Negotiating Venture Financing Transactions

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Negotiating Venture Financing Transactions

  1. 1. 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 richard.horton@squiresanders.com
  2. 2. 2 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)
  3. 3. 3 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
  4. 4. 4 Relevance of Silicon Valley and the US • 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?
  5. 5. 5 Relevance of Silicon Valley and the US • 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
  6. 6. 6 Relevance of Silicon Valley and the US • 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?
  7. 7. 7 Relevance of Silicon Valley and the US
  8. 8. 8 US Venture Capital industry
  9. 9. 9 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
  10. 10. 10 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
  11. 11. 11 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
  12. 12. 12 Sources of Capital for Startup Business • 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?
  13. 13. 13 Sources of Capital for Startup Business • 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)
  14. 14. 14 Sources of Capital for Startup Business • **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
  15. 15. 15 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
  16. 16. 16 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
  17. 17. 17 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
  18. 18. 18 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
  19. 19. 19 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
  20. 20. 20 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?
  21. 21. 21 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
  22. 22. 22 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% 800,000 shares 4,000,000 shares 6,000,000 shares Valuation: (Series A Preferred Purchase Price = $2.00 per share) $8.0 million $12.0 million 75.00% 50.0% 33.33% % % 3.33% 100.00% 100.00%
  23. 23. 23 Key Terms – Liquidation Preference • VCs always take “Convertible Preference Shares”  Founders common (ordinary) shares (“Founders preferred”?) • VC wants money paid back before entrepreneur gets his return • Liquidation Preference***  Critical exit provision – applies in sale/merger (also applies to bankruptcy/wind down)  Preference – right to have investment (or multiple) repaid before common  Participation – right to participate in upside of sale with common • Non-participating Preferred vs. Participating Preferred • Precedential value strong  If A rounds insist, get screwed by larger later rounds • -> N-P in most early rounds these days
  24. 24. 24 Key Terms – Liquidation Preference • Non-participating Preferred (NPP)  after payment of preference no participation with common stock OR  conversion to common stock and participation with common stock only  “money back OR a cut” • Participating Preferred (PP)  after payment of preference, also participate with common stock on “as converted” basis  Unlimited participation vs. capped participation  “money back AND a cut” • Company needs to manage and understand liquidation preference “overhang” to appreciate return in any exit scenario
  25. 25. 25 Effect of Liquidation Preference in Merger Preferred Investment Amount 5,000,000$ 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….
  26. 26. 26 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
  27. 27. 27 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
  28. 28. 28 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
  29. 29. 29 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)
  30. 30. 30 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)
  31. 31. 31 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
  32. 32. 32 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)
  33. 33. 33 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 commonstock 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%
  34. 34. 34 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)
  35. 35. 35 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
  36. 36. 36 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
  37. 37. 37 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

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