Last week, Mark Greig, Commercial Director of Pollenizer Global, wrote a post on the Pollenizer blog, looking at different ways to raise investment as an Australian startup. It’s received some strong interest from investors and startup founders alike. We caught up with Greig to talk us through how it all works.
Investment rounds in Australia
A startup usually goes through a series of investment rounds. The Australian market operates differently to the US, so we’ve tried to keep this relevant to an Oz reader:
- Seed Capital. Most companies start with an investment from the founder. You’ll hear people talk about “the 3 F’s” — family, friends and fools. This is when you’ve got an idea, but you’re just starting out and need some cash to kick-start your business.
- Angel Round. Angel investors will tend to invest in a company before it’s earning revenue. You’ve built a Minimum Viable Product (or MVP) and established that there is a market. The valuation of your company will usually be less than $3m.
- Series A. This round typically occurs when you’ve got people paying for your product or service, but you’re not profitable. It’s the investment from a venture capital firm (“VC”) which will help you scale. A typical valuation would be between $3-10 million.
- Series B (and onwards). There’s a sliding scale of investments after the Series A stage. These investments take place when your company is growing, and the valuation is improving.
Priced round vs. convertible notes
We’re looking specifically at the Angel Round here. As Greig discussed in his blog post, there are different ways to raise capital, and your choice will have implications down the track. There are economic rights (the right to benefit from the success of the business) and other rights that you can negotiate (these can be anything from board seats through to anti-dillution provisions to ensure you don’t lose your equity position).
Priced Round
In the majority of cases, angel investments will take place as ‘priced rounds’. In a priced round, a startup’s founders will agree on a current valuation of the company, often based on the market rate for the hours of work they’ve contributed so far.
The investor will acquire a percentage of the equity in the startup in return for their investment. For example, say a company is valued at $500,000, and the founders are aiming to raise another $500,000; that would take the total valuation to $1m ($500,000 + $500,000).
A single angel investor might be investing, say, $200,000 of the $500,000 in that round. That investment is divided by the total valuation ($200,000/$1m), which works out at 20% equity in the company.
Once the investment is completed, the founders (or perhaps their lawyer and accountant) will amend the company documentation to reflect the new shareholders, and issue a share certificate to the new investors.
Convertible Notes
Benefits in using a convertible note for a startup founder:
- You don’t get tied down in the valuation at the angel investment stage;
- It’s quicker — the legal and accounting requirements are simpler;
- It’s cheaper — quicker legal and accounting means cheaper legal and accounting.
Benefits in using a convertible note for an investor:
- You don’t have to to take a shareholder agreement to a lawyer;
- You’re not becoming party to a shareholder agreement;
- You’ll get the benefits at a later date, when your terms convert to those negotiated at the Series A stage by an investment firm.
There are some potential disadvantages too. And they can end up being pretty expensive, particularly for a founder. If the startup never makes it to a Series A capital raising, it can mean a founder is stuck paying back money that they don’t have. Because investors will usually set a cap with a maximum price but not a minimum price, the founder takes on a lot of the risk.
It can also mean that if your company isn’t valued as highly as you predicted it would be at the Series A stage, your investor could end up owning more shares than they would have if you’d gone the priced equity route instead.
Using convertible notes can create tension between investors and entrepreneurs. Simply speaking, that’s because an investor can end up with a lesser deal if they invest in a company that does better than expected (and the agreement doesn’t include an appropriate cap), and a founder can end up in trouble if things don’t go as well as they’d hoped.
There’s no easy answer on whether to use convertible rounds or not. In the end, your decision as a startup founder needs to take into account who your investors are, the nature of the business and how much risk you’re willing to take on.
There are a few links to other resources listed on Greig’s blog post so check it out.