The Entrepreneur's Guide to Negotiating a Venture Capital Financing
The Entrepreneur’s Guide to Negotiatinga Venture Capital Financing Phil Schroeder Allen Matkins Leck Gamble Mallory & Natsis LLP 1900 Main Street, 5th Floor Irvine, California 92614-7321 949.851.5413 firstname.lastname@example.org CENTURY CITY | LOS ANGELES | ORANGE COUNTY | SAN DIEGO | SAN FRANCISCO
What do you need to know? Understand the essential deal terms negotiated in a Venture Capital financing Topics Covered Background Valuation Liquidation Preference Dividend Preference Anti-dilution Provisions Board of Directors Veto Rights (Protective Provisions) Restrictions on Founders’ Right to Transfer Shares Registration Rights Current Trends in Convertible Debt
BackgroundShould your company seek Angel or Venture Capital funding? Exit Strategy Amount of money required to launch the business (will a loan be enough to get started?)
BackgroundWhat are the typical documents in a VC financing? Preferred Stock Purchase Agreement (First Amended and Restated) Certificate of Incorporation Investors’ Rights Agreement Voting Agreement Right of First Refusal and Co-Sale Agreement
BackgroundPreferred Stock vs. Common Stock Preferred Stock has certain rights and preferences that are superior to Common Stock During the life of a company, there may be multiple “series” of Preferred Stock (e.g. Series A, Series B and Series C) each having a different set of rights and preferences Typically a new series of Preferred Stock is created for each round of financing and each successive series has superior rights and preferences Rights and preferences are defined in the Certificate of Incorporation
Background“Seed” Financing Less than $1 million Possible terms of “Plain Vanilla” Preferred Stock 1x, non-participating Liquidation Preference NO Dividend Preference NO Registration Rights NO Anti-dilution Protection Limited Veto Rights (Protective Provisions) NO Redemption Rights “Most favored nations” clause with respect to rights granted to future investors
Valuation Terms Pre-Money Valuation – valuation of the Company pre- investment Post-Money Valuation – Pre-Money Valuation PLUS amount invested Investors generally want lower valuations and founders generally want higher valuations, BUT Consider the impact of valuations that are too high or too low
Valuation Valuation is what the investor is willing to pay Valuing early stage companies is “more art than science” Traditional “scientific” models are of limited usefulness Company-specific factors to consider: Market Opportunity (size, growth rate, competition) Strength of Management Team (credentials, track record, vision, drive) Product/Solution (achievable, salable, scalable, timely, protectable advantage) Progress to Date
Valuation Negotiating Valuation Best Leverage – have multiple sources of funding Negotiate based on the merits of the Company Ask the investor to explain their valuation analysis Valuation may be significantly impacted by liquidation preference and dividend preference negotiations
Liquidation Preference Distribution of payments upon any liquidation, dissolution or winding up of the Company or sale of substantially all of the assets of the Company Holders of stock with a superior liquidation preference will be paid before other stockholders Preferred Stockholders may receive a multiple of the amount they invested (plus accrued dividends) prior to the Common Stockholders receiving any payment (e.g. 1x, 2x) What happens if funds are not sufficient to cover the liquidation preference? Preferred Stockholders share funds pro-rata; Common Stockholders receive nothing
Liquidation Preference Non-participating Preferred – Preferred Stockholders receive their preference payment and nothing more Fully Participating Preferred – Preferred Stockholders receive their preference payment AND share any remaining funds pro-rata with the Common Stockholders Capped Participating Preferred – Preferred Stockholders receive their preference payment and participate pro-rata with the Common Stockholders up to a capped aggregate return Cap may be a multiple of amount invested (e.g. 3x, 4x) Incentive for investors to convert to Common Stock if the sale price is high enough and investors can receive more money by “fully” participating with the Common Stock
Dividend Preference Holders of stock with a superior dividend preference will receive dividends before other stockholders Non-Cumulative Dividends – a set dividend is defined but it will be paid only “when and if declared by the Board” Cumulative Dividends – a set dividend will “accrue” each year whether or not declared by the Board; cumulative dividends are typically paid upon a liquidation
Anti-Dilution Provisions Protects Preferred Stockholders from dilution in the event that stock is sold at a lower valuation in a later financing round Adjusts the rate at which Preferred Stock converts into Common Stock (typically, 1:1 at first) Conversion rates may effect liquidation provisions, voting rights, rights of first refusal, registration rights, etc.
Anti-Dilution Provisions Full-ratchet Adjustment – Conversion price reduced to the price at which the new shares are sold Weighted Average Adjustment The amount of the adjustment is affected by the valuation in the down round and the amount of shares issued in the “down round” compared to the “fully-diluted” outstanding shares The more shares that are issued in the “down round”, the greater the adjustment
Anti-Dilution Provisions Broad-based weighted average Company-friendly “Fully-diluted” shares includes options and shares reserved for option plan Narrow-based weighted average Investor-friendly “Fully-diluted shares does NOT include options
Board of Directors Voting Agreement Preferred Stockholders will be able to appoint one or more members to the Board (typically investor affiliates) Common Stockholders may be able to appoint one or more members to the Board (e.g. founders, CEO or other officers) Remaining stockholders may be independent directors elected by all stockholders Rights to appoint directors may terminate if stockholders sell a certain percentage of their stock
Veto Rights (Protective Provisions) The Company may not take certain actions without the approval of the Preferred Stockholders approval threshold will be a percentage of the outstanding Preferred Stock the exact percentage will be negotiated between the investors
Veto Rights (Protective Provisions) Actions that typically require approval by the Series A Preferred Stockholders: liquidate, dissolve or wind-up the affairs of the Company, or effect any deemed liquidation event; amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws; create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred;
Veto Rights (Protective Provisions) Actions that typically require approval of the holder of Series A Preferred Stock: purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, other than stock repurchased from former employees or consultants in connection with the cessation of their employment/ services, at the lower of fair market value or cost; create or authorize the creation of any debt security if the Company’s aggregate indebtedness would exceed $[____] other than equipment leases or bank lines of credit; and increase or decrease the size of the Board of Directors.
Restrictions on Founders’ Rights to Transfer Shares Why do the investors want to place restrictions on the founders’ stock? The investors are investing in the people as much as the idea The investors want to make sure that the founders remain motivated and will not abandon the business
Restrictions on Founders’ Rights to Transfer Shares Vesting Schedule – Attach a vesting schedule to the founders’ Common Stock Company has a right to repurchase the founder’s unvested stock if the founder terminates employment typically vests over three to fours years in monthly increments Repurchase Price – equal to founder’s cost or fair market value at the time of repurchase Mandatory Repurchase vs. Discretion of the Board
Restrictions on Founders’ Rights to Transfer Shares Right of First Refusal – The Preferred Stockholders and/or the Company have the right to purchase the offered shares on the same terms. prevents unknown parties from becoming stockholders of the Company Co-Sale Rights – The Preferred Stockholders have the right to sell their pro-rata number of shares to the proposed buyer effectively reduces the amount of shares that the founder may sell (stops them from selling out) gives the investors some liquidity (allows the investors to sell their stake to the same extent as the founder)
Registration Rights Background – Shares that are “registered” may be sold publicly, which creates liquidity for the stockholder Publicly traded companies must file periodic reports with the SEC (can be expensive and time consuming) In addition to the holders of Preferred Stock, the founders and management also may have registration rights Rights are subject to underwriter cutbacks
Registration Rights Demand Rights – Certain investors can cause the Company to undertake an IPO and/or register their shares Typically, can only force the company to register shares a certain number of times (usually one or two times) Demand rights typically may not be exercised until three to five years after the financing or  months after an IPO
Registration Rights S-3 Registration Rights – Certain investors can cause the Company to register their shares using Form S-3 Form S-3 is a short form registration statement (reduces workload because the Company can refer to information in prior SEC filings) Typically, can only force the company to register shares one or two times per 12-month period Minimum aggregate value of shares to be registered (typically $1-5 million)
Registration Rights Piggy-back Registration Rights – Allows certain stockholders to register their shares when the Company has already elected to make a public offering or register the shares of other stockholders
Other Terms Right to Participate Pro Rata in Future Rounds Pay to Play – penalize investors who do not invest pro rata in future rounds (convert their Preferred Stock into Common Stock, lose anti-dilution rights, lose Board seat or lose right to participate in future rounds) Redemption Rights – Investors can force the Company to repurchase their shares at some time in the future
Current Trends in Convertible Debt Alternative to Equity Financing to reduce transaction costs Loan Converts into Preferred Stock at the next Preferred Stock financing At the same price as the next round, or At a discount to the next round price Recent Trend – Cap on conversion price Effect is hard to predict; can result in a huge discount to next round valuation Complicates negotiations
Phil Schroeder Phils practice focuses on fulfilling the general corporate needs of early stage to middle market companies with an emphasis on financing transactions and technology transfer agreements. Phil provides advice with respect to transactions geared toward growth including preferred stock financings, bridge loan financings, and mergers and acquisitions. He also represents clients with respect to a wide range of other contractual arrangements including stockholders agreements, employment and consulting agreements, and employee compensation plans (including stock options and other forms of equity incentive plans). Phil has extensive experience advising founders on choice of entity and setting up new companies including limited liability companies, S-corporations and C-corporations. In addition to his corporate and securities work, Phil develops strategies for protecting hisPhilip C. Schroeder clients intellectual property and advises clients with respect to the various protections affordedSenior Counsel by patent, trademark, copyright and trade secret laws. Phils intellectual property practiceOrange County OfficePhone: 949.851.5413 involves representing clients in connection with licensing agreements, trademark prosecution,Facsimile: 949.553.8354 nondisclosure agreements, technology acquisition agreements, technology email@example.com agreements, manufacturing agreements, distribution agreements and a broad range of other commercial agreements involving the use, development or transfer of intellectual property.Focus Phil is an active member of the technology and venture capital community. He served as theCorporate and Securities firms focal point in its role as a preferred provider to Tech Coast Works, an Orange County-Emerging Companies and Venture based technology incubator, and serves as the firms designee in connection with its Capital International Trademark Association (INTA) membership. Phil is also a member of OCTANe.Technology and Intellectual PropertyMergers and Acquisitions Prior to his legal career, Phil worked as a Project Engineer for six and one-half years in the aircraft and medical device manufacturing industries. He is a licensed Professional MechanicalEducation Engineer.J.D., cum laude, Loyola Law School, MembershipsLos Angeles, 2003M.S. in Mechanical Engineering, International Trademark Association (INTA)University of California, Irvine, 1993 OCTANeB.S. in Mechanical Engineering,Columbia AdmissionsUniversity, New York, 1992 State Bar of California Licensed Patent Attorney
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