“It is, of course, cleaner to just lower the price per share, but often there are reasons (e.g., a higher-priced friends and family round) not to do so,” he adds.

If the price per share in the friends and family round is high, issuing a lower price per share in the Series A round may significantly dilute the value and holdings of friends and family investors. Seasoned angels usually try their best, within reason, to keep entrepreneurs happy. No entrepreneur wants to tell his or her friends and family that their holdings have been diluted substantially.

Discounts

Photo Credit: dizznbonn

Receiving a discount means you get to purchase shares at a lower price than the price per share for that round.

Warrants

Warrants give you the right to purchase additional Series A shares within a specified time frame.

Purchasing additional shares allows you to increase ownership and enjoy the upside if the company does well.

In cases where the company issues new shares and dilution is inevitable, exercising your warrants would help protect your percentage of ownership up to a certain amount, which would help reduce the impact of dilution. [1]

Here’s the beauty of warrants: They provide you with potential upside and dilution protection (albeit limited), but you don’t have to pay up-front. You have a choice – you can exercise them within the agreed time period, or not.

For the company, issuing warrants allows it to sweeten the deal without reducing the company’s valuation, or price per share.

Even so, warrant does come with its own set of issues. (What doesn’t?) We’ll discuss those some other time.

Exercise Price

The “exercise price” is the price you pay to purchase the warrants. The exercise price is usually set at Series A price.

Warrant Coverage

The warrant coverage is expressed as a percentage. Twenty-five percent coverage for a $750,000 Series A investment would give you the right to purchase $750,000 x 25% = $187,500 worth of additional Series A shares.

Expiration

Most warrants can be exercised from a couple of years to 10 years after closing.

In the event of an acquisition or IPO, however, warrants typically expire immediately. [2]

“Acquirors do not want to assume warrants and generally demand that warrants be exercised prior to closing,” explains Yokum Taku, corporate and securities partner at Wilson Sonsini Goodrich & Rosati (WSGR).

And “many companies prefer to have warrants expire on an IPO to eliminate the share overhang associated with the warrants.”

Seasoned angel investors always make sure the clause that gives them the option to exercise their warrants immediately before these liquidity events (e.g. M&A and IPO) is included in the agreements.

References

Unlike common stock, preferred shares are issued in series to represent each round of financing. For instance, Series A typically refers to the first round, Series B the second, Series C the third, and so forth.

* This is Part 2 of a 3-part series. Visit Part 1 at “Angel Deals: Quick Discussion on Common and Preferred Stocks.”

Image by: Stefan Baudy

Rights granted to investors of later series typically rank ahead of preferred shareholders in earlier series and common shareholders. That is, rights held by Series C investors would have more weight than Series B and Series A investors, who in turn rank higher than common shareholders; and rights held by Series B investors would have more weight than Series A investors and common shareholders. As they say, new money always has more power.

Experienced angels are careful as to the requests they make in early rounds. They know that their terms will set a precedent and that later investors will always want more rights than existing investors. Smart angels know that they might end up hurting their economic benefits by demanding onerous terms in the early stage. Their advice to new angels: Don’t complicate early stage deals.

Preferred Rounds Difficult To Justify For Small Rounds

The structure of preferred shares is more complicated than that of common shares because of the extra features (e.g., liquidation preference and anti-dilution protection, among others) that come with preferred stocks. The legal fees for a preferred round, if done properly, are around US $50,000. This makes preferred deals more difficult to justify for small rounds.

In general, experienced angels who don’t accept convertible notes usually request preferred shares if the round is larger than US $500,000. One angel said he requests preferred stocks if the round exceeds US $250,000, but added that he rarely invests in rounds of such small size, i.e., less than US $500,000.

For contextual purposes, angels who are willing to use convertible notes may accept capped notes in seed rounds between US $250,000 and US $1 million, according to the observations of Yokum Taku, corporate and securities partner at Wilson Sonsini Goodrich & Rosati, from January 2010 to January 2011. [2]

Again, though convertible notes are out of context in this brief, you may learn more about convertible debt deals in “Starting Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Up next: When Do Seasoned Angels Invest in Common Stocks?

You bet it does. The differences in taxation, the flexibility in ownership, and the capital structuring among these three company structures can be significant.

C Corp., S Corp., and LLC: A Brief Introduction

C Corporation (C Corp.): Owners of a C Corp. are called “shareholders” or “stockholders.” As an investor, you’re a part-owner and are given stock certificates to evidence that ownership.

Additionally, from a legal perspective, a C Corp. is treated as a separate entity from its owners/shareholders. This separation shields you from debts or obligations the company may incur.

S Corporation (S Corp.): Like a C Corp., owners of an S Corp. are also called “shareholders” or “stockholders.” You, as a part-owner, are given stock certificates as proof of that ownership.

An S Corp. is also a separate entity from its shareholders, shielding you from debts or obligations the company may incur.

The main difference between a C Corp. and an S Corp. is how the income is taxed. We’ll expand the discussion of taxation later on in Part 3, “Company Structures and Your Tax Money.”

Limited Liability Company (LLC): Owners of an LLC are called “members.” Instead of stocks, you (as a member/part-owner of the LLC) receive “membership interest.”

This membership interest is usually expressed in percentages (e.g., a 10% membership interest) or in units (e.g., 10 units), which generally correspond to your percentage in ownership. [1]

Unlike shareholders of a C Corp. and an S Corp., who receive stock certificates to evidence ownership, LLC members receive charter documents, e.g., “Articles of Organization” and “Operating Agreement.”

An LLC also protects members from debts or obligations the company may incur.

Note: Although all three entities intend to shield members and shareholders from obligations incurred by the company, there’s no absolute guarantee that they will be shielded. Please consult with your lawyer.

What You’ll Learn in This Report

• Which corporate structure has a high flexibility and why you need it
• Which structure angel funds can’t invest in
• 2 reasons why seasoned investors don’t like to invest in this structure
• Why experienced investors care about employee options
• Which company structure allows you to make that agreement do whatever you want
• Tax payments and tax filing requirements for C Corps, S Corps, and LLCs
• Double taxation and single taxation and how they affect your investments
• Losses in this company structure can be used to offset future company income, which will result in tax savings
• Which structures may effectively lower your net investment and raise your internal rate of return
• Which structures require you to pay tax even if the company hasn’t actually distributed any profits to you
• Which structures require you to file a separate state income tax return in each state in which the company earns income
• Which structures make individual tax reporting more complicated and slow
• “One prominent angel”  said he won’t invest in this structure because he was spending an inordinate amount of money on his personal tax returns
• Which company structure do seasoned investors favor
• You may cut half of your tax payment upon a liquidation event with this structure
• Which structure allows you to roll the profits over into a future investment to postpone tax payments
• Which structure can create significant issue with employees in technology companies
• Which structure is better for employees in tech companies
• You should invest in a C Corp. if you fit at least 1 of these scenarios
• Why VCs typically don’t invest in this structure

Bonus

When you invest in this report, you’ll also receive a quick, easy-to-read 5-page report called “5 Reasons Seasoned Investors Prefer Companies Incorporated in This State” – a must-read for new angels and first-time entrepreneurs who are planning to raise money from professional investors.

What You Get

• C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters (PDF report: 11 Pages | Word Count: 2,700+)
• 5 Reasons Seasoned Investors Prefer Companies Incorporated in This State (PDF report: 5 Pages | Word Count: 1,100+)

Available to Members Only

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Photo: AGeekMom

The loan is “converted” as if investors had literally put money in that equity round. Because investors take an early risk to invest in an unproven company, they usually receive a discount when their notes convert.

“Sometimes the notes come with warrant coverage and/or other features that are designed to provide additional benefits to the early investors,” says Riaz Karamali, partner at Sheppard Mullin Richter & Hampton LLP. [7] We’ll cover investment terms in Part 5, Term Sheet Negotiations.

Defer Valuation

With convertible notes, investors are essentially lending money to the company until an event triggers a debt-to-equity conversion. Because they are loaning money rather than investing in equities, they don’t need to determine valuation, or price per share, of the company at the time of their investment. The valuation is deferred until the company raises an A round, in which VCs come in and establish a value for the company.

In other words, angels can use convertible notes to invest now, and let the VCs do all the valuation work when they come in later. The ability to defer valuation is arguably one of the main benefits of using convertible notes. Startups, by definition, have virtually little or no sale records and financial histories, which makes them nearly impossible to value.

From Creditor to Shareholder

If a company successfully raises an A round, the entire principal amount of the angels’ notes, plus any accrued and unpaid interest, will be converted, usually at a discount, into equity. Upon conversion, they will become a stockholder instead of a creditor and thus get to enjoy the potential capital gains of owning stocks.

Similarly, the company is a “debtor” who owes the angels money until the notes are repaid, plus interest, or until the notes are converted into stocks. Once the notes are converted, the company becomes the angels’ investee instead of a debtor.

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Image by: darkpatator

* This is not legal advice. Consult with your lawyer.

In our previous article, you were introduced to Regulation D and Private Placement Memorandum (PPM) and you learned whether a PPM is required in all investment deals. Let’s continue the series with our fictitious company called Yo!Woo, Annice (an accredited investor), and David (a non-accredited investor).

Disclosure Requirements for Accredited and Non-Accredited Investors

Because a company must make very detailed disclosures if it raises money from non-accredited investors (even if only 1 non-accredited investor is involved), taking money from non-accredited investors adds substantial compliance responsibilities and drives up the time and legal costs required to prepare a PPM. Therefore, it’s often recommended that companies only raise money from accredited investors, individuals who can afford to lose their entire investment without affecting their lifestyle if the business goes south.

Visit the Regulation D Rules in Private Placement Memorandum: What Da Heck Is It? to find out the different disclosure requirements.

Definition of Accredited Investor

Accredited Investor means -

• Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds US$1,000,000 excluding the value of the primary residence of such natural person; or
• Any natural person who had an individual income in excess of US$200,000 in each of the 2 most recent years or joint income with that person’s spouse in excess of US$300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

A full definition of accredited investor.

Private Placement Memorandum vs. Business Plan

Rather than preparing a PPM, some companies simply use a business plan as a fund-raising tool.

A PPM is an investor-friendly document that discloses material facts to help investors make an informed investment decision.

A business plan, on the other hand, favors the company and management; it projects results rather than states facts.

While essential for presenting and marketing the business concept and roadmap, a business plan doesn’t provide the proper disclosure structure required by the SEC.

Why Use a Private Placement Memorandum

Obviously, Regulation D exemptions don’t exempt companies from anti-fraud provisions. No company will be excused from committing fraud.

Say, Yo!Woo has successfully raised money from Annice and David with a business plan. It’s working hard toward achieving a milestone but is taking longer than expected.

David, who’s getting impatient and wants his money back to invest in another company, can claim that Yo!Woo has withheld certain information and has, in a conversation, oversold or exaggerated the facts of the opportunity.

Whether the claim is meritorious or not, or whether Yo!Woo has done so intentionally or unintentionally due to optimism and enthusiasm, in SEC’s eyes, Yo!Woo has failed to provide full disclosure and has misled David, a non-accredited investor, into investing in the company. It’ll face monetary penalties and possibly jail time.

Without proper documentation, i.e. a PPM, it’s Yo!Woo’s words against David’s. In all likelihood, Yo!Woo will need to come up with the money to return David’s investment capital, or face monetary penalties or be held criminally liable.

Next, we’ll describe how David’s action can affect Annice (the other investor in the deal, which could be you!) and talk about some of the tough choices Yo!Woo will have to make in such difficult situation – all because it’s failed to use a PPM or properly disclose information.

Image by: Stefan Baudy

* This is not legal advice. Consult with your lawyer.

Antoine Brand asks -

What is a private placement memorandum? Should Angel Investors be concerned if the company doesn’t have one?

Since many an entrepreneur has asked the same question, why don’t we look at both sides of the table and examine the role it plays in an investment deal?

Say, an up-and-coming company called Yo!Woo is undergoing rapid growth and expansion. It needs money, and it’s planning to sell securities (debt, equity, or combination of both) to 2 angels: Annice, an accredited investor, and David, a non-accredited investor.

Under the Securities Act of 1933, any company wishing to offer and sell securities must register the offering with the Securities and Exchange Commission (SEC) — unless it meets an exemption.

Regulation D (Reg D)

You see, the registration process is anything but fun. It’s costly, complex, and time-consuming.

Luckily for Yo!Woo, Regulation D contains 3 rules that exempt fund-raising companies from registering their securities with the SEC — provided that certain conditions are met. These rules are: Rules 504, 505, and 506.

Each rule has different requirements, such as investor status (accredited or non-accredited); the maximum amount a company can raise; the number of people it can raise money from; and the type of information that must be disclosed to each type of investors.

Rule 504 allows Yo!Woo to raise up to US$1 million while Rule 505 up to US$5 million. With Rule 506, Yo!Woo can raise an unlimited amount of capital. Visit their respective links to learn more.

If Yo!Woo meets the criteria of the Rule it pursues, it can offer and sell securities to Annice and David without having to register with the SEC.

Private Placement Memorandum: What Is It?

A Private Placement Memorandum (PPM, Offering, or Offering Memorandum) is a disclosure document that details the risks, terms, and other aspects of the investment opportunity. It helps prospective investors understand the potential downfalls, and it makes it clear that the transaction is speculative in nature and only those who can afford to lose the entire investment should consider the opportunity.

Yo!Woo must include factual and realistic information about the deal in the PPM, such as a summary of offering terms and subscription procedures; a description of the company; information about the management team; risk factors and conflicts of interests; and any other information that’s considered “material” by a potential investor.

Whether a PPM is required would depend on the state laws and the specific Rule (under Regulation D) a company pursues.

If the company sells securities to non-accredited investors, “then a formal private placement memorandum, similar to that filed in a nonexempt filing, has to be provided to the investors, and the seller of the securities needs to show that the investors are ‘sophisticated,’” shares Scott Shane, author of Fool’s Gold.

Private Placement Memorandum: Subscription Agreement and Investor Questionnaire

The PPM also includes a Subscription Agreement and an Investor Questionnaire. The investors, Annice and David, will need to return a signed copy of these documents and send a check to the company if they decide to invest in the company.

The Subscription Agreement is a “sales contract” for purchasing (or subscribing) the securities at agreed terms and conditions. The Agreement also confirms that the investor has received and reviewed all documentations; is aware of the risks involved; and is either an accredited or sophisticated investor.

Just as the PPM discloses Yo!Woo’s information to Annice and David, the Investor Questionnaire discloses to the company the investors’ investing sophistication, such as background, employment, and business or investment experience evidencing their capability in evaluating an investment opportunity.

Together, these documents assure Yo!Woo that Annice and David are aware of the risks and that their wealth standard or investing sophistication meets the federal and state requirements.

Next:

• Why raise money from accredited investors
• Definition of accredited investors
• PPM vs. business plan
  
• Why using a business plan to raise money could haunt entrepreneurs and co-investors
  

Image: dan paluska

Sophisticated investors always think about exits before they invest. “Does the company have the potential to go public or become an attractive acquisition target?” If not, they’d take their money elsewhere.

Going public or IPO means the company raises money by offering stocks to the general public – you know, those stocks that anyone can buy at the public stock exchange. This allows private shareholders (e.g. founders and angel investors) to eventually cash out by selling their shares in the public market, explains one veteran angel investor.

Mergers and acquisitions or M&A, on the other hand, means the company

• is sold to or merged with a larger private company in exchange for cash or for private, illiquid shares of the acquirer company; or
• is sold to or merged with a public company in exchange for cash or for publicly tradable shares of the acquirer.

In angel investing, IPOs are far and few between. A vast majority of angel investors exit their early seed investments via M&As.

Ron Conway, the most influential early stage investor in Silicon Valley, said he won’t invest if he can’t think of five potential acquirers for a company within 10 seconds.

Conway is of course legendary. But you get the idea: Think about exits before you invest. That’s how you make money.

M&As? “That’s Hot”

According to exit strategist Basil Peters, an increasing number of young tech startups (two to three years old) are getting snapped up by big companies to increase competitive edge. Most of the M&A deals are done in the US $10 to US $40 million range, and the sweet spot is about US $30 million. Once the selling price exceeds that sweet spot, it’d become more difficult for the corporation’s M&A department to get approval for the acquisition.

With a record-breaking, all-time quarterly high of 111 startup M&A deals completed in the first quarter of 2010, M&A is the new black in the startup investment community. We did hear Paris Hilton say “That’s Hot.”

To learn more about the sell-side M&A process, we once again caught up with John J. Maalouf of Maalouf Ashford & Talbot to talk about small M&A transactions; specifically, M&A deals that are under US $50 million.

John J. Maalouf and Maalouf Ashford & Talbot

John J. Maalouf, known as the “Idea’s Man,” is a globally recognized attorney who’s been ranked by the United States Lawyer Rankings as one of the “Nation’s Top 10 International Trade & Finance Lawyers” five years in a row from 2006 to 2010.

Maalouf Ashford & Talbot regularly advises clients in the areas of M&As, IPOs, venture capital, private placements, and private equity investments, among others. They’ve recently opened their sixth office in Riyadh, Saudi Arabia. The firm also has offices in Boston, Hong Kong, London, New York City, and Shanghai.

* Edited interview

VH: What’s the typical sell-side M&A process? Let’s say the name of the selling company is called AppleSoft, whose valuation is under US $50 million.

JM:

1. Select M&A Advisors

AppleSoft needs to select experienced M&A advisors, such as an investment bank and a law firm. If AppleSoft selects a law firm first, the firm can help the company choose the right investment bank.

AppleSoft should look for advisors who specialize or have the expertise in representing companies of similar size. Otherwise, small transactions like this will be passed on to junior associates and won’t receive the senior level attention that it deserves.

2. Collect Documentation and Prepare Marketing Materials

This step involves

• collecting documentation, which will be required during the due diligence phase; and
• preparing marketing materials, which generally include an Information Memorandum as well as an Executive Summary.

3. Shop for Potential Buyers

Next, the investment bank will look for and contact potential buyers. These generally include: (i) direct competitors; (ii) companies that are in the same industry as AppleSoft but operate in a different geographic region; (iii) companies that are in a related industry and where potential synergies exist; and (iv) firms that exist mainly to buy companies, help them to grow, and then exit.

As an example to (i), one of our clients, which we’ve represented since the company was a startup three years ago, has just acquired a major competitor and is now worth over US $200 million.

Potential buyers are then vetted based on their interest level and financial ability. Shortlisted potential acquirers then submit a non-binding Letter of Intent, which spells out the proposed deal in broad terms.

AppleSoft compares the various offers and selects a single potential buyer.

4. Start Due Diligence

Enters due diligence, which is a lengthy and sometimes arduous process. It’s during this phase that many deals fall apart. Particular attention must be given to ensure that all documentation is in order and is in conformity with the information provided in the Information Memorandum.

5. Draft Contracts

The drafting phase is where actual contracts are negotiated and written. No two deals are exactly the same. It’s essential that the contracts are drafted by an experienced finance lawyer. Otherwise, AppleSoft may end up with significantly less than what they’ve bargained for.

6. Close the Deal

Once the contracts have been properly drafted, all that remains is the actual closing where the documents are signed and the consideration (either cash or stock) is delivered to AppleSoft.

Coming Up

Stay tuned next week as Maalouf talks about the roles lawyers play in the M&A process; how to prevent deals from falling apart; the purpose of Special Purpose Acquisition Corporations (SPAC); and more.

Tom Williams of McGarry Bair

Back in April, we met a patent attorney through Greg George, who suggested we do a post on intellectual property (IP).

Law? IP? *yawn*

Before you doze off, wait! This patent attorney happened to be McGarry Bair’s (@McGarryBair) Tom Williams (@RealGTom), who’s fun, witty, and enthusiastic – not your typical lawyer.

In fact, McGarry Bair isn’t your typical IP law firm either. Read Part 1 of the interview, Tom Williams of McGarry Bair: Implications of IP for Angel Investors, for a more detailed introduction, and learn about the various forms of IP and how IP produces money-making opportunities.

In Part 2, IP Mistakes Startups Make That Could Jeopardize Your Angel Investment, Williams describes several common mistakes startups make, provides an overview on IP insurance, and points out why most startups don’t have such insurance.

Here, Williams explains how IP attorneys can help investors in the investment process and how patent attorneys are different from other IP attorneys.

Where Do IP Attorneys Come In

In Profiting From Promising Startups: Improving the Odds (Part 2), we mentioned that you can seek help from an experienced lawyer to assess or reduce product risks. This is where an IP attorney comes in.

An IP lawyer can help you evaluate a potential investment opportunity. Williams’ firm, McGarry Bair, for example, offers due diligence services to investors. It can help you

• review a company’s IP holdings;
• evaluate roadblocks to product commercialization or product lines expansion;
• evaluate potential flaws in a company’s IP;
• work with trained valuation professionals to valuate and price the IP;
• perform chain of title analyses; and
• prepare IP transfer licenses and/or assignments to help prepare closing documents.

IP Attorney / Patent Attorney

According to Williams, IP attorneys have a lot of sub-specialties. Some do trademark or copyright only, some are patent attorneys as well.

A ‘patent attorney’ actually has a special meaning. It’s someone who’s obtained an approved hard-science undergraduate degree, went to law school, passed a state bar, and passed the Patent Office bar examination.

So, patent attorneys can have a number of technical specialties as well as legal specialties. Some are better at mechanical inventions, some at electrical, computer, chemical, pharmaceutical, etc.

So if you’re looking for an IP attorney to help you or your newly-formed angel group evaluate opportunities, you need to first determine your needs. Will a trademark or copyright lawyer suffice, or is a well-rounded patent attorney more desirable?

No matter what your requirements are, Williams stresses that working with someone you like is just as important.

Just for Fun

VH: Any funny anecdotes you’d like to share?

TW: It might be an indicator of the type of work we do that a “funny anecdote” about patent law isn’t popping right into my head.

But you certainly can’t say that the Patent Office doesn’t have a sense of humor, what with the new method of swinging on a swing (US6368277) or the “peanut butter and jelly sandwich” patent (US6004596).

Not everything is the light bulb…

VH: Who was your favorite cartoon character as a kid? We know it’s not Scooby Doo.

TW: Has to be Calvin of “Calvin and Hobbes” by Bill Watterson.

Calvin’s father was a patent attorney in the comic strip, and Mr. Watterson’s father was a patent attorney and worked at the Patent Office.

I mean, come on, who else has created a patent attorney cartoon character?

Now, if Batman’s alter ego was only a patent attorney…

Image: Bruce Clay, Inc

A dear reader, Taliba M., tells us she’s ready to make her second angel investment. She has an eye on a SaaS startup but lacks experience in this area. She wants to know how she should proceed. Read Effective Ways to Invest in the Unknown for our response and the purpose of this series.

Taliba also asks whether we’d cover some SaaS topics. Sure, why not? Seems like SaaS is getting sexier by the day. We’d be more than happy to look at the basics and point you to some useful resources.

* You do know that this is for informational purposes only and it’s not investment advice, right? This series is also by no means a comprehensive guide to SaaS. You can find the purpose of the series in previous post. Okay – let’s proceed.

What Is SaaS

SaaS (Software as a Service) is a software delivery/distribution model. The software is hosted on a remote server and delivered as a service. Users can access the software anytime, anywhere via a web browser. They don’t have to install anything on their computer or worry about upgrades and maintenance. Everything is handled by the vendor. Hence, SaaS is also known as Software on Demand or Hosted Solutions.

Many use the terms “SaaS” and “cloud computing” interchangeably. But they aren’t the same. Precisely speaking, cloud computing is made up of 3 segments: Software as a Service (SaaS), Platform as a Service (PaaS), and Infrastructure as a Service (IaaS). So, SaaS is the application segment of cloud computing.

SaaS Moves Fast

“SaaS companies move faster than big companies. They can introduce new features instantly versus waiting for the next major release,” Michael Skok of North Bridge Venture Partners shared at the Mass Technology Leadership Council session on Software as a Service.

Their feedback cycle is often “in days/weeks/months not in quarters/years/lifetimes,” writes Dharmesh Shah, founder of Internet marketing software HubSpot. “What this means is that when bad things start to happen (as many experienced during the start of the current economic downturn), [they’ll] notice it sooner.”

There are “lots of aspects [a SaaS venture] can tweak (examples include pricing, packaging/features and trial duration),” Shah continues. A SaaS company has more control than the traditional “shrink-wrapped business,” in which software is sold as a product to be installed on the user’s computer.

Significant Amount of Capital Required to Build Dominate SaaS Business

In a traditional shrink-wrapped software business, software is sold as a product where payment is received upfront. The company simply ships the software or makes it available for download, thus infrastructure costs are lower.

A SaaS venture, however, usually receives no upfront payment. Most SaaS companies are ad-supported (free), or usage or subscription based. Which means costs are front-loaded but payouts/revenues are delayed.

To deliver software as a service, not only does the startup need to finance the customers but it also needs to invest in architecture and infrastructure management. Shan points out that this can create cash flow issues. As sales growth increases, so does the gap in cash flows. This is why fast-growing SaaS companies often raise large amounts of capital.

Although “the best of the second generation SaaS businesses may be more efficient than [their] predecessors [like NetSuite and Salesforce],” Bessemer Venture Partners believes that “in almost all cases, significant capital will be required to build a dominant SaaS business.”

Next, we’ll look at Enterprise vs. Consumer SaaS and the capital required to get them to liquidity.

Here’s the question:

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

Dilution can be scarier than your in-laws. When the company is low on cash and has to raise money in a “down round,” outside investors get to purchase new shares at a price lower than what you’d initially paid. That is, they can buy more with less.

Let’s say the economy takes a nose dive after your investment. (No, we’re not saying you jinxed the company. Sh*t happens.) The company still has great potential but it’s hungry for cash. Existing investors can’t provide the funding it needs so it issues new shares at a price of $0.5 per share in order to attract outside investors.

Using our example in Part 1:

1st Round

• You invested $0.2m in exchange for 25% of the company
• This means the company is implicitly valued at $0.8m ($0.2m / 0.25 = $0.8m), post money
• Price per share = $1
• No. of shares you own: 200,000
• Total no. of shares outstanding: 800,000

2nd Round

• Each share is priced at $0.5
• This is called a down round since the valuation, or price per share, is lower than the previous round
• Venture raises $5m by issuing 10,000,000 new shares
• Total no. of shares outstanding: 800,000 + 10,000,000 = 10,800,000
• The no. of shares you own remains 200,000
• Pre-money valuation = $0.4m (800,000 shares from the 1st round x $0.5 per share)
• Post-money valuation = Pre-money + Investment = $0.4m + $5m = $5.4m
• Value of your investment: 200,000 shares x $0.5 per share = $0.1m
• Your percentage ownership: $0.1m / $5.4m = 1.85%

Do you see what just happened? In a down round, both the size and the value of your holdings are in the race to become The Biggest Loser, shedding pounds off left and right. Your percentage ownership has shrunk from 25% in the 1st round to 1.85% in the 2nd round. Not only that, the total value of your holdings has also dropped from $0.2m to $0.1m. Yikes.

Though you can’t prevent dilution if the company needs more money than planned, you can take measures to prevent it, or at least minimize its impact, before it occurs. We’ll look at exactly that in Part 3.