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Overview of Legal Issues in Early Stage Financings

(Energy Efficiency and Renewables)

August 11, 2006

Michael Jay BrownDorsey & Whitney LLP

(206) 903-8811

brown.michael@dorsey.com

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Topics

• Types of early stage financings in energy efficiency and renewables

• What kind of funding is available?

• Case study of early stage round

• Securities law overview

• Legal pitfalls in early stage deals

• The deal team

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Types of early stage deals

• Is it a product or is it a company ?• Type of financing depends on stage, nature of company or

product• What kinds of technologies or companies are being

financed?– Information technology– Devices– Tech-based services– Projects small, medium and large– Products– Pure research

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Types of Funding

• Angel

• Venture

• Small Institutional

• Debt (particularly for projects)

• Strategic Partnerships

• Grants

• Bank Funding

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Role of Counsel

• Different roles of company, individual, patent and project finance counsel

• Understanding the role, getting client buy-in and defining your duties

• Where issues most commonly arise in representing early stage

companies: – founders and their relationship with the company (reverse vesting,

employment agreements, scope of authority, ownership of intellectual property, other issues)

– VCs and their representatives on the board– explaining fiduciary duties to various constituencies, including significant

shareholders– Protecting i.p. – Financing snafus (addressed below)

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Case Study

• Early stage financing for technology company (as opposed to project finance or service deal)

• Agnostic as to type of technology (could be device, information technology, production, distribution, material science, etc.)

• Two founders, demonstrable technology, pre-revenue, pre-formation

• Requires $3 million => cash flow break-even in 18 months

• Venture returns predicted

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Case Study (cont.)

• Choice of entity: LLC vs. corporation• Typical corporate structure and levels of authority

– Shareholders elect directors and vote on major matters– Directors elect officers and formulate policy– Officers follow directives of board and act for entity

• Funding: – First round: $500K, accredited individuals (see below),

convertible note with discount or warrants– Second round: $2.5 million Series A venture funding after

milestones hit (e.g. technology, revenues, hiring C-level positions)

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Case Study (cont.)

• Valuation considerations: what is “pre-money” and how is it arrived at?

• Cap table: Founders with common equity, convertible notes and preferred holders, options, warrants

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Case Study (cont.)

• VC package: nature of preferred equity (liquidation preference, voting as a class, investor rights and protective provisions, board seats)

• Founder reverse vesting

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Case Study (cont.)

• Board of directors (reason for individuals’ service, number and typical makeup of board, function in private company, no proxies, to whom duties owed, nature of duties, indemnification, authority, and compensation)

• Board of advisors (liability considerations and nature of service; industry, technology and finance members)

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Case Study (cont.)

• The process:– Formation– Business plan– Structure of offering– Private placement memorandum– Securities offering

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Securities Law Considerations

• What is a security? Risk capital, Howey test (gain from efforts of another), state law definitions

• Triggers application of securities laws• Federal and state statutory and regulatory

schemes• Two principal thrusts of securities laws:

registration and disclosure

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Securities Law Considerations (cont.)

• Disclosure:– 10b-5 and state analogs– Always must make disclosure to standard of

materiality– Usually provided in Private Placement

Memorandum (“PPM”) or similar document– Generally, no formal, prospectus-like

disclosure requirements– General categories of information in PPMs

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Securities Law Considerations (cont.)

• Registration (and exemptions therefrom):– Private placements under federal and state law– Regulation D (“safe harbor”)– Conventions/requirements of Reg. D usually adhered

to:• Accredited-only offerees ($1MM net worth, certain income

tests, entity standards of accreditation)• No general advertising or solicitation• Certain filings• Disclosure documentation including business plan, description

of securities, capitalization, risks, etc.

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Pitfalls in Early Stage Financing

• Taking non-accredited investors

• Commencing accredited round within 6 months of “seed” round (“integration” issue)

• “Finders” fees and compensating non-broker-dealers

• Assessing materiality in disclosure

• Early stage structuring leading to later problems (e.g. non-market anti-dilution protection, certain founder or early investor rights, etc.)

• “Founderitis” issues: control issues, compensation, director status, reverse vesting, equity and dilution, etc.

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The Deal Team

• Lawyers

• Accountants

• Valuation firms and their utility

• Investment bankers

• Broker-dealers

• Venture capital firms

• Technical experts