from the 2.8% range on the convert w/warrant structure.
This is new and in evaluation for potential use by me right now. I’m eager to get comments and feedback.
– bkm
Miller Time!
Ryan Miller did exactly what he had to do today - played flawlessly and in the process also recorded a shutout. Ever the competitor, Miller admitted that he let in a softie in each of games 3 & 4, and vowed to fix that problem. I’m hoping those were just rookie playoff jitters and that he’s back on his game that we saw all year. Tonight gave me every confidence in the world that Miller is ready for Cup run.
The Sabres in turn also played a near flawless game and have a chance to put this series away now Let’s finish it off in Game 6 in Philly and get on to the next victim!
Goaltending is key in the NHL playoffs
As a native Buffalonian and lifelong Sabres fan, I am as excited as anyone about the team’s success this year. Thanks to NHL Center Ice, I follow nearly every game from Austin. The second loss in a row against Philly is very frustrating and I hate to say it but goaltending is the difference right now. After game 2, I thought the series would be over in 5 for sure. Had the Sabres figured out Esche on one or two of their many chances tonight, that prediction may have come true.
This is less a knock against Ryan Miller and more of a compliment to Robert Esche. Quite simply if it was not for Esche’s play (forget about Game 2 entirely) the series may very well be over … or at least heading for a finale on Sunday in Buffalo. In fact he nearly singlehandedly enabled Philly to win the first game.
Miller has not been bad, but he did let in soft goals in each of games 3 & 4. Without those softies, the Sabres may have won one or both of those games.
I thought Esche was the difference tonight …. I think we had 4 breakaways in the first two periods (including the penalty shot) and only scored once - and barely did so.
The Sabres clearly are the better team here …. but they need to figure out Esche again like they did in Game 2 very soon.
Goaltending is usually the key to winning playoff series and Stanley Cups. Buffalo needs to convert on more opportunties and Miller needs to step it up a notch to not only put Philly on vacation, but to reach the Cup finals.
– bkm
Will Starwood find Southwest?
Here one of the latest posts on the Southwest Airlines blog site. There is an interesting opportunity here that I thought I would highlight. David, a Southwest pilot, is posting essentially a review about a restaurant at the Sheraton hotel in San Diego. He is using the post with a clever, but probaby non-actionable, hook to take a Southwest flight. Really, how many of us are going to fly just to eat at a restaurant and take in a view? I need more than that to deal with an airport and security.
I think the interesting thing here is the intersection of the pilot’s life and Southwest’s brand.
The pilot sees many hotels and eats at many restaurants. This makes him a valuable resource as a reviewer of these services. Now, as a Southwest pilot, he also is a key service provider for a company and brand that stands for outstanding customer service.
These two attributes make him a potentially credible reference for restaurants and hotels, among other things I’m sure.
What does this have to do with Southwest? Well, it’s not to immediately take a flight to see this restaurant. It is however an extension of Southwest’s brand of outstanding customer service. If the pilot does a credible and honest job of reviewing these hotels and restaurants in his blog entries with the Southwest customer service quality filter, he builds further trusts with the Southwest customer base.
The results of that? Some include: (1) increase in brand equity for Southwest which leads to loyalty, (2) increased interaction with the Southwest customer base to gain a deeper understanding of their needs and values, (3) referrals to others to check out Southwest - these people may then decide to become customers.
So, now the pilot can extend his ability to grow the Southwest brand and increase sales, all while providing valuable free content to existing customers.
I’m curious to see how long it takes Starwood / Sheraton to identify David’s post and engage in the conversation. Robert French and John Cass have recently pointed out Starwood’s challenges in their current blog approach.
David may even be able to lower Southwest’s costs by getting free hotel stays just in the event he may review the hotel!
Comments welcome.
– bkm
Nuts About Southwest
If you click that link it will take you to Southwest Airline’s new corporate blog. This is a compelling example of the start of Enterprise 2.0 value creation, and why I have decided to co-found Kalivo.
The Austin American-Statesman, my hometown newspaper, just ran this story today about the launch of Southwest’s blog, and below are some salient points that were made ….
Southwest officials said the blog will be a good way to connect with customers.
"There was a growing online community having conversations about travel and Southwest," said company spokeswoman Linda Rutherford. "We could watch that conversation, or become part of it."
Southwest launched its blog, "Nuts about Southwest," last week. Rutherford said about 20 employees, including a flight attendant, a pilot and a mechanic, have volunteered to write for the blog. She said Southwest will try to update the site at least three times a week.
Southwest expects some negative comments, Rutherford said, and will counter them with explanations from the carrier’s point of view.
Southwest gets Enterprise 2.0. Though, it should be no surprise to anyone that they do get it. This is because Southwest has always understood the value of great customer service and listening to their customers. They also get the value of cultivating loyalty among their customers, and what it means to have customer "apostles".
Needless to say, Southwest amplifies some of the offerings and value propositions that we intend to deliver with Kalivo, namely:
- connect with customers
- watch the conversation and become a part of it
- empower employees at all levels to engage in the conversation with customer & influencers
- don’t hide from negative comments, identify and address them head-on
Ultimately this level of direct engagement with customers and influencers drives both customer loyalty and employee loyalty, which is good for profits and competitive advantage in the long-term. For Southwest, this is just an extension of their existing customer and employee focused M.O.
However, for them and those companies that embrace this level of engagement in the broad Web 2.0 environment, to be effective this approach will go well beyond blogging alone and will actually become a new Marketing process in the Enterprise 2.0 world.
Kalivo’s website and my corporate blog will be up in 2 weeks or less.
(Robert Scoble and John Cass at BackBone Media add some interesting analysis & ideas for Southwest to the online discussion of Southwest’s new foray into blogging).
– bkm
Taking the plunge
After another long absence from blogging, I am back and this time I am in with both feet firmly planted. I have recently decided to take the plunge into two waters - a new startup and angel investing.
My new startup is Kalivo. This will be another one of those growing Enterprise 2.0 companies. Enterprise 2.0 is somthing I have been thinking about for a long time - well relatively long time of about 12 months. Like Web 2.0, it is a space that I expect will be overhyped in some senses of that definition. However, also like Web 2.0, it is a space where I do believe fundamental changes are occuring and thus where fundamental value - and very profitable new companies - will be created.
Kalivo’s web site is not live yet, but it will be shortly. I will also maintain a personal corporate blog there if such a term exists. Both will be live in the next 2 weeks, and as a resuult, so will our value proposition. For now, let’s say that our offering is social in nature, involves blogs and communities, and is targeted at the marketing function to start.
As for the motivation, let’s just say that I have a firm and strong belief that applying the social technologies of Web 2.0 appropriately to the enterprise will result in (1) greater enterprise value for those companies that embrace them, and (2) greater value and responsiveness for customers of these companies. A true win-win situation where companies and their customers can get closer together and receive mutual value. Kalivo will profit nicely as well : )
This post by Peter Rip at Leapfrog Ventures had an interesting point on the opportunity in Enterprise 2.0, highlighted below (although Peter may not agree with my angel investing focus!):
I subscribe to the thesis of enterprises as a natural user of all this technology and have for a while. Companies are communities. Supply chains are social networks. A customer base is a community, albeit often not interconnected, except by indirect methods like lawyers and analysts. Shareholders are a community, often interconnected the same ways.
Oddly enough, my other plunge into angel investing can cynically be read as a hedge. However, after "playing" with consumer side stuff over the past 12-15 months, I can say two things: (1) I do not believe my passion or expertise lies in delivering consumer value propositions and (2) many interesting opportunities exist to create value on the consumer side and I can learn a lot to apply the consumer side solutions to enterprises by being actively engaged.
So, I will likely be making a few small investments in interesting consumer plays with great profit potential in the near future. I will post those investments here exclusive of my Kalivo blog, and intend to post on why I decided to invest and the progress of these companies as well. I will offer insights into the angel investing process as I go along as well.
That’s it for now …. I’ll be back on a regular basis now.
– bkm
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