Need to Know | Investing at different stages of a company’s lifecycle

Candice: [00:00:03] Welcome to talk money to me. I'm Candice Burke. [00:00:05][2.3]

Felicity: [00:00:06] And I'm Felicity Thomas. And this is your Need to Know Wealth podcast, where we make the complex simple. We draw on our extensive expertise and experience to help educate you on all aspects of your financial landscape. [00:00:17][11.0]

Candice: [00:00:17] Before we get in today's podcast episode, here comes the required legal disclaimer. Even though we are registered financial advisors, please note that this podcast and the content discussed does not constitute as financial advice, nor is it a financial product. The content on this podcast is general in nature and you should seek professional advice before making any financial decisions. So today it's our Need to know episode and we're going to be talking about early stage investing and late stage investing. [00:00:45][27.3]

Felicity: [00:00:45] And in our role, we don't come across too many early stage investments. We do, however, come across a lot of late stage investments as we typically speak to companies that are two, three years out from IPO, which is initial public offering. We do think though, this is an exciting space to invest in if you're willing to lock up your money for an extended time period, as well as take on the additional risk aspects that come with this. [00:01:09][23.7]

Candice: [00:01:10] And interestingly, we've seen a lot of pre-IPO or convertible note investments lately come across our desk where the investors are asked to lock away capital. It might be for one to two years before the company either decides to go public to the stock market or maybe a trade sale. But, Felicity, let's firstly break down exactly what early stage investing is. [00:01:30][19.8]

Felicity: [00:01:30] So early stage investing funds the first three stages of a company's development. It can be divided into three distinct funding types. So first, you have seed funding or seed capital. Now this money is provided to help an entrepreneur start a business. The second is Start-Up. Money is used here to help a company develop products and start marketing those products. And then thirdly, you've got early growth funding where there's money to help establish and boost manufacturing and sales. Now, early stage investors understand that building a new business takes time and ongoing support. So they typically expect to make multiple investments in a single company as it develops. Because there are more risks associated with new companies that don't yet have a foothold in the marketplace, not all investors are inclined to put money into them. So that's a brief introduction into early stage investing. But let's now take a look at late stage investing. Candice, what are the key differences between early and late stage investing? [00:02:26][55.7]

Candice: [00:02:27] Well, really, the key difference between early and late stage investing is pretty much in the name. So late stage investing supports companies that have moved beyond that start up phase of development and have now rapidly started to grow sales. And late stage investing is considered less risky for investors than early stage, mainly because at this point the companies are now funded and they've established themselves in the marketplace and their investments can therefore be converted more quickly into cash. But before we dive into the typical investment structures of a late stage or growth stage investment opportunity, it's important to know the six stages of a company life cycle. [00:03:04][37.9]

Felicity: [00:03:05] And it's also important to note that there's multiple funding rounds which provide outside investors like you and I the opportunity to invest in a growing company in exchange for equity or partial ownership of that company. But before we delve deeper into the various stages of investing, let's hear from our sponsors. [00:03:22][16.1]

Candice: [00:03:24] So, Felicity, as I've just said, let's now outline the various stages of a company, I'm going to kick it off first. So the first stage is often referred to as the pre-seed stage. This is the idea phase or the phase of analysis. So typically a business will be thinking of a solution. Is a solution a real answer to the problem being solved? Can my solution affect other pain points in the industry by either aggravating them or maybe reducing the acceptance of a target market? Maybe the business is thinking, is my solution similar to an already existing one out there in the marketplace? Usually this would be funded at this stage by the entrepreneur who's come up with a concept and they're spending most of their time convincing other potential partners or investors to join in. [00:04:10][45.6]

Felicity: [00:04:10] So you've heard what the first stage is. The second stage is a more common term in the industry. It's called the seed stage. What is primarily sought in the seed phase is actually to validate the business model along with personal funds. This is usually where angel investors in government funding can come into play. A very common term in this ecosystem is the Triple F - Family, Friends or Fools. Now, these are the people that may not exactly believe in what you are doing or understand what you're doing initially, but they'll invest because they like you. These investors can also be known as seed investors or angel investors. [00:04:45][35.3]

Candice: [00:04:46] And I love this term seed investing because when I typically read a deal, I automatically picture planting a seed in the ground to promote future growth and development of the business. [00:04:56][9.4]

Felicity: [00:04:57] That's a great analogy. So I'll continue on it. Once you gather your seeds, the next round could be known as Ceres A, B and C funding rounds, which would usually fall under early stage. [00:05:07][10.9]

Candice: [00:05:08] So at this early stage, in addition to funding agencies, Felicity mentioned, this is where companies gain larger venture capital investors. So typically wholesale or sophisticated professional investors known as your angels. So these firms also help support emerging ideas and accelerate their business models with access to new customers. Often during this stage, companies will be continuing to develop their ideas, likely in the testing phase, to see if they have a minimal viable product or MVP. So typically, at this stage of a company, you can gain access as an investor via different crowdfunding programmes. Now there's a range of different MVP's out there which Start-Up companies can use to develop their ideas. You know, from software prototypes to product designs, demo videos, landing pages, and what's also known as The Wizard of Oz, which is really a model that's created to act like the product already exists, when, in fact, it's just still in development stage. Arguably, one of the most famous and successful MVP's is Amazon. Most people know that Amazon began as an online bookstore. Right. But what you may not know is that Jeff Bezos actually started out sitting in his laptop buying books from distributors and then shipping them directly to the customers each time he heard that another order was made. So therefore, like you can think about this analogy and how it originally started, the high book sales meant that it made sense for him to keep adding more products to his store and then eventually to acquire warehouses. And then the growth just exploded from there,. [00:06:44][95.4]

Felicity: [00:06:44] Which takes us to the fourth stage growth. As with the Amazon MVP, strong market demand is met. If a startup's product or service is reached this stage, this means that will be upward figures in terms of new customers, recurring revenues and billings profitability here is paramount. This is when the company really starts to grow. Recruitment begins. This is where private equity can come in and take a 50 percent stake of the company or more venture capital investors come in or even family offices because they feel like it's a safer investment. Their main focus is always going to be financial return. Now, naturally, as a business experience, is this strong growth in demand for its product? The next phase is all about the roll out. [00:07:28][44.1]

Candice: [00:07:29] That's right. So the fifth stage is commonly referred to as the expansion phase. We're going to the moon. So faced with a more widespread definition of the term start up, a scale up demonstrates a proven business model that allows it to be more considerate in their ambitious goals. You know, for example, maybe they're thinking, let's expand new international markets or expand to sectors hiring new professionals. So a good example of the expansion phase that comes to my mind is Airbnb. So beginning with the founder's own apartment, Airbnb gave people the option to list their room for short term rentals to earn extra income. You know, everyone loves a good side hustle, but as we now know today, travellers are willing to stay in someone else's home to save extra money on accommodation. And the platform just expanded from there. So starting from that one listing in the one country to now. Over two point nine million homes on Airbnb worldwide in 2021, according to the definition of the scale up Institute of the United Kingdom and the OSI Dezi for a company to be considered a scale up. It must have at least grown in the last three years at an annual growth rate of more than 20 percent. That's a massive hurdle when you think about it. So we're going to company go from here. Maybe they might look at a potential convertible note or pre-IPO equity race. [00:08:51][82.3]

Felicity: [00:08:52] Exactly. So I think this takes us to the final stage known as the exit phase. Now, this output can occur in many ways, although there's three common options that really stand out to me. You've got the sale of the founder shares to another company. You have acquisition by another company, or you have the initial public offering, which means they're entering to sell and the public market. Now, we've gone through the six different stages of a Start-Up business. I think it's important now to explore the opportunities investors can look out for if they're interested in investing in late stage or growth businesses. To Kenis, what kind of terms and conditions should investors look out for? [00:09:30][37.8]

Candice: [00:09:31] Like you've said, Felicity. So there's the various different life stages, right? For a business to go from potentially private to public. But one opportunity that really comes to my mind is a convertible note. So what exactly is a convertible note? A convertible note is a short term debt vehicle that converts into equity in the context of seed financing. The debt typically automatically converts into the shares of the preferred stock upon the closing of the series funding round. So in other words, think of it this way investors loan money to an early or late stage company. Rather than get their money back with interest, the investors receive shares in the preferred stock or the company as part of the start ups initial stock financing round or based on the terms and conditions of these notes. [00:10:15][44.8]

Felicity: [00:10:16] And it's also really important to note that they're set in terms when it comes to debt investments. [00:10:22][5.6]

Candice: [00:10:23] Exactly. So this is where I want to hone in on the differences that investors need to really look out for. In contrast to equity owners, debt holders don't have ownership or interest in the company that they're investing in, so they don't have voting rights. However, when it comes to the priority of payments in a liquidation scenario, debt holders are paid in full before equity holders. So they have a preference over the original shareholders and it's therefore perceived as less risky. So in short, convertible notes are originally structured as debt vehicles, but they have that provision that allows the principal plus any accrued interest to convert into equity at a later date. [00:11:03][40.2]

Felicity: [00:11:04] And I've actually had an investment go south where having the debt holders repaid first is paramount. So I know how important it is. What are the typical terms and provisions that a convertible note investor needs to look over? [00:11:20][16.2]

Candice: [00:11:21] So the first thing you would have looked at, falsities is the interest rate, right? So while the convertible notes in place, the investment fund earns a rate of interest, just like any other debt investment vehicle, the interest is not typically paid in cash, but builds up over time [00:11:36][15.5]

Felicity: [00:11:38] and can also kind of see that the higher the interest, the more risky the investment and the lower the interest, the less risky the investment. What else should we be looking at? Is it the maturity date and maturity dates? [00:11:51][12.9]

Candice: [00:11:51] Very important. Does sound a little morbid, but it's not. Let me let me explain. Convertible notes carry a maturity date at which the notes are due and payable to the investors. If they've not already been triggered into equity, some convertible notes have an automatic conversion upon maturity. So definitely watch out for those. [00:12:11][19.7]

Felicity: [00:12:11] Well, this leads us into probably the most important provision, the conversion provision. [00:12:16][4.6]

Candice: [00:12:17] Yeah, and that's because the primary purpose of a convertible note is to really convert into equity some point in the future. Right. As we now know, the most common method of conversion occurs when an equity investment exceeds a certain threshold or if the private company undergoes an IPO offering, so joins the stock market. So let me give you this example. Let's say we invest in a company convertible note at a dollar 60. Right. Which has been told we've got a 12 month term rate and is going to pay us a 10 percent coupon rate. So going into the investment, we know the convertible note will trigger into equity at the 12 month mark. And the valuation of this business is given out to Dollars per share upon IPO, which will happen most likely 12 months. So really, this pre-IPO convertible note is offering us a 20 percent discount to the business valuation. [00:13:06][49.5]

Felicity: [00:13:07] I absolutely love that. So not only do investors get a 10 percent interest coupon, they're picking up a stake in the private business at a 20 percent discount. Well, that's a wrap for today's episode on early and late stage investing. We hope you enjoyed the episode as much as we enjoyed doing it and learnt something. About investing in private companies, so now that we understand these terms, by definition next week, we can really hear about them in practise. We're welcoming two very special guests who have lived a lot of these phases already and are in the rapid expansion phase. If you'd like to get in contact with either Candice or I. All the details here in the show notes below. Until next time. [00:13:07][0.0]

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