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Inside The Mind Of The Venture Capitalist: Decoding Legal Structures & Investment Terms


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Published in: Economy & Finance, Business

Inside The Mind Of The Venture Capitalist: Decoding Legal Structures & Investment Terms

  1. 1. Decoding Legal Structures & Investment Terms
  2. 2. About The Lawyer Mark McLaughlin - 10+ years of corporate legal experience - Counsels companies on legal formation and initial rounds of investment - Represented clients in purchase, sale, public and private securities issuances - Assists clients with daily business issues such as employment agreements and license agreements - Works with Golenbock Eiseman Assor Bell & Peskoe LLP and worked with a number of New York law firms including Weil Gotshal and Reed Smith 2
  3. 3. About The VC J. Skyler Fernandes - VC @ Centripetal Capital Partners, invests $1-3M across industry sectors - VC Mentor @ ER Accelerator - Entrepreneur - co-founded a number of internet startups - Leader Of Missing Middle Initiative, launched at World Economic Forum Connect With J. Skyler Fernandes: 3
  4. 4. DisclaimerThis presentation is intended to be used for educationalpurposes only and not to replace independent professionaljudgment. Statements of fact and opinions expressed arethose of the participants individually and, unless expresslystated to the contrary, are not the opinion or position of anycompany or organization. Inside the Mind of VentureCapitalist and its speakers do not guarantee the accuracy orcompleteness of the information included in thispresentation and accepts no responsibility for anyconsequence of its use. 4
  5. 5. Choosing A Business StructureMost Common Entities:• Sole Proprietors• Partnerships• Limited Liability Company (LLC)• Corporation (Inc.)Issues to Consider:• Potential risks and liabilities of your business• Formalities and expenses involved in establishing and maintaining the business structure• Income tax situation• Investment needs 5
  6. 6. Limited Liability Company (LLC) (VC’s 2nd Choice) For the majority of small businesses, creating an LLC is the best choiceProtects: • Personal assets from debts & liabilities of the businessRequires: • Adequate capitalization, observe corporate formalities, create and maintain separate bank accountsLLC Profits Are Not Taxed: • Single level of taxation: only at personal level (i.e. salary/distributions) • Tax benefit of passing losses to investors during early stageFlexibility: • LLCs are incredibly flexible = can make complex (for better/worse) • Can be converted into a Corp, before going public (IPO) 6
  7. 7. Corporation (Inc) (VC’s 1st Choice)It Makes Sense To Create A Corporation When…• You expect to have multiple investors in your business or IPO in future• You want to provide fringe benefits to owners• You want to entice or keep key employees by offering stock options and stock bonus incentivesCorporations Require…• formal record keeping and less flexibility in management structure and method of distributing profits and losses• Less flexible, but more straight forward for stock option plans, creating two or more classes of stock (Common, Preferred), transferability of equity, etc.“C” corporation profits are taxed• Double taxation: the business and your salary/distributions• Tax gains / losses held within company, not passed through to investors“S” corporation tax benefits• Shareholder may pay less self-employment tax than an LLC member with similar income 7
  8. 8. Securities Regulation / Capital Raise• Non-Accredited Investor (Ex. Friends/Family)• Accredited Investors (Ex. Friends/Family/Angels) – A net worth of $1M+, not including primary residence – Made $200,000+ last two years ($300,000 with spouse) and expect to make same amount this year – A general partner, executive officer, director or a related combination for the issuer of a security• Qualified investor (Super Angels/VCs) – Qualified investors are individuals, trust accounts or institutional funds with at least $5 million to invest 8
  9. 9. Securities Regulation / Capital Raise• Investment Banking Fee vs. Referral Fee• Seed Round (Friends/Family/Angels) (Up to $1M) – Equity (Ex. 3M-5M valuation) – Convertible Debt w/ Interest • @ set share price after period of time • Into Series A • Discount price into Series A• Series A (VC’s & Financial Institutions) ($1M+)• Series B, C, D (Follow on rounds) 9
  10. 10. Intellectual Property Types Of Intellectual Property:Copyrights / Trade Secrets PatentsTrademarks 10
  11. 11. Copyright• Covers original works of authorship fixed in a tangible medium – Books, dance, movies, music, computer programs – Protects expression not ideas• Term – Life of known author plus 70 years – Shorter of 95 years from publication or 120 years from invention 11
  12. 12. TrademarkRight created to protect the identification of the sourceor affiliation of goodsCovers: – Words – Symbols – Colors – SoundsTerm: Potentially unlimited if protected and not abandoned 12
  13. 13. Trademark• Strength is in distinctiveness• Registered with the government• Use it: – Affix it to goods, stationary, documents, etc.• Indicate that it is a protected mark – TM and SM indicate federally registered marks – [circle R] not federally registered but still protected mark• Abandonment – Failure to protect as outlined above – License the mark alone without other assets – License the right to control the mark 13
  14. 14. Trade Secret• Covers: Proprietary information ­ Customer lists ­ Training methods ­ Business strategy ­ Formula for Coke and Pepsi• Property of the business• Subject to confidentiality protections• Not registered or filed• Proprietary (not in the legal sense) can also be… – Team / Individuals (There is only one of YOU!) – Experience (Unique insight) – Network (Able to reach /execute where others cannot) 14
  15. 15. Patent• Covers – Non-obvious new and useful inventions – Description, drawings and claims• Comprises exclusive rights - Make, sell or offer those inventions• Term - 20 years from filing a patent• Process can be long and expensive - Consult IP attorney• Design - Visual (non-functional) features of manufactured goods• Utility - Protects process, machine, manufacture, or composition• Non-provisional - Establishes filing date and begins examination• Provisional - Only establishes filing date and expires after one year 15
  16. 16. Patent• Preparing Patent Application• Filing Application – Secure filing date, claimed invention is officially “patent pending.” – Filing fees may be in the range of $500-$1,000• Prosecuting Your Patent Application – Assigned patent examiner to review, searching relevant prior art, make any objections and rejections of claims – Lengthy/Expensive process• Allowance / Issuance – Utility: $1,510, Design: $860 (Half price for small entities)• Maintenance – Maintenance fees 3.5 ($980), 7.5 ($2,480) and 11.5 ($4,110) years – Half price for small entities 16
  17. 17. Intellectual Property – TipsProtect brand by staking out Online / Social Media Real Estate: Web URLs 17
  18. 18. Valuation• Valuation Should Be Reasonable – Not to high too, not too low (Build value) – Investors ultimately determines valuations NOT Entrepreneurs – 2-3+ rounds before exit, don’t want to do a down round• Size of Capital Rounds – Too much capital is just as bad as not enough capital (Dilution)• Terms of current round is built on results from previous round• If company doesn’t meet expectations – Next round investors will require higher return and more rights 18
  19. 19. Equity• Common Shares – Indicates ownership of a company – Right to company’s assets AFTER company pays debt & preferred shares• Preferred Shares (Special rights) – Liquidation Pref, 1x, 2x, 3x principal capital invested (prior to common) – Warrant Coverage (Cash/Cashless  Preferred or Common shares) – Anti-dilution (Weighted Average, Full Ratchet, Not price based) – Blocking rights (Company sale, equity financings) / Demand Sale or IPO – Rights to invest on a pro rata basis in future equity financings – Information & inspection – Voting: Rights to approve certain corporate actions / Board Members• Participating / Convertible Preferred Shares – Special Rights & Voting – Dividends: Rights to payment prior to Common (% of Investment) – Converts to common stock (Double Dipping) 19
  20. 20. Waterfall Dividends + Preferred Converted To Common Preferred, Liquidation Pref 1x-2x 20
  21. 21. Waterfall Exit Value $ 90,000,000 $ 14,250,000Date Preferred Return Invested Liquidation Pref Preferred Return Preferred Return2005 Series B - Venture Fund $ 5,000,000 2x $ 10,000,000 $ 10,000,000 Series B Dividends $ 1,000,000 $ 1,000,0002003 Series A - Venture Fund $ 2,500,000 1x $ 2,500,000 $ 2,500,000 Series A Dividends $ 250,000 $ 250,0002002 Founders Shares $ 500,000 1x $ 500,000 $ 500,000 Total Preferred Return $ 14,250,000 $ 14,250,000 Remaining Cash $ 75,750,000 $ X - Common Return Invested Ownership Common Return Total Return Multiple Common Return2002 Investor A $ 500,000 5.00% $ 3,787,500 $ 3,787,500 7.6x -2002 Investor B $ 500,000 5.00% $ 3,787,500 $ 3,787,500 7.6x -2002 Investpr C $ 500,000 5.00% $ 3,787,500 $ 3,787,500 7.6x -2002 Investpr D $ 500,000 5.00% $ 3,787,500 $ 3,787,500 7.6x -2002 Investor E $ 500,000 5.00% $ 3,787,500 $ 3,787,500 7.6x -2003 Venture Fund A $ 2,500,000 30.00% $ 22,725,000 $ 25,475,000 10.2x -2005 Venture Fund B $ 5,000,000 20.00% $ 15,150,000 $ 26,150,000 5.2x -2002 Founders $ 500,000 25.00% $ 18,937,500 $ 19,437,500 38.9x - Total Common Return $ 10,500,000 100.00% $ 75,750,000 $ 90,000,000 $ - 21
  22. 22. Dividends• Accruing Dividends for first 1-2yrs (early stage companies)• PIK = Paid-In-Kind (via stock), when unable to pay cash• Carrot (cash) & Stick (dilution)• Cash along the way vs. just as the end 22
  23. 23. Key Terms for Founders / Employees/Advisors• Founders (Uneven ownership is best)• Employees (Salary + equity)• Advisors (0.25%-1%, with milestones that lead to revenue or capital)• Vesting, single-trigger, 4yrs, termination clause• Deferred salary with interest, catch up upon exit (above common upon liquidation)• Upon Hitting Milestones – Additional Options / Warrants (Adding shares) – Clawbacks (Reducing / Transferring shares)• Employee Bonus Pools – Created before or after investment rounds 23
  24. 24. ExitsLiquidation: the exit strategy – IPO – Strategic Sale (Competitor / Partner) – Financial Buyer (PE - Strong cash flows) – Merger – Management Buyout 24