PREPARING FOR
EARLY STAGE FINANCING
June 11, 2013
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Anthony Millin - Bio
Anthony Millin has a corporat...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Agenda
• Investor Packages
– Creating a compelling...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Investor Packages
4
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Investor Package
• “Teaser”
• Non-Disclosure Agree...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Investor Packages
6
SECTIONS TO COVER IN INVESTOR ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Teaser
• 1-2 pages
• Goal of a “Teaser” is to get ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Non-Disclosure Agreement
• Most VCs and many angel...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Executive Summary
• 5-10 Pages
• Expands on each s...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Financial Model
• It is important to build a finan...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Financial Model
• Performs Sensitivity Analysis
– ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Financial Model
• What items from the financial mo...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Investor Presentation
• Prepare for the Presentati...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Stages of a Company
14
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Stages of Company
• Seed Stage
• Early Stage
• Gro...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Stages of Company - Seed
STAGE SEED
Investor • Sel...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Stages of Company - Early
STAGE EARLY
Investor • A...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Stages of Company - Growth
STAGE GROWTH / EXPANSIO...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Term Sheet
19
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Term Sheet
• Term sheets can take several differen...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Three Key Negotiation Areas
• VALUE OF THE COMPANY...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Value of The Company
• Key Valuation Concepts
–Pre...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Pre-Money/Post-Money
• The Pre-Money Valuation is ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Pre-Money/Post-Money
Example - Entrepreneur is rai...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Fully-Diluted Basis
• To calculate the share price...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Fully Diluted-Basis - Example
• Shares issued and ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Rights and Preferences
• Liquidation Preference
• ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
The Liquidation Preference
• A mechanism by which ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Participating vs. Non-Participating
Non-Participat...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Cumulative vs. Non-Cumulative
No Preferred Return ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Anti-Dilution Protection
• Protection to investor ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Anti-Dilution Protection
• Three Forms of Anti-Dil...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Preemptive Rights
• The investor’s pro rata right,...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Right Of First Refusal
Co-Sale Right
• In the even...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Drag Along Rights
• The right of a pre-requisite n...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Redemption Rights
• Right to have the company rede...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Registration Rights
• Grants the investor the righ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Information Rights
• Right to financial informatio...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Protective Provisions
• Board Representation/Votin...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Protective Provisions
• Investors and entrepreneur...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Definitive Documentation
41
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Form of Securities
• Corporation
– Common Stock
– ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Form of Securities
• Common Stock/Units
–Founders,...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Common Stock
• A security that represents an equit...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Convertible Note
• Debt instrument, with interest ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Convertible Note With A “CAP”
• A Convertible Note...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
“CAP” - EXAMPLE
• A Company with 1 million shares ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Preferred Stock
• Security that represents an equi...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Common Stock/Units
• Common Stock
– Stock Purchase...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Convertible Note
• Convertible Promissory Note Pur...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Preferred Stock/Units
• Series Seed/Series AA (Lim...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Due Diligence
52
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Due Diligence
• A comprehensive review of a compan...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Due Diligence on Investor
• Early investor becomes...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Preparation Of Documents
• Documents will include:...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Preparation Of Documents
• Documents will include ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Preparation Of People
• Make sure all key members ...
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Regulatory Compliance
58
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Regulatory Compliance
• Ability to raise money fro...
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Contact Information
60
Anthony Millin, Esq.
Partne...
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Preparing for Early Stage Financing - Pedley, Millin & Gordinier - June 11, 2013

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Presentation from a June 11, 2013 workshop titled “Preparing for Early Stage Financing”. Topics covered include:

1. Creating a compelling investor package and preparing for investor presentations
2. Evaluating the sources of financing and legal structures for each stage of a company’s lifecycle
3. Negotiating a term sheet – a deep dive into the key legal provisions and their impact
4. Understanding the different set of documents that comprise the “Definitive Documentation”
5. Preparing for the due diligence process
6. Complying with federal and state regulatory requirements

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Preparing for Early Stage Financing - Pedley, Millin & Gordinier - June 11, 2013

  1. 1. PREPARING FOR EARLY STAGE FINANCING June 11, 2013 Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Anthony Millin, Esq. Partner Pedley, Millin & Gordinier, PPLC
  2. 2. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Anthony Millin - Bio Anthony Millin has a corporate and securities practice, focusing on start-up and emerging growth companies. Anthony is also a successful serial entrepreneur who has co-founded multiple companies in the United States and China, several of which have been institutionally funded. This experience in raising capital, and building and running companies, provides Anthony with valuable insights into the legal and business needs of his clients. It enables Anthony to understand a business, its goals and its challenges from the perspective of the entrepreneur. Anthony’s legal practice includes general corporate counseling, preparation of investment materials and presentations, equity and debt financings, joint ventures, corporate governance, and mergers and acquisitions. He also has worked closely with angel investors and a range of institutional investors. Anthony serves businesses across multiple industries, including internet/technology, biotech, clean energy, education and health care. He also brings his China-based experience to assist early-stage and middle-market companies interested in conducting business in China. Anthony also serves as Founder and Chairman of Bramley Ventures, Vice Chairman of the Board of Bethesda Green, Member of the Board of Directors of the Montgomery County Chamber Community Foundation, Co-Founder and Member of the Board of Directors of Lauren’s Light, and Member of the Advisory Board of the Maryland Clean Energy Center. 2
  3. 3. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Agenda • Investor Packages – Creating a compelling investor package and preparing for investor presentations • Stages of Company – Evaluating the sources of financing and legal structures for each stage of a company’s lifecycle • Term Sheet – Negotiating a term sheet – a deep dive into the key legal provisions and their impact • Definitive Documentation – Understanding the different set of documents that comprise the “Definitive Documentation” • Due Diligence – Preparing for the due diligence process • Regulatory Compliance – Complying with federal and state regulatory requirements 3
  4. 4. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Investor Packages 4
  5. 5. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Investor Package • “Teaser” • Non-Disclosure Agreement (NDA) • Executive Summary • Investor Presentation (PowerPoint) • Financial Model • Business Plan (Internal Document)/ Implementation Plan 5
  6. 6. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Investor Packages 6 SECTIONS TO COVER IN INVESTOR MATERIAL • Vision • Business Summary/Executive Summary • Market Need/Opportunity / Problem You Are Solving • Your Solution – Your Products and/or Services • Market • The Competition and Your Competitive Advantage • Marketing/Sales/Distribution Strategy • Business Model – How Do You Generate Profit • Current Milestones Achieved/ ”TRACTION” • Management Team • Financial Summary • The Ask (Funds Seeking) and Uses
  7. 7. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Teaser • 1-2 pages • Goal of a “Teaser” is to get to a meeting • Tool for you and your advisors to easily share with prospects • Quick to read, compelling • Prior to an NDA - Share only information comfortable sharing more broadly 7
  8. 8. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Non-Disclosure Agreement • Most VCs and many angel groups will not sign • How should you proceed ? – Judgment call specific to each potential investor – Risk Level and Risk Aversion – Should label all your documents “Confidential” 8
  9. 9. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Executive Summary • 5-10 Pages • Expands on each section of the “Teaser” • Includes detailed bios of the management team and a more detailed financial summary • Distribute to potential investors after initial meeting 9
  10. 10. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Financial Model • It is important to build a financial model • Forces you to understand your underlying business model • Investors understand that actual results will usually vary from your projections • The key is your understanding of the assumptions that drive the Revenue, COGS and SG&A in your business • Summary Income Statement and Cash Flow projections for 3-5 years • Very detailed Cash Flow projections for next 12 months 10
  11. 11. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Financial Model • Performs Sensitivity Analysis – What if your assumptions are off by 10%, 25%, 50% – What if the first sale takes 6 months longer than projected – What if the pricing needs to be cut by 30% – Understand the impact on Cash Flow • Try to raise sufficient capital to ensure that you do not run out of cash under the more conservative set of assumptions 11
  12. 12. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Financial Model • What items from the financial model should you include in the investor package – Teaser • Revenue and EBITDA line for 3-5 years – Executive Summary and Investor Presentation • Summary chart of Income Statement and Cash Flow Statement for 3-5 years – The more detailed financial model will be shared with potential inventors with whom you are engaged in serious discussion and/or due diligence 12
  13. 13. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Investor Presentation • Prepare for the Presentation – Research who you will be meeting (Investor Bios, Investor focus areas, portfolio companies relevant to your market) – Know how much time you will have to present your company – Customize presentation to address your audience and allotted time – Practice, Practice, Practice !! • Invite questions and make the presentation interactive – Increases the likelihood that you will address the specific questions and concerns of the audience • Be Passionate - If you are not, your audience will not be • If you do not know an answer to a questions, it is OK to acknowledge that and follow-up later with the answer 13
  14. 14. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Stages of a Company 14
  15. 15. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Stages of Company • Seed Stage • Early Stage • Growth/Expansion Stage 15
  16. 16. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Stages of Company - Seed STAGE SEED Investor • Self • Friends & Family • Angels Objectives Include • Complete organization structure • R&D related to building or testing product/service offering • Validation - assessment of potential/early customer interest • Develop a marketing and sales plan Structure • Common Stock/Membership Units • Convertible Note • Series AA Preferred Stock/Membership Units 16
  17. 17. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Stages of Company - Early STAGE EARLY Investor • Angel • Institutional Angel • Venture Capital Objectives Include • Launch initial product and/or service • Continued product development • First commercial sales • Build Management Team, Board, Advisors Structure • Series A Preferred Stock/Membership Units • Convertible Note 17
  18. 18. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Stages of Company - Growth STAGE GROWTH / EXPANSION STAGE Investor • Venture Capital • Other Institutional Investors (PE/Hedge Fund/IB Group) Objectives • Scale Marketing, Sales and Distribution • Scale Operations • Expand Product Lines • Expand Geographically Structure • Series B Preferred Stock • Series C Preferred Stock 18
  19. 19. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Term Sheet 19
  20. 20. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Term Sheet • Term sheets can take several different forms, depending on the preferences of the Parties involved – A brief list of terms – A letter agreement – A short agreement • Reasons for Using Term Sheets – Highlights key terms of the transaction – Enables earlier discovery of points of contention or deal breakers – While it requires additional time and cost upfront, ultimately reduces the amount of time and expense incurred by facilitating the drafting and negotiation of the definitive transaction documents – Makes it harder for parties to change their business positions later • Term sheets are generally non-binding, but may include a few binding provisions 20
  21. 21. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Three Key Negotiation Areas • VALUE OF THE COMPANY – Drives the percent of the Company you are selling in the financing • INVESTOR RIGHTS & PREFERENCES – Drives the investors’ preferences with respect to distributions of profit or distributions upon a liquidity event – Drives the investors ‘ rights to participate in new issuances of securities and transfers of issued securities • INVESTOR PROTECTIONS (CONTROL) – Drives the level of control that the investor (usually holding only a minority interest) exerts on major actions of the Company 21
  22. 22. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Value of The Company • Key Valuation Concepts –Pre-Money vs. Post Money Valuation –Fully-Diluted Basis 22
  23. 23. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Pre-Money/Post-Money • The Pre-Money Valuation is the valuation of the Company not including the new cash to be raised • The Post-Money Valuation is the valuation of the Company including the new cash to be raised 23
  24. 24. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Pre-Money/Post-Money Example - Entrepreneur is raising $500,000 and the investor and entrepreneur agree on a valuation of $2 million • Is the $2 million pre-money or post-money? – If it is pre-money, the business is worth $2.5 million upon closing and the investor will receive 20% ($500,000/$2.5 million) of the company upon closing – If it is post-money the business is worth $2.0 million upon closing ($1.5 million pre-closing) and the investor will receive 25% ($500,000/$2.0 million) of the company upon closing 24
  25. 25. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Fully-Diluted Basis • To calculate the share price or membership unit price – Divide the value of the company by the number of shares/units issued and outstanding • How do you account for stock options, warrants, or convertible notes that could become issued and outstanding units upon exercise or conversion ? – Investors almost always want to avoid having their shares diluted in the future when these instruments are exercised or converted, often at a price lower than the price paid by the investor • The investor will want the share/membership unit price calculated on a “FULLY DILUTED BASIS” – Includes the number of shares/units subject to options, warrants, convertible notes in the denominator 25
  26. 26. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Fully Diluted-Basis - Example • Shares issued and outstanding - 1.8 million • Stock Option Plan: 200,000 (Includes options not yet granted, and granted but not yet vested or exercised) • Investment Amount: $ 500,000 • Pre-money valuation: $ 2 million Based on Shares Currently Outstanding Divide the pre-money valuation by the sum of the shares issued and outstanding 2,000,000/1,800,000 = $1.11 per share Number of shares issued in financing = $500,000/ $1.11 = 450,000 Investor will acquire an 18 % ownership interest (450,000/2,450,000 = 18%) Fully-Diluted Basis Divide the pre-money valuation by the sum of the shares issued and outstanding plus the options in the stock option plan 2,000,000/2,000,000 = $1.00 per share Number of shares issued in financing = $500,000/ $1.00 = 500,000 Investor will acquire a 20 % ownership interest (500,000/2,500,000 = 20%) 26
  27. 27. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Rights and Preferences • Liquidation Preference • Participating vs. Non-Participating • Dividend Rights/Preferred Return • Anti-Dilution • Preemptive Rights • Right of First Refusal & Co-Sale Rights • Drag Along Rights • Redemption Rights • Registration Rights • Information Rights 27
  28. 28. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. The Liquidation Preference • A mechanism by which the investor seeks to recoup its original investment or a multiple thereof, plus any declared and unpaid dividends, before there are any distributions to the common stockholders/unit holders • Usually is defined to occur upon a liquidation, dissolution or winding up of the company, a merger, or a sale of the company or its assets • Example - $1 million dollar investment: 1X Liquidation Preference = $1 million to investor before common shareholders/units holders get 1st dollar 2X Liquidation Preference = $2.0 million to investor before common shareholders/units holders get 1st dollar 28
  29. 29. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Participating vs. Non-Participating Non-Participating Preferred Limits the investor to its Liquidation Preference (In practice, an investor will exercise its right to convert its preferred stock/units into common stock/units and give up its Liquidation Preference if it would get a larger return as a common stockholder/unit holder) Participating Preferred with A Cap Investor receives its Liquidation Preference plus further distributions on a pro-rata basis with the common stockholders/ unit holders up to the Cap (In practice, an investor will exercise its right to convert its preferred stock/units into common stock/units and give up its Liquidation Preference if it would get a larger return as a common stockholder/unit holder) Participating Preferred With No Cap Investor receives its Liquidation Preference plus further distributions on a pro-rata basis with the common stockholders/ unit holders 29
  30. 30. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Cumulative vs. Non-Cumulative No Preferred Return 8% Non-Cumulative Preferred Return 8% Cumulative Preferred Return The preferred stockholders/ unit holders and common stockholders/unit holders participate in dividend distributions on a pro rata basis 1st – Company must pay 8% dividend to the preferred stockholders/unit holders for the current year before making a distribution on any junior securities 2nd – Preferred stockholders/ unit holders and common stockholders/unit holders then share in dividend distributions on a pro rata basis 1st – Company must pay 8% dividend to the preferred stockholders/unit holders for the current year, and for all prior years for which a Preferred Return was accrued but not paid 2nd – Preferred stockholders/ unit holders and common stockholders/unit holders then share in dividend distributions on a pro rata basis 30
  31. 31. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Anti-Dilution Protection • Protection to investor in the event the Company issues new shares/units at a price lower than the price paid by the investor • Adjusts the investor’s conversion ratio for the conversion of Preferred Stock to Common Stock (from a 1:1 ratio) to increase the number of shares of Common Stock the investor receives on conversion 31
  32. 32. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Anti-Dilution Protection • Three Forms of Anti-Dilution Protection * – Full Ratchet - Least favorable to Entrepreneur • Only accounts for the share/unit price of the new issuance. A single new share/ unit issued at a lower price will result in the original investor receiving such lower price on their full prior investment – Narrow Based Weighted Average - More Favorable to Entrepreneur • Accounts for the share/unit price of the new issuance plus the size of the new issuance relative to the number of shares / units issued and outstanding – Broad Based Weighted Average - Most Favorable to Entrepreneur • Accounts for the share/unit price of the new issuance plus the size of the new issuance relative to the number of shares/units issued and outstanding on a fully diluted basis * Subject to customary exceptions 32
  33. 33. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Preemptive Rights • The investor’s pro rata right, based on percentage equity ownership, to participate in subsequent issuances (usually only financings) • If the investor owns 20% of Company before the subsequent financing, the investor has the right to take 20% of the subsequent financing 33
  34. 34. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Right Of First Refusal Co-Sale Right • In the event a shareholder/unit holder receives a bona fide offer to buy its stock / units, the remaining shareholders/unit holders have a pro rata right to either acquire those shares/units on the same terms, or to sell their shares/units, on an as-converted basis pro rata, as part of such sale of such shares/units 34
  35. 35. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Drag Along Rights • The right of a pre-requisite number (i.e., a majority) of the selling shareholders/unit holders who all agree to sell their shares/ units, to drag along the remaining shareholders in the sale of the Company 35
  36. 36. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Redemption Rights • Right to have the company redeem investor’s shares/units • Usually at the greater of the purchase price or the FMV as determined by a formula, the Board, or an independent appraisal of the Company • Could be at the investors’ option or mandatory • Payment terms are critical to Company, since Company does not know its cash situation at the time of redemption 36
  37. 37. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Registration Rights • Grants the investor the right to either: – Force the Company, after a period of time, to register the investor’s shares and offer them publicly, or – Register and sell the investor’s shares as part of a registration and public offering, including a registered offering initiated by the Company or another stockholder 37
  38. 38. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Information Rights • Right to financial information such as income statements, cash flow statements, and balance sheets • Right to other information such as budgets and budget reconciliations, a dashboard of key metrics, and Board observation rights • Could be on an annual, quarterly or monthly basis. Need to weigh benefits to investor vs. burden on management to produce • Could be unaudited or audited 38
  39. 39. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Protective Provisions • Board Representation/Voting Agreements • Provides investors, who are minority shareholders (i.e., control less than 50%), significant control over designated actions of the Company • Requires the approval of a majority, or supermajority, of preferred shareholders/unit holders voting as a separate class • May also require the approval of a majority of the Directors designated by the preferred shareholders/ unit holders 39
  40. 40. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Protective Provisions • Investors and entrepreneurs will negotiate over which protective provisions to include. Examples are: – Amending the Certificate of Incorporation and Bylaws / Operating Agreement – A repurchase or redemption of equity – A material change in the nature of the Company’s business – A change in the size of the Board – The issuance of new equity or securities convertible into equity (pari- pasu, superior or junior to existing securities) – The sale of all or substantially all of assets of the Company or merger into another company resulting in a change of control – The liquidation, dissolution, and winding up of the Company – Incurring debt above a designated amount 40
  41. 41. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Definitive Documentation 41
  42. 42. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Form of Securities • Corporation – Common Stock – Preferred Stock (Rights & Preferences/Protections) • Limited Liability Company – Common Units – Preferred Units (Rights & Preferences/Protections) • Corporation and Limited Liability Company – Convertible Note (Secured or Unsecured) 42
  43. 43. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Form of Securities • Common Stock/Units –Founders, Friends and Family • Convertible Note – Friends and Family, Angel • Preferred Stock –Angel, Institutional Angel, Venture Capital 43
  44. 44. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Common Stock • A security that represents an equity ownership interest • First form of stock issued upon creating a new corporation • Conveys some basic rights – vote, right to dividends and proceeds of sale • Usually comes with restrictions – e.g., restrictions on transfer • Right to the assets of the company upon liquidation, after distributions to the holders of debt and preferred equity 44
  45. 45. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Convertible Note • Debt instrument, with interest that usually accrues • Bypasses the need for upfront agreement on valuation • Can be secured or unsecured; subordinated • Convertible into a company’s stock /units: – Automatically, at the time the company closes on its next qualified round of equity financing – If no such round occurs, at pre-agreed upon terms – Anytime prior to maturity, upon a vote of a majority of the convertible note holders • If no conversion, repayable along with accrued interest, upon its maturity • Provides investor with a discount to the next round (may also include warrants) • Relatively simple legal structure, lower transaction cost • Priority status over common and preferred shareholders/unit holders 45
  46. 46. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Convertible Note With A “CAP” • A Convertible Note is often the first non-friends and family investment • Comes into the Company during a period of very high risk (market risk, execution risk, technology/product risk and financing risk) • To compensate for all of the risk, many investors now negotiate a “CAP” on the conversion price (Negotiating maximum conversion value upfront) • Protects investor in event of rapid value growth prior to conversion • Investor will usually have the option to convert at the lower of: • A negotiated discount (i.e., 20%) to the next equity round • The agreed-upon valuation cap 46
  47. 47. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. “CAP” - EXAMPLE • A Company with 1 million shares of common stock/units outstanding • Issued a $500,000 convertible note, with a conversion discount of 20% and a conversion cap of $6 million • The start-up was able to raise $15 million at a pre-money valuation of $45 million in its next round of financing $ 6 million Cap 20% Discount No Cap or Discount Valuation $6 million $36 million $45 million Per Share Price $6.00 $36.00 $45.00 Shares Upon Conversion 83,333 13,889 11,111 % Of Company (Post) 5.9% 1.0% 0.8% 47
  48. 48. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Preferred Stock • Security that represents an equity ownership interest • Rights and preferences (priorities): – Over the common stock related to the assets and profits of a company – Rights in the event of issuance of new equity or existing shareholders sale of equity • Protective provisions that limit actions that can be taken by the Company without preferred stockholder approval 48
  49. 49. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Common Stock/Units • Common Stock – Stock Purchase Agreement or Subscription Agreement – Stockholders Agreement • Common Membership Units – Membership Unit Purchase Agreement or Subscription Agreement – Amended and Restated Operating Agreement 49
  50. 50. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Convertible Note • Convertible Promissory Note Purchase Agreement • Convertible Promissory Note(s) • Pledge & Security Agreement (If Secured) 50
  51. 51. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Preferred Stock/Units • Series Seed/Series AA (Limited Rights and Protections) – Stock Purchase Agreement – Investor Rights Agreement – Amended and Restated Certificate of Incorporation • Series A Membership Units – Membership Unit Purchase Agreement or Subscription Agreement – Amended and Restated Operating Agreement • Series A Preferred, Series B Preferred, Series C Preferred – Stock Purchase Agreement – Investor Rights Agreement – Right of First Refusal and Co-Sale Agreement – Voting Agreement – Amended and Restated Certificate of Incorporation 51
  52. 52. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Due Diligence 52
  53. 53. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Due Diligence • A comprehensive review of a company's business • Components of Due Diligence – Legal Due Diligence – Business Due Diligence – Financial Due Diligence • Time to complete due diligence - Two weeks to two months depending on the size of the investment, the group making the investment, the stage of the company, and the level of preparation by the Company 53
  54. 54. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Due Diligence on Investor • Early investor becomes an important partner in the success of the Company • Company should conduct due diligence on the investor – Understand investor’s expertise, track record, value beyond money being provided – Speak to other CEO’s funded by investor to learn how the investor was to work with (in both good times and bad times) 54
  55. 55. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Preparation Of Documents • Documents will include: – Organizational Documents • COI, Bylaws, Operating Agreement, Stockholder Agreement, Good Standing Certificate, Qualifications) – Ownership • Capitalization Table (Ownership) • Share Certificates – Corporate Document • Minutes from Board and shareholder meetings – Financial (Up to 3 years if available) • Tax Returns, Financial statements (Income Statement/ Cash flow Statement/Balance Sheet) – Customers/Suppliers /Strategic Partnerships • Names; Copies of agreements • Contact information for reference checks 55
  56. 56. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Preparation Of Documents • Documents will include (continued): – Intellectual Property • List of all Intellectual Property (Patents/Trademarks/ Copyrights) – Insurance policies – People • Organization chart • Bios of key managers – Agreements • Copies of all prior financing agreements (debt & equity) • Copies of all other material agreements – Marketing collateral and marketing and sales strategies – Detailed product or service descriptions and information – Business plans 56
  57. 57. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Preparation Of People • Make sure all key members of the team who will interact with investors are prepared for the process • If Investors plan to contact a few key customers and/or partners – Let the customers and/or partners know that they may be contacted by investors – If there have been issues with a customer, explain the situation to the investor ahead of time 57
  58. 58. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Regulatory Compliance 58
  59. 59. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Regulatory Compliance • Ability to raise money from individual investors regulated by the Securities Act of 1933 (the “Securities Act”) and certain state securities laws (“Blue Sky Laws”) • Security Filings will be required with the Securities and Exchange Commission, and unless the financing falls under a self-executing state exemption, with state security agencies 59 59
  60. 60. Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved. Contact Information 60 Anthony Millin, Esq. Partner Pedley, Millin & Gordinier, PLLC 4520 East West Highway, Suite 700 Bethesda, Maryland 20814 Tel: (240) 235-1101 Cell: (301) 908-0005 Fax: (240) 235-1097 Email: almillin@pedleymillin.com Web: www.pedleymillin.com
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