December AAIA Event Recap
Vital questions about raising capital for your startup
On Wednesday, December 2, Asia America Innovation Alliance (AAIA) held its third event of the 2020 series. In this event, guest speakers Morgan Guo, Shui Luo, Alex Chen, and Sean X. Zhang, along with the event moderator, Ling Loerchner, answered some vital questions about startup fundraising.
1. When to fundraise and why should you funraise?
Alex: The timing of raising funds varies case by case. Personally, we raised funds from early on, almost immediately after incorporation, because our business needed the capital for R&D. On the other hand, I know a company reached an annual revenue of $20M with one round of fundraising from an angel investor. Companies such as Applyboard had a strategic fundraising path to becoming a unicorn, raising funds when business requires. Timing for fundraising really depends on what makes sense for your business.
Ling: While receiving funds for your business is worth celebrating, as a founder, it’s important to weigh the pros and cons of fundraising. Retrospectively, some founders may question their decision to raise funds very early.
2. What are the stages of fundraising?
Alex: I would say there are three different stages of fundraising before IPO. It is common for startups to start with Seed, Pre-A, and Pre A+, and Series A. Once the company matures and enters the growth stage, they might consider Series B & C. The final stage is Pre-IPO. Startups incubated at the incubator Velocity are usually in the first stage. Companies who have completed their Series A fundraising round will most likely graduate from Velocity. In China, companies like Pinduoduo went through similar funding rounds.
Morgan: For early medical device startups, fundraising is highly relevant to technology (the device) and regulatory clearance (FDA, Health Canada) milestones. Even at seed stage, investors expect founders to have a clear road map on the above two items. On the technology side, in early stages (seed, angel, pre-A), finalized product design — which involves technical feasibility, functional validation, quality assurance system and IP protection – can be a milestone. On the regulatory side, milestones are determined by need for clinical data and future classification of the device. For many devices, FDA pre-submission meeting reports are important milestones before VC funding.
3. What are the channels/ways to look for investors?
Ling: Sometimes when we want something we can’t find it, but when we stop looking we find it. This phenomenon also applies to finding investors. Some startups work tirelessly on their product at the beginning, but when they are ready to fundraise, they can’t find anyone. In the next part, we want to discuss some ways and channels to look for investors. We will first invite Alex to discuss equity dilute options.
Alex: Finding investors is similar to customer acquisition in that they require you to establish a pipeline. Echoing what Ling said, it is important to start developing relationships with investors prior to fundraising. Investor sourcing channels are divided into three main categories: virtual incubator, events, and personal network. The most common virtual incubators are Y Combinator and Techstars. Also, there are platforms such as Angellist and Crunchbase that connect companies with investors. The second channel is startup events. There are local events such as Velocity VFF and nation-wide events such as Collision, the North. These events provide opportunities for your company to gain exposure. The last channel is your personal network. You can develop your own investor network through family and friends, business advisors, lawyers, and colleagues.
Ling: Many spin-off companies from Watco receive their early funds from GTAN and Angel One. Morgan will speak to us about incubators and accelerators with physical spaces.
Morgan: Accelerators usually offer working space for startups to collaborate. In large cities where investors are most active, accelerators can be a great way for founders to meet investors. If you are based in a relatively smaller city where investors are less active, you may want to consider virtual accelerators such as Creative Destruction Lab and Next Canada. These virtual accelerators have partnerships with major universities and offer opportunities to meet investors based on the stage of your business. In addition to accelerators, Regional Innovation Centres (RICs) also offer resources including Seed Funds to help startups. If you are based in the United States, there are government programs such as SBIR and STTR that offer non-equity dilute awards up to $1M for companies who collaborate with research institutions. In Canada, the National Research Council offers similar government funding.
Ling: Government grants and pitch competitions offer non-equity dilute funding for your startup.
4. What are the options of fundraising?
Shui: In Canada, the most common options are SAFE, convertible notes, common shares, and preferred shares. SAFE (Simple Agreement for Future Equity) originated from Y Combinator; it is an agreement between an investor and a company that provides rights to the investor to purchase future equity at a discounted rate. Although SAFEs are considered to be simple and cost-effective, investors may be reluctant to accept SAFEs as an investment vehicle because the money provided to the startup does not yield any interest nor does it have a maturity date. SAFEs have valuation caps, which simply means investors are entitled to equity at a lower cap in future financing rounds.
The second most common option is convertible note. Unlike SAFEs, convertible notes are generally considered a safer option because they are debts, and debts will include interest rates and maturity dates. However, one drawback is that if the future financing round never happens, the convertible note will remain debt and not converted to equity, thus requiring repayment.
The next fundraising option is to issue stocks. Issuing common shares requires the company to determine the value of the business and the price of the shares. A common shareholder has the right to vote and is entitled to dividends.
Lastly, preferred shares can be issued. Preferred shares are most common in the later stages of start-up fundraising because legal fees associated with issuing preferred shares are significantly higher. The share provisions of the preferred shares first issued by the company will become a precedent for subsequent fundraising rounds, thus requiring careful consideration and crafting by lawyers representing the company and the investor. As such, preferred share financing is less appealing to founders in early stages.
Regardless of the fundraising method, it’s important to abide by the rules and regulations under securities laws. For early startups, unless otherwise exempted, the investment funding must come from accredited investors. An accredited investor needs to meet certain thresholds of financial strength. For example, having at least $5M in net assets, or earning at least $200,000 before tax as an individual or $300,000 combined income with a spouse for at least the last 2 years.
5. How to prepare for an investor meeting?
Alex: Meeting an investor is similar to dating – the first impression is very important. Making your first introduction to potential investors can make or break a deal. Therefore, founders should spend a reasonable amount of time on building an attractive, concise, and articulated pitch deck. Once that’s established, both parties will enter the “getting to know each other” stage to determine whether the project is worth investing in. In this stage, you and the investors will likely want to sign an NDA so the investor can acquire more business information such as company documents, financials, and IP through your data room.
Shui: If the investor established interest in investing the company after business due diligence, the investor will likely proceed to legal due diligence. Generally speaking, the investors will review at your minute book, regulatory approval and/or government licenses, inventory of IP, and commercial contracts and employee agreements.
Ling: As you heard, there are many things to prepare for to avoid delays in the fundraising process. Preparing for an investor meeting is a 90 minute session on its own. Please stay tuned to our future events as we will dig deeper into this topic.
6. How to prepare a term sheet? What are some of the most common terms included in a term sheet?
Shui: A term sheet is a brief document entered into by the investor and the start-up company outlining the key terms and conditions under which an investment will be made. I’d like to highlight some of the key terms for investors and start-ups to pay attention to.
Valuation is the paramount issue that the founders and investor should agree upon. Valuation is often defined either as pre-money or post-money but they are essentially the same with the only difference being that the post-money is the pre-money plus the amount invested by the investor. A contentious issue associated with the valuation is the size of the option pool. The investor often asks for a bigger option pool which will allow them to receive more shares at a lower per share price as the price is determined on fully diluted basis, which, on the other hand, results in more dilution to the shareholding of the founders.
The second key issue are the terms for the preferred shares. The preferred shares embrace a bunch of rights and privileges which are particularly negotiated with the investor, for example, the dividend right, the liquidation preference, the conversion right and anti-dilution right. A start-up company normally does not distribute dividend so VC investors often do not expect any dividend from the company. The liquidation preference is an important way for investors to exit which gives investors the preference right to take back their investment amount in situations like liquidation, sale of company, etc. The conversion right means that the holders of preferred shares can convert the preferred shares to common shares at any time they prefer and the anti-dilution right gives the investors a right to reduce their share purchase price if a down-round financing occurs to the company subsequent to their investment.
The next key issue is the controlling rights of the investors given by the company, which consists of two folds. The first is the board seat to be given to the investors, and the second is the veto rights that the investors
Ling: Term sheets require a lot of effort and strategic thinking. There are resources like TTO in universities to help you review term sheets and negotiate with investors.
7. How do term sheets differ in China?
Shui: Popular terms often seen in term sheets from China such as Bet-on Agreement/Valuation Adjustment Mechanism, buyback terms, and personal guarantee are rare in practice in North America. Those terms and agreements are usually used to favor the investors reducing their risk of investment. I think the North American market fosters a healthier environment which motivates more entrepreneurs to innovate. However, those terms and agreements are there due to differences in markets, policies, and cultures.
8. What are good money and bad money?
Alex: Finding the right investor can help your company reach its full potential. Investors with extensive experience in your field and industry resources will boost your company’s growth significantly. There are abundant examples where investors opened up a foreign market for the company and achieved exits in less than 3 years. Seeking advice from your advisors, industry experts, and lawyers will help you select a suitable investor for your business.
Morgan: Good money means the investor has more to offer than funds. Bad money brings potential harm to your company. If a founder is seeking money from an angel investor, it’s important to review the investor’s portfolio and his/her investment principles. If the investor is reluctant to share the investment portfolio with you, that indicates a warning signal. If you are situated outside of a metropolitan city and you wish to learn more about the investors, you can consult local accelerators and incubators.
Sean: The amount of money an investor can bring is important but is not the only factor when picking the right investor for your company. Fundraising is part of your long-term strategic planning, thus you should consider the long-term value the investor can bring to the company. Some factors to be considered include whether investors can bring more purchase orders from different channels, whether the investors can be good future advisors or whether reputation of the investor in the industry can help company’s image building.
Ling: In addition to what our guests said, good investors can often help negotiate better terms when the company enters M&A.
Ling: I hope what we’ve discussed above can provide some guidance for your startup companies. If you have any feedback or suggestions for our future events, please contact us at firstname.lastname@example.org or contact our WeChat Admin account at: “aaia-admin”. Looking forward to meeting everyone in our next AAIA webinar event.