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Conquering The Term Sheet Everything You Need To Know About Deal Terms Part 3

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Join us for the 3rd (and final) installment of our Q&A session with OurCrowd Partners, Zack Miller (Investor Community) and David Stark (Investments), about the fundamentals of deal terms in startup investing.

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Conquering The Term Sheet Everything You Need To Know About Deal Terms Part 3

  1. 1. Conquering the Term Sheet Everything You Need to Know About Deal Terms Part 3
  2. 2. David Stark Partner, OurCrowd @starkupnation Zack Miller Partner, OurCrowd @newrulesinvest
  3. 3. OurCrowd Leading equity crowdfunding platform with 8000+ investors from over 100 countries
  4. 4. Mailbox: Liquidation preferences It depends. Pro rata rights are a right, not an obligation. Things to remember: Lean on your winners. Avoid being crushed. Important note: If you have the opportunity to buy up, why not? Q: Should I exercise my pro rata rights?
  5. 5. Quick Review Lesson 1 - Equity Valuation Liquidation preferences ESOP Key takeaway Need to look at the WHOLE term sheet to see the full picture Lesson 2 - Equity Pro rata rights Anti-dilution protection Control provisions Key takeaway Need to have opportunity to continue backing your winners
  6. 6. Today’s agenda Convertible notes Pros and cons (investor/entrepreneur) Amount/maturity Interest Conversion Discount Cap Auto/voluntary conversion Repayment SAFE
  7. 7. Convertible Notes Structured as a loan, converts to equity if certain events occur (generally upon a future financing)
  8. 8. Why use a convertible loan? • Increases STM (Speed to Money) • Can be a “bridge” to next round, maximizing value creation and reducing dilution • Increased flexibility with size of investment, equity stake sold • Often no control provisions, board representation The entrepreneur’s Perspective
  9. 9. Why use a convertible loan? • Faster, easier, cheaper • Enables securing of deal • Get some built-in upside • Downside protection The Investor’s Perspective • First investment: displaces valuation discussion onto larger institutional entity • Follow on: provide company with bridge to next round Use Cases
  10. 10. Keeping the faith Eventual rights and preferences are unknown at the time of investment…
  11. 11. Loan Amount How much money is going to be invested by you + How much money will be invested by others (What is the timeframe for others to join)
  12. 12. Maturity Length of the loan period Typically 12-24 months
  13. 13. Interest Convertibles are loans and have interest rate associated with them
  14. 14. Secured vs. Non-secured Underlying assets to seize or personal guarantee
  15. 15. Prepayment Note may not be prepaid without the consent of the lender
  16. 16. Interest Interest accrues rather than being paid out Simple vs Compound Interest 8% interest per annum Invest $1M, converts to equity in exactly one year Equivalent of having invested $1.08M Example After 2 years: $1.16M vs. $1.1664 M
  17. 17. Conversion Move from debt to equity
  18. 18. Automatic vs. Voluntary Conversion Exactly as it sounds, some conversions are forced when certain conditions are met Others are optional
  19. 19. Automatic Conversion “Prior to the Maturity Date, upon receiving notice from the Company that the Company has raised more than $X million in funds in which it has issued preferred shares (“Qualified Financing”), then the Note will automatically convert all principal, together with all accrued and unpaid interest under the Note, into the shares issued in such Qualified Financing. The conversion price will be a price per share equal to…”
  20. 20. Automatic Conversion “Prior to the Maturity Date, upon receiving notice from the Company that the Company has raised more than $X million in funds in which it has issued preferred shares (“Qualified Financing”), then the Note will automatically convert all principal, together with all accrued and unpaid interest under the Note, into the shares issued in such Qualified Financing. The conversion price will be a price per share equal to…” Threshold ensures balance between institutional lead investor and pragmatic fundraising plans
  21. 21. Automatic Conversion “Prior to the Maturity Date, upon receiving notice from the Company that the Company has raised more than $X million in funds in which it has issued preferred shares (“Qualified Financing”), then the Note will automatically convert all principal, together with all accrued and unpaid interest under the Note, into the shares issued in such Qualified Financing. The conversion price will be a price per share equal to…” Important because don’t want common stock
  22. 22. Automatic Conversion “Prior to the Maturity Date, upon receiving notice from the Company that the Company has raised more than $X million in funds in which it has issued preferred shares (“Qualified Financing”), then the Note will automatically convert all principal, together with all accrued and unpaid interest under the Note, into the shares issued in such Qualified Financing. The conversion price will be a price per share equal to…” Well, it’s just automatic
  23. 23. Automatic Conversion “Prior to the Maturity Date, upon receiving notice from the Company that the Company has raised more than $X million in funds in which it has issued preferred shares (“Qualified Financing”), then the Note will automatically convert all principal, together with all accrued and unpaid interest under the Note, into the shares issued in such Qualified Financing. The conversion price will be a price per share equal to…” See Lesson 1,2 of our lecture series Get rights and preferences of equity round
  24. 24. So, now you know which shares you’ll receive. But what are you paying for them??
  25. 25. Conversion Price The conversion price will be a price per share equal to the lower of: (i) y% of the price paid in the Qualified Financing (ii) a price per share reflecting a company pre- money valuation of $X Discount Cap
  26. 26. Conversion Price Discount to the price/share paid in the next equity round Typically 10%-30% (most often 20%) Discount Cap “(i) y% of the price paid in the Qualified Financing”
  27. 27. Conversion Price Discount Cap “(i) y% of the price paid in the Qualified Financing” Time-triggered discount: no discount if next round w/in 90 days from closing Escalating discount: 15% within 90 days, 25% after 90 days but prior to 180 days, 35% after 180 days Examples of variations
  28. 28. Real Life Example Conversion Price 20% discount: next round = $1.00 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share. $500,000 convertible note —> 625,000 shares ($500,000 / $0.80) New $500,000 equity investor —> 500,000 shares ($500,000 / $1.00) Discount Cap
  29. 29. Conversion Price Discount Cap (ii) a price per share reflecting a company pre-money valuation of $X Maximum conversion valuation (regardless of valuation of next round)
  30. 30. Conversion Price Discount Cap (ii) a price per share reflecting a company pre-money valuation of $X breakeven point is $X/Y% eg. lower of 80% of pps or $20M cap —> $20M/8% = $25M <$25M 20% discount >$25M $20M cap (discount > 20%) Next round valuation
  31. 31. Conversion Price Discount Cap Importance of a cap for investors • Protect upside on risk-adj basis • Align interests • Protection vs. tail risk Balance with management not wanting cap to set next round’s valuation
  32. 32. Non Qualified Financing Financing round that doesn’t meet the criteria Can voluntarily convert
  33. 33. M&A prior to conversion Don’t want to just get repaid 1. Receive multiple of investment (e.g. 2x or 3x) 2. Convert at a discount to purchase price 3. Convert at predetermined price (e.g. last round’s post money) 3 options
  34. 34. What happens at maturity?
  35. 35. What happens at maturity? Repayment or Conversion at Predetermined Price Repayment (w/ option to convert): • entrepreneur can view as ticking time bomb • investor unlikely to get repaid anyways • inability to repay = insolvency Automatic Conversion @ Predetermined Price: • valuation signal when trying to raise equity round?
  36. 36. Issues with Convertibles • have more downside protection than full ratchet (Lesson 2!) • can result in >1x liquidation preference (Lesson 1!) • have features of debt even though intention is equity
  37. 37. Alternatives
  38. 38. Priced Convertible Debt Floor to go with the ceiling
  39. 39. SAFEs: Simple Agreement for Future Equity
  40. 40. SAFEs
  41. 41. Next step? Thanks for joining us for our Term Sheet series OurCrowd.com Check out our real-life term sheets by accrediting on our website

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