Deal Structures with Yasmine and Tim - Sponsored by BDC

Hi friends! Welcome to the blog recap of our Entrepreneur Education Series. Today, we’re sitting down with Yasmine Al-Hussein (YAH) from Accelerate Fund and Tim Kwok (TK) from Panache VC to talk all about deal structure. A big thank you to BDC for sponsoring this session today! 

Let’s do some quick introductions. 

Yasmine is a dedicated contributor to the Alberta startup community, trusted as a team leader and investment analyst, and actually used to work with us! Now Yasmine works at the Accelerate Fund, which provides financing to Alberta’s tech startups at the pre-seed and seed stages.. The fund helps to foster the growth of Alberta’s technology sector and diversify the province’s economy. Yasmine completed her MBA from University of Alberta in 2020, following a degree in Business Economics and Law.

Tim is an associate at Panache Ventures, an early-stage venture fund with offices in Toronto, Montreal, Vancouver and Calgary, and is responsible for helping the team cover Western Canada. One of the things Tim enjoys most about his job is using his engineering background to help founders create compelling stories around their businesses using data.

TNT: Thanks for joining us today, Yasmine and Tim! Let’s jump right in and talk about raising funds vs bootstrapping vs venture debt vs small business loans. 

YAH: 100%. So I think it really depends on what you want to use the capital for. 

For example, in a typical tech startup, you usually have experts and a great idea/technology, but you don’t have revenue yet. Thus it’s common to go after grant funding or non-diluted funding. And then once you get revenue, you approach more traditional capital, like VC or banks. 

And when you talk about bootstrapping, which is putting in your own money or your savings, or working on it as a side hustle and developing revenue,  that is also really typical to see in early stage companies. 

Typically, it makes more sense for you to look at VC and institutional investors when you’ve already done a pre-seed or seed round, you’ve got product market fit and revenue, and you’re now looking to grow and scale your company. 

TK: Agreed. I read an article that referred to VC as rocket fuel, which I agree with. If you’re a founder that wants to really dominate the market, and scale 10x in 5 years, you can’t do that just using cash flow. You need VC funding to take you to the next level. 

And in terms of bootstrapping, I think that every founder should bootstrap first. I think if you raise VC when you’re still in the mode of figuring things out, you could end up diluting yourself too much. And if you do that, when you truly need venture capital, VCs might be reticent to invest. 

TNT: Very good points from both of you. Ok, so let’s move on and talk about what entrepreneurs should look for in a deal, beyond capital. 

TK: Well, at Panache, our mission is to help early-stage founders in Canada get to a Series A, and ideally raise with a top-tier US VC. To do this, we’ve created a Series A Bootcamp where we bring in VCs from the Valley to share their knowledge on how to raise capital with our founders, and a portal for our 150+ founders to connect and learn from each other.

YAH: As an entrepreneur, I think you need to figure out what is most important for you on your journey. There’s a lot of programs that VCs offer, accelerators and the like, but you need to know which are going to help you. Do you need a network? Do you need advice on your go-to-market strategy? Do you need a mentor? 

It’s about knowing who and what can get you to the next level, and who you want to be aligned with for the next 5-8 years in partnership. That’s what you should look for with VCs, lead investors, and in a deal.  

TNT: Love it. We’re going to head over and take a question from our audience now. The question is: With cost of funds rising lately (and possibly into the foreseeable future), how do you see the investing space evolve in the next 12 months (as it relates to pre-seed to Series-A stages)?

TK: Valuations in the public markets have gone down, which affects what a late stage startup can IPO at, which affects what a Series D+ VC will pay for a company, which affects what a Series C VC will pay for a company, and so on. This domino effect has yet to fully reach pre-seed and seed stage startups but we are starting to see valuations come down at the early stages. It’s hard to say what the venture capital industry will look like in 12 months, but VCs are still investing, albeit maybe at a slower pace, and you could say that things are a lot more reasonably priced than a year ago.   

YAH: Agreed, and you’ll see that VCs are starting to conserve their deal flow, so the pacing or velocity of deals won’t happen as fast. The people making decisions will be tightening their belts, and looking hard at the startups that know how to manage cash and keep their cash flow going for the long-term. 

TNT: Gotcha. So what do you think drives VC’s to pursue this asset class? 

YAH: For Accelerate Fund, our capital comes from Alberta Enterprise Corporation, which is an organization that works on behalf of the Government of Alberta to invest in VC funds to support the growth of early-stage tech companies. With that funding, our mission is clear - to help early-stage tech companies get to revenue and grow! 

For the asset class in general, I think you need to be ok with the risk, because it is very risky. You want to be in the game early, and you get to jump into a space, help mold the ideas and projects, and see the company grow. 

For me, I think that’s the most exciting time of a business. Not only will you receive returns as the company succeeds, you also have a chance to see the founders flourish and the company realize its potential. 

TK: And for Panache, our partners are ex-entrepreneurs who have all built businesses from the ground up. They’re big believers in founders and tech, and they know how hard the entrepreneurial journey is, and they want to pay it forward by investing in startups and helping founders.. 

TNT: That’s so great! Ok, let’s get down to it - deal types! There’s so many kinds. We’re going to start off by talking about equity deals. 

TK: For sure. Equity is owning a piece of the company, usually in shares (common or preferred). Common shares are usually owned by the founders and employees whereas preferred shares are usually owned by investors. When a company sells or goes public, preferred shareholders get paid back first (assuming there’s no debt) and then common shareholders. 

Other items to consider in equity deals are things like board rights, voting rights, pro-rata allowances, preference share sales, participating preferences, etc. 

TNT: Great, thanks Tim. Let’s break down what convertible notes are and what SAFEs are, and their differences and pros and cons. 

YAH: Yeah, for sure. So a convertible note is essentially a loan from your investor that turns into equity in some future time. The main key difference is that you’re setting up the terms of the deal today, and you have a valuation, and you’re saying to the investor that you are going to raise funds again, and at that time, their shares will materialize. 

A typical term on convertible notes is the interest rates, which are usually paid semi-annually, annually, or when the term is up; and discount rates, which means that when the company raises again, the VC will receive a discount of X% on the next round of funding, and the shares will be worth more. 

TK: And a SAFE is an acronym for Simple Agreement for Future Equity. It’s effectively a convertible note, just without the interest rate and maturity date. 

Basically you have a valuation cap and a discount rate, and you’re saying to the founder “Look, we want to invest in you, but we don’t know your value, so let’s defer the valuation until you raise an equity round.” 

But keep in mind that because there is no maturity date, if the founder never raises again, the SAFE will never convert to equity and the investor will never have ownership in the company. Unless you have a clause about liquidation, which can be inserted - those clauses usually say that the investor gets their money back if the company is sold, even if they never raise funds again. There can also be conversion clauses, which would say something like, hey, if you haven’t raised funds in the next 2 years, we will convert to equity. 

*A note from Tim Lynn - YC has a great set of docs for SAFEs, and the latest and greatest has a clause to include dividend payments to SAFE holders. 

TNT: And also, a convertible note does put you as a debt-holder in the company, and you sit higher in the pay-out priority waterfall. 

TK: Yeah, great point. 

TNT: So what are some of the pros and cons of SAFEs and convertible notes? 

TK: I think SAFEs are more founder-friendly than convertible notes, because there’s no interest. And honestly, as an investor, we don’t care if it’s a SAFE or convertible note. That’s not the biggest issue we look at when we’re thinking of investing in an early-stage company. We’re looking at the founder and if what they’re building could be really, really big.

YAH: For us at Accelerate, we usually don’t lead a round, so we’ll follow the instruments that are set out. We can include a side letter with any specific terms we need, and that can go hand-in-hand with the SAFE or the convertible note. 

One small point for entrepreneurs, is that since SAFEs are standard templates, you’ll likely spend way less time and money on a lawyer, as it’s already set up. So you can save on legal fees there. 

TNT: Ok, here’s a question from the audience. “Does a complex cap table with multiple different SAFES or convertible notes, turn you off a deal?” 

TK: It CAN make it harder to get a deal done. Something that we’re very concerned about in the beginning is founder ownership. In an early-stage company, you’re investing in the founder, so you want to make sure that they’re incentivized enough to stay with the company in the long run, one of those incentives being enough ownership. 

If there are multiple SAFEs, the founders may have over diluted themselves, and that’s a concern. It’s important for founders to understand the SAFE conversion, so they know what the full dilution will be. 

YAH: It’s not always a red flag for us, but we always make sure to do the dilution calculations, and to let the founder know what they are, in case they haven’t. Actually, a really good resource we use is the Founders Pocket Guides, particularly the Cap Table edition. There’s a downloadable guide that helps to calculate the valuation and ownership position. 

TNT: Awesome, thanks for that resource, Yasmine! Ok, another question from the audience: “How do your pre-seed funds feel about companies that don't follow a pre-seed with a Series A, but instead, are profitable without the need for further raises?”

YAH: I think it depends on what you raised on. If it’s straight equity, with percentage ownership with all the terms laid out nicely, our question is will this company, that’s profitable, get the kind of returns that we as VCs would want? 

I think typically, you would probably look at angel investors at this point vs VCs, because angels are typically fine with getting their principle and a little more back. 

TK: From the perspective of an entrepreneur, this is great, because you’ve created a profitable company! 

And I don’t think you should necessarily buy into the narrative that you have to raise venture capital. You don’t always need it. Like I mentioned before, venture capital is like rocket fuel. It’s used to grow and scale your company, and to go for world domination. So if your goal isn’t that, and your goal is just to build a profitable company and scale based on cash-flow, then you don’t want or need venture capital.

TNT: OK, let’s talk about valuations now. How do you determine a fair valuation or cap? 

TK: I think it’s important to look at the market and see who is similar to you. You can check out their valuations, figure out a benchmark, and see where you stand against that benchmark. The valuation is really discovered when you create a market (of interested VCs) around your company. 

YAH: And at the early stage, it’s about understanding how much you want to sell off, and how much do you need to keep to incentivize yourself, and what do you need to give your employees (in an ESOP for example) to keep them motivated. 

It’s also an understanding of what do you need to get to the next level? What do you need to make sure you have a 12-18 month runway to grow and scale the company? And what investors do you want to align yourself with for a long period of time? 

I think it’s important to really lean on your lead investor to help walk you through these conversations. You can talk to them about what they’re seeing in the market, because they see so many deals every day. You can talk through how the sector is shaping up, and deals that they’ve done in similar businesses. 

TNT: And how do you think entrepreneurs can best convey or justify their valuation? 

TK: Honestly, don’t even worry about it. When you’re raising, go out with an idea of how much you want to raise, and use the rule of thumb that says you’re going to be diluted by 25%. 

Don’t focus on what you value your company at, because that can give VCs a number to fixate on. If it’s too high, it’ll dissuade them from investing. If it’s too low, they’ll jump at the deal, and you will have sold your company for too little. 

Once you have term sheets, that’s when you can have the conversations about valuation. 

YAH: I think it’s important for founders to be willing and open to move their valuation, so that a lead investor knows that there is room to negotiate. 

I think founders need to show their understanding of the market and the space they’re in. And when they’re going to bat for their valuation, they should talk a lot about their current and recurring revenues. You can mention your pipeline, but understand that your current traction is what’s important to the VC. 

Also understand that the VC is going to be looking to double or triple their position in each subsequent fundraising round, so know what kind of revenue you need to get to, to hit those milestones and move onto the next round. 

TNT: This has been a fascinating and enlightening conversation! Alright, and the last question. Has negotiation and leverage changed as startups have access to a broader range of VC’s, and more international VC money comes into the Prairies? 

YAH: It’s wonderful to see more capital coming into the Prairies. More competition is great - it  makes us work harder to get the deals we want. 

There is a big difference in the way capital flows from Canada to the States. The resources, the cost of labour, etc. is usually cheaper than the States, so we’re not expecting Canadian companies to raise as much or as high of a valuation as American companies. 

I think as more capital flows in from America, we’ll see the discrepancies in deal flows reduce and even out. 

TK: I think there’s a lot of pros with global and American VCs coming into Canada. The VC industry in the States has been around a lot longer, so having those American VCs share their knowledge, perspectives and experiences with us, with founders and startups, is great. They also have larger networks too, so that opens up more doors and opportunities for founders. 

And I agree with Yasmine - it forces us to compete with them, forces us to be better, so that’s great too. 

TNT: Again, fantastic conversation Yasmine and Tim! Thanks so much for joining us today.