FIN 435 Exam 2

Lifetime

1/churn rate

Sales Funnel: Distribution channels

Sales funnels can be tracked for each distributions channel. It is important to track the distribution channel through the unit economics process because LTV can vary by channel.

Pitch Decks Specific Slides- Appendices

Save the very detailed information for the appendices.

State Corporate Law

State law sets certain governance procedures in the event that they are not provided for them in the formative documents.

Pitch Decks- Slide Order

-Problem First: Start with the problem/opportunity. Don't lead with the product. -Biggest issue third: Investors usually have one big question. If the start-up does not address this question immediately the investor will be distracted for the rest of the presentation. -Team late: Don't put the team slide early in the pitch unless the team is extraordinary or synonymous with the business itself.

3 most important parts of a scorecard

1)Team, 2) Size of opportunity (TAM), and 3) Tech

Scorecard typical pre-money valuation amount

5 million

Pay to Play

A lead investor may want to require that all investors must continue to participate in future rounds or lose certain rights, such as their liquidation preference.

Unit Economics: The Unit

A single customer. It is important that this unit stays the same throughout the analysis on the revenue and cost side.

No shop provision

Although the terms themselves are not legally binding, it is often the case that the parties will agree to use their best efforts to try and close the deal. The company raising the money will agree to not continue to seek funding for a fixed period of time. This obligation is legally binding.

Payback of CAC

CAC/Net revenue per month

Insurance

Confirmation of critical insurance such as workers compensation, directors and officers (D&O) insurance and other insurance as appropriate for the business.

Corporate formative documents and board activity

Confirmation that formative documents have been properly prepared and procedures followed. Review of board minutes.

Management (Corporate Governance)

Decisions: Day-to-day such as hiring, firing, and compensation of non-executive employees, limited choice of expense categories and amounts, and limited contractual decisions. Selection: The executive management team selects lower level management. The board selects the CEO.

Board of Directors (Corporate Governance)

Decisions: The board makes high level decisions such as significant borrowing, selection and compensation of the CEO and major purchases and sales. Selection: The board is elected by the shareholders or members according to the formative documents. Size: Corporations generally must have a board of at least one person. A board is not normally required by state law for an LLC. Boards usually start small and grow as the company grows.

Shareholders/Members (Corporate Governance)

Decisions: The most important decisions of the company usually require shareholder vote. Examples include a merger, liquidation or sale of substantially all of the assets of the company.

Pitch Decks- Design

Don't under-estimate the importance of good slide design. Many investors will consider bad slide design to be a sign that the start-up will not be able to communicate well with customers.

Drag-Along Rights

If one group of shareholders agrees to a sale, all of the other investors must agree as well.

Liquidation Preference

If the company liquidates, the investor will have a claim of $X on the proceeds ahead of the common stockholders. Typically, this amount is equal to the investment plus any accrued and unpaid dividends.

Financial audit

If the financial statements are not audited, a detailed review of significant items.

Sales Funnel: A/B Testing

In digital marketing channels it is common to test alternative tactics and then choose the best one with the best conversion rates/CAC.

Employees

Interview employees to assess quality, potential and needs.

Customers

Interviews with customers to audit financials as well as assess customer adoption.

Investors invest in lines not dots

Investors invest in relationships and not one time meetings

Right of First Refusal

Investors may ask for the right to invest in the future at terms agreed to by the Company with another investor (beyond their pre-emptive right to participate pro-rata). This can make it more difficult to raise money as it introduces a third party into the negotiations.

Pre-emptive rights

Investors typically have the right to invest in future rounds to preserve their percentage ownership. For example, if an investor owns 10% and the company is issuing 1,000 shares, the investor has the right to buy 10% or 100 of the shares.

Anti-Dilution Protection

Investors typically will want to be protected from dilution from shares being issued in the future for less than the amount that they pay, often called a "down round." This is generally accomplished by issuing the existing investors additional shares in such an event.

Information Rights

Investors will likely require the periodic delivery of financial statements and timely tax information, such as a Schedule K-1 in the event of a partnership.

Start-up Term Sheets General- Who initiates

It is common for the lead investor to initiate the term sheet

Protective Provision

It is common that certain major corporate events, such as a sale, must be agreed to by a majority or super-majority of each class of shares. This allows a minority investor to be protected from the unilateral will of the majority. Note that there is always some degree of protection in the form of fiduciary duties owed by directors and officers to all shareholders.

Value versus pricing terms

It is common to refer to the pre-money and post-money valuations of start-ups. See Start-up Rounds and Pricing. These are pricing terms and do not necessarily represent value.

Preparation

It is important for start-ups to be prepared for due diligence before it begins by creating a virtual "data room" with documents to be reviewed.

Market Terms

It is important that all parties to a term sheet know what is normal in the market for the type of deal that is being negotiated.

Background checks

Key individuals for criminal, civil and credit issues.

VC method

Know what drives multiples, higher growth rates the higher multiples, VC need very large potential returns which causes them to make sure its in a company which can hit a big home run

Important contracts

Legal review of important contracts with partners and other.

Net Lifetime Value

Lifetime Value - CAC

Unit Economics: Churn rate

Lifetime is measured by the attrition rate per period (churn rate) i.e. the percentage of customers who leave every period. Average lifetime equals 1/churn rate.

Primary groups responsible for corporate decision making (corporate governance)

Management, Board of Directors, and Shareholders (or members in an LLC)

Start-up Investing Due Diligence

Once a term sheet is agreed to the lead investor begins due diligence. The purpose of due diligence is to check to make sure that there are no major items that would substantially reduce the value of the investment. The amount of due diligence required varies by the size and complexity of the start-up business.

Tag-Along/Co-Sale Rights

One group of investors cannot sell shares unless all other investors have the opportunity to participate in the sale on a pro-rata basis.

Tax compliance

Potential undisclosed tax liabilities that could create personal liability for investors.

Pitch Decks Specific Slides- Title

Put the name of the audience on the title slide. People like to see their name and they are less likely to forward the deck if their name is on it.

Multiple with dilution

Required multiple / (1-%dilution)

Required multiple

Required value surviving firms/investment per firm

Required value of surviving firms

Return proceeds / (# portfolio companies - # companies fold with 0 return)

Lifetime Value

Revenue per month times lifetime(in months)

Technology

Revenue technology in place and needs. Assess any security issues.

IP Ownership

Review of contracts transferring all claims of ownership to intellectual property to the company. Review of IP applications and office actions. Discussions with attorneys related to defensibility.

Human resources

Review of issues, HRpolicy document, contracts and non-compete agreements.

Accounting systems

Review of systems and policies.

VC Method General

Simple method of valuing a start-up by forecasting a liquidity event (exit event) such as sale or IPO and discounting the value at that future date to today given a required return and dilution. The VC method is related to Valuation with Probability Trees.

Pitch Decks Specific Slides- Intro

Some people suggest an introductory elevator pitch slide. Others say that this can be distracting and risks getting off course early.

Condition Precedent

Something that must happen before the funding closes.

Valuation of Start-ups

Start-up companies are difficult to value because they often have no reasonable expectation of free cash flow for the foreseeable future. This means a traditional income based/ Discounted Cash Flow (DCF) analysis is not practical.

Growth

Start-up investors demand growth in sales. Once sales start, there must be steady growth to keep investor demand. For this reason, early stage start-ups are focused on tracking and reporting month over month top-line growth numbers.

Dividends

Start-up shares often have dividends, but they are rarely ever paid in cash. The dividends accrue until a sale or liquidation.

Cash Flow Tracking

Start-ups fail when they run out of cash. More so than any other type of company, as cash gets closer to zero the ability to bring in more cash through financing gets geometrically harder. For this reason, it is very important to track cash balances and forecast cash needs very closely.

Unit Economics General

Start-ups must prove that their new product or business model is profitable at the level of a single customer (unit economics), before they can raise money to scale. Business is complicated and start-up economics can be especially confusing. It is critical that start-up managers understand and optimize their unit economics.

VC method steps

Step 1) Forecast the project value of the company in the future. This is often accomplished with multiples based on acquisitions of similar companies or prices of comparable public companies. See Valuation with Multiples. Step 2) Consider the amount of dilution that will be required to achieve the forecasted liquidity event. Specifically, add the number of common shares that exist today to the number that will need to be issued prior to the liquidity event. Determine the value per share at the time of the liquidity event using this fully diluted share count. Step 3) Determine the return required by investors. This could be in the form of a simple multiple, e.g. 5x, or an IRR. Apply this required return to the expected value per share from step 2. This is the current value per share. Multiply this per share value times the number of current shares to obtain the total current value. Example Assume current shares = 1,000,000 and expected shares on exit = 2,000,000 If expected value on e

valuation of pre exit

Step 1: Forecast the date of the exit. This could be an IPO or a sale. For example, in 3 years. Step 2: Identify comparable publicly traded companies. These should be companies with similar business models, economic drivers and growth rates. You may want to weight the comparables. Step 3: Pick a multiple to use for valuation. A financial mutliple such as a multiple to revenue, EBITDA or earnings is better than a volume multiple, such as users, unless the market clearly trades off of a volume multiple. You may chose to pick more than one mutiple and weight them. Step 4: Forecast the relevant metric for your company at the time of exit. Step 5: Apply the multiple for the comparables to the forecasted metric. This results in a forecasted valuation at the date of the exit.

valuation of pre exit pt 2

Step 6: Forecast the number of shares that will be outstanding at the time of exit, considering the need to issue additional shares prior to exit. Step 7: Determine the forecasted per share price at exit by dividing the forecasted valuation by the forecasted number of shares. Step 8: Discount the per-share price by the appropriate discount rate. Unless the company is very large with a liquid market for its private shares, this will likely be determined as a multiple - such as 5x, meaning the investors require an expected 5x return on their investment. Step 9: Multiply the discounted share price times the current number of shares to determine the current valuation.

Voting on Board Members

Straight/Statutory Voting: Each shareholder votes for each director based on the number of shares owned. For example, if there are two board seats open, a shareholder with 1,000 shares would vote 1,000 shares for each open seat. Cumulative Voting: Shareholders can place all of their board votes on one seat. For example, in the case above, the shareholder could vote 2,000 shares on one director for one seat. This favors minority shareholders.

Start-up Term Sheets- Timing

Term sheets are normally delivered after several meetings between the lead investor and the start-up. Start-ups hope to obtain term sheets from multiple investors in order to increase their bargaining power. The term sheet will often state how long the terms are available to be accepted by the start-up. The parties will then negotiate the terms. Once the term sheet is signed, the parties will work to close the transaction. The term sheet will often state a target close date, which is typically within weeks or a few months, depending on the complexity of the due diligence process.

Start-up Term Sheets General- Legal/Reputation importance

Term sheets are normally not legally binding. The contracts are not final until the full documentation os signed. However, it is considered very bad form for a party to a term sheet to back out of a deal unless significant new information is found during due diligence.

Start-up Term Sheets General- Purpose

Term sheets are used by business people to document the basic economic terms of a deal before starting the documentation and due diligence process. The idea is to make sure the important terms of a deal are agreed before spending time and money on the details.

Start-up Term Sheets General- Standard form

Term sheets are usually 1 to 5 page documents. The are normally in a standard form, but they can also be in the form of an email or other casual presentation. They can be full, with many terms outlined, or limited to the biggest terms such as amount and price.

No Shop Provision or Exclusivity

The Company will often be asked to refrain from trying to raise money from other potential investors for a fixed period of time.

Use with early stage companies (VC)

The VC method is also used as a back of the envelope sanity check when investing in an early stage company as follows. The investor may consider the exit valuation that is required for it to achieve their target return and consider whether they think that the company that they are considering investing in can achieve such a valuation.

Use with later stage companies (VC)

The VC method is most effective when a liquidity event is reasonably likely to occur within a short period of time (e.g. 3 years)

Unit Economics: Lifetime Value (LTV)

The amount of gross profit that is earned by the start-up on sales to the customer. Gross profit is revenue less expenses directly related to the revenue, such as cost of goods sold. This is calculated by multiplying the periodic gross profit e.g. monthly, by the number of periods in which the customer is expected to remain a customer (lifetime).

Corporate formative documents (sources of authority)

The articles of incorporation, corporate charters, bylaws and operating agreement (for an LLC) detail the division of governance responsibilities between management, the board and shareholders.

Unit Economics: Customization

The computation of unit economics is different from each business model. A SaaS company will not compute unit economics in the same way as a consumer goods product with inventory or freemium adverting or subscription model.

In person versus take away

The content of the slides should always be tailored to both the audience and the delivery method. If the presentation is in person only, the best design may be with only sparse information that won't distract, with the details being spoken. However, it is often the case that presentation materials are forwarded to others in the investment firm who need to be able to understand the presentation from the presentation itself.

Unit Economics: Cost of Acquisition

The cost of acquiring a customer (CAC) is compared to the lifetime value of a customer to determine if the business is profitable on a unit basis. The lower the CAC compared to the lifetime value the better.

Sales Funnel: Incremental cost

The cost of each stage of the funnel is divided by the conversion rate to determine the cost of the next stage. Using the example above, if it costs $1 to attract a visitor to the website, then the cost of acquiring a signup is $10 or $1/10%.

Contingency

The investor may want to condition the investment on certain milestones being hit. This can introduce counterproductive incentives on management, but may be necessary in certain situations.

Sales Funnel General

The most important tool for measuring CAC is the sales funnel in which customer leads are tracked through a distribution with every element in the process measured and optimized.

Sales Funnel: Conversion rates

The rate at which a potential customer moves from one point in the funnel to another is the conversion rate. For example, if a website has 1,000 visitors and 100 sign up, the conversion rate from visitor to sign up is 10%.

Voting

The rules for board and shareholder voting can vary. Majority: Simply majority of >50% carries Super Majority: A majority in excess of 50% is required, for example 2/3

Start-up Term Sheets Economic Terms General

The standard venture equity investment is created as participating preferred stock. This means that the investor will have a preference on liquidation like preferred stock, but also participate in the upside like common stock.

Participation

This is usually structured as a conversion of the instrument to cmoon at the option of the holder. The holder can convert its preferred shares to common at a price equal to the pre-money valuation divided by the pre-money shares.

Pitch Decks Specific Slides- Thank You Slide

This slide stays on the screen for a long time during Q&A. Make sure it has valuable information such as a repeat of a tag line and contact information.

Sales Funnel: Cohort analysis

To compare performance of tactics or customer groups over time start-ups divide customers into groups called cohorts. A cohort can be a group of customers of a certain type of who become customers at a certain time.

Assignment

Transfer of shares is usually highly restricted except to certain affiliated parties. Assignment in this context means transfer.

Revenue per month

net revenue/gross profit

Churn rate

the rate at which customers leave a product or service each month