Patently Strategic - Patent Strategy for Startups
Patently Strategic - Patent Strategy for Startups
Startup Capital: Strategic Fundraising and Patent Value
Whether you’re a founder looking to take the next fundraising steps beyond bootstrapping, an aspiring angel investor looking to understand the risks of seed investing, or even a practitioner hoping to get a better grasp of how this all works hand-in-hand with patent strategy, today’s topic provides an incredible springboard into the high risk, high reward world of strategic fundraising for early-stage startups.
** Guest Host: Charlie Pascal **
To help us with the specifics, we’ve enlisted the assistance of Charlie Pascal. Charlie is the founder and principal attorney at Pascal Advisory LLC, where he’s spent the last decade focused primarily on working with early-stage tech and life science companies to navigate the legal complexities of everything from the pre-incorporation cocktail napkin stage to helping founders pick teams and build a board, on through our focus today, which is advising on all of the funding rounds from friends and family on through venture capital. Much like Aurora does with many of our early-stage clients, Charlie functions as what you can essentially think of as fractional general counsel for companies that aren't yet ready or able to engage full-time in-house legal counsel.
** Episode Overview **
Charlie and the panel discuss:
⦿ The various routes and rounds of fundraising available to early-stage companies.
⦿ How patents can play into each and how differences in business models can significantly impact patent strategy.
⦿ As a founder, what goes initially into projecting a budget for fundraising needs, and later, how to think about valuation.
⦿ How to get the most out of your patents when it comes to valuation and approaching investors.
⦿ And great pro tips on some surprising sharp corners related to things like preferred stock, down rounds, the investor payout waterfall, and the very commonly used and freely downloadable SAFE equity agreement created by Y-Combinator.
** Related Content **
⦿ What Investors Want in Patents: https://www.aurorapatents.com/blog/what-investors-want-in-patents-with-sridhar-iyengar
⦿ Government Grants and Patent Rights: https://www.aurorapatents.com/blog/government-grants-and-patent-rights
⦿ Key Considerations for IP Diligence: https://www.youtube.com/watch?v=oeeAmgAMtQA
** Follow Aurora Patents **
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⦿ Twitter: https://twitter.com/AuroraPatents
⦿ LinkedIn: https://www.linkedin.com/company/aurora-cg/
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[00:00:00]
Josh: Good day and welcome to the Pat Lee Strategic podcast where we discuss all things at the intersection of business, technology, and patents. This podcast is a monthly discussion among experts in the field of patenting. It's for inventors, founders, and IP professionals alike, established or aspiring. And in this month's episode, we're talking about raising capital and the important interplay with patent portfolios.
Whether you're a founder looking to take the next fundraising step beyond bootstrapping. An aspiring angel investor looking to understand the risks of seed investing, or even a practitioner hoping to get a better grasp of how this all works hand in hand with pet and strategy. Today's topic provides an incredible springboard into the high risk, high reward world of strategic fundraising for early stage startups.
To help us with the specifics, we've enlisted the assistance of Charlie Pascal. Charlie is the founder and principal attorney at Pascal Advisory LLC, where he spent the last decade focused primarily on working with early stage tech and life science companies to [00:01:00] navigate the legal complexities of everything from the pre incorporation cocktail napkin stage, to helping founders pick teams and build a board on through our focus today, which is advising at all the funding rounds from friends and family on through venture capital, much like Aurora does with many of our early stage clients.
Charlie functions is what you can essentially think of as fractional general counsel for companies that aren't yet ready or able to engage full-time in-house legal counsel. Along the way, Charlie and the panel discuss the various routes and rounds of fundraising available to early stage companies, how patents can play into each, and how differences in business models can significantly impact patent strategy.
As a founder, what goes initially into projecting a budget for fundraising needs and later how to think about valuation. How to get the most out of your patents when it comes to valuation and approaching investors and great insider tips on some surprising sharp corners related to things like preferred stock down rounds, the investor payout waterfall, and the very commonly used and freely downloadable safe equity agreement created by Y Combinator.[00:02:00]
Charlie is joined today by our always exception group of IP experts, including Dr. Ashley Sloate, president and Director of PET Strategy here at Aurora. Dr. David Jackal, president of Jackal Consulting. Kristen Hanson, patent Strategy specialist at Aurora Marie Smith, patent agent at Break Hughes Beman, LLP.
Much like patent protection, securing investment dollars can be a crucial step in your innovation journey on the path to market success. Both of these tools often can and should walk hand in hand, so this relationship is something we'll continue to drill deeper into in future episodes. In the meantime, if you find this episode helpful, we also recommend that you check out two prior podcast episodes.
Season three, episode four, what investors Want in Patents Per key Insights from an investor on how angels and VCs think about your patent portfolio and what it means in terms of reflecting the soul of your invention and its place in the market. In Season three, episode seven, government grants and patent rights for a deep dive into the sometimes sneaky IP ownership strings [00:03:00] that come attached to commonly sought grants like SBIR and STTR.
And if you're a current or aspiring angel investor, we recommend our YouTube video on key considerations for IP diligence. I'll be sure to link to all of these in the show notes. And now without further ado, take it away Charlie.
Charlie Pascal: I'm gonna start especially given, the audience's use for the information I can provide. And and what might be interesting, given that you probably don't do this stuff all the time I'm gonna talk generally about.
Early stage startup fundraising, the different routes that people typically take, some that they don't typically take. And the challenges that come along with that. And then, specifically where I can tie into how patents play into that.
Awesome. Okay. And then if we have time, I, I was going to do a deeper dive into how at certain stages of investing valuation discussions and negotiations can be critical in, in, in getting those investors to be [00:04:00] happy, but also not giving away too much both in terms of.
The value of the company that you're selling and also the rights that you're that the company is giving to the new investors who are gonna have, preferred stock, which is senior to, to comment.
Let me just get a show of hands. Does any, does anyone have any real experience, either through your clients or otherwise with this kind of, topic, what investors are, thinking about startups and, what's, what options startups have to raise the capital they need, for example, to to file, a patent application and support it?
Dave: Yeah, sure. Before I was a patent agent, I was in the startup world, so I was working for like Silicon Valley startups and solar, mainly image sensors as well. And was involved in some board level discussions in terms of fundraising and saw it go well on some rounds and then saw it not go well and companies dissolve and auctions, et cetera.
So I've seen that process as well. Yeah. [00:05:00] Anyone else?
I've seen a little bit of the the stock piece of it. We actually had a client that actually still is a client of ours, where we knew the individual for many years and actually received a payment for some of our work, some stock. They're still kind, trying to get the data and everything they need to, to find their perfect customer. It's a really great technology, but just a great solution looking for the perfect problem. And but also, more familiar with just the general funding path that sorts can take.
But, here's to hear more in depth thoughts on that.
Charlie Pascal: Sure. So let's just start at the beginning. You have a great idea whether it's tech, it's maybe a potential molecule for life science type stuff, or therapeutic. And you have a buddy or two who either you went to school with or you think they're gonna be a really good teammate and you say, Hey, I think we could give this a go.
And you start, doing some preliminary work on either the product development or you're in the lab and then. You realize, [00:06:00] okay this is starting to cost some money. How are we gonna do this? And so the most normal typical route in that very beginning stage is what people commonly call bootstrapping, which simply means you're using your own savings resources knowhow, to just get things moving to a point where you think you'll be able to show it to someone.
Either because you want their input, to join the team or be an advisor or to help fund it. So depending on your resources that can last for, a few weeks. It could be, four or five months, but at some point, most of the time you're gonna need to seek additional funding.
The next place people usually look for for dollars is natural. People call kind of the friends and family round, and that's when you do just that. It's back when you were a kid and you were selling Girl Scout cookies or whatever, it's like, who are you gonna, who are you gonna go to?
Go to door. The people, the people that like you, that trust you. If your parents won't give you a couple bucks, if they have it, [00:07:00] then maybe your idea isn't, or maybe they're jerks. But so that will typically, bridge a company, for another, several months.
It depends, how much you can raise and how much you need. And I would say knowing how much you need is, it's not as hard as getting the money, but a lot of people don't put enough thought into, it's like, all right, we're gonna need, at least a few hundred thousand. And they just throw a dart.
And most commonly it's actually too little. Although you can have the reverse problem where, you know you took money from a lot of people and they're saying, okay, where's the beef? You know what's going on, and you hadn't really planned on how to use the capital. So things take longer than expected.
Carly, is there typical softwares or methods that companies use to try to plot that out? I'm sure it's kinda just like budget, right? This is what, we need to build whatever thing, this is what, service costs. But is there like any other methodology outside of just knowing how to create a budget?
Charlie Pascal: I don't know if there's a specific there. I'm sure there is. There's an app for [00:08:00] everything now, but it is exactly that line of thinking, charting out in the very beginning, probably not much more than, six months or so. I think beyond that, there's too many what ifs.
Until you've got an MVP or you've got something in the lab that gives you evidence that you're really looking for. It's in the beginning, it's, it's, let's try this, let's try that. Maybe we need to pivot. But it is exactly that. Okay, what do we need the money for?
That's where you start, say, okay, do we need to bring on new team members? Okay, we really need some tech developers for the app. Okay. We don't know how to build it. We have the idea, we know how we want it to look. We have some ideas about the design, but we don't code, we don't know how to do it.
Okay? So then, you do your research and, look at offshore firms, nearshore onshore, US domestic groups that can do the development. And you either, make a choice or arrange and you say, okay, we're gonna need, three or four developers at. 50 grand a pop for a year, whatever, I'm just making stuff up.
But we're going to, we're gonna need to file a patent. You say we, we gotta have [00:09:00] good patent counsel, and I strongly support that. There's a lot I can do. I will not touch, filing a patent, it's very specialized and you don't want screw it up. You guys know this probably better than I do okay.
So we're gonna hire, a reputable firm that's gonna be a lot of, who knows, but thousands if that, tens of thousands of dollars. So you start building that budget, hopefully you, earmark or just inflate everything a little bit for a cushion. 'cause things never go exactly how you hope.
But so you come up with your, financial, business plan budget and your projections as far as reasonable. You can see in a lot of cases it's, we don't know when we're gonna make revenue because we have to get to from A to B and B will tell us if we have something that is ready to take to market or not.
And this is where, the friends and family piece comes in because they're not investing so much in normally in the the fate they have in the business. It's more you. And this carries on into later investment [00:10:00] rounds. The team how much confidence they have in you.
Have you done this before? Did you have a prior exit, successful exit as a founder? Those things can weigh very heavily into investors calculus on whether to take a bet on you. But taking a step back to the friends and family round, what does that look like? To the uninitiated, some people just sell stock, maybe sometimes just common stock, and they say, I don't know what's reasonable.
50 cents a share. Okay. A better way to do that. And you'll see as we talk about the later investment rounds, why it's important, I always encourage founders to use a convertible instrument in the very beginning. Either a safe, a simple agreement for future equity. Are you guys familiar with that?
Yeah, most people. So a safe, okay. Okay. So yeah, go ahead.
Explain it,
Charlie Pascal: Charlie. Yep. Yep. Are people familiar with a convertible note or have you heard a convertible note? Yep. Okay. [00:11:00] They're very similar.
Convertible note is a debt instrument. It has a maturity date, just like the note on your mortgage or a car loan.
But in addition, it has a convertible feature, which means upon certain events, namely a qualified financing of X dollars, a million dollars, that loan automatically converts into equity of the company in the priced round. The qualified equity financing of preferred stock. Normally friends and family is essentially, a bridge or an on-ramp to serious funding which is, normally selling stock with a price.
So priced round, series C, series A, whatever.
So the, so in a Safe is very similar in that it converts as well under the same sort of circumstances, but it's not dead. What is it exactly? People are still scratching their heads. It was created by this accelerator incubator Y Combinator.
It's very famous. They just made this, they invented this thing. They just made it [00:12:00] up as an alternative for early stage companies to save a bundle on legal fees because the documentation is very simple. So simple that the idea is you download the safe form from the Yc y Combinator website, and all you do is plug in blanks.
The idea is it's not really negotiated. It's a quick, efficient, cheap way to get capital into the company. Now beware because although that's the idea, a lot of either individual founders or their council get a little devious and do make a lot of changes. And so you really need to be sharp and make sure that either nothing's been changed other than inserting the, the numbers in the blanks, et cetera names, dates or that you understand the changes they made and that you're okay with them.
For example, I've seen at least one where they really undermine the whole intent. The idea is that it [00:13:00] converts in the next round of financing of preferred stock. And the one, this one I'm talking about explicitly said it would convert it to common stock, which is really misleading. The whole idea is you're taking additional risk as an early investor in the state for the convertible note.
And you need to be rewarded for that. And the reward in both instruments is. Is either one of two things or a hybrid of those two things.
And those two things are, one, a discount, typically 15 to 20% off of the price that you're selling the preferred stock to the venture capitalists. Okay? So if they come in and agree on a valuation of the company that results in, a dollar per share and you got a 20% discount, you, your stock converts in as if it was an 80 cent price and you're gonna get more shares than the folks that are just putting in money later, right?
The other way, which is it's an and or is valuation cap. And what the valuation cap [00:14:00] does is say essentially it's a backstop that the investor that's buying the safe or the convertible note is in no event going to accept a valuation or pay a price that is equivalent to a valuation.
Of X number. And in the hybrid situation where you have a discount and a cap, they work together so that if the valuation is very close to the valuation that you later, you know, using in the price round, if you nailed it and the safe, you said, okay as a valuation cap, we think the next round is probably gonna be around $10 million.
We'll put that in the safe. If the round is at 10 million, then the valuation cap doesn't apply, or you wouldn't use that because you'd be getting the same exact price, right? So $10 million, say divided by 10 million, even shares dollar a share. But then you say, no, I'm gonna use the discount because I'm gonna get 80 cents.
Now if the for whatever reason the valuation and the price round was [00:15:00] extremely high. The discount resulted in 80 cents, but the lower valuation in your safe, if the math turned out that you'd be getting, 60 cents, 65 cents a share or whatever then you'd use the cap.
I generally advise my clients, if they can get away with it, is to choose just the discount.
Because once you put that valuation cap in there, investors latch onto it. And even though it was intended as a backstop and really just a way to give your early investors some comfort, it's a data point. And if it was on the high side they'll probably say that was too high and they're gonna try to come low.
The bigger risk is you pick a number that was too low, and so if you were really hoping for a valuation in your price route of 10 million. And in your safe, let's say the safe was six months ago or a year ago and you've had a lot of traction, things are going great since then they're still gonna say, okay, so six months ago you put a value [00:16:00] on the company an estimate, on the future financing round of 6 million, now you have to fight your way back up to 10.
You get the idea, if you can avoid it and just punt on valuation. I think it's it saves a lot of stress and anxiety on the part of the company. And then you're free to make your case for valuation. That's fair. At the point when you're negotiating with the investors the venture capital investors,
Charlie, not to fully side for a second sidestep, what goes into, and I'm sure this is like not an easy answer, but what goes into valuation?
If I'm a founder wanting to value my technology, how do I come to an A number that. Reasonable. And that you do hear these different stories where somebody says, oh, my company's valued, and you're like, there's no way your company's valued at that.
Charlie Pascal: Yeah. That's a great question and I have a, I have some slides on that we can maybe get into, but in general, there's no magic [00:17:00] formula.
I talked earlier about confidence in the, the team and their prior experience. That can carry a ton of weight. If you have successfully been granted a patent that has real value that's an asset of the company, regardless of whether the company is successful using the patent the way they want to.
Certain, particularly strategic investors. And what I mean by that is, say I don't know, pick your big company that's in a huge space, in the medical field like Medtronic or Amazon and the tech space, right? And they have people watching patent filings and there's certain keywords that, they're always looking for.
So somebody comes up with something unique, they patent it, they think it's gonna be great for X product, and X big company says, oh my gosh, if we had that, we could leverage it in our thing or go in this direction. So regardless of what the company's worth, the patent, depending on [00:18:00] how much they want, it has its own tangible, intrinsic value.
And that can play a lot into it. Sometimes you get your first price round and you haven't been able to afford to patent, and that's what you're using some of the money for. Okay. But then your next round, it will carry its own weight. So companies can be bought early on just because they've they've figured something out and they've they've patented it and it's theirs.
Another way to do it is like when you're house hunting or a bank, you're getting a mortgage and the bank is trying to,
Determine whether you're paying too much for the house. You do comparables, right? So you try to find companies that have raised recently in your space and you point to those and say these guys, got a valuation of, 20 million and they were at the same stage and they're also in this SaaS, space or what have you, right?
So you say, look at these guys. Now to Ashley's point that there's been ridiculous valuations, particularly. A few years ago [00:19:00] interest rates were so cheap, people were pouring money into VC funds because they couldn't find real, returns elsewhere. And so companies were fighting to put money into the most attractive companies.
And one of the ways that they can win being the lead investor on a deal is to offer a higher valuation because, essentially and why do we want a high valuation, right? The higher the valuation, that means that the investor's gonna be paying a higher price per share, which means they're getting less shares and less solution for the founders, right?
So getting that higher price is very beneficial. Another way to do it is through your projections. And often this is a package. You say, here's where our financial projections and market fit are leading us. We think if we can, get X customers and we can get this price point, on our product, then you just start doing multiples and you say, okay.
And so in the next six months we think we'll have, some sales, and then you just start compounding [00:20:00] it. And that's a guess, but it's, if you put it together thoughtfully and you can back up the data you're using to support, your estimate on the price and the number of customers, et cetera it can be compelling,
Charlie Pascal (2): There's another way you can get a valuation that's normally used outside of the fundraising realm. And that's when you're issuing equity to employees or contractors, mainly employees, you have to issue stock at fair market value. So if you're hiring an employee and say, we don't have a lot of cash to give you, but we're gonna give you x options or shares, right?
Charlie Pascal: You have to sell those shares or pick a strike price on an option that reflects the, then the then current value of one share of stock. So the price of one share of stock, that's at least no less than arguably the fair market value of the stock at that time. Now very early on, typically founders just.
[00:21:00] Pick a reasonable number, and that's totally legal. The board has to approve it, but the board doesn't have to rely on anything other than their own gut, whatever data they think is relevant. And not the other way to do it. If you have a little bit of cash, meaning, two, three grand, I don't know what the, what the competitors are offering now, and you get what's called a 4 0 9 a valuation.
And 4 0 9 a is a section of the internal revenue code that has to do with how employees are compensated. And so that, that's why it's called a four nine A. And you can engage an independent appraisal firm to come in and look at your financials and the market space, all those things that we talked about.
And they'll do it as an independent, arms length professional and spit out a number and say, we think that your common stock is valued at blank today. So that's really important. And it's a tool. You can, you could use it as a data point for raising money as well and say, Hey, we just had a four nine [00:22:00] a it put our stock at a dollar per share.
Now we're going to, start selling preferred stock to you venture capitalists. That could be, an objective good data point if it's reasonably high, if it's much lower than you want to negotiate for it, maybe you don't talk about it. But so those are the ways you get to, numbers.
But at the end of the day, it's, there's no you can't just plug it into a formula and it's a lot of. Less science and more art or feel, particularly on the side of the investors, you can point to all, these great numbers that you're gonna hit. But at the end of the day, it comes down to their confidence in the founders, in the team whether they've done it before, whether you think they can do it.
You got that great, quote from, I think Sequoia about sand bank and feed. They didn't do any diligence on him. They didn't really, they ignored all the data and the risks and just they loved him. They were like, look at this guy. He's playing video games that are at his pitch.
He must be great. I don't [00:23:00] understand that, but that's an extreme example of investors putting all their money on the founder and roll, just rolling the dice, and that didn't go very well.
Kristen: Charlie, let me ask you this, since we're talking about valuation, really on the finance side and very much on tangibles, if we bring it back to patents
Yeah.
Kristen: And you advocate for so many companies and you have done this for years, are you seeing any kind of lock step of you have to have three, four patents before you're going to be assessed in this way? Or is there any kind of rules that you have noticed over the years,
Charlie Pascal: Certainly a patent, a family that you know, actually works together for your intended product or service?
Yeah, certainly, but just, having a bunch of patents to your name that maybe aren't as specific or don't, or aren't required. For the business, not so much. You could file, your first patent could be really comprehensive [00:24:00] and that's what you need. And the investors won't be looking for more because that gets the job done.
So maybe further down the line, you modify the product, you modify, the patent, whatever you file supporting patents for stuff that, changes or, can strengthen it. But no, there's no real, I wouldn't say that volume of patents has a lot to do with it again, unless they tie together and are necessary to rely on each other.
Okay. Having said that, more patents, assuming they're all assigned to the company properly, the bigger the portfolio, assuming they're all useful, which is maybe a big assumption, the more patents there are more value there potentially is that, someone could execute on all of them.
Kristen: Okay. Do you work on the other side too, where you're getting asserted against and having to actually use. Company patents to serve cease and desis to ensure that they can attack other competitors. If others are doing what they're doing and they're, they work first, do you ever [00:25:00] work on that side of it or do you just work on the I do.
Charlie Pascal: I will tip my my toe in to offer a cheap way to essentially send a nasty letter cease and desistance saying, you, you're clearly, infringing on this stop. And if they don't, then, I would bring in specialty litigation counsel that focuses on patent,
Charlie Pascal (2): infringement disputes.
But yeah. Any other questions? Actually, a
quick follow up to Kristen's question two for patent evaluation. So there are, you see these, advertisements for valuation, like certain, like different groups or companies that will like value portfolios or patents they have some methodology process.
How like used are those entities, how reliable are there, do companies use them? Or to your point, is it more oh, I just saw that Medtronic bought this patent, this is what it went for? We've done all of our diligence, right? We've done our patentability stuff, we've done freedom to operate.
It's granted in a few places, it's, covers our product and workarounds. What's the, do you need [00:26:00] that real formal opinion of it by some independent group, or is it let's just figure this out?
Charlie Pascal: I think it's more the latter. I think it could be helpful, but I think it's, maybe that's why these, these companies exist, unless you really get into the weeds on what the company's trying to do.
And I guess you could just in a vacuum look at the patent or the patent family and put in the package and say, these could be used for all these things. So there's value there. But then you're essentially, asking third parties to decide, random stuff that you could do with your patents as opposed to what you want to do.
I will say some of the value in the patent for investors who aren't necessarily strategic, so they don't really want the patent, but having a patent obviously, builds this, they call, a moat around your technology so that it's protected. So let's say investors, they love the idea, they love the technology, but you can't patent it or you haven't.[00:27:00]
Which means, someone else could jump in and do it. That's much more risky if you say, yep, we've buttoned it up, we spent all the money and got a patent. And, we have that protection. So you can rely on, if this works the way we think it does, you're not gonna have to worry about someone coming in and stealing it.
Or if they do, we can go after 'em. So that, the moat is what people, often call it, is this, are you able to protect what you've invented? And and that can give investors a lot of a lot more confidence. And even if they're not as strategic, they know there is at least an asset if the company fails.
If all you have is your idea and it doesn't work, you run outta money. Investors really have no recourse. Unless I. There's a little bit of money left, and in which case you'd wanna be a convertible note holder. If you hadn't hit that priced round yet. Because creditors always sit at the front of the line, if there's an insolvency or a company fails debt holders always go first.
[00:28:00] So if there's only, a hundred thousand dollars and you've got, three creditors, they divide that up. And if there isn't enough for them, no one gets anything else. Now, if you have the patent, even if you're not a strategic investor, you're gonna go find someone that wants to buy it and, spread that money out over the other the other investors.
Dave: And the, yeah. One of the big firms that did that ocean Tomo back in the day did a lot of valuation work and auction work, et cetera. I did a, I was involved. I did some work for them doing some patent valuation for a company, but I was also at a company that hired them to value RIP.
So I've seen the process from both sides. And that's great.
Charlie Pascal: Can you say a little bit about your experience and
Dave: kind of Yeah. It's tricky. I agree with everything you said. It's very tricky. It's very subjective, but on market's a huge it's a huge factor in figuring out whether the value of a patent, because is this gonna be applicable to a space that has a $10 million, a, or is [00:29:00] this a $10 billion market?
That makes a huge difference. And and I think the patent side is you're right, you have to really get into the weeds to get accurate numbers. And the other side of it, which I think is also equally interesting and even more tricky, is trade secrets. A lot of companies, especially like you think about a manufacturing company their processes to make these things and how to run the tools, how to get high yields.
Some of it's in patents, but a lot of it is just knowhow. And knowing how to do that stuff has a lot of value. It's very difficult to put a number on. And, so some of the, a co when company, the. Projects I've been involved with, companies are going under and wanna sell a patent portfolio.
So then you need a number of course, 'cause you wanna sell it. Another situation is a company's looking for a later stage company. Maybe they had a down round, they're looking for venture debt or something like that to keep the lights on. And they're using the patent [00:30:00] portfolio as basically collateral for all of that.
So again the number is super important. The people who are investing are possibly paying for this valuation because they wanna know what they are buying, how much it's worth and it's a very inexact science or art, if you will. Yeah. Unfortunately. Can you
talk about the down round and the, can you for our audience, kinda talk about those two Yes.
Topics that just got brought up? Thanks David. That was awesome.
Charlie Pascal: Yes. So one of the dangers that. It's really a trap for the un weary, I just feel I basically just made the case for arguing for the highest valuation possible in your fundraising round. And this isn't theoretical. This is what happened when venture capitalists had more money than brains.
They had to deploy the capital fast. They, they were making decisions that they're now thinking harder about in, in funding rounds today. So on the one hand, arguing for a super high valuation sounds like a [00:31:00] win because you get less diluted. The problem comes in with, now you have to satisfy that number.
You argued your case that, in 18 months, we're gonna go from X sales to blank sales. And maybe you really felt that. Or maybe you're like, if they. If I can convince them, then great, we get the valuation. Then in the next year and a half, you have to hit those milestones.
And if they were unreasonable to begin with, you're, it's gonna be really hard. And if that happens, then you come into the dreaded down round. So you persuade these investors to give you really high valuation. You missed the mark because it, the bar was set too high and you didn't think about the fact that this could or would happen.
So the investors are pissed because you ran out of their money before you hit the goal. You said you would, so you need more money. So then you go back to back to probably not the same investors, [00:32:00] but maybe, they may double down and say, okay, lesson learned. You learned it, we learned it.
But they're not gonna, they're not gonna give you a higher value. So normally when you think about the stock market, right? Is it red today? Is it green? It goes up and down all the time, right? You don't want your startup to look like that. It makes sense in a public market because stock trades every day and there's a lot of factors out of your control.
Now, there may be factors outta your control in a startup, but it's your job to, to manage those no one's, buying and selling your stock every day. So it's it shouldn't fluctuate like that. So a down round is okay, so you did your friends and family, and then you did a series C, and then you did a series A and you're doing great.
And then for your series B, you aim way too high. And you say, if we get this $20 million, we are gonna be here, and you end up here, right? So then they say, you screwed up. We'll give you more capital. Or new investors say, we'll give you capital. But we're gonna do it at a lower valuation. So if it was, [00:33:00] a $20 million valuation in your A round, when you go to the B now it's 15 million.
Real bad look. And now you're you're back at the bottom of the mountain and trying to prove yourself so it can actually come back to bite you. That was a really weird time, when interest rates were at zero and capital was just flowing, like wine or water, whatever is, I guess water.
And so people got all just caught up in the excitement and, it was a lot of fomo. Venture capitalists were like. Oh, we want that one. We want that one. No, we want it. And it's a little bit of, who's who's willing to take the biggest risk.
So that's the down round. And it is a bad look. It typically ends up with, the company suffering some sort of, making some kind of sacrifice, whether it's cutting folks or, certainly, now you have, now you've got a a bigger dilution than you had in your prior round, which sucks.
Particularly if if you, if you had a good, you have a good idea and you figured it out and, you just didn't have the sense to be reasonable you could have, you probably could have, hit [00:34:00] numbers that were more reasonable.
Dave: Could you explain how the down round like wipes out certain, like common shareholders, but maybe the preferred shares are treated differently or what have you.
Yeah. What happens to like the old debt ver the original debt versus the, or the new old investors versus new investors. How does that all shake out? Is that kind of right, Dave?
Charlie Pascal: Yeah it gets complicated. What I thought David was talking about is something a little bit different.
So a down round basically just means that what we just talked about. But more importantly, typically if you're on the right trajectory and the valuations always go up, every new round of investors pays more for the stock and gets less of it for the same money. So it's like inflation.
When you have a down round, you have a weird situation where the series B investors have a lower price [00:35:00] than the A investors. Okay? So now they're in a really weird place. They thought they were getting an earlier and they're million dollars bought 20, 30% more shares than they were expecting in the B round.
And not only that, but, preferred stock investors, one of the biggest rights that they have preferred over preference over the common stock is that when the company is sold, or whether a good sale or a bad sale, whatever money's on the table, they typically get first. So the preferred investors get paid out first.
So if you have someone in line in front of you that now you know, not only is gonna get and it goes in layers. So if you make it to like series seed round and then you sell the company a year later. The series Seed guys are gonna get paid first. Then if there's enough money, then the B, then the A, then the seed, then the common, the founders, right?
So the series A investors in our illustration are gonna [00:36:00] be, pretty pissed because not only does the, do the B or C folks go first, but now they're gonna take more money off the table because they got more shares than they would have had the valuation been higher. And so it's like a double, it's like a double whammy.
What I thought David was talking about, it's what's called a cram down and a crammed down is similar. But essentially, it's a, it's more of a recapitalization. You've got stock all over the place. Every, the cap table's a mess and the company's not doing amazing.
And so essentially the company prints more shares. And says we're gonna give a bunch of new shares to new investors.
Charlie Pascal (2): And that
Charlie Pascal: Much just, much more disproportionately dilutes the existing common holders than if it was, a normal scenario. So if it's a, if it's a much cheaper price and they're getting a lot more stock it dilutes everyone below that, that, that new investor [00:37:00] level a lot more than it should.
So the same thing. So
Dave: yeah, thanks for explaining all that. This is usually what happens in the boardroom, be behind closed doors that nobody ever gets to see or understand. It's 'cause it's complicated, like you said.
Charlie Pascal: Does that kind of make sense though? I, I. I wish I had had, better illustrations.
But is it making sense? Are you following, me saying it verbally? Does it make sense?
I think it really illustrate, I really like too, I think it I don't think I fully appreciated the payout order too. So family and friends, when you're bringing it, when you're doing that early on, not only is it risky because it's super early and who knows, but let's say you do make it reasonably, even like just a couple x they still may not recoup much.
Charlie Pascal: Maybe anything.
Maybe anything because they're getting paid back so late. So that's really now I understand more why it's friends, family, and fool. And then if you
Charlie Pascal: Yeah. And then if you have real [00:38:00] creditors. That's another way to raise funds. You can get a, SBA loan or you borrow money from your uncle who you don't know that well, but he is really rich.
He doesn't like you, but okay, here's, with 20, with 10% interest, I'm happy to loan you a million dollars. It gets worse, right? So now that wasn't a convertible note. It didn't fold in, in one of those financing rounds. So Uncle Jim gets his million plus interest before even the series c holders or the B hold, whatever the last round was.
So that money goes off the top and whatever's left you cascade through what's called, it's called the waterfall. So you can imagine waterfall that goes into a pool and then it goes over you into the rock and into a pool. Those pools are the l the various levels of investment tranches that get paid.
And then there's it's really out of fashion now. Having said that raising capital is really difficult right now. And so we're starting to see a little bit more of it. So without confusing you getting too much into the detail, [00:39:00] lemme see if I can do this high level. So normally the preferred investors get paid back first, right?
But then they're out and then whatever's left trickles down to the lower rounds. And the common if, I don't know if anyone's ever heard of this, but if you get a term sheet or your client gets a term sheet that has participating, preferred in it, watch out. It's really aggressive on the investor's part.
What that means is they get paid back first and then whatever money's left, they come back in and pro rata their ownership, they get to divide the rest of the pie with everyone else. It's it's really uncomfortable if you have to take an investment and like that. But if it's the best deal you have, then might, you might have to do it, but that's bad.
And you're right. The, those, the friends and family that you know, you wanna help the most, on your exit, you don't have a lot of control over it. Now, if it's an amazing exit, they're gonna do great because they paid very little for the stock. They were in early, they [00:40:00] took the most risk, and they're gonna get the best, bang for their buck.
The later investors, they're gonna get paid first, but they should be paying the higher price. And that's why the down round screws everything up because they're getting a good price without, being one of those early guys who assume they're probably not gonna get anything back. Does that make sense?
Ty: Yeah I had a question, Charlie. It, it almost brings up like a point of no return. Do you have a rule of thumb or is there any way that you can quantify as far as fundraising where that point of no return is?
Charlie Pascal: Meaning when there's an exit
Ty: is probably
Charlie Pascal: never gonna pay everyone back.
Yeah, no it's tough. Presumably if people keep giving you money, there's enough of a belief that the company can be successful. If not, I don't know, why they're still giving you money. Even in the down round, they could say, Hey, these guys, they had to pivot. They were so sure this thing was gonna work and the [00:41:00] early investors believed in it, it didn't work.
But we still have this patent, and if we think about it this way, what about this market, tackling the product a different way or a different, different target customer. Okay, so then you may still have a down round because the capital dried up and you didn't get where you were hoping to go.
But say the series B or C investors come in and say. We like to pivot idea and they're gonna get a price that's similar to, the seed or the or an a round. So they've gotten to see the, the progress, the failure whether they've held the patent portfolio together, et cetera at a much later point in time.
So they have that knowledge and that data and maybe able to make a more informed decision about whether to put their money in when it's really early, especially if you don't have an, an MVP or a prototype that's actually works. People are really, they're gambling.
And, for better or for worse that's the game. And some people see it that way. A lot of people, venture [00:42:00]capitalists, we need them, but they get a bad rap. Especially in these cases where, really aggressive terms like the participating preferred, so we're, we got a few minutes left. I'll let you guys decide. Do you want me to keep talking about, further, investment rounds and stuff like that, or alternatives or you wanna just ask questions? 'cause it's up to you guys. Ashley, did you have a, I have no,
I guess if there's any, I mean we could end with if there is any just, I think you mentioned Charlie, just like some gotchas and things like that in general.
I don't know if we can scratch the surface of a few of the other ones. Maybe we didn't fully get to. Sure. But I think that would be good. But otherwise, go ahead Dave.
Dave: And maybe, yeah, because this might tie in as well. So this is a broadish question of just to how, where you see patents being useful for as you add a advice for founders and specifically depending on which type of business model.
So if you have a licensing business model, your patents are your product, and that's like key of obviously, but if you're planning to sell a product, you're [00:43:00] in a space where it's crowded or litigious or if you're planning to build something to get a big guy's attention and then want them to buy you how for, depending on the business model and the exit or the goal, how do patents benefit different companies?
Charlie Pascal (2): Yeah.
Charlie Pascal: I think you you nailed it. It, it depends on what, what stage the company's at. What life is left on the patent. First of all, sometimes people early on they say, I gotta get this thing on file. And then, then they have kids or whatever, and 10 years later they're like, oh, I wanna use that.
Now you've, you, you've only got, a decade left, and that sounds like a long time, but depending on how much, how long it takes to raise capital, how long it takes to actually develop the product that you know drew or laid out in your patent. That's the one thing we didn't talk about.
So a patent is, de decreases in value, over time, right? And that's one of the reasons that strategics would buy a company early because they've got the [00:44:00] most life left on the patent. And if they see some great use for it, it's a tremendous value. So I don't see it as much as, there's no sort of like strategic, let's.
Not file the patent or let's you know that decision should be made more strategically.
And this is where I come to Ashley and say, okay, because sometimes the decision is let's not put this out there. We know that the Chinese and some others are gonna cheat and they're not gonna honor our,
Our patent protection.
And it's really hard to go over and sue them. We're not we're not familiar with that. They may not hear the court case, whatever. Or you just have a situation where by the time you do get a court case, it's already too late, they've flooded the market with copycat products or whatever.
So the first step should be, I have something that's patentable. Should I put this in the public domain and file it? And I think David, raised an example, one of the classic ones that everyone can understand is Coke the formula for Coke? Still locked in the [00:45:00] basement, down in Atlanta, and they've never had a problem.
But keeping, keeping that stuff under wraps, especially in an early company where people, there's a lot of churn, people leave for greener pastures, the, they're presumably under a confidentiality agreement, but stuff gets out, right? So if you're gonna go the trade stick route, you really have to have a plan in place, and literally have that, in a vault that only the two founders or whatever have access to.
But you can save a ton of money and potential competition by holding onto it. Now, of course, the fear is that someone else would come in and file the patent before you do while you're holding it as a trade secret. But that's an analysis again, that I, I impart rely on Ashley and her team to.
To help with that analysis. Getting, particularly if you're applying for, another way to raise funds obviously is grants. If you're applying for an SBIR grant or something, I would say, having patents [00:46:00] is, they look at more as like a bank lending money on a house or something.
They're not venture capitalists. They need to be prudent with the money that they're giving out, which are basically the taxpayers money. And so they want to see as much, security enough comfort as they can in the business that, they're giving funds to basically.
And so in that, in a case like that, I think being able to say, yep, and we've got our patent, and that, that's like a big checkbox. Okay, these guys are legit, they're building, this patent moat, maybe we're more comfortable to go ahead and give 'em, a grant or the bigger end of a grant, for example.
We're almost, we're hour at a time, but, so one. Gotcha. I'll leave you with to, for Ashley's point in valuations, one thing that gets a lot of people, and this, you probably won't need this or use it, but if you ever able to chime in, it's, it'd be a big one. You'd get a, you'd get a big star.
So there's deciding on the valuation, so basically, finding the number is the hard part. But in, in the simplest [00:47:00]terms typically a company's valued in a pre-money valuation. Pre-money means just that. It's the value of the company before the investors put in their money in a priced round.
All right, so let's say, using round numbers the company has $10 million valuation pre-money. Okay? And they've got 10 million shares just for a couple round assumptions. Post money is simply adding the pre-money valuation to the amount of money that the investors are putting in. So if they're putting in, $2 million post money valuation is $12 million.
Okay, that's easy. Where it gets tripped up. Oh, and this isn't a magic number either, but there's always, there should always be a delta between the preferred stock and the common stock, meaning they're paying more than the common. So if, say you had your four nine a valuation recently to issue options to employees, that number's relevant for determining, the [00:48:00] valuation and the priced round.
But it's always understood that there's, it can be 30%, more than the common because the preferred have those special rights. And that's worth something. So that's just a, that's just a explanatory background. But the gotcha is. Founders say, okay, we're comfortable with the 10 million valuation.
After they put their money in, that's gonna leave them with 20% of the company. And you're okay with that? The wrinkle is when the investors in the term sheet, which is like 20 pages long, there's a lot typically in there. But one of the things is investors always wanna make sure when they're investing in a company that there's enough room in the cap table for the company to grow essentially to, provide equity to new team members as they come on new employees.
That's normally 15 to 20% of the total cap table. So let's say you were smart in the beginning and you set aside [00:49:00]20%. 2 million of your 10 million shares are in the option pool, and that's exclusively reserved to give equity to new hires. But by the time you get to your priced round, you've exhausted that pool or nearly the investors are gonna say, we gotta top that up because there's no equity for bringing in new talent. And you're talking about scaling. You wanna grow bigger, you're gonna need more people, and we gotta incentivize them. They're not gonna go to a startup to not get, any equity. So the wrinkle is how that increase to the option pool.
Essentially we need to create more shares that are gonna be available in the pool for new employees. So the wrinkle is that, are those additional shares added before the new money or after? Because in our example, let's say we need to add 2 million shares to top up the pool to be 15 to 20%.
If we add the shares before the new money comes in, that 2 million is added to the denominator of the, the stock that's already in the company. So now, instead of dividing your number of shares by 10 million is 12. So [00:50:00] you got that dilution, the investors didn't. So they come in. And their money's, just on top of that, if you were to do it the other way, after the money comes in, everyone suffers the dilution proportionately.
And ev and the common stock, the current team members, the founders get less diluted. So that's a little gem that a lot of people miss. And it's painful because if you have essentially run out of the stock you allocated for options, it's gonna be, a pretty big number to get it back up to that reserve.
15, 20%.
So the takeaway on that one is to make sure that you're doing that dilution after the new money. If you can have to be great, your next round,
Charlie Pascal: if you're smart enough to, or your attorney, catches it and says, wait a minute guys, do you realize, it's not just 10, between 10 and 12, if the pool comes in first, they're gonna own more than 20%.
Or whatever, right? But you're still gonna have to negotiate. They may say no, and that, and then it comes back into [00:51:00] how much do they like the company? How much do they like the team? Do they have, do you have that patent? They just have to have. And, it depends who has leverage.
And then there's no, it's not like at a series, seed stage investors aren't supposed to ask for the pool to be in, free money or something like that. There's no metric on that. It's negotiable, but it would suck to just by accident, realize the math went that way after you signed the term sheet.
Yeah, sure. That ing good food for thought. A lot of behind the scenes and makes me more, I've always thought about angel investing that makes me more wary.
Charlie Pascal: It's really risky. I can't I've done angel investing myself. And it's impossible. E even these huge firms, they can call out the big winners, Facebook, whatever, but if they told you how many losers they had that they were all in the, in their, huddle saying this is a winner.
It's impossible. It's really hard. And all those numbers you hear, one out of [00:52:00] 10 startups fail. It's generally true. Even if you separate kind of the wheat from the chaff, assuming that companies, there's a lot of companies that fail before they start, it was a stupid idea to begin with.
If you actually get investors, if you can raise a couple million bucks, you have something that someone thinks is worth pursuing. So if you take that pool, people who get to a series seed round where they actually get venture capital investment. The chance of success is much greater.
But it is often very difficult to even get to that point. So hopefully the market keeps the normal market keeps going the way it's going because you probably would've done a lot better in the last few years than you would, throwing money at startups. But, all depends on if you hit that, one or two that, that have a good exit, it can really be a game changer.
But but yeah, be very careful even with crowdfunding stuff it's oh, I can do it for a thousand dollars. One, if the company is successful, you're gonna have such a tiny percentage that it's really and you're probably just pissing it away. Those are companies that are, totally unvetted.
It's the [00:53:00] Kickstarter type stuff basically. But I don't wanna take time away from your day. It is really a pleasure to be here. Yeah. This has been. Happy to go in further on depth on anything if people want to do follow up. And I hope it was, useful or helpful in some way.
Yeah. Might be easier follow up, thank you. Up on more term sheet stuff and or yeah, people, the crowdfunding thing, it might be to kinda, how do you value crowdfunding companies and,
Charlie Pascal: It could be interesting, my thought on that, which I share directly with clients. I see crowdfunding as the fund of last resort.
And if you need to do it, you do it, but you gotta go in knowing, you wanna make sure that you satisfied yourself. That you can't bring in. Real investors before you do that. Because once you do a crowdfund, you're tagged as, oh, no one else wanted to invest. So they went to the masses.
And I, it usually just doesn't, it usually doesn't work. You'll get money for sure, but if you're trying to raise, [00:54:00]$500,000, then I could count on one hand the number of times I've seen people, hit that it's extremely difficult. But yeah, that's part of the fun.
Indeed. I know, and no startup is the same, and so that's, I'm sure you see all sorts of things, which is what gives you your, edge cases that are important to be careful for.
Charlie Pascal: Absolutely. Absolutely. Again, thank you for thank you for having me. Happy to be a resource sounding board.
Whatever. If people run into something and you, you feel like it's a dumb question or something you don't want to ask someone in your office, happy to. I can't guarantee I'll have the answer, but
we appreciate that. Thank you. Thanks. Thanks, Charlie.
