Sonit Agrawal | Fundwave

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If You Can’t Measure It, You Can’t Manage It

San Francisco’s population. Social Media Likes. Your height. Apple’s Revenue. There is one thing tying them all together – they are all metrics. They have been measured by someone for some use.

Why metrics?

Let’s assume there are two startups – Moonscape and IceCorps.

 

They are trying to raise funds and approach two seed investors – Ashley and Brook.

Ashley, decides to invest in Moonscape after seeing the quarterly revenue data and concluding that Moonscape is the faster growing company.

Brook opts to focus on profitability instead of growth and looks at the EBITDA data instead.

Profitability Analysis

Reaching the conclusion that IceCorps is more profitable despite lower revenues, Brook chooses to invest in IceCorps.

Revenue and EBITDA are nothing but a metric.

Metrics are a way to track and measure an activity. They help you make decisions. And as a fund manager, you will make important decisions throughout your fund’s life – where to invest, how much to invest, when to exit, and so on.

By collecting and understanding EBITDA data, Brook reached a different conclusion than Ashley. Different investors use different metrics. Metrics provide a baseline for encouraging discussion and reaching a decision.

What metrics should I collect?

As an investor, you are constantly evaluating and investing in multiple companies. Every business has its own metrics which should be monitored regularly to make the best investor decisions and stay ahead of the curve. Here are some examples.

SaaS Metrics

The SaaS industry has grown exponentially and shows no signs of slowing down. Customer retention and recurring revenue are the key metrics to track here.

SaaS Metrics

SaaS Metrics
 

Real Estate Metrics

For your real estate investments, here are the metrics to track.

Real Estate Metrics

Real Estate Metrics
 

Impact Metrics

Companies engaged in solving social issues keep track of a unique set of metrics depending on their area of expertise. GIIN has designed metrics to measure the social, environmental and financial performance of an investment. Some of the common ones are:

Impact Metrics

Impact Metrics
 

Fundraising Metrics

You need to keep track of whenever your portfolio company raises funds as it impacts your ownership and returns significantly.

Fundraising Metrics

Fundraising Metrics
 

Financial Metrics

Financial health is important for all stakeholders involved – more so for investors. Financials provide a bird’s eye view of a company’s performance. More importantly, they are also a good source of identifying red flags. Use these metrics to track you portfolio company’s financial health.

Financials

Financial Metrics
 

Want to track and analyse metrics for other industries?

Sign-Up on Fundwave

How do I collect metrics?

With Fundwave, it is easy to collect metrics. You can schedule email requests and ask portfolio companies to send you data in a secure manner, at just a tap.

Schedule Email Requests

It’s even easier for portfolio companies to share their metrics in a hassle-free manner.

 

Track Your Portfolio Company’s Performance with the Right Metrics, at the Right Time

Start collecting metrics from your portfolio companies today

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By |December 6th, 2018|Fundwave Blogs, portfolio management|

The Perils of Liquidation Waterfall – Part 2

In our last post, we discussed investment scenarios with only a single investor. However, in reality, most companies have multiple investors investing in multiple financing rounds. In such a case, determining liquidation waterfall becomes extremely challenging. With multiple investors in play, a new clause enters the term sheets – “Seniority”

Simply put, seniority is the preference order in which investors get their money back. Also, the seniority ranking is usually allotted to share classes and not individual investors. For instance, Series B would get a seniority ranking of 3 and Series A would get a seniority ranking of 2. Common shareholders usually have the lowest seniority ranking of 1.

Higher the Seniority ranking, Higher the preference in liquidation waterfall.

 

Usually seniority preferences flow downward. That is, later investors get higher preference. So, Series B are paid back their dues before Series A investors receive their share of the pie and so on.

Let us assume that FW raises Series B, with VC firm ISA Ventures investing $5m for 37.5% stake in FW. The updated captable would look like this.

Investor Share Class Investment (in USD) Fully Diluted Stake
ISA Series B $ 5,000,000 37.5%
MPG Series A $ 3,000,000 25%
Founder Common $ 10,000 37.5%

 

The share class details would be as follows

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series B 1x Yes Yes 2x 3
Series A 1x Yes Yes 2x 2
Common No No N/A 1

 

In case of an liquidation event, first the Series B shareholders would be paid back followed by Series A shareholders followed by common shareholders

Seniority

FIGURE 1

As seen in figure 1, till a value of $5m only Series B shareholders are paid back. After that Series A shareholders join in. Common shareholders join in the last – at an exit value of $9.8m

Sometimes, this structure might be reversed – later investors might be paid after early investors. Series A would be paid back before Series B. This structure is not very prominent and rarely practiced.

Finally, seniority might be pari passuInvestors across all stages have the same seniority status. In this situation both Series A and Series B would have same preferential rights over exit proceeds.

Pari Passu

FIGURE 2

Here, both Series A and Series B start sharing proceeds at the beginning itself. Initially, as the exit proceeds are insufficient to cover liquidation preferences of both Series A and Series B, exit proceeds are shared in proportion of amount invested till $8m, at which point the exit proceeds are sufficient to cover liquidation preferences of both the share classes. Common shareholders join at an exit value of $8m after which the proceeds are shared on a proportionate basis of the FD stake.

Finally, there might also be a hybrid of pari-passu and usual seniority – i.e some classes might be pari passu within themselves but senior to other classes. Let’s take a hypothetical example.

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series E 1x Yes No N/A 4
Series D 1x Yes Yes 3x 3
Series C 1x Yes Yes 3x 3
Series B 1x Yes Yes 2x 2
Series A 1x Yes Yes 2x 2
Common No No N/A 1

 

Here, Series E holds the highest seniority among all classes. Series E shareholders would take their share of the proceeds before other shareholders can take their share. After that shareholders of Series B, C and D would take their proceeds on a proportionate basis. Thus, Series C is senior to Series A but equivalent to Series B and Series D in terms of seniority.

Clearly, seniority makes a lot of difference, especially if the exit value of the company is not high as expected. Senior classes will take the lion’s share of the proceeds and leave nothing on the table for junior classes. That said, seniority makes little difference if the exit value is really high and comfortably covers all liquidation preferences and preferred participation. Also, in case of an IPO, all the preference shares usually convert into common shares automatically, eliminating all the liquidation preferences.

Gap in expected proceeds and actual proceeds increases as more and more financing rounds happen due to stacking up of seniority levels and liquidation preferences of late investors. You might expect 30% of the proceeds due to holding 30% of shares but in reality, receive a much lower percentage due to liquidation preferences of later investors.

 

The best way to minimize this gap is to know beforehand the impact of future investors’ liquidation preferences and seniority are going to have on your returns and use this knowledge to negotiate accordingly.

Analyze your portfolio company’s liquidation waterfall

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By |April 24th, 2018|Fundwave Blogs, portfolio management|

The Perils of Liquidation Waterfall – Part 1

What good is your investment if you cannot calculate your returns, or worse, calculate them incorrectly. It would become a classic situation of counting your eggs before they hatch.

Times were simpler when gains were distributed in the proportion of individual contribution but unfortunately, times are not so simple anymore. With clauses like Liquidation Preferences and Preferred Participating, term sheets have become complicated and calculating your returns is equivalent to untangling a pair of headphones, it’s just not possible in 30 seconds.

In this post, basic clauses shall be explored. The more complicated ones will be untangled in another post. Let us try to make sense of the basic clauses one by one.

  1. Liquidation Preference: Simply put, it is the amount of proceeds which the investor is guaranteed before the common shareholders in case of a liquidation event. Stated as a multiple of amount invested in the company, this can go as high as you want, but is usually restricted to 1x, considering the fact that this clause was initially created to safeguard investors in case the company was sold for a value less than expected. A 1x liquidation preference ensures that the investor recovers at-least the initial investment.

Let us take an example to explain this. Investment firm MPG invests $3m USD in series A for a 40% stake in FW, a fintech company. Let us assume there is no preferred participation and MPG is the sole investor in FW.

Table 1

Liquidation Preference Investment (in USD) Company Valuation Proceeds to MPG % of Proceeds
1x $3,000,000 $7,000,000 $3,000,000 42.85%
2x $3,000,000 $7,000,000 $6,000,000 85.71%
2x $3,000,000 $5,000,000 $5,000,000 100%

 

As one can see, despite having a 40% stake in FW, MPG pocketed more than 40% in each scenario.  In the last case, MPG pockets everything, leaving nothing for FW founders.

If preferred shareholders simply have a liquidation preference, they are also called non-participating preferred. In that case, the investor might choose to convert to common stock, if payout from common stock is more than liquidation preference. In our example, MPG will convert their liquidation preference stock of 1x to common stock if the company is sold for more than $7.5m.

Non Participating Shares

  1. Participating Preference: In contrast, participating preferred, also known as double-dip, allows the investor to participate in the remaining proceeds as well on a pro-rata basis in addition to the liquidation preference. Continuing with the above example, MPG would get 40% of the remaining proceeds as well.

Table 2

Liquidation Preference Investment (in USD) Company Valuation Proceeds due to Liquidation Preference Proceeds due to Participating Preference Total Proceeds to MPG
1x $3,000,000 $10,000,000 $3,000,000 $2,800,000 (40% of $7m) $5,800,000
2x $3,000,000 $10,000,000 $6,000,000  $1,600,000 (40% of $4m) $7,600,000

Participating preferred holders will never convert to common stock since they are adding their participation on top of the liquidation preference, something which common shareholders don’t get.

Preferred Participating Shares

 

As you can see, this would be highly unfavorable for entrepreneurs, And thus, the cap was born.

  1. Participation Cap: The participation cap provides protection to the entrepreneurs the same way liquidation preferences protect the investor. Also, stated as a multiple of the invested amount, it provides a conversion threshold for participating preferred shareholders. For instance, a 3x cap would ensure that the investor can only receive up to 3 times the invested amount and would have to convert to common shares to receive a higher payout.

Let us continue with the MPG example, wherein MPG has a liquidation preference of 1x.

Table 3

Participation Cap Investment (in USD) Company Valuation Proceeds due to Liquidation Preference Proceeds due to Participating Preference Total Proceeds to MPG
2x $3,000,000 $12,000,000 $3,000,000 $3,000,000 $6,000,000
3x $3,000,000 $12,000,000 $3,000,000 $3,600,000 (40% of $9m) $6,600,000

 

As seen in the first case, the total proceeds are capped at 2x ($6m). This ensures that the common shareholders get an additional $600k.

Participation Cap

Till $3m, MPG will get all of the proceeds due to Liquidation Preference. Afterwards, till $10.5m exit value, both series A and common will share the remaining proceeds in 40:60 ratio, till the 2x cap of $6m is reached. Post that common takes all the value till $15m, after which it is advantageous for MPG to convert to common shares and get more than $6m.

As seen throughout the post, cash flows vary widely depending upon the rights your share class has. The distribution varies even more when there are multiple investors in multiple series of investments and clauses like seniority come into play. We will explore the seniority clause in another post.

Analyze your portfolio company’s liquidation waterfall

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By |June 7th, 2017|Fundwave Blogs, portfolio management|

The Mechanics Behind Investing in Convertible Notes

Historically, traditional debt and common equity have been prominent investment instruments used by venture capitalists. Gradually, preferred equity took prominence due to the various safeguards and benefits it offered. Post the dot-com boom, investors came up with a new instrument known as Convertible Notes. Primarily used by angel investors, convertible notes have become so popular that incubators such as YCombinator and 500Startups have come up with own standardized convertible note instruments called SAFE and KISS respectively.

Now what exactly is a convertible note?

A convertible note is primarily a short term debt instrument which can be converted into equity at a future date, typically when a new financing round occurs. Though these notes earn interest, most of the returns are earned by converting the debt into stock, usually preferred.

One of the primary challenges with early stage investing is agreeing upon a valuation of the company. This is further complicated by the fact that some of the early investors are friends and family. A convertible note allows the investors and the founders overcome this challenge by delaying valuation of the company till the next financing round i.e. Series A when the company is in a position to be valued more accurately due to availability of data.

The next question arises is how do convertible note holders generate returns if they are not getting any equity at the time of investment and the interest charged is not high enough to compensate for the risk taken?

There are three mechanisms through which the noteholders earn from their investment.

  1. Interest Rate: Fundamentally, the convertible note is a debt instrument and earns interest over time. However, unlike traditional debt instruments, the interest is not usually repaid and instead accumulates and is added to the principal value at the time of conversion.

Therefore if the $200k note had an interest rate of 5% and was converted after one year of issue, then the noteholders would convert an additional $10k ($200k multiplied by 5%).

However, as mentioned above, interest earnings are a small portion of the overall returns generated by convertible notes and alone are insufficient to compensate for the amount of risk taken by the investor.

  1. Conversion Discount: The conversion discount is a mechanism to compensate the noteholders for their risk by allowing them to convert the note value (principal, plus interest) at a discounted price compared to the price paid by the incoming investors.
For example, if the investors in a $200k convertible note financing round were granted a discount of 20%, and the incoming investors are buying the company shares at $2 in a new round, then the noteholders would convert the note at an effective price (conversion price) of $1.6 and thus receive 125k shares ($200k, divided by $1.6) worth $250k (125k shares at $2 each).
  1. Conversion Valuation Cap: The third mechanism allows the noteholders to be compensated for their efforts in increasing the value of the startup due to their advise, funds, etc. Basically, the valuation cap puts a ceiling on the value of the startup, thereby permitting investors to convert their loan, plus interest at a discounted price compared to the price paid by the incoming investors.

Continuing with the same example, let’s assume the valuation cap was $1 million and the premoney valuation at Series A is $2 million. If the noteholders invested $200k and the incoming investors are buying the shares at $2, the noteholders would receive a 50% discount ($1 million/$2 million) and thus convert at a price of $1, thereby receiving 200k shares ($200k/$1) which is twice what the incoming investor would receive for his $200k investment. The note would be worth $400k (200k shares at $2 each). (See Table 1)

Table 1

Investor Investment (in USD) Share Price Number of Shares Value of Investment
Note Holder $ 200,000 $ 1 200,000 shares $ 400,000
Series A $ 200,000 $ 2 100,000 shares $ 200,000

As you can see below in Table 2, noteholders with simply a discount and no cap would receive a fixed amount of shares irrespective of the pre-money valuation

Table 2

Instrument Investment (in USD) Discount Discounted Share Price Number of Shares Value of Investment
Uncapped Note $ 200,000 20% $ 1.6 125,000 shares $ 250,000
Note with $1m cap $ 200,000 50% $ 1.0 200,000 shares $ 400,000

 

Thus, noteholders holding a note without a valuation cap

  1. are penalized as investors are unable to share in any increase in value of the startup ,and
  2. the interests of the founder and the investor are misaligned as the founder would want to maximize the valuation whereas the investor would want to minimize the valuation in order to obtain a larger part of the company.

Therefore,usually, the investor negotiates for both a discount as well as a valuation cap, in which case the lower conversion price (higher discount rate) would be applicable. Thus in our example, the conversion price of $1 (50% discount) would be applicable to calculate the number of shares issued upon conversion despite the discount rate agreed to initially being 20%.

Interestingly, note that even if the valuation of the company is more than $1 million, say $1.25 million, even then the noteholder would receive a discount of 20% and the cap would trigger only post $1.25 million

Historically, convertible debt were instruments created in the mid-19th century issued by companies with low credit ratings to keep a lower coupon rate due to its flexible convertible nature. These instruments converted into shares at a later time for a fixed share price. Later on, this instrument was picked up by Venture Capitalists and used as a source of “bridge financing” during later financing rounds. However, the true evolution has come by way of its use in angel investing.

We have tried to explain the basic mechanics of the convertible note and how the discount rate and especially the valuation cap have a visible impact on the shareholding pattern after the next financing round. However, the convertible note valuation also depends on other factors such as the size of the option pool and whether the note is being converted pre-money or post-money.

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Further Reading

How Convertible Debt Works – Brad Feld

By |May 10th, 2017|Fundwave Blogs, portfolio management|