Negotiating Venture Financing Transactions

37 Offices in 18 Countries

Negotiating Venture Capital

Deals – Perspectives from

Silicon Valley

Venture Capital Seminar Series 2014

(Seminar 1: February 27, 2014)

Richard Horton

Sydney – Silicon Valley

[email protected]

mailto:[email protected]

mailto:[email protected]

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Squire Sanders

• Dual qualified US – AU attorney

Only active Silicon Valley lawyers in Australia

Work in both jurisdictions; in and out of US and AU law interchangeably

Dragging Silicon Valley into AU venture deals

– Understand “market” for US venture deals

• Squire Sanders 2,000 lawyers globally

39 offices in 19 countries

2 in Silicon Valley (Palo Alto, San Francisco)

Recently voted into top 10 firms in the world (Number 9 globally**)

Top-20 global legal practice based on number of lawyers

Practicing law in more than 140 jurisdictions, in more than 40 languages

• Representing major SV funds and numerous incubators and startups

In US and Australia: represent all major venture funds and numerous start-ups

Startmate, muru-D, Pushstart, Ignition Labs

• **Specialize in cross border deals into Silicon Valley (Australia, China,

Japan, Middle East, England, Italy, Germany, Russia)

• Global venture capital and M&A expertise

• Members NVCA (US) and AVCAL (AU)

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Relevance of Silicon Valley and the US

Silicon Valley still the place to be (?)

• About 30 billion dollars invested in 2012 and 2013 (about 4,000 deals in US) vs. 120 billion 1999 – 45% SV 2013 NVCA/PWC Moneytree report

• Deals Internet and software (aka “digital”) are leaders – ultimate start up

business

Return to fundamentals of capital efficiency

Scale without huge cost and technical risk

AU: less than 200m invested; VC and Angel community small, but growing

Is a move to Silicon Valley inevitable?

• Mecca for most start-ups (globally) – (Rude Baguette, Berlin)

• Must be HQ’d in Silicon Valley

Aussies will invest in USCo, but not vice versa

– Often AU investment drives flip to US

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• Investors (and customers) must know committed

Need to know key personnel and support in US

Be prepared to talk to US investors and customers with US-centric focus

– Understand process to get to US if necessary » Flip

» E-3 visa etc.

• Smart money, better valuations/terms

AU vs. global opportunity

Broad range of deep subject-matter experts

Complexity and cost of taking money locally

• E3 Immigration – American Australian Free Trade Agreement

US importing human resources?

Problems with visas? May be withdrawn

• Customer payments

May need US entity

Subsidiary?

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• Why not just stay in Australia initially? Traction is key anywhere

– Traction in Australia with familiar surroundings and connections

Great AU talent and more stable

Many AU gov’t grants (R&D tax concession, CA, EMDG etc.) available

• Set up in US initially? Many AU start-ups incorporate in Delaware first, then set up AU sub to

have AU presence and receive AU benefits

• Australia then flip to the US? Flip if get a term sheet

Can negotiate AU or US venture deal while AU HQ’d

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• The Future in Australia?

More to remain HQ’d in Australia as venture and entrepreneurial community grows

Currently too many first time entrepreneurs - need more experienced entrepreneurs

Industry thriving quickly, but not enough good deals in AU yet

Several new VC funds in Australia and many new incubators and accelerators

Other issues – AU tax treatment of Stock Options

– Valuation

– Other?

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US Venture Capital industry

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Plan for Success

• Introductions to Angels, VCs and other funding sources

Best if through lawyer or highly regarded business person; not direct

10,000 bus plans per year; invest in 0.1%

• Venture capital is a mature industry

Well known set of deal terms and variations

Need a lawyer with experience

Don’t try to be cute or novel**

• Most VCs hate complexity

• Look like a duck

Delaware C corporation (Pty Ltd in Australia)

Founders: Common stock with repurchase right (i.e. 4 yr founder vesting – 1 year cliff; 1/36th per month thereafter)

Employees: Common stock options with vesting over 4 years

Investors: Convertible preferred stock (preference shares)

IP must be owned or bullet-proof exclusive license*

– No “reserved” IP rights

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Plan for Success

• ***You will close doors to later investment by doing funky early round

deals (or your early investors will need to relinquish rights)

Good sense of “market” terms: analysis of deal terms used by all major US

incubators and accelerators

• Interview CEOs of previous investee companies for all investors

(angel, VC or corporate)

• Expensive mistakes

• Question mark re Australian startup reputation for corporate

compliance

Tax considerations

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Sources of Capital for Startup Business

• Self Funding

• “Bootstrapping” and “Organic Growth”

Common mistake for Australian startups

Always an execution play: requires $

All new business concepts have short half-life

100% of nothing is nothing!

• Smart money is good money

• Reputable investors create self-fulfilling prophecy

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• Seed/Angel/Super Angel

(Pre-angel: Incubators, accelerators etc.)

$50k-1m (New Series A VC round?)

Many sophisticated Angels in SV from dot com era and subsequently

Higher risk, pre-VC money

– Small speculative raise to achieve initial milestone and build valuation (e.g. to build prototype)

– Fundraising theory

– Keep an eye on your cap table

Can be good and bad

– Sophisticated, subject matter expertise, add huge value/connections

– Unsophisticated don’t understand the business or how the industry works

Common shares, Preferred or Convertible Note?

– Prices common for options

– Generally “Series Seed” Preferred Stock financing

– Convertible notes – see later » Faster, cheaper, no valuation discussion?

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• Traditional VCs

Specialize in subject-matter (semi-conductors; cleantech; life

sciences; social media)

Investment professionals

Can finance all pre-public activities (Series A-D/E)

– May specialize in certain stages only (e.g. early stage or late stage)

Pressure to perform for LPs

Homerun game

– Explosive growth

– Global application

– 10x return?

Looking for exit 4-6 years

– Want to control exit with favorable economic terms (drag along and

liquidation preference; veto rights)

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• **Be careful with your confidential information

VC don’t want to be “contaminated” so will not sign NDA initially

• Don’t “shop” the deal too broadly

Agree on the list and keep track of responses

Understand that VCs rarely say no directly

• Be prepared: you never know who you will meet when

Have an “elevator” pitch

Have a powerpoint of Business Plan

• **Try to have at least two interested parties/term sheets Never know who is real, so keep competitive till the end if possible

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Sources of Funding

• Corporate Investment/Strategic Investment Usually equity investment by large corporation and significant grant

of rights – E.g. Exclusive license

Beware additional rights – ROFR regarding future licensing applications or markets

– Capped royalty license

– ROFR or option to purchase business

– **Some just ROFN

Strategic motivation

Follow on funding?

Involvement may put off future customers or investors if competitors of strategic

Misuse confidential information – Excessive demands for information

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Process to Signing a Deal – The Term

Sheet

• Term Sheet

This is where deal is done

Non-binding, except

– No Shop

– Confidentiality

– Cost shifting (if any)

BUT, effectively binding if deal proceeds** – Limited ability to walk away as Company; due diligence out for Investor

National Venture Capital Association (www.nvca.org)

Must have legal advice

More complex in later round financings

• Legal Documents Based on term sheet

Usually 2-4 weeks, depending on due diligence findings and any “clean

up”

• Unsigned Term Sheet can set benchmark for valuation

Corporate cleanup or realignment of founder equity holdings before

http://www.nvca.org/

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Due Diligence

• Initial due diligence

• Continues in earnest after signing of term sheet

• DD process (approx 1 month)

• Due diligence

Technology

Founder stock

Management team; hidden founder (Facebook)

Financials accurate

Business Plan based on good faith assumptions

Existing capital structure and terms of previous financings

IP portfolio (owned and licensed)

Business to date (any significant IP rights given away?)

Litigation – trade secret misappropriation; IP of former employer

– 2870 Cal Labor Code; patent litigation

• **May have a material impact on valuation

Australian lack of corporate compliance relevant

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Key Terms: Financing I

• Valuation: percentage of company

• Preferred Return

Convertible Preference Shares

Dividend preference

Liquidation preference

– **Economic and control rights that exceed minority equity ownership

– Economics of merger exit: preferred vs. participating preferred

– Right to convert to common

• New Rounds: Anti-dilution/“Pay to Play”

• Members of Board

Founders

Investors

Independents

Who controls – usually investor wants to control

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Key Terms: Financing II

• Vesting for founders

• Protective provisions (veto rights for preferred)

Includes right to approve subsequent investors

• Pre-emptive rights and rights of first refusal

• Tag along rights

• Drag Along

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Key Terms - Valuation

• Primary issue in fundraising

Very contentious - drives answer to cost of equity

Highly speculative – many pre-revenue

Not the truth; must be compelling

• Too low

• Too high no good either

Investors disappointed -> down round

• Stock options pricing impact if sell common

• Pre-money vs. Post-money?

• Convertible notes and bridge financings

Avoids valuation?

Cap relevant for tax purposes?

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Key Terms - Valuation

• AcmeCo example

Pre-money valuation $8,000,000

– Founders – 3,000,000 shares of common stock – 75%

» Consideration?

– Drug and software IP/technology?

– Earnout (repurchase)

– Share option pool – 1,000,000 common stock – 25%

Amount to be raised – $4,000,000 => Post-money valuation of

12m

– 2,000,000 Convertible Preference Shares @ $2 each

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Key Terms – Valuation (example)

Capitalization (Cap table)

13.33%

Capitalization

Pre-Money

Post-Money

Founder’s Common Stock 3,000,000 shares 3,000,000 shares

Outstanding Preferred Stock 0 shares -- 2,000,000 shares

Outstanding Stock Options

Reserved Options 200,000 shares 5.00% 200,000 shares

800,000 shares 20.00% 800,00 0 shares

4,000,000 shares 6,000,000 shares

Valuation: (Series A Preferred Purchase

Price = $2.00 per share) $8.0 million $12.0 million

75.00% 50.0%

33.33%

% %

3.33%

100.00% 100.00%

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Key Terms – Liquidation Preference

• VCs always take “Convertible Preference Shares”

Founders common (ordinary) shares (“Founders preferred”?)

• VC wants money paid back before entrepreneur gets his return

• Liquidation Preference***

Critical exit provision – applies in sale/merger (also applies to

bankruptcy/wind down)

Preference – right to have investment (or multiple) repaid before

common

Participation – right to participate in upside of sale with common

• Non-participating Preferred vs. Participating Preferred

• Precedential value strong

If A rounds insist, get screwed by larger later rounds

• -> N-P in most early rounds these days

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Key Terms – Liquidation Preference

• Non-participating Preferred (NPP)

after payment of preference no participation with common stock

OR

conversion to common stock and participation with common stock only

“money back OR a cut”

• Participating Preferred (PP)

after payment of preference, also participate with common stock on “as converted” basis

Unlimited participation vs. capped participation

“money back AND a cut”

• Company needs to manage and understand liquidation preference “overhang” to appreciate return in any exit scenario

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Effect of Liquidation Preference in

Merger

Preferred Investment Amount 5,000,000$

Percentage purchased 30%

Sale Price of Company 25,000,000$

Participating

Preference Only Converted Preferred

Sales Price 25,000,000$ 25,000,000$ 25,000,000$

Amount to Preferred

Liquidation Pref 5,000,000$ 5,000,000$

--------------- --------------- ---------------

Amount after Preference 20,000,000$ 25,000,000$ 20,000,000$

Percentage of Balance 30% 30%

As Converted 7,500,000$ 6,000,000$

--------------- --------------- ---------------

Total to Preferred 5,000,000$ 7,500,000$ 30% 11,000,000$ 44%

Common Stock 20,000,000$ 17,500,000$ 70% 14,000,000$ 56%

Non Participating Preferred

In this climate Founders may need a massive exit to make any money….

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Key Terms

• Drag Along Rights

Investors (usually “majority of Preferred”) can force Founders to vote for a sale

Combined with strong liquidation preference

Risk to Founders

Protection

– Minimum sale $$ for common stock shareholders

– Requires vote of majority of common as well as preferred

many founders believe giving away ordinary shares

• Dividend Preference Fundamentally, startups can’t pay dividends

Usually just that preferred must get (fixed) dividend before common if declared

Beware cumulative dividends

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Key Terms

• Protective Provisions (aka “Reserve Matters” in AU) – veto

rights requiring majority of Preferred

• Common and preferred vote together as a single class on as-

converted basis except Preferred veto regarding:

Authorize new financings**

Authorize more shares of that series (i.e. authorize future investors)

Authorize series with more senior rights

Change rights of that series

Sale of company

Changes to size of option pool

Limits on changes to number of members of Board of Directors

More complex implications in later stage deals

May involve votes of individual classes of preferred

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Key Terms

• Board level protective provisions?

Decisions requiring board approval and affirmative vote of Series [A] director(s)

Another level of control/veto

Sometimes more granular than Shareholder provisions – Issue options; change remuneration of key employees

*Fiduciary obligations, unlike if exercisable at shareholder level

• Board of Directors

Rights of Investor to appoint members of Board

Varies, but often 2 from founders, 2 from investor and an independent

Observer rights only?

Information rights

• Participation Rights/Pre-emptive Rights**

Preferred granted first offer rights to participate in future equity financings based on their pro-rata, as-if-converted ownership stake in company

Allows preservation of percentage ownership

Some beyond percentage ownership

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Key Terms

• Right of First Refusal**

First right to purchase stock of selling Founders

(generally does not apply to Investors in the US; more common in

AU)

– May be restriction on investor selling to competitor of company

• Co-Sale (aka “Tag Along Rights” in AU)

Gives Investors right to sell shares pro-rata if Founder wants to

sell shares

Does not usually apply to selling investors (more common in AU)

Even if ROFR not exercised

**Further locks in Founders

In AU tag along may apply to sale by any shareholder (or at least

to protect a minority where majority finds home for its shares)

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Key Terms – Anti Dilution

• Conversion occurs by dividing the Original Purchase Price by the Conversion Price. Initial Conversion Price is Original Purchase price => Conversion ratio of 1:1

• If a “down round” – subsequent investors pay less for Preferred Stock

• Anti-dilution protection for Investor

Full Ratchet – ratchet’s conversion price down to purchase price of newly sold stock

– Very punitive on Founders

Weighted average – partial protection for previous investor based on amount of new financing raised

• “Pay to play” provisions (participate or conversion to security with lesser rights (lose anti-dilution, lose pre-emptive rights, convert to common)

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Key Terms – Anti Dilution

• Ratchet

• Broad based weighted average

• Narrow based weighted average

• Pay to play provisions (participate or conversion to security

with lesser rights)

• Exclusions

Option pool of limited size

Mergers/acquisitions

Warrants for banks/leasing companies

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Effect of Anti-Dilution Formulas

• Merger Returns

Series A % of Company and

valuation thereof post - money

Assumes 4,000,000 additional shares of Series B

Preferred Stock issued at the following per share

prices:

$1.50

$0.75

Example A: Preferred without antidilution

protection

20.0% ($3.00 MM) 20.0% ($1.50 MM)

Example B: Weighted average antidilution

formula protection

21.9% ($3.36 MM) 25.5% ($2.06 MM)

Example C: Full ratchet antidilution protection 25.0% ($4.00 MM) 40.0% ($4.00 MM)

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Calculating Anti-Dilution

One, not “the” approach

:

X Co + $ = C1

X + Y

Application to Issuance of 4,000,000 Shares of

Series B Preferred at $1.50 per share:

(5,200,000 2.00) + $6,000,000 = $1.78

5,200,000 + 4,000,000

Where: X = number of shares of common stock outstanding or deemed to be outstanding (including

common stock equivalents) prior to new issuance

Each share of Series A converts into Common at

ratio of $2.00 or 1 to 1.12.

$1.78

Co = old conversion price Post Series B Common Equivalents:

C1 = new conversion price % With

Weighted

Average

% Without

Antidilution

Protection

$ = aggregate consideration received for

new shares issued

Common (including

options)

39.05% 30.0%

Y = number of new shares issued Series A 21.9 20.0

Series B 39.05 . 40.0

100.0 100.0%

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Key Terms

• Founder Vesting - Retention and Golden handcuffs

Management team: bet on jockeys, not horses

Vesting = repurchase rights for issued Founder stock

– lapses over 4 years: 1 year “cliff”, thereafter 1/36th per month

– Income tax issues (83b election)

– Shares purchased for cash not subject to vesting

Vesting important for each other founder too

Accelerated vesting

– termination without cause, resignation for good reason

– **Sale or “Double trigger” (sale and subsequent termination) » Often negotiated with acquirer

– Stock options under option plan?

Investor may reset existing vesting schedule

“Founders Preferred Stock” to allow partial exit?

• Key Management/Employees: Employee share option pool

Usually options vest as above (25% after year 1; 1/36th per month thereafter)

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Key Terms

• Redemption – The Living Dead

Forced liquidity when company hasn’t gone public

– May require sale or fire sale

– For founders it’s the quick or the dead

Timing: 3-5 years after investment

Amount (all at once or percentage)

Forced exercise during certain period or “any time” after target date

Statutory limits on share repurchase

• Registration rights Stock cannot be sold publicly without filing registration statement. Allow

stockholders to sell shares publicly by means of registered offering

Often IPO underwriter renegotiates

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Documents for Funding

• See www.NVCA.org

• Preferred Stock Purchase Agreement = AU Subscription Agt

Schedule of Exceptions

Due Diligence

• Certificate of Incorporation = AU Constitution

• Investors Rights Agreement

• Voting (and Drag Along) Agreement

• Right of First Refusal and Co-Sale Agreement

= AU

Shareholders

Agreement

http://www.nvca.org/

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Convertible Notes

• Convertible notes?

Quicker, cheaper since not shareholder

– No shares issues/rights negotiated

Not priced round -> avoids valuation discussion/debate

– Bridge financing too (warrant coverage)

Same terms and shares as next “Qualified Financing”

Earlier so riskier -> Cap or Discount (priced?)

Problems if strong preferences (multiple liquidation preference)

Sale Event

Always unsecured in SV

Means to an end, not an end in and of itself

Economy & Finance

Negotiating Venture Financing Transactions