Startup Wealth: How the Best Angel Investors Make Money in Startups by Josh Maher

Author:Josh Maher
Language: eng
Format: mobi
Publisher: Booktrope Editions
Published: 2015-10-05T14:00:00+00:00

What are some of the other tricks people play in early-stage finance?

Let's talk about warrants. Leave aside desperation deals where they must offer warrants to raise money. Let's assume it's a company that’s in a position to do a normal raise. Warrants as they are generally done are one of the worst ways to induce investors to put money into the company. They are bad from the company's perspective, they are bad from the investor's perspective. Why? Because the typical warrant in an early-stage raise has a life of somewhere between five and 10 years. This means that the warrant won’t generate capital for the company in any time frame that’s meaningful for an early-stage company. However, it is a permanent or at least a medium- to long-term call on the value of the equity of the company. Put another way, a five or 10-year warrant is in fact a substantial discount on today's equity value. It also permanently, or in the long term, screws up your cap table. It is cleaner to say “I will value my company at $2 million with no warrants instead of two and a half million dollars with a whole bunch of warrants that won't bring me any capital in the future.” Why? Because if I give warrants in this round, I probably will give them in my next round. Period, end of story. Each time I will be rolling forward. I will have the equity appreciation. If I get an exit in four years I won’t have had any access to that capital, but I will give away part of my value on my exit. This makes no sense from the company's perspective.

Let's look at it from the investor's perspective. This is a terrible idea. Why? Because, number one, I own less of the company today. To the extent that it ever matters that my votes get counted, which it almost never will, I have fewer votes. Number two, if I want to maintain my sort of implicit ownership I have to write another check, whether or not it's convenient, whether or not I have cash, whether or not it makes sense at the time. The worst is if there’s an exit, and I haven’t exercised my warrant at least a year in advance, now on my equity appreciation I pay short-term cap gains rate instead of long-term cap gains rate. Gee, I would have been better off buying in at a lower valuation and getting long-term rates and just owning a little more outright from the beginning than holding a warrant.

Warrants are bad for the company, bad for the investor, everybody loses; oh and by the way, the attorneys get to charge more and the accountants will tell you that you need to do your 409(a) valuations, although for most early-stage companies that's not true. There is no obligation to have an outside person value your 409(a) until you have been in business for 10 years, or you have certain levels of assets and revenues.

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