Investment in startup businesses is a complicated matter, and there’s a whole set of jargon and technical terms that are need-to-know for anyone attempting to fund a startup.
Startup investment is not a continuous process, it happens in discontinuous chunks called “rounds”. The rough guide to rounds is:
- Seed round: the initial funding of an idea before it gets traction, revenue, or employees. Usually funded by “the 3 F’s”: Friends, Family & Fools. This is also where most startups fail, so it’s very high-risk investment.
- Series “A”: usually an Angel leading other small investors. The startup has usually got a product or service at this point but may not have got product-market fit. Still very risky, but less risky than the seed round.
- Series “B” onwards: more money in increasingly large amounts to fund the growth and expansion of a successful company. Increasingly less risky as the company grows.
Not all companies will follow this pattern, and some companies will issue different types of stock at different rounds.
Likewise there are various stages in a startup’s growth, usually. These stages are usually identified as:
- Seed Stage :- The pre-revenue part of the lifecycle of a startup where it’s an idea being built.
- Build Stage :- The stage in the lifecycle of a startup where it is using a product to engage with the market to attempt to find product-market fit.
- Growth Stage :- The post-product-market-fit stage of the lifecycle of a startup where it has established a workable business model and is attempting to grow.
Not all startups will follow this pattern, and the amount of time spent in each stage may vary, but generally speaking it’s a common pattern.
An Accelerator is an investment program that invests in seed-stage startups. An accelerator program may feature one or more of the following:
- cohorts – the invested startups go through the program in groups and are expected to work together and help each other
- a fixed amount of investment for a fixed equity stake (i.e. a fixed valuation) for all startups in the program regardless of the likelihood of success or the likely value of the final business
- mentorship from successful entrepreneurs
- a fixed length of the program, culminating in a “Demo day” event where the cohort exhibit their progress with the aim of securing further funding
The Amcom Upstart accelerator program is Perth’s only “classic” accelerator program at the moment; it invests $40,000 in return for an 8% stake in its startups, and provides a 3-month mentoring program for them to make the most of that investment.
An Incubator is a seed-stage program that usually provides one or more of the following:
- office space / working space
- assistance with the mechanics of building a startup by providing in-house technical, legal or professional resources
- investment on variable terms depending on the requirements of the startup
Atomic Sky is a classic incubator in Perth; it provides working space through the Tech Hub, has professional resources available, and provides investment.
An Angel is an experienced business person, who has successfully taken their business to exit and is now re-investing some of their cash in new businesses. The difference between an Angel and other seed-stage investments is that the Angel will get involved in the business and provide advice and contacts.
VC’s used to be the primary source of funding for startups, but VC’s have reduced their appetite for risk over the years and now don’t get involved until much later in the lifecycle. They tend to only invest in Series ‘B’ and later, and tend to invest larger amounts of money. VC’s can also usually provide some assistance with contacts to sales prospects and partners. Perth has no VC’s investing at the moment.
An Exit by acquisition where the acquiring company is more interested in hiring the employees than acquiring the product or service. Usually seen as a better alternative to the outright failure of a startup.
A startup that reaches a huge valuation, usually set at over US$1 billion. The standard strategy of startup investing is to invest in lots of promising startups, knowing that most of them will fail, because there’s a chance that one of them will become a unicorn and pay back the losses on all the others.
Usually a loan that can convert into shares at some future point (though there are a myriad of options and variants). Investors like this because they get the preferred payout of a loan in the event of a disaster while also having the ability to convert to equity in the event of awesomeness. Founders like them because they don’t actually set a price on the company, so they get to use the money to build a company and then raise more money later at a better rate. However the terms usually favour the investor and can get very complicated so beware: here be dragons.
Public vs Private Companies
Public companies are able to sell their shares on public stock exchanges, but are expensive to run, because of the amount of paperwork and reporting required by ASIC. However they can always raise more funds by selling more shares on the share market.
Private companies can sell their shares, but there are restrictions; there is an upper limit on the number of shareholders, and some private company shares cannot be traded without permission of the company board. So private companies can only raise more capital by selling large allocations of shares to a small number of people.
The goal of all investors is the exit, when they get their money back. An exit is usually either from being bought out by a larger company (variously referred to as a “trade sale”, “acquisition” or “merger”, depending on the arrangement made and the parties involved), or the company becoming a public company and listing its shares on the stock exchange.
Pre-money and post-money valuations
Investment adds money to a company, so the company is worth more after the investment than it was before. A company that’s worth $500,000 will be worth $600,000 after a $100,000 investment, so it has a “pre-money” valuation of $500,000 and a “post-money” valuation of $600,000. For example: if an accelerator is funding startups at $40,000 for an 8% stake then it is automatically assigning a pre-money valuation of $460,000 and a post-money valuation of $500,000.
Be very careful when talking with valuations on a company whether you’re talking pre-money or post-money, especially when it comes to equity percentages. Someone investing $1m on a $1.5m pre-money valuation is in a very different position (40% equity, no control) to investing $1m on a $1.5m post-money valuation (66% equity and control of the company).
The process of investment involves buying shares in a company. Those shares are usually created from thin air (as opposed to being existing shares owned by existing investors). So when an investment round happens the existing investors own less of the overall share pool. This is referred to as being “diluted”. E.g. a company has 1000 shares before investment, and an angel investor owns 100 of them (10% of the shares). A new investment round creates 1000 new shares and sells them to the new investors, so the Angel now owns 100 shares out of 2000 total, and has been diluted from 10% to 5%.
A lot of early-stage investors have “anti-dilution clauses” in their terms that allow them to join any subsequent funding round on favourable terms to prevent dilution.
Preference or Protection
Shares that are given a higher priority to be paid out in the event of a disaster or buyout. So if a company pays out its shareholders then the shares with highest preference are paid out first in full, then the next preferred shares, and so on down. Founders are usually the bottom of this list, as preference is one of the levers that investors can use to limit their risk, so it’s entirely possible (but not very likely) for a company to be bought out for huge sums of money and the founders to get nothing because they were lowest in the preference chain. This fairy tale warning does the maths.
Reverse Buyouts aka Backdoor Listing
In a reverse buyout, a failing or small public company (called a “public shell”) buys a promising private company. The public company then changes its business (and sometimes name) to the private company’s business, and starts trading in the same manner as the private company. Effectively, the private company just became public and able to raise money on the stock market without having to go through all the hassle and expense of listing its shares on the market in the normal manner (hence a “backdoor listing”).
Reverse buyouts are common in resource industry investment, but are seen as “cheating” by some people. They are unpopular with conventional tech startup investors because they don’t allow for the huge returns that other investment models provide. But they are popular with resource investors because the shares are “liquid” – they can be sold at any time.
Equity-based Crowd Funding
Because of the expense of making a company public, there have been suggested ways of selling private company shares to the public without all the compliance and paperwork of making the company public. Equity crowd-funding is one of these. It provides a means for a private company to sell shares in its business to members of the public. Australian share rules prevent this at the moment, but there are moves to make it easier to do.
When an investor is interested in investing in a company, they will usually conduct a thorough investigation into the finances and operations of the company to make sure everything is as it was presented to them and there are no skeletons in the cupboards. This is referred to as “due diligence”.
When an investor decides to invest, they send the potential investee a list of their terms in non-legal language, called a term sheet. Term sheets are not binding agreements; if both sides accept the term sheet and agree on the investment then the legal agreement will be drawn up based on the term sheet.
Term Sheets are usually valid for a short period of time, and startups getting investment attempt to collect as many as possible so they can compare them and get the best terms.
The scalability of a business is the ability of the business model to grow easily without large capital investment. For instance: a factory that produces widgets needs to invest in machinery and production line space linearly with its output, so is not scalable. A tech startup that can sell 1 million subscriptions from the same code base as 1 thousand subscriptions is scalable.
Investors look for businesses that can scale because they can get the most returns from those businesses. Putting a small amount of capital into a business that can scale to a huge customer base with no further investment is the holy grail of startup investment.
Businesses that can’t scale, or that won’t scale because the founders don’t want to run a huge business, but are happy running a small business, are called “lifestyle businesses”. The name comes from the fact that they provide a nice lifestyle for the founders, but no returns for the investors.
This is probably the biggest conflict of interest between startup founders and startup investors: investors invest in many businesses and need every single one to get as large as possible as fast as possible, regardless of risk, because that’s how they make their returns. Founders invest in one business at a time and need it to be stable and successful, regardless of how big it gets or how long that takes.
There is also a difference in attitude between Silicon Valley-style investors, for whom Lifestyle Businesses are anathema and failing while trying to scale is OK, and Australian investors who tend to be less risk-prone and for whom failing at all is anathema and creating a lifestyle business is OK.