Fintech

Chapter 13: Startup Financing

Startup Financing
“Mo’ Money, Mo’ Problems”: The Notorious B.I.G.

• Credit cards and cash on hand

• Friends and family
• Loans
• Crowd funding
• Angel investors
• Accelerators
• Venture capital
• Public markets
• ICOs
Startup Financing
Credit Cards and Cash on Hand
• Legendary stories of founders living hand to mouth,
making payments using personal credit cards,
draining personal bank accounts.
• Some of these founders may have kept their startups
afloat,
• But high frequency of startup failure
• Incredibly risky to use limited personal funds to get a
startup going.
• Credit cards are widely available but they carry
interest charges that are higher than almost every
other source of financing.
• Defaulting on payments is damaging to credit ratings.
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Friends and Family
• over 90% of startups fail at the initial financing stage.
• numbers suggest that friend and family investors backing
startups will see no return.
• strain this can cause on personal relationships
• most founders and investors are financially unsophisticated,
the nascent company won’t yet have financial statements
• A successful company is also not a guarantee of a better
relationship with these investors. As The Notorious B.I.G. so
eloquently put it: “Mo’ Money, Mo’ Problems”.
• Ambiguous role or equity participation of friend and family
investors
• may be an obstacle to later VC investments.
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Loans
• Bank lending difficult where no profits, little or no revenue, no
profits, might be no coherent business plan
• SBA
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Crowd Funding
Crowd funding refers to raising money for a project through small contributions
from a wide number of people, most of whom have no connection to the project’s
sponsors.

The benefits to the entrepreneur are:

• they receive funding for the project;
• the crowdfunding supporters act as a test or focus group, giving valuable
feedback;
• a community of users are self-selected for future follow-on contacts.
• All this without giving up equity, incurring debt or relinquishing any degree of
control in the company.

Non-equity crowd funding

• provides some efficiencies in lowering transaction costs.
• Search costs for matching investors with founders are very low
• The small funding increments of these projects result in relatively low risk for
investors.
• And low communication costs allow founders and investors to stay connected.
Startup Financing
Crowdfunding Platforms:

 Funding is not geographically constrained

 Funding is highly skewed

 Funding propensity increases with accumulated capital and may lead to herding.

 Friends and family funding plays a key role in the early stages of fundraising.

 Funding follows existing agglomeration.

 Funders and creators are initially overoptimistic about outcomes.

 Crowdfunding capital may substitute for traditional sources of financing.

Startup Financing
Kickstarter early projects focused on the Arts:
• Musician Amanda Plummer
• Coolest Cooler
• Veronica Mars film
• Zach Braff
• Spike Lee
• 3,000 pounds of potato salad

Later projects include free software, medical,

charitable activities

Indiegogo, GoFundMe: $3 billion raised 2010-2017

Startup Financing
Equity Crowdfunding
• Loans
• Equity
• Jumpstart Our Business Startups (JOBS) Act of 2012
• Accredited vs non-accredited investors
• 25+ sites
• AngelList, CircleUp, FoundersClub, Gust, SeedInvest
Startup Financing
AngelList
• Founded 2010 on fourth attempt
• 61 startup investments made in 2013 had
unrealized IRR of 46% at year end 2015
• Some individual investors but increasing role of
“syndicates”
Startup Financing
England’s FCA concerns loan-based and investment-based crowdfunding:
• Inadequate disclosures about risk and loan performance.
• The risk of arbitrage with investment management or banking
activities.
• Firms acting in a nontransparent manner exposing investors to risk.
• Risk of firms operating in unfamiliar markets without appropriate
expertise, exposing investors to unforeseen lending risks.
• Consumers may not realise they do not have the usual protections
• Institutional investors could bring benefits for retail investors (e.g. due
diligence) but introduce risks – particularly around conflicts of interest.
• Some platforms allow investment in loans formed on other platforms,
which can make it harder for investors to conduct due diligence or to
understand the level of risk they are taking.
Startup Financing
FCA concerns (continued)
• Inadequate disclosures
• Due diligence standards vary and are not disclosed
• None of the platforms provided an assessment of the
valuation of a pitch, although they did challenge the
figures proposed by fundraisers.
• Not all firms aligned their business models with the
possible future success of the investors
• Not all firms had effective internal controls for approving
or communicating financial promotions.
• Not all firms satisfied the requirements to assess investor
knowledge or experience
Startup Financing
FCA is pursuing further consultation on the following
issues which could harm consumers:
• In the event of failure, firms should have wind down
plans in place.
• Some platforms allow cross investing of loans
originating on other platforms. This may give rise to
cascading failures.
• It may be appropriate to extend mortgage lending laws
to these platforms.
• The quality of financial communications is of concern.
Startup Financing
Angels
• Origin in theater to refer to wealthy patrons providing funds for new
Broadway productions
• Wealthy investors, may be entrepreneurs, retired executives
• Financing, but also mentoring, networking
• 300,000 Angel investors, 400 active Angel groups
• Funds they invest are their own, not OPM. Strong incentive
• Angel investments are private arrangements, not disclosed.
• Total Angel investment larger than that of VCs
• Typical investment ranges from $25,000 to $100,000
• Angel investment may provide screening, higher success level
Startup Financing
Accelerators or Incubators
• Focus on developing relationships between
startups and established businesses
• Bring startups to next level
• Some programs extremely competitive
• Office space, mentoring, access to tech and other
senior level executives
• Some offer intros to investors, may take equity
stake
Startup Financing
Venture Capital
• 2016: 253 US VC funds raised $41.6 billion in new money
• 2016: VCs invested $69.1 billion in 7750 companies
• Venture Capital: pooled investment funds which invest in early
stage companies that have products and some sales, but typically
are not yet profitable
• $5 trillion in assets
Startup Financing
VC:
• VC management solicits capital commitment from institutional investors
and wealthy individuals.
• This fund will have a name such as “VC Partners Fintech Fund 2017” and
will have a target size, e.g. $100 million
• Investors are called Limited Partners (LPs). The VC management company
becomes the General Partner (GP) of this fund
• Fee structure to GP varies, but standard is 2% of invested capital plus 20%
of profits
• GP share of profits is called “carried interest”, taxed favorably and is
controversial.
Startup Financing
VC continued:
• Large VC firm will have a number of separate funds, all paying
fees to the VC
• Time between starting a new fund: 2-3 years
• Some LPs may be in multiple funds, but each fund is a separate
entity.
• Once funds are raised, VCs perform due diligence on
companies, investing in very small percentage
• Investments in companies are made by specific funds
• Some corporations have internal VC funds, not investor backed
Startup Financing
VC continued
• Provide capital
• Validation
• Valued board members
• Mentoring and networking
• Guiding to exit
• Concerns:
• Not all VCs are great board members
• Might not be specialist in specific market
• Need to deliver return to investors in specific time frame
• Growth in funds may lead to overvaluation of startups
Startup Financing
VC Misperceptions
• VC returns to investors
• Venture Capital is not the largest source of startup funding
• VCs may risk investor capital, but it’s not their own
• Some VCs are great mentors and board members, but not all
• Size matters, but not in a good way
• VCs as innovators
 Startup Financing
U.S. Private Equity and Venture Capital Returns (IRR). USD Terms. Periods Ended December 31, 2016. In
Percent.

Sources: Cambridge Associates LLC, Frank Russell Company, Standard & Poor’s and Thomson Reuters
Datastream.
Startup Financing

Initial Public Offering (IPO)

• Raising capital for expansion, acquisitions or other corporate purposes
• Providing liquidity for founders, employees, VCs and other investors to cash out
• Realizing valuation differential for public versus private companies
• Ego stroking for founders
Startup Financing
IPO:

Costs:
• Offering costs to underwriters
• Auction
• Ongoing expenses of a public company
• Short term focus
• Dilute founders’ vision

• JOBS Act simplifications

Startup Financing
Summary of the Different Types of IPO Costs
Startup Financing
Initial Coin Offering (ICO)
• founders have an idea for a new digital coin
• They offer the rights to one of these new coins, when developed in the
future, for some amount of bitcoin or ether now
• The ICO is a means for a private company to raise funds from investors
• similar to a Kickstarter campaign,
• An analogy is that the Wright brothers could have issued ICOs to fund
their early experiments in manned flight, with the tokens redeemable for
airline miles
• In June 2017, over $550 million was raised in ICOs, more than in Angel
and VC funding.
• For all of 2017 ICOs were on schedule to raise over an estimated $2.5
billion.
Startup Financing
2014 -2017 ICO Category Breakdown and
Funding

Source:
Autonomous NEXT
 Startup Financing
ICOs continued
• ICO tokens give the holders rights to the project’s output on a “when
issued” basis.
• ICO investors may simply hope to make a profit on their coins and the
tokens will climb in value.
• Tokens can be freely bought and sold in an open market place.
• But some of these digital tokens sound like equity issues.
• the SEC determined that tokens issued by DAO were in fact securities
under the Securities Act of 1933 and the Securities Exchange Act of
1934.
• The SEC noted that automating certain functions through “distributed
ledger technology, smart contracts, or computer code, does not remove
conduct from the purview of the U.S. federal securities laws.”
• the token or coin looks more like a security until and unless it has a
substantive commercial purpose. And if it’s a security it has to meet the
regulations governing the sale of securities.
• People’s Bank of China also determined that ICOs are illegal and said it
would strictly punish offerings
Startup Financing

Matt Levine cleverly summarized the steps taken in some of these failed IPOs.
Here is his caricature of startup finance in 2017:
1. You have an idea.
2. You raise as much money as you need from VCs to make that idea a
success.
3. You build your business by making it as popular as you can.
4. One you have reached a peak of popularity, you go public.
5. You cash out the VCs, and yourself, in the IPO.
6. Then, you know, whatever.