Before Series A - Convertible Note and Series Seed Funding

for Startups

Dror Futter David Teten

SorinRand LLP ff Venture Capital

dfutter@sorindrand.com david@ffvc.com

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Biographies

Dror Futter (sorinrand.com) • Partner, SorinRand LLP, a NY/NJ law firm focused on the representation of

startups and technology enabled companies

• Previously, General Counsel of Vidyo, Inc. (a venture backed software

company) and New Venture Partners LLP (a venture capital firm specializing

in corporate speaker)

• Co-founder of PLI’s Venture Capital Law Program and

frequent speaker on topics related to venture finance and

technology

• Columbia JD, Princeton AB

• dfutter@sorinrand.com

• @dfutterlaw

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Biographies

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David Teten (teten.com) • Partner, ff Venture Capital, early-stage technology venture capital fund

• Founder and Chairman, Harvard Business School Alumni Angels of Greater

New York .

• Lead author, The Virtual Handshake: Opening Doors and

Closing Deals Online (TheVirtualHandshake.com)

• Lead author of first-ever research study on best practices in private

equity/venture capital deal origination

• Lead author of first-ever research study on best practices of

venture capitalists in increasing portfolio company value

• Harvard MBA 1998, Yale BA

• david@ffvc.com

• @dteten

Definitions

•Convertible Notes – debt instruments that convert into equity when a defined event occurs

•Series Seed Equity – stock in a venture with enhanced rights to the common stock

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Stage of Venture Development

•Typically ventures face this decision as they try to raise amounts between $150,000 and $1,500,000

•Smaller amounts are usually raised through simple notes

• Larger amounts are usually raised through equity financing under normal Series A terms

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Deal Documentation

•Convertible Note •Note Purchase Agreement •Note

•Series Seed •Amendment to Certificate of

Incorporation • Stock Purchase Agreement • Investor Rights Agreement

(depending on form used) 6

Critical Terms – Convertible Note

•Discount Rate – • the discount on share price Note

holders will receive on conversion •Typically 20-30%

•Valuation Cap •Maximum company value at

which the Note will convert 7

Impact of Valuation Cap

Common Shares Preferred Shares % Ownership

Case - 1: Note Conversion, No Cap

Raising $2M with a $6M valuation

Founders 5,500,000 69%

Debt Holders (conversion of 500K note) 500,000 6%

Equity Holders @ $1.00 2,000,000 25%

Case - 2: Note Conversion, $3M Cap

Raising $2M with a $6M valuation

Founders 5,000,000 63%

Debt Holders (conversion of 500K note) 1,000,000 13%

Equity Holders @ $1 2,000,000 25%

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Key Terms – Convertible Note

• Maturity – date on which the loan comes due unless a conversion event has occurred

• May require repayment of principal and interest or conversion at a predetermined value

• Conversion Events

• Qualified Financing – a financing event that meets specified criteria usually based on:

• Amount raised

• Nature of Investor(s)

• Usually a requirement of an equity rather than a debt financing

• May have a provision for optional conversion on financings that do not qualify as Qualified Conversions

• Interest Rate – typically 5-8%

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Key Terms – Seed Stage Equity

• Non-participating Preferred Liquidation Preference

• Board Seat

• Minimal Representations and Warranties

• Limited Protective Provisions

• Actions that require approval of the Board or the Shareholders

• Right to Subsequent Terms –

• Right to get any pro-investor terms given to investors in subsequent financing rounds

• Participation Right in Future Financings

• Information Rights

• Drag Along

• Requires shareholders to sell if a potential acquisition meets several requirements

• Payment of Investor Legal Fees 10

Seed Stage Equity vs. Series A Terms – What Is Missing?

•Anti-Dilution Protection

•Preferred Dividends

•Registration Rights

•Extended Protective Provisions

•Co-Sale Rights

•Legal Opinion

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Convertible Notes – Pros/Cons

• Pros • Usually quicker and less expensive than equity rounds • A solution when the Company and the Investors

cannot agree on valuation • Rewards early investment through discount

• Cons • Uncertainty of final value/cost of loan • If loan is too large, conversion may “crowd out” too

much of the next financing round • Investors have no control over the terms of the equity

they will get at conversion/Note holders will get the same terms as larger investors in the next financing

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Seed Stage Equity – Pros/Cons

• Pros

• Clearly values the Company

• Does not burden the company with debts on its books

• Cons

• Higher transaction costs in terms of time and expense

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Best Use Case

• Convertible Notes are most appropriate:

• Financings where the parties cannot agree on a valuation

• Smaller financings where it is harder to justify the added cost/time of an equity financing

• Seed Stage Equity is most appropriate:

• Financings where the parties have agreed on valuation

• Larger financings which can justify added transaction costs and where the size of the debt could adversely impact future financing rounds

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Legal Diligence

• Startups at this stage often have limited, inconsistent documentation.

• Diligence Review will be limited, should focus on:

• Corporate - Accuracy and completeness of the cap table

• Financial – Review of financial statements. These will frequently not be maintained in accordance with GAAP. Investors should understand how they were prepared.

• IP – Assignment of IP rights by all employees and contractors. Absence of any known infringement concerns

• Employment – Proper documentation of all employees

• Commercial Agreement – significant agreements with either customers or suppliers usually do not exist at this stage. However, if such agreements do exist, they should be reviewed 15

Disclaimer This Presentation is for the exclusive use of the recipients to whom it is addressed. References to the “Presentation” includes any information which has been or may be supplied in writing or orally in connection with the Presentation or in connection with any further inquiries in respect of the Presentation. This Presentation is not intended to serve as legal advice or the basis for any investment decision. While the information contained in this Presentation is believed to be accurate, the Preparers have not conducted any investigation with respect to such information. The Preparers expressly disclaim any and all liability for representations or warranties, expressed or implied, contained in, or for omissions from, this Presentation or any other written or oral communication transmitted to any interested party in connection with this Presentation so far as is permitted by law. In particular, but without limitation, no representation or warranty is given as to the achievement or reasonableness of, and no reliance should be placed on, any projections, estimates, forecasts, analyses or forward looking statements contained in this Presentation which involve by their nature a number of risks, uncertainties or assumptions that could cause actual results or events to differ materially from those expressed or implied in this Presentation. By its acceptance hereof, each recipient agrees that none of the Preparers nor any of their respective Representatives shall be liable for any direct, indirect or consequential loss or damages suffered by any person as a result of relying on any statement in or omission from this Presentation, along with other information furnished in connection therewith, and any such liability is expressly disclaimed. Except to the extent otherwise indicated, this Presentation presents information as of the date hereof. The delivery of this Presentation shall not, under any circumstances, create any implication that there will be no change in the affairs of ff Venture Capital or SorinRand LLP after the date hereof. In furnishing this Presentation, the Preparers reserve the right to amend or replace this Presentation at any time and undertake no obligation to update any of the information contained in the Presentation or to correct any inaccuracies that may become apparent. This Presentation shall remain the property of ff Venture Capital or SorinRand LLP . This Presentation does not constitute a recommendation regarding the shares in ff Venture Capital. No securities commission or regulatory authority in the United States or in any other country has in any way opined upon the accuracy or adequacy of this Presentation or the materials contained herein. This Presentation shall not form the basis of any contract. The distribution of this Presentation in certain jurisdictions may be restricted by law and, accordingly, recipients of this Presentation represent that they are able to receive this Presentation without contravention of any unfulfilled registration requirements or other legal restrictions in the jurisdiction in which they reside or conduct business.

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