mohammed elayan-lunch & learn presentation august 19, 2016

Equity Fundraising Basics for FoundersMohammed Elayan

[email protected]: @melayan

LinkedIn: https://www.linkedin.com/in/melayan

Introduction• Who this session is for• Who this session is not for• We’ll talk about general legal topics but this talk is not legal advice.

Roadmap1.Convertible Notes2.Typical Considerations for Equity Fundraising

Convertible Notes

Convertible Notes• Short term debt that typically converts to equity• Typically issued pre-Series A financings because founders and investors typically do not agree on valuation of company at such an early stage. The convertible note allows parties to defer the valuation decision to later.• Also, convertible notes are easier because investors are rarely given control rights (i.e., board seats).

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Convertible Notes• Discount

• A reward given to early investors for investing in the company at such an early stage.• Conversion

• Automatic conversion – if a qualified financing occurs before the maturity date• Typically done at a discount (i.e., X% of the price per share paid by the investors in a qualified financing)• Voluntary conversion if qualified financing does not occur before maturity date• Typically done at an agreed upon conversion price.• Conversion upon a change of control or qualified IPO• Typically done at an agreed upon conversion price.


Convertible Notes• Valuation cap

• Recall that a conversion price is written as $/share, so that the number of shares that an investment amount converts into is written as:• Number of shares = [amount invested] / [conversion price]• Number of shares = [amount invested] / [$/share]

• A valuation cap interacts with a conversion price as follows:• Conversion price = min ( [$/share of next qualified financing], [valuation cap/# of shares outstanding prior to qualified financing])

• As you can see by the formulation for number of shares above, anything that results in a lower denominator is beneficial for investors.


Convertible Notes• What happens if acquisition prior to maturity date?

• Investors get money back, plus interest; • Investors get to convert into equity prior to acquisition (more common); or• Investors get money back, plus interest, and an additional payment.

• What happens if maturity date comes prior to conversion of the notes?• Technically, a convertible note is a loan. If company is unable to repay the amount due, investors can force the company into bankruptcy.• Alternatives are to (i) provide for automatic conversion or (ii) negotiate an extension of the note (this is more common).


Equity Fundraising

Equity Fundraising• Seed rounds

• Usually the initial equity investment. Typically small amounts and often (but not always) from angel investors. Giving up 10-25% is not uncommon.• Rule of thumb: raise enough for 12-18 months (which is hopefully when you will be ready for venture funding).• Seed valuations are typically from $2mm to $10mm.• Venture rounds• Series A, B, C and so on.• In later rounds, amount raised will increase and, hopefully, so will the valuation.• Negotiation and deal terms may increase in complexity. • Series D rounds and higher are down in Q2 2016 compared to a year ago, meaning investors appear to be growing less patient with later-stage startups.• Regardless of round, investors and founders will negotiate over economics and control.


Economics

Price• Arguably, the most important economic term in a term sheet is the price of the deal (also sometimes referred to as the valuation).

• The price of the deal is usually stated in terms of price per share.• Another way that the price of the deal is usually stated is in term of a percentage ownership of the company. (i.e., an aggregate of $10,000,000 invested, which represents a 33% ownership of the company on a fully diluted basis).• Typically, price per share is stated on a pre-money and fully diluted basis.

• Fully diluted has different meanings. At minimum, it means assuming all outstanding common stock, all preferred stock (on an as-converted basis), and all outstanding options, warrants, and other convertible securities as if fully exercised or converted.• Pre-money valuations for Series D rounds and higher have been trending downwards.• Median pre-money valuations (Q2 2016):

• Series A - $15m• Series B - $51m• Series C - $99m• Series D+ - $192m


Price• Valuation: Pre-money vs. Post-money

• Recall that the price of the deal is often stated in terms of valuation.• There are two types of valuation that are often discussed: pre-money and post-money valuation.• Pre-money valuation is the value of the company before the investor puts in money.• Post-money valuation is the value of the company after the investor puts in money.• Obviously, this leads to the following relationship for any financing round:

• Post-money valuation = Pre-money valuation + money invested



• Ex: what percentage of a company does an investor own if she invests $10 million on a $20 million pre-money valuation?• Post-money valuation = $20 million + $10 million• Post-money valuation = $30 million.• Money invested/post-money valuation = $10 million / $30 million = 33.33%

• What percentage of a company does an investor own is he invests $5 million on a $10 million post-money valuation?• Money invested/post-money valuation = $5 million / $10 million = 50%.



• When discussing valuation (or price of a deal) with a potential investor, make sure that it’s clear that both the company and the investor are on the same page regarding whether or not the valuation is pre-money or post-money.


Price• Fully diluted

• Another issue that comes up is the concept of fully diluted.• By way of background, most startups will reserve some shares in the form of stock options (i.e., an employee pool) to motivate its employees.

• There’s no magic number, but usually companies reserve 10-20% of its shares for the option pool.• Stock options represent the right to purchase shares of a company (they do not represent actual shares) at a specified price.• So, when discussing the price per share of a company, do you include the shares that could be purchased by options that have been granted and/or authorized? • This is the where the concept of fully diluted comes in.• Fully diluted basically means you assume that all options and other rights to purchase equity have been exercised.


Price• Fully diluted

• Ex: a company has 10 million shares authorized. Five million shares of common stock have been issued. The company has reserved 2 million shares for its option pool. The company has issued options to purchase 100,000 shares of common stock. The fully diluted number could be either 5.1 million or 7 million depending on the definition used.• It’s important to clarify whether an investment by a potential investor include the fully diluted number. Investors typically want to ensure that a sufficient number of shares are reserved in the pool following the financing. Investors will also typically to increase the pool on a post-money basis. This usually leads to a lower price per share.


Price• Recall:

• Pre-money + investment = Post-money valuation• We can write this as:

• (effective pre-money + options) + investment = Post-money valuation


Increasing the pool on a pre-money basis: Increasing the pool on a post-money basis:Investment amount: $1 millionPre-money valuation: $5 millionOption pool size: 10%Increase in option pool size: 10% (for a total of 20%).Equity available to founders (pre-money): 90%Equity available to founders (after option pool increase): 80%The effective pre-money valuation is 80% of $5 million (since the increase in the option pool occurs before financing and the option pool is reserved for employees – in other words, founders’ pre-money ownership gets diluted because there are more shares potentially available to employees)1. Effective pre-money + options + investment = post-money2. Effective pre-money + 20% of $5MM + $1MM = $6MM3. Effective pre-money = ($5MM-(20% of $5MM))

Investment amount: $1 millionPre-money valuation: $5 millionOption pool size: 10%Increase in option pool size: 10% (for a total of 20% to take effect post-money).Equity available to founders (pre-money): 90%The effective pre-money valuation is 90% of $5 million.1. Effective pre-money + options + investment = post-money2. Effective pre-money + 10% of $5MM + $1MM = $6MM3. Effective pre-money = ($5MM-(10% of $5MM))


Takeaway: Increasing the option pool before the investment results in a lower effective pre-money valuation (which is a hit to founders)

Liquidation Preference• Venture investors will purchase Preferred Stock of the company. One feature that venture investors will ask for is a liquidation preference.• Basically, a liquidation preference specifies how much investors receive for each share of preferred stock they own upon a liquidation event. • Ex: a 1x liquidation preference means that investors will receive 1x of their investment in the event of a liquidation event. So, for example, if a venture investor put in $5 million dollars, she would receive back $5 million in the event of a liquidation (i.e., 1x of the investment).• A liquidation event will typically be defined to include a sale of the company.• Note: the majority of deals have a 1x liquidation preference


Liquidation Preference• Participating vs. non-participating

• One concept that is important when discussion liquidation preferences is whether the preferred stock will participate or not.• Full participation means that the preferred stock will not only receive its liquidation preference but it will also share in the liquidation proceeds on as as-converted to common stock basis.• No participation simply means that the preferred stock will only receive its liquidation preference (and nothing else).• In between these two is the idea of a capped participation. This means that the preferred stock receives its liquidation preference and will share in the liquidation process on an as-converted to common stock basis until some multiple is reached.• Note that in all 3 scenarios, the preferred stock will receive its liquidation preference (usually 1x). In other words, common stock holders will not receive anything in connection with a sale of the company until all of the preferred stockholder receive their money back.• In early rounds, it’s best to have a simple liquidation preference and no participation for the early venture investor.


Liquidation Preference• Participating vs. non-participating examples:• Investment amount: $2 million• Pre-money valuation: $8 million (i.e., investors own 20% of the company and the founders own 80%).• Sale of the company: $30 million• Assume: 2 million shares of Series A issued and 8 million shares of common stock for founders (and Series A converts on a 1:1 basis into common)• Let’s also assume 3 cases:

• Case 1 – 1x liquidation preference; no participation• Case 2 – 1x liquidation preference; full participation (note that, per our above assumption, each share of Series A Preferred Stock converts into 1 share of common stock)• Case 3 – 1x liquidation preference; capped participation at 2x


Liquidation Preference• Participating vs. non-participating results:• Investment amount: $2 million• Pre-money valuation: $8 million (i.e., investors own 20% of the company and the founders own 80%).• Sale of the company: $30 million• Assume: 2 million shares of Series A issued and 8 million shares of common stock for founders (and Series A converts on a 1:1 basis into common)

Case 1 Case 2 Case 3Venture Investors get (via liq. preference) $2,000,000 $2,000,000 $2,000,000 After satisfaction of liq. preference:

Founders get $28,000,000 $22,400,000 $24,000,000 Investors get 0 $5,600,000 $4,000,000


Liquidation Preference• Let’s try the same example but with a much larger sale price. Here are our revised assumptions.• Investment amount: $2 million• Pre-money valuation: $8 million (i.e., investors own 20% of the company and the founders own 80%).• Sale of the company: $300 million• Assume: 2 million shares of Series A issued and 8 million shares of common stock for founders (and Series A converts on a 1:1 basis into common)

• In reality, the venture investors would voluntarily convert their Preferred Stock into common stock (thereby foregoing their liquidation preference) in order to share in the larger liquidation proceeds which would be available to common stock holders.

Case 1 Case 2 Case 3Venture Investors get (via liq. preference) $2,000,000 $2,000,000 $2,000,000 After satisfaction of liq. preference:

Founders get $298,000,000 $238,400,000 $294,000,000 Investors get 0 $59,600,000 $4,000,000


Liquidation Preference• We have assumed that we have our first serious institutional investment (i.e., a Series A round). What happens for Series B, C and so on?• The typical ways to deal with liquidation preferences for follow-on investors is to either:

• Stack preferences – Series B gets preference over Series A; Series C gets preference over Series B (and Series A), and so on.• Equivalent – treat Series B and Series A liquidation preference as equivalent, so that holders of Series A and Series B get their preferences pro rata until their respective liquidation preferences are satisfied.


Pay to Play• Remember, venture investors typically purchase preferred stock of the company which, among other things, is able to be converted into common stock.• Investors often negotiate special rights and privileges as part of their investment in preferred stock of the company. Thus, such investors normally do not want to convert their preferred stock into common stock.• A pay to play provision provides that an investor must invest in a future round, according to his or her pro rata ownership, or else have all of his or her preferred stock (or a portion) converted into common stock (and, thus, lose some of negotiated rights of the preferred stock).

• The future round is either a down round (a valuation that is less than the previous round) or one where the Board of Directors of the company determines that investors must invest their pro rata share.• As of Q2 2016, these are rare (less than 5% of deals)


Pay to Play• Different flavors of the pay to play provision.

• Aggressive: if investor does not invest his or her pro rata portion, then all of such investor’s preferred stock will be converted to common (even if the investor almost invests his or her pro rata portion).• Less aggressive: if investor does not invest his or her pro rata portion, then only the amount that is not invested will be converted to common.

• From the company’s perspective, a pay to play provision forces investors to continue investing or else be converted. • From the investor’s (and company’s) perspective, a pay to play provision can reduce the liquidation preferences of the investors who do not participate fully (because their preferred stock is converted to common, any liquidation preference to be distributed to that series of preferred stock will not be distributed to fewer shares of preferred stock).


Vesting• Single trigger vs. double trigger

• When granting stock options to employees and founders, the options typically vest. • One vesting provision is what happens upon a merger or change of control (i.e., an exit event for the company).• Single trigger acceleration means full accelerated vesting upon a merger or change of control.• Double trigger acceleration means that two events must take place before full accelerated vesting occurs (typically, a merger and that the employee in question get fired by the acquiring company (or quit for good reason)).

• This is more common in deals done with venture investors.• If there is no double trigger acceleration, the acquiring company will often want some sort of management retention agreement with the key employees of the target company.


Antidilution• This comes into play when the conversion price per share of stock is lower than the previous price per share used in a previous financing.

• In a down round, existing stockholders of the company are susceptible to dilution (the same amount of money can purchase more shares if the price per share is lower).• Antidilution protection, then, is triggered when additional equity is issued and results in the adjustment of the conversion price per share to a higher price.• Remember, the formula: # of shares convertible into common stock = [original issue price of Preferred/Conversion Price] = [original issue price of Preferred/[$/share]]

• In order to offer some protection to existing investors, there are two typical antidilutionprotection provisions that are used: weighted-average antidilution and ratchet-based antidilution. As of Q2 2016, weighted average is the most common in deal (almost 90% of deals had this)• Each of these formulas adjust the conversion price of the preferred stock (the price at which each share of preferred stock converts into common). The difference is the magnitude of the adjustment.


Antidilution• Full ratchet antidilution.

• If you have this antidilution provision, then this means that if the company issues stock at a lower price than a previous round, then the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share in the down round financing.• From the company’s perspective, the full ratchet antidilution provision is problematic because the company bears all of the risk (the company must potentially issue more common stock for the same amount of money put in by investors), while the investors can potentially reap all the upside.


Antidilution• Weighted average antidilution.

• The weighted average antidilution provision takes into account the magnitude of the price issuance in the new round and the number of shares sold and comes up with a more middle of the road adjustment to the conversion price to the round with such protection.• The formula is:

• New Conversion Price = Old conversion price * [(common stock outstanding pre-deal + common stock issuable at old conversion price) / (common stock outstanding pre-deal + common stock issued in deal)]• There are two further variations on the weighted average antidilution formula. They depend on what is meant by “common stock outstanding pre-deal.”

• The first variation is broad based weighted average antidilution. This means we must include all shares of common stock, preferred stock (on an as-converted to common basis), common reserved for issuance under the company’s stock plan (including shares of common stock issuable pursuant to stock options outstanding).• The second variation is narrow-based weighted average antidilution, which means that that the common stock outstanding pre-deal includes only the common stock that is issuable upon conversion of the preferred stock outstanding.


Antidilution• Example

• Assume we have already done a Series A investment and will do a Series B investment at a price per share that is less than the Series A preferred stock price per share. Assume also that the pre-Series B capitalization is the following:• 1,000,000 shares of common stock• 2,000,000 shares of Series A preferred stock (issued at $1 per share)• 1,000,000 options

• Assume we sell 500,000 shares of Series B at $0.5 per share (total of $250,000).• What is the new conversion price of Series A?

• New conversion price = $1 * [ (4,000,000+250,000) / (4,000,000+500,000)] = $0.94


Antidilution• Exceptions to antidilution protection

• Some issuances of stock will not result in antidilution protection, such as, for example:• Shares issued under the company’s option pool;• Shares issued as consideration pursuant to a merger;• Shares issued to equipment financing; and• Shares with respect to which holders of a majority of preferred stockholders waive their antidilution rights.


Antidilution• Typically, allowing a majority of a certain class of preferred investors to waive antidilution rights is a good thing.

• It is helpful for the company’s common stockholders (which typically include the founders) and the company’s employees in case certain minority investors do want to continue funding the company in a down round.


Control Terms

Board of Directors• Typically, VC investors will require board seat(s) as part of their investment.

• The board will usually be selected by each of the preferred investors (VCs), and common stockholders, along with an independent director (usually the CEO) – sometimes, an additional mutual director is chosen by each of the common stockholders and preferred investors.• Is it better to have the mutual director chosen by the board or by the preferred and common stockholders (on an as-converted-to-common basis)?

• Typically, VC investors will also want a board observer.


Protective Provisions• Typically, VC investors will want to approve or reject certain actions by the company. These are usually “big” actions, such as:

• Changing the rights of preferred stock;• Changing the number of authorized common stock or preferred stock;• Creating a new class of stock having rights equal to or senior to the rights of the VC investors;• Repurchasing shares of common stock;• Merging or selling the company;• Amending or waiving any provision of the company’s certificate of incorporation or bylaws;• Changing the size of the board; or• Taking on significant amounts of debt.


Protective Provisions• In future rounds (Series B and later), how do you handle protective provisions for the new investors?

• Some options:• Future investors can have their own protective provisions; or• Future investors can have the same protective provisions as earlier investors

• Founders prefer that new investors vote as a single class along with the previous investors to make things easier. New investors want to vote to approve such actions separately.• Most of the protective provisions are in the investors’ favor. However, requiring investor approval before selling the company can actually help the founders. This gives founders the bargaining point that they need a price sell the company at a price that is not high enough to make the deal interesting to the VC.


Drag Along• This is a provision which forces founders and other stockholders to agree to a sale of the company if certain investors vote in favor of the sale.• As of Q2 2016, drag along provisions are very common (in 96% of deals).• Thus founders, should consider negotiating around:

• Threshold to trigger drag along• Whether common stockholders and/or Board should also approve• Whether a minimum sales price is required to enforce the drag along• Requiring that stockholder who are dragged along make very minimal reps and warranties in the applicable purchase document


Conversion• The preferred investors have the right to convert their preferred into common stock, usually at 1:1 ratio but subject to adjustments.

• This allows preferred stockholders to convert to their preferred stock into common stock if they would collect more money on a sale of the company.• Also, typically, there is an automatic conversion provision that provides that all preferred stock will convert prior to an IPO of no less than a certain amount.

• All classes of preferred stock should have the same automatic conversion thresholds.


Other Rights

Dividends• In VC deals, dividends are not what typically provide returns to investors. They are simply “sweeteners” or “kickers.”• In a typical Series A financing, dividends rates from 7% - 12% are not uncommon.

• Typically, dividends are only paid when and if declared by the board. In this case, the dividend rate is not too meaningful.• Cumulation of dividends

• Right to dividend is calculated for each fiscal year and right to receive dividend is carried forward until paid or until right is terminated.• Cumulative dividends are rare.• More typical are non-mandatory, non-cumulative dividends.


Redemption Rights• Provides that the preferred holders can force the company to redeem their shares of preferred stock at a specified time.


Conditions Precedent to Financing• These are additional conditions that must be met before the investors will invest.• Try to avoid conditions precedent if possible.• If a conditions involves the founders signing employment agreements, get the key terms of the employment agreements before proceeding further in the negotiation process.


Information Rights• Information rights simply provide that the investor will receive certain information, usually financial statements at regular intervals.


Registration Rights• These rights provide that certain investors can cause the company to file a registration statement with the SEC.• Typically, these rights do not matter much to the company in the intermediate term. In the event that the company goes public, the investment bankers involved in the deal will have a major hand in how the deal is structured.


Right of First Refusal• This provision provides that in the event the company offers to sell shares of preferred stock to anyone other than a major investor, then the company must offer such shares to the major investors first. Each major investor will be able to purchase his/her pro rata share of the offered shares.• Issues for the founders:

• What is the threshold necessary to be considered a “major investor”?• Will the major investors have the right to purchase more than their pro rata shares?


Restriction on Sales• This provision provides for a right of first refusal in favor of the company for sales of the common stock.


Proprietary Information and Inventions Agreement• This provision provides all current and former employees, officers, and consultants of the company will enter in an agreement that, among other things, assigns all intellectual property that they create to the company.

• Note: companies should always get each employee, officer, and consultant of the company to enter into such agreements before they are hired or engaged by the company. It’s good practice and will be very helpful to the company in the future (without clear ownership of intellectual property, selling the company is difficult).


Co-Sale Agreement• This provision provides that when a founder sells his/her shares, each investor will be allowed to “co-sell” his/her shares alongside the founder, on a pro rata basis.


Thank you!• melayan [at] bryancave [dot] com (send me feedback, thoughts, comments, etc.)• https://www.facebook.com/mohammed.elayan• https://twitter.com/melayan• https://www.linkedin.com/in/melayan

Thank you!

mohammed elayan-lunch & learn presentation august 19, 2016

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