Beverage School: Financial Instruments for Growth

Melissa Travers [00:10] I would like to say hello to all of you. My name is Melissa Travers. I am director of community here at Bevnet. I run our weekly community call which we just turned into a podcast. You can find that on Apple, Spotify, or wherever you listen to podcasts, and if you wanna check that out and sign up for upcoming shows, you can find that at CommunityCall.Bevnet.com. So it's such a pleasure to see all of you here. Thank you so much for joining. Joining us, I hope that I get a chance to see everybody here over the next 2.5 days. And next up I would like to introduce Jeremy Halpern, partner at Nutter. Um, Nutter is a legal firm that specializes in CPG. This is gonna be a great presentation on financial instruments for growth. Thanks so much.

Speaker 2 [01:04] Morning everybody. Oh, like halfway caffeinated. Good morning. All right, excellent. Uh, let's see, can we make this work? Probably. All right. Ah, just, I'll give you 10 seconds because I know you all hate infomercials, but Nutter, we're a law firm. We're based in Boston, offices in Massachusetts and in New York, ah, a couple of humans in California. Uh, we represent companies all over the world, uh, and our CPG practice in particular is a very national practice, so it doesn't really matter where you are. Uh, we love working with brands from all over. Ah, we're a fully integrated kind of place, so we have corporate finance. Intellectual property, commercial, tax, employment, all the stuff that you guys need with the exception of, we don't do a lot of regulatory work. Um And then just, just some shots of brands, kind of early-stage brands we work with, uh, a bunch of the growth stage brands uh that we do a lot of work with, and some examples of some of the large. And some of the, the exits. So, uh, I started my food and beverage journey actually as the effectively outside counsel to HonST, um, and I've represented, uh, Seth and Barry and in their ventures ever since. So it's, uh, it's been a wild ride, uh, a lot of fun. Um, and it's a pretty big team. Ellie Myers is in the back. Ellie, wave. Make sure to say hi to me or Elliott later, ah, but there's lots of folks on the team. Um, who am I? What's my background? It's a little unusual. So I've spent a long career as a lawyer, but I've also had a career as an investor, both as an angel investor running an investment group in Boston, as well as part of a venture capital firm. I spent some time as an investment banker, uh, because I guess I was naughty and that's what happens to you. Um, And, uh, uh, so even, even with a startup founder myself in the technology space, so I've uh put my own money in, I've put other people's money in, I've asked other people for money, I've asked other people for other people's money. I've helped advise that. I've done it as a lawyer, like it's crazy. So, long time. Um, I'm going to start today with telling you the stuff you don't want to think about, uh, and this is often the hardest thing is to get people to unwind stuff they think they know. How many of you have like a Fidelity or an E-Trade account? OK, and you buy, you buy shares. Right, who do you buy those shares from? Other people, who do you not buy those shares from? Not the bank, but The company And so what happens is in our brains we think about the world through kind of the lens of stuff we know and we think, oh, when I'm selling equity in my business, I'm selling my shares, but that's actually not true. Your shares never go anywhere. If you've started your business, whether it's a company, an LLC or a corporation, and you issue yourself some number of shares and it makes no difference what that number is, and you took those certificates and you put them in the vault, they will never be seen again until the day you sell the company. When you sell other people equity, You're not taking yours and giving it to a third person. By the way, what happens in that story? Who cashes the check in a transfer? If I sell my shares to Bob the investor, who cashes the check? Me, not the company. The company doesn't get any cash. That's not our world. In our world, this is what happens. We have some number of co-founders, 123, whatever the number is. And a minute before a deal, there's some value represented by that company. And then somebody hands us more value. So picture we have a bucket. It's worth, I don't know, 3 million bucks. And we say to someone, hey, will you put a million bucks in? And they say, great. And they pour a million bucks in. What's the bucket worth? 4 million. So what does my percentage represent? 3 million out of 4 million. I went from owning collectively as co-founders, 100% to less than 100%. Did I lose any value? No, so I experienced percentage dilution 100% to 75%, but no economic dilution. I have 75% of a thing worth 4 million. I used to have a 100% of a thing worth 3 million. Is there any difference to that? Not economically. OK? So dollars come in, increases the pie, so the pre-money plus the cash equals the post money on the deal. That's what our thing is now worth. And we went from 100 to less than 100. What does that look like? It looks like this, by the way, it makes no difference whatsoever where we start again. The pre-money number of units of counting shares. It could be 9 billion. It could be 9. It makes no difference. Here's what gets a little tricky for people. You'll talk to an investor and you're having two different conversations. You say, I think the company is worth 3 million bucks. The Investor goes, OK. You think they're putting in a million bucks. We've just agreed on a deal for 25% of the company. They're 1 million out of 4 million posts, right? Not 1 out of 31 out of 4. They're getting 25%. You agree to that deal, and in the investor's head, they're thinking about another 8 things that are on that term sheet that are going to change the economics of that deal. But you've only heard one thing. What did you hear? Yeah, 25%, a million bucks. That's what you heard. Right? And that's what's stuck in your brain, but as it turns out, the world is more complicated than that. So one of the first things that happens is, this is a straightforward transaction. 900,000, we're just using the number $900,000 in value, 900,000 shares, it's 1 buck a share. I put in 100,000 shares, I get 10% for 100,000 shares, right? And if you did it on a cap table, that's what it would look like. I'll come back to that in a second. But then the investor says, you know, you told me that you were gonna take my million dollars in our example or $100,000 on this example, and you're gonna go hire 6 people. How do you compensate those 6 people? Anyone? And Equity. They know you're going to pay them some equity. So they say, well, if I told you your valuation was $3 million that's $3 million assuming you have that bucket of people that you need to go hire with my million bucks. And I don't want to get deluded by the equity you're handing out to them. I'm assuming the existence of those shares. So now in this example it's not that we have 900,000 shares outstanding, it's we artificially create a new denominator. We add 100,000 shares. That's 10% of the pre-money. We say this is a plan and we're going to issue those shares to my new employees as we hire them. They don't exist. We haven't met those employees. We haven't retained those employees. We haven't given anybody any shares, but for accounting purposes, we're going to assume they're out there. That means that they just bought in at 90 cents a share. Not at $1 a share. So they now have 111,000 shares in this example, not 100,000 shares. Who took the dilution from that 10%? Founders, you did. You took it all. Because that's what that looks like. You used to have 100%, but because we agreed, it's as if you had 90%, and then the 10% was the plan, and then I put money in, and I, the investor, still have 10% of the post. OK, and all the rest of the dilution, your side of the ledger. So we started like this, we went like this for the plan, and then I got my 10%. But then we have the next layer of complexity. How many of you have taken money from mom, dad, Aunt Tilda, Uncle Fred? You don't have to say, but like, I don't know why you're embarrassed like me? What are you, what are you about to say, Halpern? Um, so you took money and a lot of you will have done it and we'll talk more about it in a second on safes and notes. And the other thing that new investor says is, hey, cool that you've pre-sold some investment. You've taken in these weird things you don't maybe really understand. To the extent. That you're they're owed equity that too comes out of your side of the deal. OK? It doesn't matter what you agreed with Uncle Fred and Aunt Tilda, doesn't matter. The investor says, regardless of what you agreed, I'm treating it as if my investment gets me 10%. I don't care what's happening in the other 90%. That's your problem problem. So look what happened. You had some note holders and they got a bunch of equity and it all came out of your side of the equation. Did we change the economics of the deal? In this, it was 100,000 for 10%. My other example, it was a million for 25%. No, we didn't change that. It's all still the same, but what we've done is artificially changed a bunch of terms. So I'm going to take you through a bunch of other stuff to think about, and the takeaway from this is you need to get educated and you need to get educated because you're talking to investors who are often better educated than you, and I don't mean in the world. I mean in finance. Right, so you're talking to some VC, they do this for a living. You do this 3 times in your life. And you want to be on informational parity with them because otherwise you're really having two different conversations you're hearing. 25% for a million bucks. They're hearing, sure, assuming all of the following things are true. And there's a bunch of other terms we're going to talk about. So the world breaks down really at this stage into two possibilities. Either you're going to sell equity, meaning an interest in the company that is a present interest at some valuation. Where they know what their percentage is at the moment of the closing of the deal, or You're going to do something else. What's the something else? Anyone? Safes, which are not technically safe notes, but safes or Convertible notes, right? What those are, are investments that are an indeterminate amount of equity. I, the investor, hand you cash. Michael, here's some, here's some cash. I say, how much equity do I get? Michael goes, no. It depends. It depends. That's the answer. It depends. We'll see what it depends on. One of the most frustrating things in that conversation is you do sell safes or notes, and then I kid you not, 10 minutes after we close the deal, Ellie's going to get an email and it's going to say the investor wants to know what percentage of the company we own. I don't know. It's an indeterminate amount. OK? So if you're selling priced equity interest in the company today, they get a particular percentage and that particular percentage is subject to dilution over time, but on the moment of close, we know whether they own 12%, 3%, 10%, whatever it is. And they tend to get control rights. A bunch of things that the company can no longer do without their consent. How many of you took driver's training in the state of California? or elsewhere, driver's training. What did the instructor have? Break. What did they not have? Steering wheel. This is the exact analogy for how investor control rights work. They cannot make the company go anywhere, but they can break that bad boy anytime they want to. And so what happens when they want you to do a thing? They stomp on the brake and they say, If you, I'm just going to say no until you do the thing I want. And that can mean raise any additional money. It can mean hiring people. It can mean changing the equity plan. It can mean changing the business. It can mean changing the budget. It can be changing a whole bunch of things. In a typical investment transaction. There's a list of anywhere between 5 and 25 things that they list that you cannot do without their consent. Brick. Right, it's a very effective mechanism. Important thing, and I don't want to get too far in the weeds, but we can talk about it at the table afterwards, they also bargain for a thing typically called weighted average anti dilution, and what that says is if they invest at a price x. And you later sell equity at a price per unit per share less than x. Some adjustment happens. They don't get repriced to the new price. Why? But they get something in between x and y. OK, and it works through the use of a change in a ratio. When you start off, it's 1 to 1, and if you sell equity, the denominator goes down. And so now it's 1 to something less than 1, meaning their conversion rate is more than one. Now it's as if they bought 1.2 shares, 1.3 shares, whatever it might be. OK. Once they invest, what do they want the next investor to pay? How much more? The most, right? They and you now want every next round of pricing to be the highest price possible because it reduces what? Delusion, right? If they invest at $3 a share and the next investor invests at $10 a share, they get less dilution than if that next investor invests at $5 a share. So you have alignment, you and investor, exactly the same point of view. Next price, highest price. Well, what happens if we're in the land of convertible notes or safes? So what is a note versus a safe? A note is a contract debt that says the company owes them x amount of money. With interest usually on a fixed date and it tends to be between 12 and 24 months away. So I give you a million dollars. It's earning interest at 8 or 10%. Let's call it 10%. And so you owe me $1.1 million worth of equity. Uh, or you have to pay me $1.1 million at the maturity date. What happens if you don't pay? What in theory could they do? Well, just like the bank, they can come take the house. You are giving them creditors' rights. That means they can foreclose on you. It has been known to happen. It's rare, but it does happen. OK. And what they bargain for is, I will take my $1.1 million of value and it will convert into equity at some next price. Ah, I'll come back to. So we talked about maturity. Usually, you cannot prepay the note. You can pay it at maturity but not before maturity. What are the odds you're going to have that amount of cash at maturity? Yeah, like 0.01%, right? Um, sometimes people think it's like a bank loan. It's not, there's no interest payments. The interest is accruing until the date of maturity, so you're not paying it currently. There's no amortization. So here's how they figure it out. They say, I'm going to invest today based on what happens next, some future hypothetical round. Future hypothetical round X. So you come to me, you say, Halpern, will you give me a million bucks? I say, Great, here's a million bucks. And then a year later, Ellie invests and she invests at some price X. And our deal is I get the better of. A discount against that price. The most common you'll see is 20%, but there's ones that have inclining discounts 5, 10%, 15%, 20%. Others that just have a fixed number 7, 10, 20%. Um, or a cap, the highest price that I'll pay. So what if the cap said, I'm giving you my million dollars. Michael and Michael says, great, and I say I want a cap of $5 million meaning the worst that happens to me is I invest my $101 principal plus interest as if it was a $5 million valuation. Michael can sell equity to Ellie at $20 million.30 million dollars valuation. It doesn't matter. I pay 50 million. But what if I get the better of cap or discount and Ellie agrees to a $5 million deal? What do I pay? I pay for. I got a 20% discount. So here's where entrepreneurs go wrong. This is your number one like takeaway from today's moment. If someone is willing to invest today at $5 million Fixed or do it on a note with a $5 million cap, which thing should I do? I, the entrepreneur. Nope. Priced every time because at 5 million, I know the deal I'm, I'm getting. Right, I, the entrepreneur, if I'm selling equity at a $5 million price, but if I agree to a note at $5 million cap, the best I can do is $5 million as the entrepreneur. But what just happened? I already gave up the interest, so I gave up $100,000 of value for free. And if I do the deal at $5 million in the future, then I'm old investors paying at 4 million. Right? I would have to do a deal at, I don't know, whatever the math is, uh, 6.2 million or whatever in order to get old investor to pay 5 million. Right, because of the discount. So if whatever you take away, if an investor's willing to invest at X price and you can't really agree on the price, doing a deal on a note or a safe with a cap equal to that same price is foolish for you. All you've done is give away value. Also, what happens? Let's say we just agree on a discount and no cap. So we get done. I give Michael my million bucks. Michael runs off to raise money. Remember, I'm converting a 20% discount to the next round. What do he and I now want to happen in the next round? What does he want? Highest valuation, lowest dilution. What do I want? Lowest valuation that doesn't kill the company. PS I might be sitting on his board. I might be his number one champion out in the world, and now I'm kind of rooting for like a halfway outcome. So it's fine when it's Mom. Mom's not really rooting against you. But if you have a professional investor who you agree to one of these instruments, you, you are at odds. They want a low value, you want a high value in the next round. PS, what happens if I'm the next deal? What if I'm the next round? So now I have a double incentive. The lower the price, the better my note does. Right? So this stuff is important. What's the difference between a safe and a note? A safe is just like a fancy warrant or option. It just says, I'm entitled to some amount of equity based on the same things. So it doesn't have an interest rate, it doesn't have a maturity date, it doesn't have creditors' rights, but it also will often have a cap, a discount, or both. And it's just a warrant. Uh, the tax treatment is different for LLCs and corporations, but minutia for another day. Um, one of the things you have to prepare for because we said those creditors' rights out there, what if we just create an automatic conversion of that note at maturity? How do we price it? It converts at what value? We haven't done the next round to set a price. What price do we use? Do we use just a price that we pick? Do we use a price based on performance? We did, there was a whole series of notes we did for a couple of years and they were all like, well, we're going to price the maturity date conversion at 2 times trailing 12 months revenue. They were like, OK, that's fair. I really wanted 3x my revenue on the pricing, but I understand this is kind of a penalty, so I'll take 2x. And then COVID hit. And what did their last 12 months of revenue look like? Not awesome. Right? And so that conversion was very painful for people because they took that risk. So you should have something so they never have the right to foreclose. It's an automatic, but picking that is a, is a problem. And if the whole point of doing a note or a safe was to avoid a conversation around valuation, picking a capped price and picking a maturity price has kind of dug into the value of that, that instrument. They better be really out of the money, meaning the cap price should be way above what they'd pay today. And that maturity default price should still be somewhere in that, in that band. So we talked about the bads. What are the goods? Why do people do this? Cheaper to document. Lawyer fees, much less, fewer control rights, fewer things to negotiate. Um, so they're getting an unknown percentage, limited control, but as we talked about, they're getting not weighted average protection, meaning some adjustment between old price and new price, but they're getting the next priceless a discount. That's called full ratchet, right? That's a pretty punitive measure. So That's just a feature of how convertibles work, and we talked about the disalignment. As a contrast, the priced equity, it's more expensive to document. Right? And you often need a minimum amount to close. So you'll go out to investors and say, we're raising a million dollars and they won't let you close until you raise the 1st $750 and then you can have a closing, whereas notes and safes were designed so that you can raise $250 to go and 50 to go, right? High velocity. Alright. So, let me, let me take a step back for a second because this is where it gets a little funky. If I asked you what the heck stock is or what the heck a membership interest in your LLC, about 7% of you actually know the answer to that, and the rest of you have a vague idea. Does that sound right? Right? So stock, equity, these are the residual economics to the business. After you pay off the debt, so you sell the company for $50 million you owe people transaction fees, you owe people $2 million in financing that's out there. Call it $45 million is left. The equity owns $45 million but all the equity doesn't own the same rights, and it's really important to understand the differences. Um If you think about Class, common and preferred. So when you sell preferred equity, what it literally says is Series A convertible preferred stock. Series A Is the subset of the class preferred and convertible tells you something very important. What it tells you is those investors are going to get the better of something, the preference, or their pro rata percentage. So if they own 10% at the moment of exit, they're going to get the better of preference. We'll talk about what that means in a minute, or 10%. A or B. OK? What the heck is the preference? It's usually defined as an amount of money that's related to the capital into the company. Most commonly, if you looked at most deals, it's 1 times the capital amount plus or minus an accruing dividend. So it might say 1x or it might say 1 x plus 8% accruing a year. But it also might say 1.5 x. Uh, Ellie and I, uh, have worked on deals that are 2X. I once worked on a deal that was 10x. Meaning in that case the investor put in about $40 million and they were entitled to the 1st $400 million of proceeds. I was a cancer therapeutic, not a Food and beverage company, but you take the point, right? So they can negotiate that. So imagine that investor comes back to us. Remember our original example, 1 million on 3 million and the investor says, hey, I'm gonna do 1 million on 3 million. I get 25%, but I want a 2x preference and you go, OK, I don't know what that means. Cool. Right? What that means is they get the better of if you did no further financings, they get the better of $2 million.02 times the $1 million or 25%. So if we sold the company at the end of the day for $5 million they get $2 million you get $3 million. Well, that means they got 40% of the proceeds. That's as if you sold that equity, not 25%, but 40%. And you get the $3 million and that doesn't sound too terrible, but you just heard someone say liquid death raised $200 million. I don't really know the economics of liquid death, so apologies, but imagine they had a 2x preference on $200 million. Right, those investors might own the better of 60% or the 1st $400 million. So when you read an article in Bevnet or a Nosh company sold for $100 million you don't know if the founder made anything, and there are plenty of deals where the founders made Zippo. OK? Because those liquidation preferences can add up. If the average deal cycle time is now almost 8 years, and you agree on accruing dividend of 8%, and you took in 20 million bucks. Even on a 1x preference that's 20 million plus another. Whatever 8% of 20 million is 160, that's not right, 1.6 million. Each year, do do do do for 8 years. Right? So now that's $32 million worth of preference. Right? And what if it said 2x. Now they get 40 million plus that 8%. That comes off first. Here's where it gets really scary. I said that it was A or B, preference or pro rata. Let's say that investor comes to you and says, Hey, Michael, I'm going to give you 1 million $3 million 25%. Michael goes, Alright. And I say, and it's participating preferred. Michael goes, OK. Participating preferred versus non-participating preferred means that instead of or A or B, it's and. Any of you come out of the real estate world? OK, well, real estate, this is how it works, real estate partnerships. So that means the investor in that story got $40 million of preference and then 25% of whatever's left over. It's the preference first that gets swept off the top, and then they get their pro rata on top of that. So if you've raised, let's take a pretty ordinary example. Let's say you've raised $20 million.30 million dollars in a beverage company, and you sell for $50 million. That investor might take that $30 million off first, and if they bought a third of the company, Then they get a third of the 20 million left over. Right? So they got 37 million, you and the entire team and everybody who had common stock, 13 million. And if you assume that took 8 years and there's an awful lot of people in the common holder, the founders might have cleared a million bucks each. For 8 years of work. You're all looking at me like, oh, that's not funny at all, Halpern. Yeah, not funny at all, by the way. The difference in that term sheet is that word participating or not having the word non in front of it, and in the actual documentation that's this thick, it's one line. It's super easy to miss. So whether you work with us or you work with somebody else, make sure you have counsel looking at this stuff because that makes a huge difference. And if all Michael is hearing in his head is pre-money valuation and the amount of capital coming in, he's paying no attention. To whether it's participating, non-participating, dividend accruals, multiple liquidation preferences, all this stuff you have given away all these economic terms, you just don't know it. Right, that stuff is scary. All right, we have like a minute left to go or whatever and I always like to take questions, so let me, let me take a couple, but I, I have like 20 more minutes of material too, so. Yes. What's the best way to So usually for service providers you're giving people options. Meaning you're giving them equity that's priced at today's value. So they're only getting appreciation value if the company's actually worth $10 million today and they're getting 1%. They're getting 1% of the value over 10 million because their strike price is basically cutting off the value for the 1st 10 million. Does that answer your question? Yup, so almost always options. Um, and then there's, whenever you sell equity or an interest in equity or a derivative, you are engaging in a securities transaction. So there are both state and federal laws that apply and if they're a foreign national, there may be foreign laws that apply and you must comply and giving equity to someone who is not an accredited investor. can be incredibly dangerous and can hurt the company long term. So do make sure that they fall within an applicable exemption. There was a question, yes. Quantitative tightening and Great question. So the question was, is there a difference in deal terms that's happening and uh we'll talk more about this on, on Monday and Tuesday on the panels, but terms have gotten worse, right? So valuations have come down. I had a slide that just said valuation in a circle and the question is how do you value the company and we could spend the next 4 hours talking about that. But the short version is valuations have come down. We went through a very long, probably irrational cycle where people were valuing companies at 345 times, trailing 12 months net revenue. And at the earliest stages, just picking a number because there's not enough revenue to really come to any conclusion. Those valuations have all come down. Number 2, a lot of the terms of those deals, a lot of the investors who got out of deals and had just a 1x preference, just basically had the entrepreneur rent their money for 7 years. I put in a million bucks. The company was sold for some small amount of money. I got back my million bucks. Well, in an interest rate environment that's 5%, I'm losing money. I didn't return anything to myself or my limited partners, as the case may be, so a lot of them are starting to put dividend accruals on things where that didn't used to happen as frequently, and then other changes as well. So it's a great question. Yes, terms have gotten more frustrating. I think I'm out of time and I want to be respectful. Do we have more time or no more time? No more time. All right. All right, well thank you guys.