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Issuing equity – economics versus control

In my experience, many first-time entrepreneurs seem to misunderstand or confuse the concept of “economics” versus “control” in terms of issuing equity.  The book Venture Deals is an excellent resource and strongly recommended for those preparing or evaluating a term sheet.  The book is very comprehensive and can take some time to digest, however, the underlying principles can be distilled into the following:

(i) Every equity instrument consists of two components that are of value to the investor, namely “economics” and “control”.

(ii) “Economics” represents the investor’s ability to generate a return on investment.  Generally, this includes the cost of the investment, as well as the percentage of ownership.  Howevever, there can be other complex economic terms to an equity instrument.  For example, many term sheets include an anti-dilution provision to protect the investor’s pro-rata share in the event the company subsequently issues shares at a lower valuation and lower price.  In addition, convertible preferred shares often include a liquidation preference to be enacted upon sale of the company, or some other liquidation event.  So, economics goes beyond “issuing n% of the company for $x”.

(iii) “Control” represents the investor’s ability to influence the decisions of the corporation.  It is important to note that control of a corporation ultimately resides with the Board of Directors, and a shareholder can only exercise influence to the extent that they can appoint or elect members of the Board.  The control provisions of a term sheet can be very complicated, and Board governance models can vary widely depending on the corporation, so, every situation is unique.

(iv) It follows from the previous point that x% economic interest does not necessarily translate to x% control.  For example, an investor might be issued 10% of the outstanding common shares of the corporation in the form of Class B non-voting common shares.  In this case, the economic interest is 10%, but they have no representation on the Board of Directors.  Similarly, suppose an investor owns 45% of the voting shares but none other shareholder own in excess of 5%.  Although the investor owns a minority interest, unanimous opposition would be required to prevent them from achieving control.  (NB: I like to refer to this as the ‘Dragon’s Den’ error.  Dragon’s Den is a popular show in Canada where new ventures ask a panel of wealthy business people for an investment.  Often, the supposedly astute investors ask for 51% ownership so they can exercise control, which, as demonstrated, is not the case.)

(v)  Economics and control, although separate components of an equity instrument, are symbiotic.  The greater the economic interest belonging to an investor, the greater the incentive for them to be involved in the affairs of the business, and the larger the desired control.  Given that life science ventures generally require large capital investments, it is reasonable to expect giving up significant chunks of both equity and control to investors.  So, when it comes to preparing a term sheet, it is important to arrive not only at a fair valuation, but also a fair system of representation.

Hopefully this article clarified any misunderstanding that might exist regarding the issuance of equity instruments.  As I have mentioned to many people, the finance principles applicable to start-ups can be initially confusing, however, once understood, they are quite intuitive and easy to remember.

The Entrepreneur’s Guide to Venture Capital

I have attended a number of seminars and programs for entrepreneurs aspiring to raise venture capital.  As much as these programs cover the basics of approaching a VC, such as preparing a pitch or financial models, I have yet to encounter a topic covering the inner-workings of the industry.  As much as good VCs understand and appreciate entrepreneurship, good entrepreneurs should understand and appreciate venture capital.

To that end, I recently read “The Business of Venture Capital” written by Mahendra Ramsinghani.  The book is loosely divided into three sections and covers the formation and mechanics of a fund, sourcing and closing of investments, and exits.  Although I had a fair understanding of the latter two, the first section of the book was extremely helpful in explaining the tricky dynamics between a firm and its limited partners (i.e. investors).  I would strongly recommend the book to every entrepreneur and I believe that it should be required reading in advance of any VC pitch.  For those tight-on-time, I have listed the key takeaways that I found insightful:

(i) VC money is a “drop in the bucket” – most entrepreneurs know that venture capitalists source their funds from large endowments, pension plans and family offices.  What is lesser known is that the amounts allocated to venture capital from these institutions is typically a very small fraction of their portfolio.  The book provides a great analogy in that, if an ocean were to represent the total of invested capital, venture capital would be the size of a bucket.

(ii) VC = 10 x Entrepreneur – as difficult as it is for an entrepreneur to secure an investment from a VC, it is significantly more difficult for VC to raise funds from a limited partner.  Whereas an entrepreneur might ask for $1 mil to $10 mil from a VC accompanied by evidence of traction, a set of milestones and an allowance of oversight, a VC might ask a limited partner for $10 – $100 million with little direction as to how they specifically intend to deploy the funds.  This entails an entirely different level of trust.

(iii) One percent – as evidence of their commitment, VCs are routinely expected to contribute at least 1% to a fund.  Although this might seem small, a $200 million fund managed by four general partners requires an investment of $500,000 each!  This is well beyond what most entrepreneurs raise as part of family & friends round.

(iv) 80/20 rule – as a rule of thumb, the majority of capital is raised by the top VC firms, with “zombie firms” on the outside-looking-in.  Investors are much more trusting of consistent performers than emerging managers, so everyone is scrambling to prove that they are or will be in the top-quartile.  Limited partners are not particularly forgiving of failed VCs.  Generally, two failed funds and you’re done!  A strong relationship between a VC and its limited partners is a key to longevity.

(v) Paradox of success – most founders envision guiding their start-ups from inception to exit, with few realizing that one of the largest impediments to doing so is VC investment.  It is not uncommon for VCs and CEOs to disagree as to the direction of the business, with most disagreements settled in the favour of the VC.

(vi) Good VCs have “it” – I believe that good VCs are able to appraise new businesses, technologies and markets well beyond the capacity of others, as well as coach entrepreneurs to capitalize on opportunities.  However, the path to acquire those skills is far from defined.  Some argue that successful serial entrepreneurs make the best venture capitalists, in that it takes-one-to-know-one.  But, as the book notes, whereas entrepreneurship involves working with one technology at one time, VCs must have a macro understanding of all technologies within their portfolio.  Also, it can be difficult for an entrepreneur accustomed to being an operator to transition to a VC expected to serve as a mentor or guide.  Alternatively, the path of getting an MBA or advanced degree from a prestigious school, joining a VC firm, and then matriculating to partner is no guarantee of success either.  Ultimately, good VCs just have “it”.

Having begun shortly after World War II, venture capital is still very young.  As time progresses, the industry will evolve, mature and improve for the benefit of VCs, limited partners and entrepreneurs.

Required Reading – IPO stats, DNA Storage Devices, Startup Highlights, etc.

Selected articles, books, & podcasts for August 27, 2012

Biotech Startups & Other Startup Content
  • Great new post on BiotechStart. Book Review – Founders Dilemma (here)
  • Biotech IPOs Are Beating Tech’s Big Names (here)
  • Tips for Entrepreneurs working with Industry (here)
  • Startup Incubator Pros and Cons (here)
  • Halcyon Molecular shuts down (here)
Selected Articles in Science and Industry
  • Artificial zinc fingers provide new genetic components for synthetic biologists (here)
  • Eric Schadt Interview after 1 year as Chair of  Mount Sinai School of Medicine’s Department of Genetics and Genomics (here)
  • The Rise and Fall of Amyris (here)
  • Myriad Genetics wins victory in patent ruling (here)
  • Great analysis of the mutations involved in acute myeloid leukemia (here)
  • Why Healthcare Needs More Women Leaders (here)
  • Pac Bio Commercialization Chief leaves (here)
  • The death of microarrays, finally (here)
  • Awesome new camouflage technology (here)
  • A book written in DNA (here)
  • September 2012 Issue of the Burrill Report (here)
Audio & Podcasts
  • George Church Talks Personalized Medicine and Synthetic Biology (here)
  • 23andMe Seeks FDA Clearance (here)
  • Lack of reproducibility of academic publishing (here)

Required Reading – 2012 Biotech M&A, Digital Health, Haplotype Sequencing, etc.

Selected articles, books, & podcasts for July 23, 2012
Biotech Startups & Other Startup Content
  • A great breakdown of 2012 Biotech M&A (here)
  • The remaining active Biotech VCs (here)
  • Venture debt for financing biotechs (here)
  • Synopsis of VC Trends 2012 Q2 (here)
  • The full monte of VC Trends Q2 2012 (here)
  • The fall of Digg (here)
  • Preparing your startup to raise an angle round – web centric. (here)
Selected Articles in Science and Industry
  • Book: The Creative Destruction of Medicine, by Eric Topol (here)
  • Accurate & clinically relevant haplotype sequencing (here)
  • NEJM collated data on how we die, past vs. present (here)
  • Canada approves stem cell product (here)
  • Good infogram on the impact of Alzheimer’s (here)
  • Simulation of a whole cell (here)
Audio & Podcasts
  • Mendelspod interview w/ Steve Burrill (here)
  • Mendelspod interview w/ Corey Goodman (here)
  • Genetech’s bet on Antibody Drug Conjugates (here)

Required Reading – Financing, Investing Models, Sequencing, etc


Selected articles, books, & podcasts for April 14, 2012.

Biotech Startups & Other Startup Content:

  • Steve Blank’s “The Startup Owner’s Manual” (here)
  • Virtues of differing biotech worldviews (here)
  • Third Rock’s Mark Levin: ‘Ultra-Super Positive’ on biotech (here)
  • The NSF Innovation Corps (here)
  • 100 life science twitterers worth following (here)
  • Investing in biotech isn’t just for investors anymore (here)
  • Billions in new venture cash targeted at early-stage biotech efforts (here)
  • Never negotiate piecemeal (here)
  • Quick hack for speeding up term sheets and other negotiations (here)

Selected Articles in Science and Industry:

  • Heterogeneity of mutations in tumors (here)
  • Targeted nanomedicine to enter cancer clinical studies (here)
  • The challenges of tackling fibrosis Industry (here)
  • GE ramps up investment in personalized medicine (here)
  • Burrill’s Biotech 2012 Report (here)

Audio and Podcasts:

  • Understanding the shifting patent landscape (here)

Mendelspod Series on Sequencing tech (you’ll need to register but it’s free):

  • Sequencing overview w/ Shawn Baker, BlueSEQ (here)
  • Ion Sequencing w/ Paul Billings, Life Tech (here)
  • RS Sequencer w/ Hugh Martin, PacBio (here)
  • Sequencing & Genomic Medicine w/ Cliff Reid, Complete Genomics (here)
  • Last Gen Sequencing w/ Stefan Roever, Genia Tech (here)
  • Positional Sequencing w/ Barrett Bready, NABSys (here)
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