Your first act is school, your second act is work, but have you thought about what you’re going to do in your third act? Join host Liz Tinkham, a former Accenture Senior Managing Director, as she talks to guests who are happily “pretired” – enjoying their time, treasure, and talent to pursue their purpose and passion in the third act of their life.
Inspire others to get more and to do more later in life.
Athena helps women achieve executive-level leadership expertise, polish their boardroom and executive knowledge, get closer to board seats, and make leaps in their careers.
In part two of a two-part series, Erica Duignan Minnihan—founder of 1000 Angels—continues her master class on the fundamentals of Venture Investing. In this podcast, she talks about the different stages of venture investing and how to think about the investment amounts and vehicles, term sheets, valuations, due diligence and returns needed at each stage.
Whether you’re a founder seeking funding or an investor who wants to add early-stage private equity to her portfolio, this informative podcast will get you up to speed on understanding the exciting opportunities in startup investing and how it can launch your own third act.
1:20 Stages of investment capital
7:32 Seed round sources of money
10:47 Series A/B funding
12:07 Series C to IPO funding
13:10 Why 1000 Angels invests at Series A/B
17:23 Finding good deals to invest in
19:48 Getting to know the Founder
22:17 Efficient due diligence
27:31 Determing valuations
35:46 The venture capital valuation method
41:54 Types of term sheets
If you enjoyed the podcast, please subscribe and share a review. Engage with more stories of those finding fulfillment in the third act of their lives on Liz Tinkham’s Third Act podcast at thirdactpodcast.com.
0:00:06.9 Liz Tinkham: Hi, this is Liz Tinkham, and welcome to Third Act, a podcast about people embracing the third act of their lives with a new sense of purpose and direction. The third act begins when your script ends, but your show’s not finished. Hi everyone and welcome to today’s Third Act. Today we have part two of our two-part series on Venture Investing. Erica Minnihan, founder of 1000 Angels, continues her master class on the Fundamentals of Venture Investing. This series covers the basics you need to know to build a solid portfolio as an Angel Investor. On today’s episode, Erica talks about the different stages of investing from seed to IPO, as well as how to conduct due diligence across those different stages. She explains how 1000 Angels comes up with valuations for companies and talks about the different instruments of investing from safes to equity. Whether you’re a founder seeking funding or an investor who wants to add early stage private equity to her portfolio, this informative podcast will get you up to speed on understanding the exciting opportunities in start-up investing and how it can launch your own third act.
0:01:20.7 Erica Minnihan: We’ll be moving into completely new material, which is the investment process. The investment process begins when an entrepreneur requires capital, very simple. And so there are several different stages at which they’re gonna… An investment might be made. So obviously it’s start-up, most companies need some sort of start-up capital, whether that’s from bootstrapping or from entrepreneur savings or from Angel or VC Investors, so that’s one stage and then the next is Eq Growth. So growth stage is basically considered once they’ve nailed down their system for making money, and they know that if they just pour more money into these repeatable business processes that the company will grow, and so it’s relatively lower risk. This is kind of where you see late-stage VC’s, private equity companies taking over then. And then similarly, sometimes a company will raise capital just for liquidity. So a lot of the companies that you see going public are actually raising capital for investor liquidity. Or if a private equity company comes in and wants to take a control position, very often in order to do that they’re buying out existing investors, that’s liquidity for founders, liquidity for existing investors. And then of course, just a full-on acquisition is another stage, the last stage, usually, in the investment process.
0:02:57.1 Erica Minnihan: Different sources of capital, and we’ll talk a little bit about the early stage, that’s what we’re here to talk about. So first of all, you’ve got personal funds, you’ve got friends and family, and it’s actually pretty important that these things come in first. I see a lot of people who try to go out and raise venture capital without being Serial Founders before they’ve used personal funds or even done a friends and family round. And unfortunately, it’s not great signaling, because while we get it that not everybody has wealthy friends and family that can necessarily invest in your company, it is really important for investors to know that the people around you, that know you the best, believe in you enough to actually put their money on the line. So that’s one element of signaling. The other element is that we know that that investment will be the first money lost, so you’re probably gonna have to see these people at every Thanksgiving for the rest of your life or every school reunion, so we know that you’ve got some real skin in the game as far as social capital, and that if you’re willing to take money from people that you really love and care about, that you will probably respect the investor’s money as well.
0:04:16.5 Erica Minnihan: Next, of course, grants which can come from institutions, funds and nonprofits. These are largely mostly available to healthcare, tech, biotech companies, they’re not usually available for your run-of-the mill, B2C tech start-up. But something that’s a little bit kind of equivalent to it, might be business plan competitions, etcetera. Some of these can actually dole out significant money. I’m actually a judge for several competitions. Start-up of the Year, by the way, I just did an amazing podcast for Start-up of the Year, so you guys are gonna wanna look at that podcast, I think you’ll really like it. They do an annual competition, where I think they give out about 50 grand, which is not bad, and I’m pretty sure it’s non-diluted capital for that. And then I’m also a judge for 43 North, which is like the largest cash prize Business Plan Competition in the United States, where we give out about $8 million in total prizes or no it’s $5 million. So we give out a $1 million top prize, then I think the second one is 750k, and then we give out 5 or 6, 500k prizes. So there are actually some of these competitions, you can really get real money, and it’s certainly less dilutive than the traditional fundraising route.
0:05:40.3 Erica Minnihan: Next is loans, so banks, SBA, those are really pretty difficult to get if you don’t have an asset-based business and your business doesn’t have revenue, and that’s why most people have to go the venture capital route. I do feel like at least here in New York City over the last year or so, there’s been an increase in state and city-related sources of investment on a smaller scale, maybe like 50-100K, specifically for women. So I would definitely do your research to see what’s available there, if you’re looking at that option for raising money ’cause it is becoming more of an issue, and I think that the government is trying to address it with increased access to capital for women. And then lastly, we come to equity, which is what we’re here to talk about, and so this is angel investors, venture capitalists, private equity firms, and where we play. So the various investment rounds that are gonna be made during the life of the company are really gonna be covered by different types of entities. So when you’re at preseed, you’re usually kind of people are getting common, people are getting founder stock, and this is usually where the founders are putting in their own money and maybe friends and family are putting in some money. When you get to seed.
0:07:03.3 Erica Minnihan: And this terminology has really been worked over the last five years because people just want to make themselves seem cooler than they are. I’m just gonna go with the original terminology, but right now, a true seed round is kind of what used to be considered an A before. So don’t really pay attention to this terminology on investment pays so much ’cause that’s whatever the company wants to say it is. It’s a little bit more based on the investment type.
0:07:32.1 Erica Minnihan: So we would consider a seed round when you first kind of raise money from professional investors or people that you don’t know. And so in this round, you’re likely to be using a SAFE, which is a Simple Agreement for Future Equity. If you ask me, that’s actually the best security to use for this stage of investment. You don’t really need lawyers for it. You can have a lawyer look at it, certainly it’s something that you’re unfamiliar with, but he’s not gonna have to draft something and charge you billions of dollars. That’s why people really like it. It was actually invented by Y Combinator, and you can download the docs off of their site. The next one is the KISS, which is to Keep It Simple Security. This was invented right after Y Combinator did the SAFE by 500 start-ups it’s what they use. It seems like SAFE is a little bit more dominant. I think it’s just because in the beginning people thought that if they use SAFEs, that people would think that they had been in Y Combinator even when they hadn’t. So it’s kinda funny. And then the last is the convertible note. And so the SAFE and the KISS basically replace the convertible note. The reason I would say don’t use a convertible note, or if you’re an investor, encourage the company not to do a convertible note is because the convertible note, though it is much simpler than preferred equity, is does get a lawyer’s hands on it.
0:09:02.2 Erica Minnihan: And no offense if there’s any lawyers on the call, but anytime a lawyer touches something, it’s really expensive and there’s a good chance that it’s gonna get messed up. So, I’ve had situations where I had a company do a convertible note. The lawyers just drafted so much nonboiler plate language, and then the note didn’t actually say what it needs to say, which is a pretty simple thing, which is just that, “Hey, we’re investing this money.” If the money can convert into equity at a certain valuation, and it’s just at the investors option, whether or not they want to either get repaid plus their interest or if they’d like to convert it into equity, it’s a pretty simple thing, but they managed to turn this into 20 pages of nonplain English verbiage that didn’t actually say what it needed to say. And it was a nightmare of time and effort.
0:10:04.6 Erica Minnihan: So we really like to use the SAFE maybe the KISS, but I don’t recommend the convertible note, it’s not my favorite and at this stage, you’re gonna see angel investors and Seed Funds Investing in that type of security, usually in amounts of about 1-3 million. Next is your Series A or B, which will be kind of 3-25 million total raised. And at this point, you’re now investing in preferred equity. Preferred equity in the start-up world is not the same thing as preferred equity in the public markets. It’s a completely different thing. So preferred equity in public markets is more like a debt instrument. Preferred equity in the start-up world really, truly is an equity instrument.
0:10:47.7 Erica Minnihan: Same thing with a convertible note. A convertible note in the start-up world does not sort of have the same dynamics as public market convertible notes and it also is really basically an equity instrument. Even though these things kind of provide some downside protection, they’re not secured by anything. So we would never really think of them as true debt instruments that provide that kind of protection. And that’s why even when Y Combinator replaced the convertible note, they called it a simple agreement for future equity because that more accurately reflects what it actually is. And so this is where you see true venture capital funds coming in for the Series A and Series B. That is the sweet spot, that is where you want to be as an investor, that’s where you’re getting the best risk adjusted reward for your investment. So these companies are usually pretty de-risk. You usually have to be doing at least 100K in monthly revenue to get a Series A done. So by that point, unless there’s just complete problems of capital management, the company is fairly proven.
0:12:07.4 Erica Minnihan: They’ve established product-market fit, they’ve established the revenue channels, they’re doing pretty well, and then by the time you get to Series C, D and beyond, you’re still gonna possibly be preferred mezzanine or debt is going to go on to the company. And here’s where you see private equity coming in. Here’s where you see investment banks coming in and doing private placements for companies, and you see maybe early investors and founders getting a little bit of liquidity. And then lastly, you would have public markets where companies doing IPO and the traditional asset managers get involved. So those are all kind of like the stages. And it’s really exciting and interesting. And why I think it’s so great for you guys as the investors to be in these early rounds. Right, so you’re not a venture capital fund. You can’t really be in the sweet spot in the middle right? Unless you’ve been in the seed. So where we do is we come in the seed…
0:13:10.6 Erica Minnihan: We are really selective we try and make sure that we pick companies that get to the series A and B, and then once you get to that round, because you’re an existing investor, you now have the opportunity to throw in some more money, exercise your pro-rata and take advantage of those highly valuable series A and B rounds, whereas right now, most people are totally not paying attention and then they’re coming in at this last stage when it’s in the public market when basically all the value has been captured by the guys who are in early, so that’s why we’re here learning about this stuff.
0:13:52.5 Erica Minnihan: We start with screening of deals, due diligence, structuring a deal, company getting a term sheet, the first closing, then monitoring the investment and then exit. So sadly, there’s these seven-level bubbles, but really between bubble number five and bubble number seven, it’s probably gonna be like 10 years, so it just… It takes a really long time, you know you actually like once you make an early-stage investment, if you’re working with an organization like 1000 Angels, you know we’re handling the monitoring of the investment for you, but it’s a long-term investment. Oh hi Erica, another Erica on the line. I have a question for, are seeing more price seed rounds issuing preferred equity?
0:14:40.7 Erica Minnihan: You know you pretty much will not issue preferred equity until you’re doing a three million dollar round. So in today’s vernacular, a three million dollar round is considered a series seed, I think that… So people are kind of a little weird about the terminology because it’s just optics. So in these days, what I would consider seed and where you’re gonna see the first price round happen is usually when the company is doing a three million dollar raise and by that point, they have to get to at least a 100K, so I wouldn’t say that I’m seeing more ’cause we still… There are still lots of raises prior to that, that are done with safes, but yeah, about three million is where people usually start with actual price rounds.
0:15:34.4 Erica Minnihan: I hope that answers your question. So step one, sourcing and screening, this is just like the work that you have to do of going out and… You’re welcome Erica… That you have to do of going out, finding companies, having them pitched to you and then screening out the bad ones. And it’s actually a lot of work, this is what I do professionally, so I have to spend all my time doing it, and it’s a lot of like emotional investment. One of the things that is so tricky about this job is that for me, I always feel like, okay, if I meet with a company, I want to give them really honest feedback and really good feedback. But on the other hand, you really have to realize, this is their baby. And you can’t say anything too negative about their baby.
0:16:28.9 Erica Minnihan: So really being able to, you know, make that kind of like emotional connection when you’re in the sourcing and screening, let everybody come away feeling good about themselves as a positive interaction, it’s a lot. And the honest truth is that I would say that I have to talk to 99 companies for every one that is actually something that we’ll seriously consider investing in, so that’s like a lot of interactions where you have to let people down really nicely. So it’s important if you want to be able to keep sourcing companies and screening companies that you treat every interaction with respect and with care and that they come away from the interaction having gotten something positive out of it, even if it wasn’t a “yes,” from an investment perspective.
0:17:23.5 Erica Minnihan: So how do we go about actually getting these deals? So it’s events, it’s meetings, it’s phone calls, it’s things like this that I’m doing today… Member referrals, it’s relationships with accelerators and incubators, relationships with Seed and Series A, B, C’s. We get hundreds of applications actually now, probably like each month, and then we review the applications, and when we come across companies that we really like, we then enter them into due diligence. Now, I would say that the vast majority of deals that we actually do usually come from some sort of a recommendation or a warm introduction, but we also absolutely accept like cold introductions, too. You know, just because somebody I know didn’t introduce you to me, I still put just as much effort into at least taking a look at that opportunity. Next, we move on to the next process.
0:18:20.9 Erica Minnihan: So once you’ve screened something, you think it’s interesting, now you have to do due diligence. So due diligence is what we do to mitigate risk, we don’t just meet a company and go “This is great,” and hand over a check, we have to, sort of really analyze several different factors and really what we’re trying to be aware of is business risk, people risk, and legal risk. And all of these are very important. So on the people risk side, it’s really a management team. So everything that you can do to really get to know the management team is gonna help mitigate that. One of the things that I do for my LP’s and members of 1000 Angels is that I’ve been a very successful investor because I invest a lot emotionally into the founders I work with.
0:19:14.8 Erica Minnihan: So I have to know that the founder that I’m investing in, and that our group is investing in, that they are somebody that we can trust. That we know that they’re gonna do whatever they can possible to make this work and that they’re not gonna screw us over in any way. Right… So mitigating that people risk isn’t… It’s not just like, “Oh yeah, do some background checks and some reference calls.” It’s like you should really… Probably, if it’s you just individually investing in something or if you’re with a group, know that somebody is there who’s really developing the relationship. And that’s what VC’s are for, right… Is that the fund manager, it’s their responsibility to really get to know the founder and to spend a lot of time with the founder and to… Build trust with the founder, right? So that, that person now will protect them as the company grows, protect their position. So it’s very important.
0:20:14.2 Erica Minnihan: And then also just knowing people, because we’ve seen lots of companies… And I’m not gonna name any names… But blow up because founders were doing ridiculous stuff, right? So really think about the management team, the trustworthiness of the people, and how that can present a risk to the business. The next part, business risk is probably, just what you’re normally thinking about which is, the market, the product, the financials, the marketing plan.
0:20:44.2 Erica Minnihan: I’m a former banker and so… I always do a full audit of the company’s financial model. I see so many people, and even real investors, who sometimes don’t even look at a financial model. We’ve seen companies go out of business, where they were like, “Oh, we ran out of money, because nobody did a financial model.” So I would just behoove you to always make sure that that box is checked… Because that’s kind of, the doing your homework element of, what is the future of this business. And to really go through it and make sure that it actually makes sense and that there aren’t any mistakes. So that’s one that I see a lot of people skipping. We don’t wanna to skip that.
0:21:31.7 Erica Minnihan: And then of course, a marketing plan, right? So a lot of people might have a great product, but they don’t really know how they’re gonna to sell it. That’s another thing that is really important is… Not just that the product is great, but how is it gonna to be sold. What are the distribution channels. What are the marketing channels… All these things.
0:21:50.8 Erica Minnihan: And then of course, legal risk, right? So what is the company’s true intellectual property. There are a lot of risks there. You do the best that you can to mitigate them. I have a really great portfolio company that was just targeted by a really terrible patent troll, that’s trying to extort her for hundreds of thousands of dollars… And had to deal with that. So it’s always there but in our diligence we can do our best to mitigate it.
0:22:17.2 Erica Minnihan: And so the next thing that I really wanna to focus on is just efficiency in the diligence process. So number one, you don’t want to waste the company’s time, right? And you, of course, don’t want to waste your own time. So focus on the biggest areas of concern, first… Communicate regularly with the team, right? So if you see something that’s a deal breaker, be like, we saw this and it’s not working. Don’t see the deal breaker keep going with the company, and then, a month later be like, “Oh, well, this thing that we learned four weeks ago is the deal breaker for us.” So we really just wanna be very efficient. And it’s okay to say, “No.” As we said, 99 out of 100 are gonna to get to no. So once you see something that makes it a no, communicate that right away.
0:23:09.3 Erica Minnihan: What sort of materials do you need to execute a diligence process on a company. So the primary diligence materials are, of course, the investor deck, the company’s financial model, a marketing plan, which may not be a separate document… It might be something that is included in the investor deck, and it’s obviously something that is going to be hopefully, laid out in the financial model. But if they have a separate one that’s great.
0:23:37.4 Erica Minnihan: Next would be historical financials if the company has it. And then, of course, the company’s cap table. So these are kind of the five things you actually want to request to start diligence on any company. Additional diligence items would be a client list, their sales pipeline report, any material contracts, if it’s a company that… Part of the valuation is based on a contract with like another large company… Management reference checks, customer reference checks, if you can.
0:24:06.8 Erica Minnihan: And then if they do have patents pending or patents granted, or any other sort of intellectual property, you can request evidence on that. We can see that there are some companies that didn’t ask for that and it didn’t go in a great direction. And then, of course, the next thing is to complete your independent research, right? So first, we look at the business model. Does it make sense? Can it make money? And most importantly, is it scalable? So scalability is key to making something actually investable.
0:24:38.2 Erica Minnihan: Next is the market opportunity. So has the company actually made reasonable assumptions? Is it really a billion dollar opportunity or are they overestimating the size of their addressable market? Third, the customers… Does the company have a reasonable customer acquisition plan? Is their cost of acquisition less than three times the customer lifetime value? And also what is the sales cycle and how long is the sales cycle?
0:25:04.2 Erica Minnihan: So those are the things that we wanna to make sure that we really fully understand before we invest on the financials. Does the financial model make sense? Are the assumptions and outcomes reasonable? And also is the plan scalable? Having been a managing director for Dream Ventures Accelerator for three cycles, one of the number one things that companies would sometimes learn when they built a financial model is that they had a great product but it wasn’t actually scalable within their customer base, right?
0:25:34.6 Erica Minnihan: So, let’s say… We had this one company that was making some cool technology product for developers… Some software development kit thing, or whatever, and they wanted to sell it to developers. So we said, “Okay, great.” How many developers are out there? Let’s assume, you get 1% of them to look at your thing every month, and… You sort of ran through all these assumptions.
0:25:58.6 Erica Minnihan: But when we actually put it into the model we realized, “Oh, there’s no business here.” So, even though they kind of had a cool product and a cool addressable customer when they actually ran through… How would we actually acquire these people and sell this thing to them and for how much they realized, “Wait, there’s not enough of them.” So this is why the financial model is so important because it’s gonna to show you what the real drivers of value are in your business.
0:26:29.6 Erica Minnihan: Next is to make sure that you understand the competition. So understanding the company’s value proposition versus competitors. And really most importantly also understanding if there are any substitutes in the market or if there are some new technology innovations that might actually eliminate the need for what your company is doing. So really being aware of that. I think that if you sort of looked at what happened within the meal kit business… That was a little bit of a nightmare where there were just no barriers to entry and everything got flooded and created really bad dynamics. So really kind of thinking about, “Okay, what are the competitive dynamics of this particular industry and for this particular company.” And then of course the management team, really get to know them. Do you trust these people with your money? And reference checks, background checks, all those kind of things or independent research.
0:27:31.2 Erica Minnihan: So next we talk a little bit about structuring the deal. So determining valuation. Now you’re probably not gonna be structuring the deal, but we’re gonna talk about what is involved. So number one, it’s always a negotiation. There is no hard and fast rule. There’s no 409A. There’s no accounting stuff. It’s completely a negotiation. So part of that is gonna be based on what’s already going on on their cap table. So how many founders are there, how much money needs to be taken into the future… Really just kind of like coming to a right number. There is no perfect number, but from experience, you can sort of get a sense of where you think a company should trade.
0:28:17.8 Erica Minnihan: Most importantly, since we’re coming in at the seed, we need to realize that a company is likely to do a seed round, an A round, a B round and maybe a C round. And so we need to see what is the value evolution there. For a company to be doing really great the valuation should double between rounds. So if you’re doing a pre-seed round at a $5 million cap that means that the A should probably get done… Or the seed should probably get done at a valuation of around 10 million which is an appropriate valuation for a company raising $3 million. And that means that the A should probably get done at a valuation more around like 25 million pre. And the B would be somewhere around 50 to 75, and then whatever.
0:29:06.2 Erica Minnihan: So it’s kind of like you have to look at the company’s growth trajectory and think… Can they sort of double this between rounds. It’s not 100% requirement but that’s kind of what you need to do to keep investors happy.
0:29:20.9 Erica Minnihan: So we’re gonna talk a little bit about valuation methodology. And then also just sort of things you can do to meet the investor’s needs. So the methods differ by investor type… Stage investment and availability of capital. If you guys are finance people and I’m thinking maybe some of you might be… We learn in business school discounted cash flows, right? So that does not work here because we don’t even have any idea of what the cash flows of the company are gonna be. So you just cannot really apply a traditional discounted future cash flows method to early stage investing. We do a few other methods.
0:30:03.2 Erica Minnihan: So for seed, there’s some ridiculous methods. One is the rule of thirds. It’s so old school, I’m not even gonna worry about it. Second is just deferred valuation. And that’s basically what these saves or convertible notes do. Is they kind of establish a ball park, like a maximum for the evaluation, but they do allow you to defer into the future. And then at series A which is kind of like where we’re really looking at coming with the valuations we use what’s called the venture capital method which I’ll get into as well as benchmarks, which is kind of like where are other comparable companies in the industry trading.
0:30:42.7 Erica Minnihan: At the growth stage, you’re gonna use multiples of revenue, or multiples of EBITDA, if it’s that type of company. You’re going to… The growth stage equity companies are gonna maybe thinking about what’s the valuation based on the percentage of equity that they need to acquire. Usually it’s a little bit over 50% if they want to get control. And then at private equity stage and public markets you’re now getting into the more traditional valuation methodologies of discounted future cash flows, the net present value of that, the value of their assets, P/E ratios, things like that.
0:31:22.2 Erica Minnihan: So these all kind of evolve and fluctuate, but I think it’s really important for people to understand that at the early stage you just do not use the same valuation methodologies that you do at the later stages which most people are more familiar with. So the next thing that’s really important to understand in terms of terminology is pre-money versus post-money valuation. We always talk about companies in terms of their pre-money valuation, and that’s just the value that’s subscribed to the company before the money goes in. So if an early stage company is raising a million dollars and their pre-money valuation is $3 million and they take in exactly $1 million of new money, the post-money valuation is just three plus one equals four. And the new money investors now own 25% of the company.
0:32:15.9 Erica Minnihan: So it’s a pretty simple equation but it’s really important to remember that we don’t talk about valuations in terms of post-money. The reason is because we don’t usually know exactly how much is gonna go in. So mostly it’s done at pre-money. The only time I would say that that changes is for some reason sometimes at Series B rounds I’ll very often see the rounds we talked about in post money valuation. I don’t know why, but usually when someone’s doing a Series B, they’ll be like, “Okay, we’re gonna take between 15 and 20 million, and it’ll be a post-money of a 100.” Kind of a random thing… But when you’re coming in at seed and series A stage, we almost always talk about the valuation in terms of pre-money.
0:33:06.9 Erica Minnihan: So possible valuations for a seed round… There’s this ridiculous thing called the Berkus method, which Nate Berkus invented. It’s just kind of like eyeballing it. He put this $500,000 on one of each of these categories a long time ago. I think now you’d probably have to… Because of inflation, you’d probably have to say a million. But he would say, “Okay, if you have a great idea that’s a million.” If you have a prototype, that’s another million. If you have a great management team, that’s another million. If you have a strategic relationships and a product rollout or sales, that’s another million.
0:33:44.0 Erica Minnihan: So he is kinda just like abstractly saying, do you meet these categories, add another million. And so let’s say, the maximum would now be 5 million. So that’s sort of like one method that’s very arbitrary, but also kind of makes sense because basically in a very early stage round the valuation is almost always probably gonna be like between… It could be three if you’re… I don’t know… You’re like in Detroit or Cincinnati or somewhere else where prices are just generally low.
0:34:22.2 Erica Minnihan: But it’s definitely gonna be between three and five million. If you’re a serial founder, it could probably go as high as seven, but the truth is like the range is pretty low. So it does matter to do it properly. So for example, if I invest in a company at a three million dollar valuation and the company’s eventually sold for thirty million dollars, I’m gonna get 10X. But if I had paid a five million dollar valuation I’m only gonna get 6X. So it actually like is very material on the backend. But at the end of the day the actual sort of range of valuations is like fairly narrow.
0:35:06.9 Erica Minnihan: And so next thing is obviously deferred valuation which you’re almost always gonna have implicitly in these instruments, because the way that they work is that there is a valuation cap. And then it says you will convert either at a certain discount to the next round. It’s usually 20% or at a valuation cap. So the cap sort of establishes the highest price you’re gonna pay for your equity. And then the discount gives you the optionality just in case the next round happens at a lower price than you expect.
0:35:46.4 Erica Minnihan: So the method that we really use for establishing valuation is the venture capital method. And so what you wanna do is you want to think about the terminal value at the sale of the company estimated on a multiple of sales or EBITDA. We almost always use a multiple of sales because EBITDA is just like less relevant. But the way that we do this… And this is like kind of the real way that we do it… It’s very back of the napkin… Is if I think that at year five the company is going to be doing a hundred million in annual revenue and I think that… The company will be able to trade at like three times revenue at year five… That means that at year five I think the company’s gonna be worth about $300 million. Okay. So if the company is gonna be worth $300 million at year five, and I need to… I’m an early stage investor, I need to get a 30X return on my investment.
0:36:53.8 Erica Minnihan: That means that the post money valuation of the current round, assuming this is like the only capital it needs to be raised between now and year five, needs to be 10 million. So if the company, say, needs to raise two million dollars right now, the appropriate valuation is eight million dollars. So that’s how really venture capital people truly like ascribe these valuations and it can make sense. And it… It kind of works because the amount of equity that should be raised on any particular round is generally between 20 and 33%. So if a company is trying to raise more than that percentage of equity in any one round they’ve not really got appropriate capital strategy.
0:37:42.3 Erica Minnihan: So the other thing to note is that this is also sort of based on you needing to achieve an IRR of like, at least, 256%. And those things like seem really high, but they have to be high for individual companies because some of these companies are not going to make it. They’re not gonna make their actual returns. So the IRR you actually have to demand on each individual company is pretty high, comparatively.
0:38:14.0 Erica Minnihan: So this chart here shows you some general valuation guidelines. We would say that a pre-seed round is kind of 250K to a million. The valuations are usually like two-and-a-half on like the very low end. Like that’s the lowest I’ve ever paid for a seed round valuation to about five million. Like I said, there could be a little bit of a premium if it’s like a celebrity founder. But that’s the general range. And this is like friends and family, accelerators, early angels. These companies are usually kind of pre-revenue. A traditional seed round, which would also probably be done as a safe, would be kind of one to three million dollars. Valuations ranging from like four to 12 million dollars. And this is where you’re gonna see like angels micro VCs, C and B seeds… VCs etcetera. And it’s kind of like everything up to that, a 100K in monthly recurring revenue benchmark that the real VCs are looking for. So once you get there you’re probably doing like a traditional Series A. And some people might call it series seeds so… Don’t look at the name just look at the amount that’s being raised.
0:39:25.2 Erica Minnihan: So for a $3 to $10 million raise of preferred equity from VCs you’re probably gonna get a valuation of $12 to $30 million. And at this point, you need to be doing over usually 100K in a monthly recurring revenue. A Series B is typically for raises of 10 to 25 million with valuations of 30 to 100 million. And this is also VCs. And by this point you usually have 3 million plus in annual revenue. And then Series C is 25 million and above, valuations of 75 million and above… And here’s where you see more growth stage VCs and companies with 10 million plus IRR. So the way you kind of think about it is like in a pre-seed round the company is probably raising maybe like 500K, 750K. In the seed round it’s maybe like 1.5 million, then they’re raising a Series A, it would be like 3 million and the Series B is like 10, and the Series C is like 25.
0:40:28.4 Erica Minnihan: That’s a very normal fundraising path for a reasonably capitalized start-up. The less they need to raise, obviously, the better for you. But you have to really still be aware that you’re gonna need to sort of hit these different… You’re gonna be able to have to sustain these valuations as the company grows. This chart is kind of interesting, it just gives you an idea of valuations versus traction and what can make valuations more expensive. Things like previously successful founders, valuable intellectual property, coming out of Silicon Valley or a Y Combinator. Those things are gonna add… Make things more expensive. And what things are gonna make things like nice and cheap. And cheap is good for the investor, right? ‘Cause that means like you’re getting a good deal.
0:41:17.8 Erica Minnihan: So if they’re not from the Bay Area, or NYC… If they’re from Cincinnati or Detroit or Austin, you might get a little bit better of a deal. If there’s female or minority founders, you’re probably gonna get a better deal on it. It’s just like the way our country, our system is unfortunately set up.
0:41:37.6 Erica Minnihan: And if they’re a consumer products companies they’re probably also gonna be a little bit cheaper. So this is gonna give you an idea of where your valuation lands from idea stage through product market fit, to your approach in growth.
0:41:54.8 Erica Minnihan: Next, we talk a little bit about the term sheet and some of the different securities that are available. So we have the convertible note and SAFE which are essentially loans that convert into the next price round of equity. They should always have a valuation cap. They will convert at a discount to the next round, and there are sort of different events that trigger conversion. So it sort of allows you to defer valuation issues, but always get a valuation cap. So this is sort of the most common security use there. As I said, I feel more comfortable with the SAFE, but convertible notes happen too. And then at the seed stage you have participating preferred equity or just preferred equity. So the preferred part means that you’re gonna receive a return of capital and dividends prior to any distributions to the holders of common shares.
0:42:45.1 Erica Minnihan: So just sort of recognizes the fact that you put in cash money and you deserve to get that out before anyone gets anything. The participating part, I haven’t seen that happen in probably like six years. It’s something that if we got into a capital-constrained environment might come back. But what that just means is that after the preferred distribution you then also convert into common. But I’m not gonna go into that too much because it’s honestly a really investor-friendly thing but I haven’t seen it happen recently, so we can talk about it in another session. And then of course, your liquidation preference which just means that you’re gonna receive X times your capital before distributions are made to common shareholders.
0:43:27.0 Erica Minnihan: So if you have a liquidation preference it’s usually one timed. If it was like two timed, it would mean that you need to get back two times your initial capital investment before common shareholders get anything. And this is why we always wanna be in preferred. You never wanna be in common. You need to invest in a C Corp, not an LLC, and you need to never invest in common. So that’s just the rule.
0:43:50.5 Liz Tinkham: Thanks for joining me today to listen to the Third Act Podcast. You can find show notes, guest bios and more at thirdactpodcast.com. If you enjoyed our show today, please subscribe and write a review on your favorite podcast platform. I’m your host, Liz Tinkham. I’ll be back next week with another guest who’s found new meaning and fulfillment in the third act of their life.
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