A legal perspective on VC financing in the United States. Article published by Majda Barazzutti, senior counsel of Valla & Associates law firm with offices in the San Francisco Bay Area and New York.

1. November 13, 2013
Majda Barazzutti
© 2013 Valla & Associates, Inc., P.C.
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2. The Venture Capital
Financing Process:
The Legal Perspective
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3. Financing is a Staged Process
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Common Stock
 Bootstrapping
 Friends and Family
 Angels: Equity, Warrants, Convertible Notes
“Series Seed”
Series A Preferred (B, C, etc.)
Liquidity Event
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4. Structure the Initial Process
Correctly
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Securities Laws Filings
Price must be the same: Tax Consequences of
Valuation at Early Stages
Protection of IP
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5. U.S. vs. Italian Process
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Informal
Private
No statutory auditors
No minimum capital requirements
No legal impediments to ongoing losses
Limited bankruptcy laws risks
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6. Convertible Debt
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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
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7. Warrants
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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
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8. Series Seed
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“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
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9. Alternatives: Strategic Investors
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Stage of Product Development: Scalability
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Aims Differ
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Not Interested in Helping the Company Grow
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Conflict of Interest: greater returns from
commercial rights than growth
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Expertise
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Could affect future VC financings
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10. Venture Capital
Identify the Right VC
 Due Diligence
 The Risk of “Finders”
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11. Preferred Stock (Series)
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Why Preferred?
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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
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12. “Clean Up”
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Prior to Investing:
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Document Employees
Founders Relationships
Securities filings
Confidentiality and Invention Agreements
Prepare for VC’s due diligence
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13. Sample Term Sheet
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Binding Provisions:
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No Shop
Confidentiality
Applicable law
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ALL other provisions are not binding
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See examples: NVCA (http://www.nvca.org)
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14. A Typical Term Sheet
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Valuation/Number of Shares/Price
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Liquidation Preference
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Redemption
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Conversion
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Antidilution
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Voting Rights
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Protective Provisions
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Vesting of founders' stock
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15. Valuation/Price
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Pre-money/Post-money valuation: Option pool shuffle
How are your shares valued?
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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 postfinancing 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
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16. Dividends
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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
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17. Liquidation Preferences
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Liquidation Preference: 1x or more
Participating Preferred:
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Full participation
Capped participation
Non-participating
19%
14%
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?
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18. Redemption
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Optional (Company call):
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Company can repurchase stock at original price (plus
dividends) if Investors don’t convert to Common after x years
Mandatory (Investors Put)
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Guaranteed exit path for VC if Company is “successful
enough”
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Investor can force Company to repurchase shares after x
years – beware of redemption premium
But, Company must have funds legally available
22% of all VC financings in 2012, 35% in down rounds
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19. Voting rights/Protective provisions
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Preferred usually votes with Preferred on an “as converted basis”
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Vote by Series/Class
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Usually right to vote on x directors
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Applicable law provides for rights for certain events (merger or
creation of senior preferred stock)
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Investors often add additional actions
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Terminate if Series holds less that minimum % of original
purchase (5-20%)
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Voting Switch - gain majority from an event of default
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20. Voting rights/Protective provisions
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„ Amend Articles / Certificate (or Bylaws)
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Alter rights, preferences of Series A, affect Series A
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Increase or decrease authorized shares Preferred
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Stock
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Merger / acquisition, sale of substantially all assets
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Liquidation / dissolution
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Declare or pay dividend
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Change authorized number of Board Directors
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21. Conversion
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Preferred always has a conversion to Common feature,
but loses all preferred privileges
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Optional Conversion
 Holders can convert to Common at any time
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Automatic Conversion – must convert to Common
if:
 IPO at least $ __(size + price)
 2/3 of preferred (or majority) elect to convert
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22. Conversion
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Conversion Ratio is initially 1:1
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Anti-dilution protection: conversion price adjustment, not
automatic
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“Event-Based” changes: Stock splits, stock dividends, reverse
stock splits
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“Price-Based” changes: Dilutive Financing (financing at lower
price per share)
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Retain same percentage ownership
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)
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23. Anti-Dilution
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Protect investors if company issues equity at a lower
valuation than preferred
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Full Ratchet
Weighted Average: Broad Base: more favorable
Weighted Average: Narrow Base: less favorable to
company
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© 2013 Valla & Associates, Inc., P.C.
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3%
92%
4%
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24. Exclusions from Dilution
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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
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25. Other Terms:
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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
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Demand registration rights
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Piggy-back
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S-3
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Expenses
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26. Other Terms:
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No-shop agreement
Information rights
Confidentiality
Indemnification
Counsel expenses up to ___
Lock-up provisions
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27. Financing Documentation
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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
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28. Bottom Line
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(Almost) anything can be negotiated
Pick your battles: ƒ Liquidation Preferences,
Protective Provisions, ƒ Board Control
Make sure you understand what you’re signing
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29. Thank you!
In bocca al lupo!
Valla & Associates, Inc., P.C.
1990 N. California Blvd., Suite 1060
Walnut Creek, CA 94596
USA
E-mail: majda.barazzutti@vallalaw.com
Phone: +1 925 705 7623 Fax: +1 925 705 7629
www.vallalaw.com
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