Back in December, I wrote three reasons why the North Texas Investor Community is Shifting. In this post, I’m going to dive a bit deeper into what we’re seeing across early stage investment deals in Dallas-Fort Worth. As a reference, I would invite you to visit our VW Series Seed report.
The overarching theme that I will discuss below is that the deal terms are company friendly. The investors are not too aggressive with their asks, which demonstrates that the investors are excited to invest and want to minimize (a) disruptions to the operations of the company, and (b) the strain on the company’s ability to raise future rounds. Difficult early stage deal terms can inhibit a company’s ability to complete a Series A round.
The overarching theme that I will discuss below is that the deal terms are company friendly.
First of all, our Series Seed audit demonstrates that a board seat is not a standard term in a Series Seed round deal. Let me explain — usually, a company is governed by a board of managers (if it’s an LLC), or a board of directors (if it’s a corporation). Customarily, the investors into an equity round will get a single board seat to represent the investors in board meetings. We’re just not seeing investors in Series Seed rounds demand a seat. It’s not necessarily that a board seat is not warranted, but rather many seasoned investors who understand the risk inherent in this stage of investing prefer to let the founders be. There’s a reason why the investor thinks the valuation is reasonable and wants to invest; therefore, many prefer to let the founders continue to grow the business without interference from or obligation to a Series Seed investor board member.
The next interesting point is that less than half of the Series Seed equity investments had a liquidation preference. A liquidation preference puts the investors at the top of the capital stack upon an exit or liquidation (more on this in the next paragraph), and is the hallmark of a preferred class of shares (or units in an LLC). This means that a majority of the Series Seed round investors are investing into common stock (or common units), which is a company-friendly situation.
Of the Series Seed equity investments that did have a liquidation preference, almost all were non-participating preferred liquidation preferences instead of participating preferred. Participating preferred liquidation preferences are known as “double dipping” — let me explain.
We’ve learned that Series Seed rounds are increasing in terms of the conversion cap and valuation, almost in step.
In a 1x non-participating preferred scenario, the investors get the greater of (a) 1x their investment, or (b) their pro-rata ownership. Here’s an example for you: assume that the Series Seed investors invest $500 thousand for 10 percent of the company. If the company sells for $10 million, the Series Seed investors would rather take 10 percent, or $1 million, because $1 million is greater than the 1x of $500 thousand. If the company sells for $4M, the Series Seed investors would rather take $500 thousand instead of $400 thousand (10 percent of $4 million). In a participating preferred scenario, the investors get to double dip — they get their $500 thousand back, and then their 10 percent. Assuming the same 10 percent Series Seed investor ownership but this time with a 1x participating preferred scenario, if the company sells for $10.5 million, the first $500 thousand goes to the investors, and then the investors get an additional $1 million (or 10 percent of the remaining $10 million). We’ve only seen a handful of participating preferred scenarios, which further demonstrates how company-friendly most of the deals have been.
We’ve learned that Series Seed rounds are increasing in terms of the conversion cap and valuation, almost in step. And there is a lot of investment activity in the area. The terms are generally startup-friendly, and this is a great thing for the startup ecosystem across North Texas.
Corporation or a “Corp.”
A corporation is the preferred entity structure for most startups. Corporations provide protection to the shareholders (the owners of the corporation), in that the liability is usually limited to the actions of the corporation, and not the individual shareholders or investors. Corporations are traditionally managed by a Board of Directors, and corporations are the only entity which can “IPO” or offer their shares for sale to the public via a regulated exchange. Corporations are easy to structure and it’s easy to offer option plans in order to incentivize employees and service providers. The main criticism of corporations is that they suffer “double taxation” because the corporation gets taxed on profits, and then when dividends are paid to shareholders, the shareholders pay taxes on those dividends. This can be costly for some shareholders.
Limited Liability Company
Limited Liability Companies or “LLCs” are a relatively new type of entity structure. To wit, they have only been around in Texas since 1991. LLCs provide the same type of liability protection as corporations, in that the members (that’s what we call the owners of an LLC, similar to shareholders in a corporation) of an LLC are generally not liable for the acts of the LLC. The main benefit of an LLC is that taxes “pass-through” to the members, and the LLC does not pay taxes at the LLC level. In most cases, LLCs offer more advantageous tax treatment, and for this reason, LLCs can be a great tool for startups. That said, it is more difficult (though not impossible) to incentivize employees, and many venture funds have a strong aversion to investing in LLCs. We can discuss how rational that aversion is in the future.
Note that choosing the right entity requires consideration of many more factors (both legal and tax) than listed above. Talk to your CPA and attorney to see what’s best for you.
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