Workshop: Financing Economics for Startups
By Rock Health Intern Jess Herschfield
Watch the full presentation below, or read on for our recap.
You have the next great idea that will change the healthcare industry, which likely means you need money. Venture Capitalists are your next step, but the thought of approaching a firm can be quite daunting. In order to ease some of these anxieties, Rock Health brought in Rowan Chapman and Abhas Gupta of Mohr Davidow to answer five of the most commonly raised questions from entrepreneurs.
First and foremost, entrepreneurs want to know how much they should raise, and when. And the answer is, it depends. The bottom line is to identify how much money your company will need. According to Rowan, the best way to do this is to establish value creation milestones, and determine how much money you will need to get to each milestone. In order to determine these milestones, Rowan walked us through some key considerations for a digital health company’s valuation. Here’s the breakdown:
In order to accurately determine your valuation, you must consider how far along your startup is in the four categories above. Once you understand where you initially stand, you can determine the next milestone you wish to reach in each category and how much money you think you will need to get there.
Rowan suggests working backwards, in order to forecast your needs. Ask yourself what resources you will need to get you from point A to point B, point B being your next round of funding, and point A being where you would be with the money you raise now. Question how many months it will take you to get there, how many man-hours, what kinds of people you will need, etc. Once you find reasonable answers to these questions, you can calculate an accurate amount to ask for.
When asking for money, raise only what you need, but be sure you will be able to hit those milestones. Having to raise an additional round of funding because you failed to raise enough in the beginning may mean a smaller share of your company in the end. This can be seen in the case below, in which each startup raised the same amount of money, but did so in different manners:
Ok, so we now we know how much money to ask for. But typically, how are digital health companies valued by the venture capitalist? Well, once again, it depends. Typically, at the seed stage, raises are un-priced, and include a discount of 10-20% per annum plus a cap. This is because valuation at early stages is less quantifiable, and depends on less tangible things such as achievements, raise size, needs of the cap table, acceptable dilution, competition for the deal, etc.
Once we understand our startups valuation and you decide to partner with a VC, it is time to make a deal. The major question entrepreneurs grapple with during this stage of raising is what the standard deal terms are.
There are two types of stock you will allocate: preferred stock and common stock. Here’s the breakdown:
At this stage in fund raising, the VC will typically ask for preferred stock, as it costs more than common stock, but they have more say in the company.
Once you agree to partner with a VC, it is time to set the terms of the deal. Rowan walked us through some of the most common deal terms, ones you should most definitely consider during your raising process.
- Cap Table: This section deals with valuation and the size of the option pool. A venture capitalist will look at your startup as a pizza, considering how big a slice of the pie they own.
- Decision-making and Information: Practically speaking, this section describes how the company is run, and what occurs at board meetings. Voting rights, board composition, information rights, board meetings, and protective provisions are all considered in this section.
- Founder Terms: This section is vital to ensuring both the VC and the founder are wholeheartedly invested in the success of the company. Vesting is the primary concern of this section.
- Future Financings: Since your startup is at such an early stage in its life, you will almost certainly go through another round of fundraising. This section determines the rights of the investing VC when such event occurs. Right of First Refusal, Pro-rata Rights, and Anti-Dilution Rights are all discussed in this section.
- Exit Events: These terms will most likely be the most controversial terms you will discuss with your Venture Capitalist. This section deals with liquidation preference, drag along provision, and conversion rights. The way you formulate these terms are extremely important, as it can mean huge differences in what you get out of the deal. See the example below, of the exact same monetary valuation, but how differences in exit event terms changes who gets what:
Be very conscious of your terms, and make sure to go through each detail with your VC, as your terms can have a major effect on the valuation of your startup, future financings, and liquidation.
Now you have agreed to terms with your VC, and you have your leftover option pool of equity. The question now, is how much of the equity should you give to advisors, and how much to new employees. Typically, option pool sizes are 10-20% of the post-A round. Therefore, in order to determine how much equity to allocate, Rowan suggests working backwards from needs. Try and determine what kinds of people you need, and how much your stock option budget is during this round of funding. Employee’s grants are usually determined by their title/responsibility. For example, during a series A round, CXOs may get 2-10%, VPs 1-2%, board members 1%, and senior engineers 0.5-1%. Finally, for advisors, it really depends on how much time they are committing to you. Rowan highly suggests offering advisors time-limited grants. And as is always the case, the board needs to approve all grants.
And that brings us to the last question: anything else founders need to know? First and foremost, Rowan walked us through some of the most common mistakes entrepreneurs make when seeking funding:
- Lack of clarity on milestones and vision
- Raise too little
- Raise too much
- Fundraising too early
- Granting advisors too much equity
- Poor self-awareness (know your weaknesses and gaps)
- Unrealistic plans
- Talking to too many VCs concurrently
- Targeting the wrong VC
Rowan likens raising VC funding to a marriage; it takes courting, then dating, then marriage. You must find someone who is willing to stick with you through the good times and the bad.
So let the courting begin! Raising your first round of venture funding can be extremely daunting, but with the right tools, and confidence, you are poised to find the perfect mate.