Venture Capital Financing

© 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 1

Majda Barazzutti

November 13, 2013

The Venture CapitalFinancing Process:

The Legal Perspective


Financing is a Staged Process Common Stock

Bootstrapping Friends and Family Angels: Equity, Warrants, Convertible Notes

“Series Seed” Series A Preferred (B, C, etc.) Liquidity Event


Structure the Initial Process Correctly

Securities Laws Filings Price must be the same: Tax

Consequences of Valuation at Early Stages

Protection of IP


U.S. vs. Italian Process Informal Private No statutory auditors No minimum capital requirements No legal impediments to ongoing losses Limited bankruptcy laws risks


Convertible Debt Bridge loan before financings Useful when the company does not have

a satisfactory valuation Risks of repayment feature No minimum capital but insolvency

changes the rules Better include a provision to force

conversion


Warrants: option to purchase company shares at a price within a set period

“Kicker” to increase the potential investment value

Warrants increase in value as the value of the underlying shares increase in relation to the exercise price

Usually issued with bridge financing


Warrants

“Open source”, simpler, standard No antidilution, redemption, dividend

protection, price based anti-dilution, registration rights

Will acquire same rights as the next series of Preferred

Smaller financings


Series Seed

Alternatives: Strategic Investors

Stage of Product Development: Scalability

Aims Differ Not Interested in Helping the Company

Grow Conflict of Interest: greater returns from

commercial rights than growth Expertise Could affect future VC financings


Venture Capital Identify the Right VC Due Diligence The Risk of “Finders”


Preferred Stock (Series) Why Preferred?

Liquidation Preference Preserve a low common stock value for option

grants (ratio 1:4 to 1:8): Common Stock was bought at cheap

price, $0.10 to founders. If Common were sold at same time at

$5.00 to VC, tax consequences for founders.

No limits to Preferred/Common ratio


Prior to Investing: Document Employees Founders Relationships Securities filings Confidentiality and Invention

Agreements Prepare for VC’s due diligence


“Clean Up”

Sample Term Sheet Binding Provisions:

No Shop Confidentiality Applicable law

ALL other provisions are not binding

See examples: NVCA (http://www.nvca.org)


http://www.nvca.org/

A Typical Term Sheet Valuation/Number of Shares/Price Liquidation Preference Redemption Conversion Antidilution Voting Rights Protective Provisions Vesting of founders' stock


Valuation/Price Pre-money/Post-money valuation: Option pool shuffle How are your shares valued?

8M pre-money valuation, 6M shares outstanding $8M pre-money ÷ 6M existing shares = $1.33/share, right?

WRONG: The share price is $1.00 WHY? Read the term sheet: “The $8 million pre-money

valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”

$8M pre-money ÷ (6M existing shares+2M options )= $1/share.

Pre-money valuation includes a large unallocated option pool for new employees -- lowering pre-money valuation

Hence, develop a hiring plan © 2013 Valla & Associates, Inc., P.C.

www.vallalaw.com 15

Dividends No expectation of dividends, but: Cumulative Dividends: __ % cumulative dividend accrues

over time, whether or not the company declares it - PLUS participation with Common Stock on an as-converted basis.

Non-cumulative Dividends: “An amount equal to $[_____] per share of Series A Preferred when, as and if declared by the Board”

PIK (payment-in-kind) dividends. Company option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

Usually payable on liquidation or redemption, not conversion


Liquidation Preferences Liquidation Preference: 1x or more Participating Preferred:

Full participation 19% Capped participation

14% Non-participating 67%

Preferred has the option to convert into Common

Interaction of various series: First pay B, then A, then all; all participate equally, etc.

Deemed Liquidation: good times and bad times; IPO?


Redemption Optional (Company call):

Company can repurchase stock at original price (plus dividends) if Investors don’t convert to Common after x years

Mandatory (Investors Put) Investor can force Company to repurchase shares

after x years – beware of redemption premium Guaranteed exit path for VC if Company is

“successful enough” But, Company must have funds legally available

22% of all VC financings in 2012, 35% in down rounds


Voting rights/Protective provisions

Preferred usually votes with Preferred on an “as converted basis”

Vote by Series/Class Usually right to vote on x directors Applicable law provides for rights for certain events

(merger or creation of senior preferred stock) Investors often add additional actions Terminate if Series holds less that minimum % of

original purchase (5-20%) Voting Switch - gain majority from an event of default


Voting rights/Protective provisions

Amend Articles / Certificate (or Bylaws)� Alter rights, preferences of Series A, affect Series A Increase or decrease authorized shares Preferred Stock Merger / acquisition, sale of substantially all assets Liquidation / dissolution Declare or pay dividend Change authorized number of Board Directors


Conversion Preferred always has a conversion to Common

feature, but loses all preferred privileges Optional Conversion

Holders can convert to Common at any time Automatic Conversion – must convert to

Common if: IPO at least $ __(size + price) 2/3 of preferred (or majority) elect to

convert


Conversion Conversion Ratio is initially 1:1 Anti-dilution protection: conversion price adjustment,

not automatic “Event-Based” changes: Stock splits, stock dividends,

reverse stock splits Retain same percentage ownership

“Price-Based” changes: Dilutive Financing (financing at lower price per share) Exclusions

Pay to Play: must keep “paying” (participating pro rata in future financings) in order to keep “playing” (not have his preferred stock converted to common stock, lose antidilution)


Anti-Dilution Protect investors if company issues equity at a

lower valuation than preferred Full Ratchet 3% Weighted Average: Broad Base: more favorable

92% Weighted Average: Narrow Base: less favorable to

company4%


Exclusions from Dilution Carve-outs from anti-dilution:

Options grants to employees, consultants (negotiate all or only authorized pool)

Warrants to lenders (approved by majority vs. unanimous board approval)

Warrants to service providers, strategic partners

Shares issued in mergers / acquisitions Exercises or conversions of current stock or

grants


Other Terms: Vesting of founders’ stock, acceleration Right of first refusal: new issuance and

transfers by founders Employee pool Co-sale agreement (drag along, tag along) :

force a sale Registration rights

Demand registration rights Piggy-back S-3 Expenses


Other Terms: No-shop agreement Information rights Confidentiality Indemnification Counsel expenses up to ___ Lock-up provisions


Financing Documentation Legal and business due diligence Draft definitive agreements (purchase

agreement, Certificate of Incorporation, voting agreement, investor rights agreement)

Prepare closing deliveries (Schedule of Exceptions)

Consents, opinions, government filings


Bottom Line (Almost) anything can be negotiated Pick your battles: Liquidation �

Preferences, Protective Provisions, �Board Control

Make sure you understand what you’re signing


Thank you!In bocca al lupo!

Valla & Associates, Inc., P.C.

1990 N. California Blvd., Suite 1060 Walnut Creek, CA 94596

USA

E-mail: [email protected]: +1 925 705 7623 Fax: +1 925 705 7629

www.vallalaw.com


Economy & Finance

Venture Capital Financing