March 20, 2021 Valuation, Cap Tables, Terms Sheets and

SDAngelConf

Valuation, Cap Tables, Terms Sheets and Other Legal and Financial

Considerations

Kr i st in Fox | Va nta ge Po int A d v i s o rs

Patr i ck A n d in g | DL A P ip e r

TheSDAngels.com

March 20, 2021

SDAC

Vantage Point AdvisorsVantage Point Advisors is a leading provider of valuation services for tax reporting and compliance, financial reporting, transaction advisory, fairness and solvency opinions, litigation support, and other business advisory services, with offices in San Diego, Los Angeles, Portland, Seattle, New York and Dallas-Fort Worth.

SDAngelConfTheSDAngels.com SDAC

Kristin FoxVantage Point AdvisorsDirector of Business Development

11455 El Camino Real, Suite 450San Diego, CA [email protected] 773.251.5731

DLA PiperDLA Piper is a global law firm with lawyers located in more than 40 countries throughout the Americas, Europe, the Middle East, Africa and Asia Pacific, positioning us to help clients with their legal needs around the world.


Patrick AndingDLA PiperPartner

4365 Executive Drive #1100San Diego, CA [email protected] 415.603.8150

AGENDAWhat we hope to accomplish today:

• Review the principal types of seed financing

• Debt, Equity, Alternative

• Key Terms

• Benefits / Risks

• Explain the basics of valuation and considerations that should be top of mind for early stage founders during negotiations

• Provide an understanding as to why valuation is important in protecting founders’ ownership


Poling QuestionAre you an entrepreneur or an investor?

• Entrepreneur

• Investor

If an investor, how many investments do you make per year?

• 1-2

• 3-5

• 5+

If a founder, what category do you fall into from a fund-raising stage perspective:

• Pre-Seed

• Seed

• Series ASDAngelConfTheSDAngels.com SDAC

Principal Types of Seed Financing

• Cash contributions by founders• Convertible debt / bridge financing• SAFEs (Simple Agreement for Future Equity)• Preferred stock equity financing (Series Seed)


Founder Cash Contributions• Initial fund raising from 3rd parties can take 6-12 months.

• Companies have expenses prior to 3rd party investment:

• Founders often provide their companies with initial working capital for startup expenses and early development expenses.


• Incorporation costs• Software development / prototyping / wireframes• License fees (software, patents, trademarks)• Domain names / websites

• Travel expenses• Accounting expenses / tax filing• Legal fees• Office space• Consultants / employees / service providers

Founder Cash ContributionsFour ways to structure a cash contribution:

• Contribution to capital• Upside increased cost basis in their common stock; cheap & easy. • Downside founders don’t get their money back.

• Purchase common stock• Upside get more shares of common (but they have so many already!).• Downside sets value of common stock; tax implications for other founders;

increases the exercise price used for option grants (409A).• Invest in SAFEs, convertible debt or preferred equity.

• Upside get additional company securities with investor terms.• Downside legal fees; complexity of documentation; investors may not like the

terms if founders set terms; may need to wait for 3rd investors before contributing cash.

• Founder loan (non-convertible promissory note) [My Preference]• Upside No 409A issues; simple & cheap, founders can sometimes get repaid

by company (or convert in next round on investor terms), most flexible.• Downside Liability on balance sheet, interest accrual.


Founder Cash Contributions• Founder Loan Short Form Promissory Note

• Non-convertible note.• Simple interest (don’t forget AFR).• Maturity earlier of 3 years or time of first financing.• Can be set up to accommodate multiple loans.


Seed Money / How Much?• “How much should I Raise?”

• This is business not legal, but startups need our help with this. This is an opportunity to win clients on the basis of business experience and guidance.

• Answer should be driven by:• Near-term capital needs based on development roadmap & business• Long-term fund raising plan based on valuation inflection points• Raise to and through next valuation milestones• Typical funding raising cycle from first pitch to close can be 6-12

months

• What does the founder need to show the next round of investors (data, product market fit, validation, patents, prototype)?• What do you want in the next pitch deck? Build towards that!


Convertible Notes / SAFEs• Convertible debt

• aka convertible promissory notes, bridge notes, bridge financing, converts, convertibles.

• Simple Agreement for Future Equity• aka SAFEs, Safes, Safe Notes (though not really “note”).

• Both solve the early stage valuation problem• Early stage companies hard (maybe, impossible) to value (no

revenue, no assets, etc.). How do you negotiate with investors?• If priced, would be so low investors would own the company.• Companies want to raise money to execute plan to reach value

inflection points, then value company in priced round.

• Like prepaying for stock in the equity round.


What Is A Convertible Note?A debt instrument with, among other features:

• Automatic conversion . . .• . . . of principal and interest . . .• . . . into capital stock . . . • . . . typically at a discount . . .• . . . in a financing in which a minimum threshold is raised

(“Qualified Financing”)• Ability to default; creditor status.


Purpose of Note/SAFE Offerings• Unlike traditional debt, the expectation of the Note investor

and the issuer is not that the investor will receive a return equal to principal plus interest, but instead . . .

• Expectation is that the investor will become an equity holder when Qualified Financing achieved.

• SAFEs have a similar purpose as Notes, but eliminate concept of ability to foreclose on assets, maturity date and accrued interest.


Perceived Benefits for the Issuer• Faster and cheaper to close then Preferred

Stock (fewer documents and terms to negotiate, no charter amendment).

• Able to avoid pricing the round. • Q: how does that impact FMV of common?

• SAFEs, as compared to Notes, have additional benefit for issuers of eliminating debt features.

• Enables ability to customize pricing and other deal terms for particular investors.


Perceived Benefits for the Investors

• Faster and cheaper! Important to remember that the investors money is paying for the both issuer and investor transaction expenses. So more cash for the company.

• Less negotiating / friction with founders.• Some investors (particular angels) appreciate

the debt concept and priority in liquidation.• For more most startups, this doesn’t matter as

most have little/no liquidation value.• SAFES mirror the same priorities by contract,

but some investors are still suspicious.


Later Stage Convertible Debt / SAFEs

• Standard for early stage, pre Series Seed/A.• But also used in later stage–Post-Series A (often Post

Series B or C).• Bridge the gap between equity financings or before

a sale.• Typically, later stage non-equity financing are debt

and not SAFEs, but that has been evolving.


Transaction Documents• Term Sheet

• Summarize the key business terms of the financing.• Not as common in SAFE financings.

• Note Purchase Agreement • Not used in SAFE financing, but used in most debt financing by

custom, though not all.• Sets the $ amount of notes that can be sold and establishes the

timeframe for sale of notes (multiple / rolling closes).• Company and investor representations.• Sometimes additional commercial terms or investors rights.

• Form Convertible Notes / SAFE• The security and/or evidence of indebtedness.• Contains principal, interest rate, terms of the repayment &

conversion, events of default and other core terms.


Transaction Documents• Warrants

• Rare for seed capital investments.• More common in later stage investments.

• Security Agreement• Rare for startup seed investments No assets to provided security.

• Subordination Agreement • Rare in early stage investments, unless there is already outstanding

debt, such as bank line.

• Board and Stock Consents• Always needs board consent.• Sometimes need stockholders consents (waiver protective provision or

negative covenants; interested party disclosure, disinterested 3rd patty consent).

• Other 3rd party consents (other lenders)?


Key Terms• Size of offering • Period of additional closings. Multiple/rolling closes.

• Maturity Date.• For Notes (but not SAFEs): payable upon demand after maturity

(typically, 1-3 years). Only pre-payable with holder consent

• Interest (but not SAFEs). • 4-8%

• Automatic conversion trigger. • Size of equity raise that triggers a conversion (i.e. what qualifies as a

“qualified financing”). YC SAFES no $$$ threshold, just sale of preferred stock in priced round.

• Typically, set to target for first equity round. $1M-$3M• Should be more than the bridge round.


Key Terms• Conversion price

• Discount off priced round (approx. 10-25%),• Price based on valuation cap.• Lesser or discount of valuation cap. (Market)

• Optional conversion on maturity. • Into common stock or preferred at agreement upon price. Never allow

FMW conversion price!

• Event of default (but not SAFEs).• Can include CoC to ensure no overhang on exit.

• Amendment/voting thresholds. • Holders of majority of principal; sometimes lead has block. Important

for debt as extending the maturity date is common.


Key Terms• Conversion price

• Discount off priced round (approx. 10-25%),• Price based on valuation cap.• Lesser or discount of valuation cap. (Market)

• Optional conversion on maturity. • Into common stock or preferred at agreement upon price. Never allow

FMW conversion price!

• Event of default (but not SAFEs).• Can include CoC to ensure no overhang on exit.

• Amendment/voting thresholds. • Holders of majority of principal; sometimes lead has block. Important

for debt as extending the maturity date is common.


Key Terms• Definition “Fully-Diluted Capitalization” for calculating conversion

price.• Does it include full option pool, only issued options, other

convertible notes or Safes, warrants issued with other debt.• Newest yCombinator used “Post-Money” calculation instead of

pre-money calculation.

• Treatment in change of control.• For Notes: if acquired prior to conversion, repayment with

premium (typically, principal + interest + premium of 50% to 200%).

• For SAFEs: if acquired or IPO prior to conversion, investor can elect either repayment of investment without premium or convert at the “Liquidity Price” (treated as if converted at valuation cap).


Key Terms• Converts into Preferred Stock.

• Liquidation preference based on new investor per share purchase. • Conversion price is discounted, so the note/SAFEs are paying less than

the liquidation preference.• Example

• Series Seed share price of $1.00• 20% discount means notes/SAFEs paying $0.80• If converting $800,000 of Notes/SAFEs then $1M preference.

• Difference in conversion price to liquidation preference can be very meaningful when using valuation caps.

• SAFEs solve for this by creating “SAFE Preferred” where conversion price and liquidation preference are the same.


Additional Investor Asks in SAFE/Note Financings• Additional rights. Less common in Note and SAFE financing with

institutional investors; but some ask.• Participation rights.• Most favored nations rights.• Security interest in assets; blanket subordination by future

lenders or creditors.• Major investor approval of amendments.• Negative Covenants.• Cover legal expenses for review of legal documents upon

conversion.• Board observer (or board seat).• Information rights.


Investor Considerations

Pros:• Simpler mechanism than Preferred Stock to deploy small amounts

of capital

• Valuation cap and discount provide built-in anti-dilution and price protection until next priced round.

• If there have been prior priced rounds, convertible note provides structural liquidation preference until converted.


Investor Considerations

Cons:• Rights, protections and diligence often lighter than priced round.

• Typically no board seat and little or no mechanisms for management oversight and control.

• Since not a stockholder, does board owe investor fiduciary duty?


What’s Market (According to Data)• Interest

• 87% of deals less than 8%

• Maturity• 78% of deals greater than 12 months

• Discount • 60% of deals have a 20% discount• 20% of deals have a discount above 20%• 20% of deals have a discount below 20%

• Valuation Cap• 69% of deals have valuation cap• Mean in 2019 for valuation cap was $9M• Mean Q1 of 2020 for valuation cap was $4M

• Warrants• Less than 2%

Source: Wilson Sonsini Q1 2020 Entrepreneurs Report for Pre-Seed convertible debt rounds


What’s Market (My take)• Interest

• 4-8% simple interest, typically 6%

• Maturity• 2 years

• Discount • 20%

• Valuation Cap• $4M to $10M• Depending on sector and target Seed/Series A valuation

• Conversion Trigger• $2M

• Change of Control• Principal + interest + premium equal to 100% of principal

If you offer terms in this range, you’ll be in the market.


Poling QuestionAre you considering utilizing convertible debt or a SAFE to raise a seed round of financing?

If so, what discount is market?• 5%• 10%• 20%• 30%


Venture Debt: truly non-dilutive?

Venture debt providers coin their financing options as “non-dilutive capital”. But is itreally? What to be aware of…

• Venture term loans typically have warrant coverage. This means you are beingoffered a typical interest bearing loan but also giving the lender essentially“options” to own an equity stake in the future, above a fixed strike price.

• Convertible notes often seem attractive but discount factors at conversion canoverly dilute founder’s ownership. Example to follow.

• High yield debt with no equity component can still trigger dilution. How?

• Above market interest rates mean a higher burn rate and less cash flowretained. This equates to a shorter cash runway and the need tofundraise that next round earlier (triggering earlier than necessarydilution).


Raising convertible debt – why the discount mattersMost “first-in” debt financiers want a discount on their future conversionto equity and that discount matters…

•Assume $1,000,000 convertible promissory note at 8% interest

•Next qualified financing (“NQF”) / conversion is 2 years from issuance date

•Interest accrued would be $160,000

•Principal and interest would be $1,160,000 at NQF

•10,000,000 shares of common stock are outstanding in addition to theconvertible note.

•The next qualified financing issue price is expected to be $1.00.


Raising convertible debt – why the discount matters•Ownership given up with no discount = 10.4%

• Converts into 1,160,000 shares

•$1,160,000 / ($1.00 * (1 – 0%)) = 1,160,000

•Ownership given up with conversion at 20% discount = 12.7%


•$1,160,000 / ($1.00 * ( 1 – 20%)) = 1,450,000

•Ownership given up with conversion at 50% discount = 18.8%


•$1,160,000 / ($1.00 * ( 1 – 50%)) = 2,320,000


Series Seed Equity Financings

• Preferred vs Common Stock• Common stock is generally used for compensatory purposes (i.e., as a form of

payment to employees, board members, consultants, advisors and other service providers) and issued to founders at incorporation.

• Preferred stock is generally used for investment purposes and has many more rights, preferences and powers than common stock.

• Common stock is typically “priced” at a lower price than preferred stock (i.e., for option granting purposes).

• Preferred stock issued through the creation of multiple “series”.• Common stock typically a single series/class, though occasionally companies

my implement multiple classes of common stock to provided for different voting rights or governance controls.

• Preferred stock is typically convertible into common stock.


Preferred Stock

(a) Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any or all of which classes may be of stock with par value or stock without par value and which classes or series may have such voting powers, full or limited, or no voting powers, and such designations, preferences and relative, participating, optional or other special rights, and qualifications, limitations or restrictions thereof, as shall be stated and expressed in the certificate of incorporation or of any amendment thereto, or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors pursuant to authority expressly vested in it by the provisions of its certificate of incorporation…


§ 151 Classes and series of stock; redemption; rights

Authority in Delaware General Corporate Law

Overview of Preferred Financing Stock Terms

SDAngelConfTheSDAngels.com SDAC35

Economic Terms• Valuation• Investment amount• Use of proceeds• Liquidation

preference• Anti-dilution

protection• Conversion features• Dividends• Redemption rights• Registration rights• Preemptive rights• ROFR/Co-sale• Pay-to-play

Control / Governance• Protective provisions

• Board composition

• Management rights

• Observer rights

• Information rights

• Post-closing covenants (D&O insurance, mandatory board meetings)

Other Deal Terms• Legal option• Multiple closing / single closing /

tranches & milestones• Reincorporation (DE, convert

from LLC)• Exclusivity / no-shop period• Due diligence• Founder/employee vesting• Employment agreements, non-

competes, non-solicits• Legal expenses• Confidentiality• Regulatory matters• Commercial agreements• IP matters

Series Seed Financing TermsSeries Seed Preferred Stock

• “Series Seed” equity rounds begin to in Silicon Valley in late 2000s• Technology advances allowed for companies to launch with less

money than typically needed in “Series A” financing ($1.5M vs $4M).• Typical Series A terms too complicated for a small financing and

some investors really do want equity (rather than convertibles).• Series “Seed” was intended to reduce transaction costs for equity

rounds by limiting the terms/rights and documentation.• Also, allowed for higher valuations at Series A and beyond, which

founders and VC funds liked optically.


Seed Series Equity Financing Terms• Following the trend, attorneys from Fenwick & West released form Series

Seed Documents that striped away many standard Series A terms. The documents removed :• Preferential dividends• Price-based antidilution protection• Redemption rights• Closing conditions or closing certificates• Legal opinion• Many reps & warranties• Registration rights• Management covenants• Co-sale rights

See: https://www.seriesseed.com/


https://www.seriesseed.com/

Seed Series Equity Financing Terms


• So what remained were 30 pages, rather than 100 pages of documents.

Economic Terms

• Valuation

• Investment amount

• Liquidation preference• Preemptive/participation

rights• ROFR over founder’s stock

sales

Control / Governance

• Protective provisions

• Board composition

• Observer rights

• Information rights

• NEW: Most-favored nation status with rights the investors in the next round of financing get

Series Seed Equity Financing Terms• Adoption of “Series Seed” help contribute to increasing valuations for Series A and

beyond.

• Founders liked this because a higher valuation Series A had the optics of being a more successful, in-demand, or “hot” startup.

• Companies eventually even began having “Series Pre-Seed” financings.

• Today, a tech company may have a SAFE/debt financing, a Pre-Seed, Series Seed, and Series Seed-1 before raising a Series A.

• As valuations increased through out the 2010’s, Series Seed financing began looking a lot more like a Series A.

• Series Seed financing today have many or most of the standard Series A terms (antidilution, preferential dividends, registration rights, management rights, etc.).

• Today, many investors use “Series Seed” and “Series A” to refer to the same set of rights, preferences, and powers.


Poling QuestionDo you know the range of multiples companies in your industry are trading at?

Do you have a financial forecast for your startup?• Yes• No

• If you answered yes, is your forecast:• High Level

• Detailed


Equity Valuation


• Valuation: how much the company is “worth”

• No matter how a Company will be financed, valuation will play a major role in the terms

• Negotiated terms between the company and the investors using many different data points

• Simplified - All business valuations hinge upon 3 main factors:

1) Growth

2) Cash flow generation (margin & earnings)

3) Risk

• Investors pay for future expected cash flows (earnings).

• Underlying assets (systems, products/services, or technologies, etc.) produce that expected cash flow.The rate of return captures the risk of achieving those cash flows.

• Most SDAC affiliated companies currently are:

• High risk;

• Low to no margin/earnings;

• But with hyper growth potential.

Basics of Valuation


All companies, even early stage start-ups, can be valued using one of 3 main valuationapproaches:

EquityValuation

Market Approach

Guideline Public Company Transaction Analysis

Cost Approach

Replacement Cost Analysis

Income Approach

Capitalization of EarningsDiscounted Cash Flow

Enterprise Value

Balance Sheet Adjustments

Basics of Valuation


• Income Approach – Discounted Cash Flow Method

• Where the company’s future performance discounted at an applicable rateof return indicates its worth today.

• Should include future efforts of built-out management team and thebenefits of the capital raise.

• Discount rate selection is big. Using a public company cost of capital(single digits or low teens) will over inflate your valuation and makeyou look unsophisticated to some investors.

• Using a typical venture-backed rate of return (20%-40%) is appropriateand will make you look like you know what you’re doing!

Basics of Valuation


• Market Approach – Guideline Public Company Method or GuidelineTransaction Method

• Pricing pre-money value off of multiples of future, projectedmetrics.

• Examples: Pre-money valuation based off 2x 3-year forwardrevenue forecast or 8x 3-year forward EBITDA forecast.

• Cost Approach – Replacement Cost Method

• Method is applicable for tech companies where developed IP isthe main asset of the company.

• Aggregation of the amount spent to date (including sweatequity) multiplied by an expected yield.

Equity Valuation• Valuation is expressed in terms of pre-money and post-money.

• Pre-Money is the valuation of the company before VC’s invest• The Number of Shares Outstanding On a Fully Diluted Basis

Multiplied by the Share Price = The Proposed Pre-Money Valuation

• Post-Money is the valuation after investment • Pre-money + VC Investment= Post-money

• How much of the company are the current stockholders willing to give up.


Valuation VS. % Equity Ownership• Valuation vs. percentage of equity ownership

• For early stage company, valuation is very subjective and based on forward looking opportunity. During negotiations, oftentimes valuation will end up being a proxy for ownership percentage.

• Post-money ownership percentage for investors is:• Investment amount divided by post-money valuation• Post-money valuation = pre-money + investment amount


Valuation VS. % Equity Ownership

Example:“We’re willing to put $3M in at a $6M pre-money valuation”

“We need to have 33.33% of the company if we are going to invest $3M”

Post-money = $6M (pre) + $3M (new cash) = $9MInvestors Ownership = $3M / $9 = 33.33%

Founders ownership = 100% - 33.33% = 66.66%


Valuation: why it’s important to startups


A Simple Example – Most startups use the basic formula of how much ownershipthey are willing to initially give up and how much they need to fundraise. Asfollows:

•Seeking to raise $1 million in Series A

•Current shares outstanding are 100

•I’m only willing to give up 20% ownership

•Post-Money = $1 million ÷ 20% = $5 million

Now 25 Series A shares out of 125 total shares

•Pre-Money = $5 million post-money less $1 million invested = $4 million

Valuation: why it’s important to startups


What if a full valuation was performed and the Co. determined its pre-money value was actually $7 million??

•Post-Money = $7M Pre-$ + $1M raised = $8M

• $1M/$8M = 12.5% ownership given up

The owners have managed to keep 7.5% more ownership than at the $4M Pre-$. We’ve thwarted off unnecessary dilution!

Valuation equally important for debt financing where lenders focus on solvency metrics.

•Loan to enterprise value - $1M/$4M = 25%

•Loan to enterprise value - $1M/$7M = 14%

Summing it Up


But remember…ultimately, your Co. pre-$ valuation is what the market is willing to bear.

• A prominent VC once said that funding a company’s first round comes down to largely 2 things:

1) Do I TRUST this founder?

2) Did this pitch BORE or CONFUSE me?

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FEATURES TO BE AWARE OF (INVESTOR FAVORABLE)

Financing Feature

Debt – warrant coverage

Debt – deep discount conversion %’s on convertible notes

Debt – above market interest rates

Equity - participation

Equity – cumulative dividends

Equity - >1:1 conversion

Equity - >1x LP

Poling QuestionFounders: Are you raising capital in the next 6 – 12 months?

If so, what amount are you looking to raise?• $100K - $250K• $250K - $2M• $2M+


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