How to Prep for Venture Capital Funding Part 2: Venture Capital Terms

© 2020 Haynes and Boone, LLP
Idea to IPO
How to Prep for Venture Capital
Funding Part 2: Venture Capital
Terms
#startup #ideatoipo
Roger.royse@haynesboone.com
1
Roger Royse
@rroyse00

© 2020 Haynes and Boone, LLP© 2020 Haynes and Boone, LLP
Disclaimer
No information contained in this presentation is to be construed as legal
advice. No information contained in this presentation is intended or
related to any particular factual situation. Nothing herein forms an
attorney-client relationship. If legal advice or other expert assistance is
required, the services of a competent professional should be sought.
2

Venture Capital
3

4

5

6

Executive Summary
 Team
 Projections
 Market
 Industry
 IP and Patents
7

Pitch Deck
 Market Size
 Team
 Product
 Go To Market Strategy
 Financials
 Financial Plan
 NOT VALUATION
8

Diligence
 Cap Table
 IP
 Other Legal
9

Cap Table
 Common Stock
 Options
 Warrants
 Convertibles
 Preferred Stock
10

Capitalization
11
Founders 5,000,000 38% 5,000,000 45%
Stock Pool 2,000,000 15% n/a
Series A 3,000,000 23% 3,000,000 27%
Series B 3,000,000 23% 3,000,000 27%
total 13,000,000 100% 11,000,000 100%
Fully Diluted % Issued %

Effect of Valuation Caps
12
Founders 4,000,000 100% 4,000,000 100%
Stock Pool 0 0% n/a
total 4,000,000 100% 4,000,000 100%
Company sells a $1,000,000 SAFE with a $4,000,000 pre money valuation cap
That means that the SAFE will take 20% of the capitalization ($1,000,000/$5.000,000)

Capitalization
13
Founders 4,000,000
50% 5,000,000 63%
Stock Pool 1,000,000
13% n/a 0%
SAFEs 1,000,000
13%
2,000,000
25%
Series A 2,000,000
25% 3,000,000 38%
8,000,000 100%
10,000,000 100%

Capitalization
14
Founders 5,000,000 38% 5,000,000 45%
Stock Pool 2,000,000 15% n/a
Series A 3,000,000 23% 3,000,000 27%
Series B 3,000,000 23% 3,000,000 27%
total 13,000,000 100% 11,000,000 100%

Effect of Valuation Caps
15
Founders 4,000,000 100% 4,000,000 100%
Stock Pool 0 0% n/a
total 4,000,000 100% 4,000,000 100%
Company sells a $1,000,000 SAFE with a $4,000,000 pre money valuation cap
That means that the SAFE will take 20% of the capitalization ($1,000,000/$5.000,000)

SAFEs and Convertible Notes
 Convertible Notes
 Debt obligations that convert to preferred stock
 SAFE
 Convertible equity
 Valuation Cap
 Sets a maximum valuation at which note will convert
 Discount
 Early investors get a discount to the preferred price
 MFN – most favored nation (e.g. discount and cap)
 Change of Ownership
 Investors convert to common or get a multiple on a sale of the company
prior to a priced financing round
16

SAFEs – Valuation Cap
 SAFE price = valuation cap/Number of shares
 Discount – 80% of Preferred price, in SAFE Preferred shares
 SAFE preferred based on price paid for preference and conversion
 e.g. preferred price is $1 and SAFE is $.80 – preference for SAFE should
be $.80
17

SAFEs
 Advantages over notes
 Effect on later rounds
 SAFE Preferred
 Pre Money
 Based on pre investment cap table
 Investors share dilution on increases in option pool
 Pro rata in the B round
 Post Money
 Options and SAFEs dilute founders
 Post Money cap is cap on value (with SAFEs) before the equity round
 Post money SAFE pro rata rights (side letter)
 Right to participate in equity round to maintain percentage
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Pre Money vs Post Money SAFEs
 Pre Money
 Simpler
 Investors share dilution
 Cannot calculate post money percentages
 Post Money
 Options and SAFEs dilute founders
 More complex
 Investors know what percent they will have before equity round
19

Series Seed Preferred
 Priced round with one stock investment agreement
 Non-participating preferred liquidation preference
 Limited protective provisions
 MFN on registration rights, price-based anti-dilution, redemption
rights, etc.
 Right of first offer on future financings
 P/s gets one of 3 Board seats
 Unaudited financial statements.
 Drag along
 Legal fees of $10K for investors counsel
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Series Seed vs Series A
 No Dividend preference
 No Registration rights
 No anti-dilution protection
 Limited protective provisions
 No Co-sale rights
 No Voting agreement
 Limited representations and warranties
 No legal opinion
21

IP Diligence Issues
 IP Rights
 Patents
 Invention Assignments
 Licenses and ownership
 Data security
22

Other Diligence Issues
 Employment Claims (Homejoy)
 Tax Claims
 Regulatory
 Litigation
 Claims by prior employer
 Entrenched management
 Material agreements
23

Staged Financings
 Enough to get to next valuation event
 2X
 1 to 2 years
 Up vs Down rounds
24

Term Sheets
 Valuation
25

Money –The Priced Round
 VC or Institutional Investor
 Preferred Stock
 Valuation Methods
 Score Card
 Venture Capital Method
 Berkus Method
 Cayenne Calculator
 Risk Factor Summation
 Negotiation
26

Money –The Priced Round
 More Valuation Methods
 (Patents + People) x $1 Million
 Comparables
 Discounted Cash Flow
 Market Multipliers
 Discount to Public Companies
27

Participation
 Participating preferred stock returns its investment and then shares
pro rata in proceeds of a sale
 Non-participating convertible preferred stock either gets a return of its
investment or its pro rata share of proceeds
 Participation may be capped at a multiple of the investment
 Conversion to common – auto-conversion and majority vote
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Dividends
 Preferred will have a dividend preference.
 Preferred dividend paid before common
 A cumulative dividend on preferred shares must be paid before any
other dividends on common.
 If the company can't pay out a cumulative dividend in a year, the amount
is carried forward.
 Common in private equity deals, not in venture
 Non-cumulative: If the corporation does not pay dividends in a
year, no right to claim the unpaid dividends in future
 When as and if declared.
29

Liquidation Preference
 Who gets paid first and how much?
 Multiple preference (e.g. 2X)
 Caps
30

Example of Liquidation Preference
 1X Non-participating convertible preferred
 $1,000,000 invested for 10%
 Ex 1: Exit (sale) of company for $5,000,000
 Ex 2: Sale for $20,000,000
31

Board Representation
 Size of board
 Founder-friendly boards
 Role of the Board
 Observers
 Indemnification
 Insurance
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Board Rights
 Indemnification
 D&O Insurance
 Right to designate
33

Protective Provisions
 Class vote or majority vote
 Super majority vote
 Delaware law
 Separate vote for later investors
 Do the interests of different
investors diverge?
34

Protective Provisions
Standard:
 Right to veto or block certain corporate
actions
 Sale of the company
 Amendment to the company’s certificate or
bylaws so as to adversely alter or change the
rights of preferred stock
 Increase or decrease in the number of
authorized shares of preferred or common
 Authorization or issuance of equity security
having a preference over, or being on a parity
with, preferred stock
 Redemption of shares of preferred stock or
common stock
 Declaration or payment of dividends
 Change in the authorized number of directors
of the company
Other:
 Hiring, firing or change in the compensation of
officers
 Any transaction with any director, executive or
employee of the company
 Incurrence of indebtedness in excess of
$[____]
 Change in the principal business of the
company or the entering into any new line of
business
 Any purchase of a material amount of assets
of another entity
 Option plan increase
35

Information Rights
 Financial statements and other information
 Thresholds
36

Registration Rights
 Requires a company to list the shares publicly so that the investor
can sell
 Demand rights
 Piggyback rights
 S-3 rights
37

Pro Rata Rights
 Major investors
 Right to maintain percentage in later round
 May be an issue for an oversubscribed round
38

Common restrictions: Co-Sale Rights,
ROFR, Drag Along
 Co Sale and Tag-Along Rights – right to participate in a sale
 Right of First Refusal – right of company (first) and investors (second)
to require shares to be offered to each of them before a third-party
sale
 Drag Along – right to force shareholders to sell in an exit
 Board, common and preferred approvals
 Small shareholder carveout
39

Founder Vesting
 Term, milestones, commencement
 Acceleration
 Single and double triggers
 Resetting or unvesting
 Extended exercise periods
40

Option Plan
 Increased pre money
 409A valuations
 Extended exercise periods for NSOs
41

Redemption Rights
 Feature of Preferred Stock
 Right to put stock to company, usually after a period of time and over
time
 Is effectively a right to force a sale of the company
42

Anti-Dilution
 Broad-based weighted average
 Narrow-based weighted average
 Full ratchet
43

Exclusivity
 No-shop
 30 to 60 days
44

Non-Binding
 30 day no shop
 Confidentiality
 Is it really nonbinding?
45

Section 382 – In General
 The U.S. has rules that prevent trafficking in losses.
 Section 382 restricts the ability of a “loss corporation” to claim NOLs
generated before the sale against income earned after the sale if there
has been an “ownership change.”
 An ownership change occurs if the percentage of stock owned by 1 or
more 5 percent shareholders increases by more than 50 percent
during a 3 year period.
 The NOL limitation for any year after an ownership change is equal
to the value of target immediately prior to the change, multiplied by
the long-term tax-exempt rate
46

Planning for Later Rounds
 Overly favorable terms
 Valuation planning and down rounds
 Reverse splits
 Cap table management
 Fire the CEO
47

Corporate Venture Capital
 Strategic objectives
 Less operational involvement
 Right of first refusal, right of first offer, right of first look
48

Troubled Company Terms
 Forced conversion to common
 Full ratchet
 Uncapped participating preferred
 Insider rounds
 Low valuations
 Down rounds
 Trigger anti dilution protection unless waived
 Pay to play
 Requires existing investors to invest on a pro rata basis in subsequent
rounds or they lose preferential rights (anti-dilution, liquidation
preferences, voting rights)
49

Comparing Term Sheets
50
VC 1
$3 million
1x Non participating
Valuation - $8 million
Option Pool 20%
VC 2
$4 million
1X participating
w/cap
Valuation - $8.5
million
Option Pool – 25%

Successful Exits
 IPO
 Sale or Acquisition
51

Unsuccessful Exits
 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and creditors?
52

In re Trados Inc. Shareholder Litigation
 Board adopted a management incentive plan (MIP) that was
structured so that once an offered sale price for Trados exceeded the
venture capitalists’ liquidation preference, compensation to the
preferred stockholders would increase substantially at the expense of
common stockholders.
 Preferred received most of their preferences, MIP got $7.8 million,
common got nothing
 Interested director transaction
 Entire fairness standard
 Fair process
 Fair price
53

Best Practices
 Duties to common and preferred
 Independent boards
 Entire fairness standard
 Good process and minutes
 Bankers
 Separate votes
54

Other Unsuccessful Exit Issues
 Tax Liability
 Personal Liability
 Tax
 Employment
 Fiduciary Claims
 Securities Law Claims
 Contractual
 Pierce the veil and creditor claims
 Serial Entrepreneurs and failed companies
55

AUSTIN
600 Congress Avenue
Suite 1300
Austin, TX 78701
United States of America
T +1 512.867.8400
F +1 512.867.8470
CHARLOTTE
101 S. Tryon Street
Suite 2250
Charlotte, NC 28280
T +1 980.771.8200
F +1 980.771.8201
CHICAGO
180 N. LaSalle Street
Suite 2215
Chicago, IL 60601
T +1 312.216.1620
F +1 312.216.1621
DALLAS
2323 Victory Avenue
Suite 700
Dallas, TX 75219
T +1 214.651.5000
F +1 214.651.5940
DALLAS - NORTH
2505 North Plano Road
Suite 4000
Richardson, TX 75082
T +1 972.739.6900
F +1 972.680.7551
DENVER
1050 17th Street
Suite 1800
Denver, CO 80265
T +1 303.382.6200
F +1 303.382.6210
FORT WORTH
301 Commerce Street
Suite 2600
Fort Worth, TX 76102
T +1 817.347.6600
F +1 817.347.6650
HOUSTON
1221 McKinney Street
Suite 2100
Houston, TX 77010
T +1 713.547.2000
F +1 713.547.2600
LONDON
1 New Fetter Lane
London, EC4A 1AN
United Kingdom
T +44 (020) 8734 2800
F +44 (020) 8734 2820
MEXICO CITY
Torre Esmeralda I, Blvd.
Manuel Ávila Camacho #40
Despacho 1601
Col. Lomas de Chapultepec,
DF 11000
Mexico City, Mexico
T +52.55.5249.1800
F +52.55.5249.1801
NEW YORK
30 Rockefeller Plaza
26th Floor
New York, NY 10112
T +1 212.659.7300
F +1 212.918.8989
ORANGE COUNTY
600 Anton Boulevard
Suite 700
Costa Mesa, CA 92626
T +1 949.202.3000
F +1 949.202.3001
PALO ALTO
525 University Avenue
Suite 400
Palo Alto, CA 94301
T +1 650.687.8800
F +1 650.687.8801
SAN ANTONIO
112 East Pecan Street
Suite 1200
San Antonio, TX 78205
T +1 210.978.7000
F +1 210.978.7450
SHANGHAI
Shanghai International
Finance Center, Tower 2
Unit 3620, Level 36
8 Century Avenue, Pudong
Shanghai 200120, P.R. China
T +86.21.6062.6179
F +86.21.6062.6347
THE WOODLANDS
10001 Woodloch Forest Drive
Suite 200
The Woodlands, TX 77380
T +1 713.547.2100
F +1 713.547.2101
WASHINGTON, D.C.
800 17th Street NW
Suite 500
Washington, D.C. 20006
T +1 202.654.4500
F +1 202.654.4501
56

How to Prep for Venture Capital Funding Part 2: Venture Capital Terms

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