Understand the go-to-market strategy and product-market fit before investing. see more
What are the biggest challenges facing start-ups? In our blog "The Top Reasons Why Start-ups Fail," we discussed some of the main reasons start-ups fail. A common theme that caught our attention and was one of the main reasons for failure was the lack of a proper go-to-market (GTM) strategy and product-market fit.
Go-to-Market Strategy & Product-Market Fit are the two core components that investors should consider in order to reduce investment risk:
When framing a go-to-market strategy, it is important to assess whether a company is focusing on the right target group and entering the market at the right time and whether the market is saturated. The last thing you want to do is invest in a company launching an unprofitable product. Similarly, product-market fit describes how well a company's target customers buy, use, and tell others about a company's product in sufficient quantities to sustain the growth and profitability of that product. Achieving product-market fit is the key to a successful business. This means that there is a market demand for the product and people are willing to pay for it. Eric Vest delivered his keynote address at the May 2022 Keiretsu Forum Northwest & Rockies Roadshow, discussing the go-to-market strategy and scope of emerging start-ups. With over 25 years of entrepreneurial experience, the core theme of his presentation is understanding how to reduce risk in a portfolio through go-to-market strategies and product matching from an investor's perspective.
Simply put, a go-to-market (GTM) strategy is a step-by-step process of introducing new products and/or expanding existing products into new markets. Any good strategy should be able to answer the following questions: What are you selling? Who are you selling it to? What problem does it solve? How and where will you sell it? In which markets will you sell it? What are the needs? Who are your competitors? How did you get interested?
Bringing a product to market can be challenging, no matter how advanced the technology or how good the team is, developing a strategy that considers every possibility is the only way to ensure that you avoid mistakes and create a strong path to success for your company and investors.
Go-to-Market Strategy Framework
An efficient go-to-market strategy should include the following:
Defining the Ideal Customer Profile (ICP)
As an entrepreneur, the first and most important step is to figure out your overall target market. You need to define who your target market is, what problem you are trying to solve and create the ideal customer profile (ICP). It is important to create a more specific target audience who will gain value from your product and will eventually become the driving force for company sales.
Once you have an idea of your target market, you need to dig deeper into your new market strategy and look at the competition and underserved parts of the market. When you do, you'll also begin to understand whom you can actually compete with and how to effectively differentiate yourself from them.
Develop your messaging
A good messaging strategy includes many key points that provide information about your business and the value you add to your customers' lives. Once you've identified your market, created the ideal customer profile, and researched your competitors, you need to develop a messaging strategy for your business. Your strategy should include your positioning, value proposition, and mainly should align with the company values and the strategic narrative you have decided upon. The company messaging while strongly related to your brand and product should be distinctive enough to be differentiated from your competitors.
Setting your targets
All good GTM strategies have clear models. You can build these models within the capacity/budget you have.
Choosing your tactics
To implement ICP, you need to use multiple strategies at the same time. This includes data, marketing strategy, content planning, and partnerships. These 4 components must be further developed according to your strategy.
Establish feedback processes across all marketing, sales, product development, and other core departments to ensure key learning outcomes are implemented into the GTM strategy. To create this cycle, you need to hold individuals in your organization accountable for different parts of the strategy. If these people report their progress in regular meetings, you can overcome stumbling blocks together.
Eric now says he sees start-ups from an investor's perspective, and he sees them very differently. He believes that good strategies come from experience. All components of an entrepreneurial strategy are mostly based on theory, and only an investor with experience in the field can judge whether the strategy is good or bad. Simply put, a GTM strategy is a roadmap that measures the viability of a solution's success and predicts its performance based on market research, past examples, and competitive data. Finally, he points out that good product-market fit plays an even more important role if investors want to reduce the risk of investment failure.
Eric explained that in his experience, it all boils down to the product being a good fit for the market. Whether it's a group of founders or young entrepreneurs, as an investor, you need to take a close look at their deck and examine many different areas to see if it makes sense. They need to assess whether the business model is good, whether the market is large enough, and whether they have a competitive advantage.
What is it?
Product-market fit happens when you successfully identify your target customers and offer them the right product. After the product-market fit is achieved, the next step is to scale by researching to find more customers in the target market. Establishing product-market fit is a critical task for a new start-up.
So where does this concept lie?
Entrepreneur and investor Marc Andreesen, who is often credited as the developer of the concept, believes that product-market fit means finding a good market for a product that can satisfy that market. See the pyramid below to see how product-market fit connects the two sides of a company.
How can an entrepreneur achieve a good product-market fit?
- Make sure the strategy is well thought out
A key element of a go-to-market strategy is that it must make sense as a whole. Eric explained that the distribution model plays an important role in the overall strategy, but it is a component that investors often overlook. Especially when it comes to selling, it is important to keep friction as low as possible
- Learn how to achieve product-market fit
Learn how a team or individual entrepreneur will achieve product-market fit. It doesn't guarantee overall success, but the right product-market fit can help reduce the risk for emerging businesses.
- Teams that focus on product-market fit are more likely to succeed
Achieving product-market fit and winning customers should be the goal of everyone in the company. Everyone from the CEO to the team that interacts with customers should work together to find the right product for the market, as this ensures a great chance of success.
ABOUT THE SPEAKER
Eric Vest is a strategic and M&A advisor, specializing in laboratory informatics and all technologies related to biotech, pharmaceuticals, clinical trials, public health, and healthcare. He has a unique skill set that combines deep domain expertise with:
1) 25+ years as an entrepreneur, operator, and board member with three verifiable exits.
2) Rich experience working with private equity and venture capital (buy-side and sell-side).
3) Many years of fundraising at seed, early-stage, and growth-stage levels
He works as an advisor or board member, mainly assisting private equity firms, their portfolio companies, and other growth-stage organizations who are trying to plan for an exit, raise capital, or make acquisitions.
Mike Volker shares tips for investors on how to better protect their investments. see more
The Keiretsu Forum Northwest & Rockies Roadshow offers investors the opportunity to hear a selection of presentations from top emerging start-ups across multiple industries, as well as the latest news from past presenter companies. The topic for March was Term Sheets & Cap Tables and we brought together thought leaders like Mike Volker, Rob Tucci, Karen Howlett, and Mark Girouard to deliver keynote speeches at the virtual event. We try to provide investors with best practices using their knowledge and expertise on the subject.
Joining us for our first forum meeting in Vancouver was Mike Volker, CEO of WUTIF (Western University Technology Innovation Fund), an entrepreneurial angel fund, and president of the Vancouver Angel Network, VANTEC, and Keiretsu Forum Vancouver Chapter. In his keynote, he offered his insights on how investors can protect their investments. We walk you through the key takeaways of his presentation, especially common challenges investors face and suggestions on how to mitigate them.
WHAT CONSTITUTES A TERM SHEET?
According to Mike, whether it's a pre-seed, late-stage, or a Series-A round, the key components of a Term Sheet are securities, valuation (pre-or post-stage), Shareholder Agreement(s) (SHAG), amount, board & governance, legal compliance, rights, restrictions, vesting and CAP tables. Each Term Sheet must include a fully diluted CAP table with options. In the past, when it came to issuing securities, the preferred choice of shares was common shares, but more recently, especially in the U.S., there has been a shift to other classes of Preferred Shares. Other forms of securities offered also include SAFEs, debt instruments such as notes and debentures, and other than Common Shares; all of these instruments are convertible into Common Shares. This is an important factor when planning an exit.
THE DECLINING SECURITY OF SAFEs
SAFE stands for "Simple Agreement for Future Equity" and was created and issued as a simple replacement for convertible bonds. In practice, SAFEs allow start-ups and investors to achieve the same overarching goals as convertible bonds, although SAFEs are not debt instruments.
The Challenge for Investors
SAFEs offer little benefit to investors, they offer no ownership, no rights, and are fraught with a lot of uncertainty.
Entrepreneurs, on the other hand, benefit from SAFEs because they avoid the valuation question, act as money savers because they don't have to issue many special classes of shares, and can defer legal fees. There are some precautions in using SAFEs, and the SEC and FINRA caution investors against using SAFEs.
Safety: Simple Agreement for Future Equity with Shares Today. This is a simple arrangement for future equity, done by issuing shares.
- Instead of a SAFE, issue common shares priced at valuation CAP
- Include a term (in a subscription agreement) to allow conversion to a new class
Using this method, when Common Shares are issued, they include provisions in your standard subscription agreement that allows the conversion of what the investor buys and saves the Common Shares to convert those into the new class of shares. This provides investors with safety in the form of common or preferred shares and they enjoy all the rights and securities as shareholders.
WHY SHOULD AN INVESTOR CHOOSE LIQUIDATION PREFERENCE?
Through his keynote, Mike continues to highlight the importance of Liquidation Preference over common or preferred shares. He states that it plays an important role during the time of exit as investors get their capital back and then participate in the remaining cash balance on an as-if-converted basis. This helps reduce high valuations by increasing the IRR potential. In the event of an exit, investors who have a liquidation preference get their invested capital back and the rest is distributed to the remaining investors. Mike provides us with real-world examples of WUTIF investing in 3 different companies, all with different outcomes. The purpose of these examples is to give investors an idea of when Liquidity Preference may or may not be a good strategy.
Case 1: In 2014, a Media Company was looking to raise $500K with a post-money valuation of $3.25M. WUTIF purchased $75K in Common Shares and negotiated a 1X Participating Liquidation Preference on Common Shares. This right was covered in the Shareholders Agreement (SHAG) and approved by all Shareholders. In 2017, the company was sold for only $1.12M, and after repaying all the company debts $110K was available to distribute amongst the Investors. WUTIF received $8K in proceeds due to liquidation preference. WUTIF had also invested $10K in debt instruments which gave them a pay-out of $21K. In an alternative scenario, if WUTIF had invested their initial amount of $75K in debt instruments instead of equity, they would have received a payout of $41K.
Lessons Learned: A liquidation preference offers recovery when the company does not achieve projected profits; it is a better option than investing more in equity or purchasing preferred shares. It's also better to invest in debt instruments, especially when the company's financial outlook doesn't look promising.
Case 2: In 2012, an Agtech Company did a seed round with a pre-money valuation of $1.2M and it raised $300K via Common Shares. Since the company was having difficulty in raising funds, WUTIF negotiated a 1X Participating Liquidation Preference to attract investors and thus $300K. From 2013 to 2017, the company raised $11M in 6 seed rounds. They also exercised warrants during these seed rounds by lowering the price of the warrants originally offered to attract investors who could exercise them before their expiration date. On exit, the company was sold for $26M, which was a 17X return based on the original valuation of $1.2M. However, the share price only saw a 2X return. The investors only got a 2X return on investment. WUTIF received $282K on their investment of $150K by way of regular payout. Their special right for Liquidation Preference was not honored by the company. WUTIF filed a lawsuit against the company and won, after which their right to Liquidation Preference was honored and they received a payout of $432K.
Lessons Learned: As an investor, be careful when including special clauses in shareholder agreements, they are only agreements that can be easily broken. The only way to enforce a shareholder agreement is through litigation. In this case, having preferred shares would be better than adding special clauses.
Case 3: In 2020, an AI company did a seed round for $1M with a pre-money valuation of US $10M and was offering Class Seed Preferred Shares. WUTIF negotiated a 1X Participating Liquidation Preference with the expectation of a 10X exit in 5 to 10 years. The company exited 10 months later with an exit value of a little more than US $25M. WUTIF received US $330K on their investment of US $100K by way of Liquidation Preference.
Lessons Learned: In this case, with a large payout, the cost to shareholders is minimal. Participating LPs moderated the high valuations and the company was able to raise the necessary capital. A 2x return in 1 year is better than a 10x return in 5 years.
INVESTOR TO-DO LIST
Mike states that you must always put your interests first. Keep this in mind the next time you invest, negotiate a term sheet, or plan an exit. Instead of chasing 10x returns all the time, investors should start thinking more about IRR than multiples. As an investor, it's time to become vary of SAFEs, or even better avoid them altogether. The easiest way to mitigate high valuations is to opt for liquidation preferences, warrants, and sweeteners. Last but not least, please be aware of legal documents, they are not binding and do not guarantee the expected results.
ABOUT THE SPEAKER
Michael ‘Mike’ Volker is an Entrepreneur active in the development of new high technology ventures. A University of Waterloo Engineering grad, Mike started his own company (Volker-Craig Ltd) in 1973. After selling his company in 1981 he decided to work with entrepreneurs in building new companies. Recently he directed Simon Fraser University's Innovation Office. Presently, he is chairman of TIMIA Capital, [TCA.V] a public company that invests in young growth companies. He is CEO of WUTIF - the Western Universities Technology Innovation Fund - an "angel" fund for start-ups. Mike is President of the Vancouver Angel Network, VANTEC, and the Vancouver chapter of Keiretsu Forum. He's chairman of New Ventures BC - an annual business competition. Mike was chairman of the Vancouver Enterprise Forum for several years. Click here to watch his keynote address.
Learn how a few extra steps can improve your decision-making see more
You may have heard many times about due diligence in the investment world. A good due diligence process ultimately becomes the deciding factor in whether or not to invest in a company. It also lays the foundation for smooth integration.
But what is personal due diligence? How is it different from Keiretsu Forum’s five-stage due diligence process? How is it done? And why is it absolutely necessary?
Keiretsu Forum member and investor Mark Kerschner sheds light on the topic. He has been investing since 2017 and has made 11 investments since then. Here is his 5-Step Due Diligence Process.
5-Step Personal Due Diligence Process
1) Understand your strengths and weaknesses
Mark says the first thing to consider when you start investing is understanding your strengths and weaknesses. He explained that his experience in different financial roles in various countries helped him see things from a different perspective.
If you're an investor in a company's due diligence team, and you have a solid understanding of its industry, use that knowledge to drive the discussion forward. Alternatively, if you're on a due diligence team and feel like your knowledge is not relevant to the sector, ask yourself who you can add to the team to better comprehend your questions and challenges.
Evaluating your position in the due diligence team is the first step. During due diligence, you should ask yourself: What am I bringing to the conversation? How can I use my strengths? How can I overcome my weaknesses?
2) Do you know why you want to be an early-stage investor?
Mark says there are many different reasons to invest, and every investment will put you down a different path. It's important to ask yourself, he continued, why are you investing in a certain type of business? Is it because you want to support environmental and social causes? Is it because you are rich and want to give something back? Is it because you are a capitalist and want to support young entrepreneurs?
Investing in early-stage companies can be extremely advantageous to investors. Investing in a start-up from the beginning benefits investors as in most cases it leads to significant returns. Investors can work alongside the higher-ups of the company, give their input, and make instrumental decisions for the success of the start-up. Investing in a start-up can also be very risky, but if successful, the rewards will exceed the initial capital provided. Knowing this and then starting your due diligence with a company that fits your investment appetite is a crucial step. There are several reasons why people invest in start-ups, here are a few:
- Saw Shark Tank and thought it would be fun to imitate
- You are a capitalist and want to help young entrepreneurs
- Retired, bored, and looking for work
- Wealthy and want to “give back”
- You want to diversify your portfolio
- Need a quick return on investment
- Support environmental and social causes
3) Determine how much you are willing to lose?
The hardest idea is that you have to accept that you can lose the amount you invested.
Angel investors are individuals who provide capital to promising start-ups in exchange for ownership, usually in the form of equity. As an investor, you must accept the risk factors and know that the chances of a significant return on your investments are slim. Mark recalls getting the same advice from another member of the Keiretsu Forum: " Never forget that early-stage investments are very high risk."
Only invest in what you are willing to lose! Mainly because the risk is so high that it takes a lot of work to look at a company profile before investing, especially if you want to reduce and/or eliminate risk as much as possible.
4) Determine your time horizon
Are you planning for a liquidity event in 3, 5, or 10 years from now?
Time horizon is important because it is an important factor in determining whether an investment is suitable for an investor. It is also a crucial factor in determining the level of return on investment. The longer the investment period, the higher the potential return. As an investor, you need to consider your age, income, lifestyle, and risk tolerance before investing. Mark noted that he often finds that liquidity time frame expectations do not always match reality. Liquidity events are often delayed, and as an investor, you should always consider a delay in this process when investing.
5) Create a checklist to set yourself up for success
Join Multiple Angel Groups: Mark shared that if he could go back in time and start over, while also being part of other groups, he would make Keiretsu Forum his primary angel investor group. For example, he is currently part of Atlantic Bio Angels, as his investment interests continue to be drawn to therapeutics and medical devices. Joining multiple angel groups can be a great learning opportunity, especially when you notice the qualitative differences between groups, and learn from other investors’ insights, backgrounds, and perspectives.
Embrace the power of Mindshare: As an investor, it is important to be part of a diverse group and harness the power of mindshare. This is where you learn the most, especially about yourself.
Get to know fellow angel investors: Nothing beats some old-fashioned networking! Whether you're a seasoned angel investor or new to the game, there's always something to learn as you meet and build relationships with your fellow angels.
Invest with patience: Invest patiently! As an investor, you may be happy to invest in the first company you come across, but the truth is that rounds always come and they don't always end tomorrow. You need to spend several rounds of due diligence to really vet companies and understand them.
Participate in Due Diligence: Mark remembers that the best investments he made were when he was involved in the due diligence process. It gives you the opportunity to have professionals who understand the company or other parts of the industry, have a different perspective, and really study the company in depth. The due diligence process can also give you a complete picture of the company you are considering investing in.
Ask questions to the CEO: You can spend time with the CEO and get to know what they think. Do they stick to their cause, or are they willing to accept outside opinions? Will they listen to the board or advisory committee? If you are not on the due diligence team, he recommends that you still make sure to have multiple conversations with the CEO.
Speak to the Advisory Committee:
Meeting team members along with the CEO is also important. If a company has an advisory board, call them and ask to meet with them. Ask how involved they are and how often they are involved in what's happening at the company. Due diligence, while very time-consuming, creates the greatest chance for success.
Conduct a site visit: Visiting the site and really getting to know the company can be time-consuming, but it is a very important step before making any investment.
Winners & Losers in Investing (With Examples!)
Mark shares some examples of companies he has invested in, and looking back at his past investments also gives him a chance to see where he's made the right decisions and where he's gone wrong.
Example 1: Company XYZ
Mark’s relationship with the company:
- A Keiretsu Member called about an opportunity
- Technology company, his bailiwick. “Company has great technology”
- Spoke to CEO who seemed knowledgeable about the space
- Impressive deck
- No Due Diligence or Mindshare
- No site visits
- Invested the lowest amount
Mark said it was one of his biggest mistakes. Another Keiretsu member who brought him to the company reminded him that it takes 22 investments to get a 2X or 2.9X return. Mark regrets that he did not conduct a thorough personal due diligence with this company and he did not enjoy the benefits of participating in mindshare and a due diligence process with the team. As a precaution, it's one of his lowest investments, and it's one of two that are currently hanging by a thread. He said he would not have invested in the company if he had taken the time to research it further.
Example 2: FEMSelect
Mark’s relationship with the company:
- Watched a 60-minute clip on the plastic mesh disaster in surgery
- Witnessed FEMSelect in an Angel Investor Fair. Fellow BSA members explained how open the relevant markets are
- Multiple meetings/talks with CEO, with a final meeting in New York
- Reviewed all available materials about the company
- Reviewed Keiretsu Forum's Due Diligence report and saw an updated presentation
- Stayed in touch with management
FEMSelect is a company that Mark has invested in through Keiretsu Forum. He recalled watching a 60-minute presentation on the disaster of plastic mesh in surgery. He spoke to the CEO multiple times, reviewed materials, called company employees and associates, and even reviewed the Keiretsu Forum due diligence report. FEMSelect is currently in the commercialization stage, is starting its VC round, and is well on its way to profitability. Mark is very happy with his investment and praises the research that helped him get ready to invest.
Example 3: Seneca Therapeutics
Mark’s relationship with the company:
- Two-hour discussion with the founder’s advisor
- Lunch and four-hour discussion with founders and advisors
- Personal research - what is an oncolytic virus, patent protection, etc.
- Initial Investment
- Keiretsu Due Diligence Team Member (investment disclosed)
- Ongoing dialogue with founders on how to strengthen the company
- Secondary investment
- Invited to be a Board Member
- “Volunteered” to become the company CFO
Mark took a 2-hour train ride with a member of Keiretsu Forum and one of the advisors to the founder of Seneca Therapeutics, where he had the opportunity to briefly learn about the company. He found the experience interesting and ended up organizing a personal follow-up meeting with the founder and advisors, which lasted 4 hours, through which Mark was able to learn about areas he was unfamiliar with. Mark started researching oncolytic viruses and patent protection and eventually made a small initial investment in the company. The company then presented at Keiretsu Forum, and after Mark disclosed his investment in the company, he worked on the due diligence team and got to know Seneca's team very well. After making his second investment, he was invited to join the board and eventually volunteered to be the company's chief financial officer.
Mark's advice to investors is to do personal and team due diligence before you start thinking about investing in any company.
ABOUT THE SPEAKER:
Mark Kerschner is an Angel Investor, Advisory Board Member, and Board Member. He began his career with PWC in NYC and has been a CFO of both public and private companies, working in the chemical, engineering, and pharma industries. Currently, he serves as a Board member and CFO of Seneca Therapeutics, Inc. He is an active member of the Broad Street Angels, Mid Atlantic Bio Angels (MABA), and Keiretsu Forum.
Wondering how to use Term Sheets to your advantage? We show you how! see more
Mark Girouard, CEO and founder of Stage Right Ventures, and member of Keiretsu Forum Northwest & Rockies joins us as our keynote speaker as we wrap up our last March 2022 Forum session in Portland/Oregon. In his speech, he talks about what he likes and dislikes about Term Sheets, and how you can use them to your advantage.
Mark started his keynote by pointing out the importance of a balance sheet. He explained that the balance sheet is the financial basis for understanding capitalization and dilution. Cash is generated by issuing company stock. When debt is converted into equity (convertible bonds) or equity is issued, these events lead to new capitalization events and may dilute existing shareholders. He went on to stress the importance of capitalization tables. Mark says the CAP table is the history of every good or bad Term Sheet the company has written. It helps if the investors make an effort to analyze the reason why the company continues to raise money in the first place.
A Term Sheet is a document exchanged between two parties that contains the terms of their agreement. It is a summary of the main points of the agreement and clarifies any differences before finalizing any legal agreement. While the Term Sheet will not change the balance sheet or CAP table, the execution of the related agreements will. Mark sees the connection between the balance sheet, CAP table, ownership claims, and Term Sheet. They are usually offered by companies, but can also be offered first by investors.
According to Mark:
- A Term Sheet is a person's idea of a possible agreement that affects the terms of ownership. It starts negotiations and hides many potential points that investors and companies must ultimately agree on, either implicitly or explicitly.
- A Side Letter is a condition that a particular investor requires outside the scope of the Term Sheet. It is advisable to commit to an investment once you have understood all the components of the document.
Summary: When you look at a CAP table, Term Sheet, Balance Sheet, Ownership & Investment, you have a clear idea of the company's situation.
SO, WHAT ARE THE MAKINGS OF A TERM SHEET?
Mark explained that in his experience, there is no standard format for Term Sheets. Some are long, some are short, but they generally provide information related to funding, pricing, liquidation preferences, governance, cost, and timing. It also depends on the business, but the main parts of the Term Sheet are:
- Liquidation Preference
- Conversion into Common Stock
- Voting Rights
- Board Structure
- Drag Along Rights
CATEGORISING THE ‘TERMS’ IN A TERM SHEET
Mark noted that companies or investors can distribute Term Sheets to start negotiations, and often target terms that favor the author of the document. Each party can be either informed, foolish or nefarious and designed to encourage or deter behavior through the business process set out in the Term Sheet. Generally, the terms within a Term Sheets fall into the following categories:
Economic Terms: Price, Liquidation Preference, Pay-to-Play, Vesting, Exercise Period, Employee Pool, and Anti-dilution.
Control Terms: Board of Directors, Protective Provisions, Drag-Along Agreement, and Conversion.
Other Terms: Dividends, Redemption Rights, Conditions Precedent to Financing, Information Rights, Registration Rights, Right of First Refusal, Voting Rights, Restriction on Sales, Proprietary Information, and Inventions Agreement, Co-Sale Agreement, Founders’ Activities, IPO Shares Purchase, No-Shop Agreement, Indemnification, and Assignment.
HOW DO SIDE LETTERS IMPACT YOUR INVESTMENT?
A Side Letter contains clauses that supplement or in some cases modify the terms of the investment agreement and are usually contained in a letter approved by the parties. Side Letters are often used to grant special rights and privileges to lead investors. (Seed investors, strategic investors, individuals with large commitments, employees, friends, family members, or government-regulated individuals.) Bad Term Sheets or a complex set of unique investor needs may require side letters.
Side Letters cover the following areas:
- Information Rights
- Resale Exemption
- Pro-Rata Rights
- Most Favored Nation
- Board Observer Rights
- Attorneys’ Fees
- Any other contractual right, waiver, and an amendment to the Term Sheet or Investment Agreement
WHAT DO TERM SHEETS REFLECT ABOUT YOUR INVESTMENTS?
There are 3 main investment types to be aware of: Equity, Convertible Notes & Debt. All other investments like options and warrants are byproducts of these 3 basic types. A Term Sheet can contain one or all potential investment decisions. Mark goes on to say that a Term Sheet can lead to an investment agreement and a potential relationship of five to seven years or more. It is important to realize that for those looking for funding, the supply of Term Sheets is endless and must be chosen wisely before engaging in this type of relationship.
WHAT ISN’T A TERM SHEET?
The Term Sheet does not contain all the information needed to make an investment decision. It's mostly a depiction of the market and helps in starting a conversation between investors and companies. Ideally, Term Sheets allow for the creation of a "possible agreement" zone for the parties to reach an agreement in further discussions. Term Sheets are non-binding, brief, general, limiting, and should not be agreed upon without a deeper introspection and an assessment of the capabilities of the parties. Here are some of the key elements missing from the Term Sheet:
- Conversation with anyone in the company during happy hour or over coffee
- Prior Term Sheets
- Term Sheets sent to other investors
- Side Letters that have been signed or not yet signed
- Other agreements affecting the interests of other investors
- The Investor’s interests unless they created the Term Sheet
- A clear indication of who has their “Skin in the Game” in the past, present, or future
- The full agreement and understanding of all related parties
WHAT MARK LIKES WHEN IT COMES TO INVESTING
In general, Mark said, as an investor, he wants to have a clear view of the money he has invested in the company and the exit. He also wants to have a thorough understanding of what can be achieved, and a consensus between all parties to make that happen. Specifically, he is looking to be paid a return of his money and then a return on his money. He went on to say that if there is no prioritization or confusion on this process, then it is not an investment. Clear approval and compliance to hit milestones, not comfort or charity, is what he or other investors are looking for. It is important to strike a reasonable balance of performance to pay back regarding the right investment type, soft needs, and term types. In essence, it is important to note starve the company and also not to let them run wild.
Investment Type (Mechanism) Soft Needs (Non-economic) Term Types
- Debt backed by Cash Flows and milestones
- Equity once de-risked
- Royalty or Dividend Methods
- Recap Methods
- Regular Reporting
- Regular accountability with non-management oversight
- High Trust
- High Skin in the Game
- Performance Incentives aligned to Investors
- Preferences & Protections
- Control (in the event of a failure)
- Economic incentives (reward investors and the Founder is an investor)
WHAT MARK DOESN’T LIKE, WHEN IT COMES TO INVESTING
Mark outlines things he doesn't like about investing, such as bad deals, little accountability, and more. He also suggests some things to watch out for as an investor. Bad Deals have Bad Terms and Bad Communication and are surrounded by vultures every step of the way.
Bad Terms Bad Communication Vultures in the past, present, future
- No Information Rights.
- Later investors with excessive rights. Avoiding early investors.
- Management with too much control, too little oversight.
- New Terms are only communicated to interested parties, not all investors. Fiduciary duty.
- Moving the company HQ.
- What management is being paid in total?
- What cash any member of the CAP Table has put in.
- Advisory Agreements without a purpose, or too many shares.
- Misaligned boards.
- Speeding up the process unnecessarily such as “Please read the 150-page document in 1 day and please send a check”. The devil is in the details.
TYPES OF INVESTMENTS THAT MARK RARELY LOOKS AT
Mark follows Warren Buffett's two investing rules:
- Don't lose money
- Don't forget the first rule
He went on to say that he rarely considers any term or activity that doesn’t put investors first or create exit opportunities for investors. According to Mark, any Term Sheet that confuses this is not one to look at. He explained that people in the finance and funds industry love terminology and jargon, but if you start with enough bad terms, it's best to stay away from bad deals with no exit possibility. While it's nice to have a range of terms, it's more important to stay away from bad deals. Unless the terms are easy and take into account all parties, it can go a long way in achieving a realistic exit and be a nightmare to align interests.
Here are some examples:
- Events that never happen: It's nice to have clear rights, but more complex terms only come to play after certain events occur. It is important to understand the probability of such events
- Rights that don’t apply to me: Many of the “rights” have colloquial names that help investors close deals on the edge. Often these terms can be used to justify economics or control, which may not be a "right" at all. It is important to know which terms do not apply to you and which terms generally apply to others. Find out which rights affect your investment.
- Performance Exuberance: any term that includes an exuberant, illogical share price trigger based on performance that has never occurred
- Bad incentives: Incentives based on negative performance. Sometimes people use this word to see if you're listening.
MARK’S EXPERIENCES AS AN INVESTOR
A Term Sheet is a combination of what happened before, what worked, what didn't, and people's favorite terms. If a company messes up, there are fewer terms available, but usually seeks to pit one group against another. Here are some examples of important terms to be aware of:
- Invest now, I will send you the investment agreement later
- Penny warrants when only a few investors remain
- 50% discount for family members on IPO/exit
- Dividend and payroll liabilities on exit
- Excessive control terms for certain parties
- Excessive economic terms for certain parties
- Pricing triggers, valuation triggers, performance, and share issuance to management
- Any benefit/penalty to either party
- Over a period of time, the encouragements and discouragements for specific parties get outlandish in good and bad deals
AN EXAMPLE OF TERM SHEET NEGOTIATION
Balancing the interests of all key parties is critical to a successful Term Sheet. Excluding certain groups creates problems. The following parties are listed in order of importance:
- Previous Investors
- New investors
- Staff (to develop the business)
The table below is based on Mark’s personal experience. It is an example of leading the next down round, bringing consistency, and hitting milestones.
The Past The Event The future
- No Communication.
- Down Round from high overpricing.
- Poor performance and use of capital.
- Asked to lead a down round, almost walked away.
- Making promises with few options left.
- A never-ending supply of Employees and Advisors not contributing cash.
- COO negotiating the Term Sheet quits 6 months later.
- During covid, the company did surprisingly well.
- Clear consistent communication, required investor relations.
- Better management & team goals.
- Better investor coordination.
- Exit likely in 1-2 years.
TERM SHEETS AS A SCIENCE
In the end, Mark pointed out that every time you see a Term Sheet, it indicates something bigger and more comprehensive. Mark believes that Term Sheets are a science where you can play your cards and influence the value of your company in the future. He asked do you want to own 100% of a $1 million company or 1% of a $1 billion company? He went on to say that when valuations rise, ownership falls, and when investors' money is used efficiently, economic performance improves. Increasing the percentage of ownership of less valuable property and wasting cash is sure to lead to failure! Finally, Mark points out that every time you see a Term Sheet, it points to something bigger and more comprehensive.
ABOUT THE SPEAKER
Mark Girouard is the CEO and Founder of Stage Right Ventures, an Advisory, Investment, and Technology Firm focused on building high-quality companies with a successful divestment plan. His extensive background in corporate finance and transaction services uniquely positions him to provide expertise and advocacy for entrepreneurs and investors. His exclusive approach drives clients to build enterprise business value, robust financial models, integrated solutions, and profitable transactions. Click here to watch his keynote address.
Here's how a thorough due diligence process can protect your investment interests. see more
You probably already know that starting a business can be a challenging journey. Few companies have the right product-market fit, the right team, and the right business model to guarantee their future success. Have you ever wondered where most businesses go wrong? How and why, do they fail? The factors that hinder success are often not just one, but many. As an investor and entrepreneur, it is important to understand why before you invest and/or start a business.
Rob Neville has been active in the Keiretsu Forum NorCal region for ten years, initially as an entrepreneur and investor. In the Portland chapter of our May 2022 Roadshow, he outlines the top three reasons start-ups fail. They are as follows:
TOP REASONS WHY START-UPS FAIL
According to Rob Neville, the top three reasons start-ups fail are capitalization, poor product-market fit, and teams. The reasons below cover over 90% of start-up failures.
The first hurdle start-ups need to acknowledge after their launch is that they don’t have enough capital, this can be due to the failure to raise money, or that they did not raise enough money.
The CEO must be a good storyteller
The process of raising capital is closely tied to whether the CEO is a compelling storyteller. At the end of the day, if you cannot tell a story about your company, you cannot motivate your audience to write a check. Any CEO who cannot do that will have a hard time raising money. Rob recalls hearing presentations from companies in the past, where the idea was great, but the presentation did not convince him to write a check. During the due diligence process, he often helps revise presentations and coaches CEOs on how to tell the company story more persuasively.
Address the most important risks early
From a capitalization perspective, start-ups are always risk-oriented, so as an investor, everything is about addressing those risks. During the due diligence process, it is important to identify significant risks early on, before any funds are invested in the company.
Align GANTT Charts, Revenue Usage, and Financials
A GANTT chart is a bar chart that represents a project timeline. Rob recalls that he rarely encountered a company's GANTT chart where the revenue and financials were all lined up. As an investor, it is important that you work with the company to adjust all elements on the chart and accurately reflect it in all other documents.
Talk to primary vendors
It is vital not to blindly believe what the company says, and to have a dialogue with other stakeholders such as primary vendors. Example: If there is a manufacturer that makes widgets for a company, you should talk to them and confirm that the timeline shared by the company matches their timeline for delivering a complete and functional product. If not, adjust the GANTT chart and financial data accordingly.
Appropriate security and terms
Proper security is an important factor in this process, as you take many risks when investing in a business. So, whether you see a $1 billion valuation or even a $100 million valuation, if the company is coming to angels for investment, the numbers are probably not 100% credible. It's wise to spend a lot of time making sure safety measures are in place. Investors generally prefer convertible bonds to SAFEs because they are safer.
2) PRODUCT-MARKET FIT
The second hurdle to overcome is product-market fit. As an investor, don’t simply trust the data the company provides, do your due diligence to see if the product has a place in the market or not.
Validate every assumption
The CEO said the product is in high demand. Don't believe it.
The CEO said the product has a 70% profit margin. Don't believe it.
Don't believe in assumptions and don't listen to opinions. If there's one thing to watch out for, it's peer-reviewed data. For example, if a company is making assumptions about data, then every number they talk about, every number in their executive summary, and every number in their slideshow needs to be correlated, challenged, and validated.
It is important to develop your Total Addressable Market (TAM), Serviceable Addressable Market (SAM), and Serviceable Obtainable Market (SOM) and challenge the business with your data. In most cases, they will probably just adjust their model based on your input.
Market Validation (early traction, survey)
How to measure market efficiency? The first step is to look at customer acquisition cost (CAC) and lifetime value (LTV). This can be done by mapping sales in the marketplace, but if a company isn't already selling anything, it's important to know the size of its customer base. This can be done initially with a qualitative survey; you use your network for this. Next, conduct quantitative research with the help of the company to understand who the customer is and what their buying process is like.
Never invest in a sinking ship. Any investment you make should be in an expanding industry. Therefore, adapting the product to the market is critical, which is why investors should spend a lot of time talking to as many customers as possible during the due diligence process.
If a company has a good team, all other factors generally fall into place. As an investor, how do you approach the challenge of understanding the people behind the company?
Get to know the board and team
For angel investors, the only real opportunity to meet the team of the company you invest in is during the due diligence process. So, what can you do to overcome this challenge and know if the team behind the company has what it takes to make the company successful? Spend time with them formally or informally. A due diligence meeting is one thing, but you can also meet informally, such as for dinner or set up discussions during a sporting event. Conduct secondary reference and background checks, talk to as many people as possible, and make sure any data shared by the CEO and executive team is validated by these checks.
Wild Assertions/Lack of Humility
Always pay attention to any assertions made by the CEO. If he or she makes an exaggerated statement, treat it as a red flag. As an investor, you don’t want wild assumptions, you want a humble CEO who understands the ups and downs and sticks to the facts.
It is important that the core team working for the company are investing their own money into the business and are there in a full-time capacity. It is imperative to judge teams by their backgrounds and whether they have the grit and tenacity to move the company forward.
The following chart by CB Insights outlines additional reasons why start-ups fail.
Rob’s Due Diligence Philosophy
- Due diligence is more than checklists and fact-checking
- The Due Diligence process should shape the company into a viable and investible entity
- How can this be done? Focus on what makes start-ups crash
- It should validate your pre-defined investment criteria
- Due Diligence continues well after the DD report is done
Rob explained that as an investor, you should always go beyond the due diligence checklist. When a company comes to you and you have a legitimate interest in the company and see areas for improvement, it's important to take action, especially when doing due diligence. If the CEO can't tell the company's story well, you should spend weeks or even months helping them solve the problem and turn it into something convincing. The process of due diligence shapes a company into a viable and investable entity, not just through its pitch presentation, but also through its financials and go-to-market strategy. This can only be achieved by taking an active role in the company. If you have completed the due diligence process, you may not be ready to invest 100% in the company. You can invest the minimum amount and watch the company’s performance over time, and once you are confident that it can achieve its goals, you can go ahead and invest more money. Thus, the due diligence process continues way beyond the completion of the report.
ABOUT THE SPEAKER
Rob Neville is a successful entrepreneur now turned angel investor. As CEO of Savara, Rob attracted one of the largest historical amounts of angel investment ($50m from 400 angels including $15M from Keiretsu) - Savara was listed on NASDAQ in 2017. Prior to co-founding Savara, Rob founded and served as CEO at Evity, which he subsequently sold to BMC Software returning 30X to angel investors in just over 1 year. Based on his work at Savara and Evity, Rob was honored as a three-time finalist for the Ernst & Young Entrepreneur of the Year Award, winning the life science award in 2018. Rob now serves as a repeat judge in the Earnest & Young Entrepreneur of the Year Award. Rob is currently Managing Director at Springbok Ventures, investing in and assisting early-stage startups.