1. Fintech
Chapter 13: Startup Financing

2. 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

3. 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.

4. Startup Financing 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.

5. Startup Financing Loans
Bank lending difficult where no profits, little or no revenue, no profits, might be no coherent business plan
SBA

6. Startup Financing 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.

7. 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.

8. 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

9. 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

10. 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”

11. 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.

12. 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

13. 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.

14. 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

15. 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

16. 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

17. 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.

18. 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

19. 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

20. 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

21. Startup Financing
U.S. Private Equity and Venture Capital Returns (IRR). USD Terms. Periods Ended December 31, In Percent.
Sources: Cambridge Associates LLC, Frank Russell Company, Standard & Poor’s and Thomson Reuters Datastream.

22. 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

23. Startup Financing IPO: Costs: Offering costs to underwriters Auction
Ongoing expenses of a public company
Short term focus
Dilute founders’ vision
JOBS Act simplifications

24. Startup Financing
Summary of the Different Types of IPO Costs

25. 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 ICOs were on schedule to raise over an estimated $2.5 billion.

26. Startup Financing 2014 -2017 ICO Category Breakdown and Funding
Source: Autonomous NEXT

27. 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

28. 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.