Term Sheets and Convertible Notes:Structuring the DealHanson Bridgett LLP425 Market Street, 26th FloorSan Francisco, CA 94...
Convertible Note Basics• Key Points:• Term• Conversion: Optional or Automatic• Discount• Prepayment?• Interest Rate• Warra...
Examples• Total loaned = $1,000,000• Automatic Conversion upon “Qualified Financing”• Qualified Financing = $2,000,000• Lo...
Term Sheet Basics• What is a Term Sheet?• Is it Binding?• No Shop• NDAs• Fees
Deal Basics• Type of Security• Purchasers – Accredited v. Nonaccredited• Documents to get the deal done
Dividends• When paid• Noncumulative v. Cumulative
Liquidation Preference• What is it?• How Much?• Participating?• Capped?• Trigger
Examples• Assume a Series A Preferred round that raises $1,000,000 based on a $2,000,000 pre-money valuation $1 + $2 = $31...
Conversion• Optional• Automatic• Ratio 1:1
Antidilution• What is it?• Weighted Average• Narrow- includes preferred and common• Broad- includes preferred, common, opt...
Difference Between Broad and NarrowWeighted Average• The definition of Stock Outstanding• Broad: includesCommon, Preferred...
Example: Ratchet• Assume:– $1,000,000 raised in Series A at $1.00 per share– Pre-money valuation = $3,000,000– Series A co...
Weighted Average FormulaAP = OP x CSO + (NM/OP)CSO + ASAP= Adjusted conversion price (after the application of weighted av...
Example: Broad Based WeightedAverage• Assume:– $1,000,000 raised in Series A at $1.00 per share– Pre-money valuation = $3,...
Example: Narrow Based Weighted Average• Assume:– $1,000,000 raised in Series A at $1.00 per share– Pre-money valuation = $...
Redemption• Mandatory – 5 years (investors may give this up)• Optional
Board of Directors• Total number• Number elected by common• Number elected by preferred• Outside directors?• Advise at lea...
Protective Provisions• Voting In General• What Protective Provisions Cover– Senior securities– Liquidation, change of cont...
Registration Rights• Demand• Piggyback• S-3
Miscellaneous• Right of First Offer (Right to make first offer)• Right of First Refusal (Right to make last offer)• Co-Sal...
Angel Killers• No Term Sheet• Variance from Term Sheet• Hiding the Ball/Due Diligence Surprises• Cap Table Problems• Manag...
The End
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Hansen Bridgett: Term Sheets & Convertible Notes, Structuring the Deal

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Jonathan Storper, Partner Hanson Bridgett & Leslie Keil, Senior Counsel, Hanson Bridgett

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Hansen Bridgett: Term Sheets & Convertible Notes, Structuring the Deal

  1. 1. Term Sheets and Convertible Notes:Structuring the DealHanson Bridgett LLP425 Market Street, 26th FloorSan Francisco, CA 94105415-777-3200Jonathan S. Storper and Leslie A. Keiljstorper@hansonbridgett.com and lkeil@ hansonbridgett.comMay 8, 2013Spring 2013 Venture Fair and ForumSan FranciscoMay 7-9, 2011
  2. 2. Convertible Note Basics• Key Points:• Term• Conversion: Optional or Automatic• Discount• Prepayment?• Interest Rate• Warrant Coverage• Security• Covenants
  3. 3. Examples• Total loaned = $1,000,000• Automatic Conversion upon “Qualified Financing”• Qualified Financing = $2,000,000• Loan converts into equity according to the following formula:(Balance of loan + interest accrued)Per Share price in Qualified Financing• Thus, if $2,000,000 raised in a Qualified Financing at $1.00 a share, amount loaned convertsinto 1,000,000 shares; if $2,000,000 raised at $0.50 a share, the amount loaned converts into2,000,000 shares• Effect of 20% Discount:– Discount applies to the per share price at which the loan would otherwise convert.– If the $1,000,000 loan would otherwise convert at $1.00 a share, the discounted conversion pricebecomes $0.80 a share, yielding 1,250,000 shares on conversion rather than 1,000,000– If the $ $1,000,000 loan would otherwise convert at $0.50 a share, the discounted conversion pricebecomes $0.40 a share, yielding 2,500,000 shares on conversion rather than 2,000,000
  4. 4. Term Sheet Basics• What is a Term Sheet?• Is it Binding?• No Shop• NDAs• Fees
  5. 5. Deal Basics• Type of Security• Purchasers – Accredited v. Nonaccredited• Documents to get the deal done
  6. 6. Dividends• When paid• Noncumulative v. Cumulative
  7. 7. Liquidation Preference• What is it?• How Much?• Participating?• Capped?• Trigger
  8. 8. Examples• Assume a Series A Preferred round that raises $1,000,000 based on a $2,000,000 pre-money valuation $1 + $2 = $31/3 = 33%• Thus, upon the closing, the preferred investors will own 33% on a fully diluted basis• Assume a sale for $10,000,000• Liquidation Preference = 1x non-participating– Preferred investors get $1,000,000 if they do not convert to common– Preferred investors get $3,333,333 if they convert to common• Liquidation Preference = 1x participating– Preferred investors get $4,000,000 if they do not convert to common($1,000,000 + $3,000,000)– Preferred investors get $3,333,333 if they convert to common• Liquidation Preference = 1x participating capped at 3x– Preferred investors get $3,000,000 if they do not convert to common– Preferred investors get $3,333,333 if they convert to common
  9. 9. Conversion• Optional• Automatic• Ratio 1:1
  10. 10. Antidilution• What is it?• Weighted Average• Narrow- includes preferred and common• Broad- includes preferred, common, options,warrants, others• Ratchet• Carve-outs
  11. 11. Difference Between Broad and NarrowWeighted Average• The definition of Stock Outstanding• Broad: includesCommon, Preferred, options, warrants, etc.• Narrow: includes only the Preferred• The more narrow, the larger the adjustmentto the conversion price = greater punitive toFounders
  12. 12. Example: Ratchet• Assume:– $1,000,000 raised in Series A at $1.00 per share– Pre-money valuation = $3,000,000– Series A converts to common on a 1:1 basis• Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of4,000,000 total)• Assume:– $500,000 raised one year later in Series B at $0.50 a share– Pre-money valuation = $2,000,000– Series B converts to common on a 1:1 basis• Thus, Series B owns 20% of the Company on as-converted basis (i.e., 1,000,000 out of5,000,000 total)• Assume:– No anti-dilution protection, Series A owns 20% of Company after the sale of the Series B (1,000,000shares out of 5,000,000 total).– Full ratchet anti-dilution protection, then the conversion price for the Series A Preferred is reducedfrom $1.00 per share to $0.50 per share.• Thus, full ratchet means that upon conversion, Series A entitled to receive 2,000,000 sharesof common stock rather than 1,000,000 shares of common stock.
  13. 13. Weighted Average FormulaAP = OP x CSO + (NM/OP)CSO + ASAP= Adjusted conversion price (after the application of weighted avg anti-dilution)OP= Old conversion price (before the application of weighted avg anti-dilution)CSO= Number of shares of Common Stock Outstanding immediately prior todilutive issuance [the difference between Broad and Narrow]NM= New Money raised as a result of the dilutive issuanceAS= Number of Additional Shares issued in the dilutive issuance
  14. 14. Example: Broad Based WeightedAverage• Assume:– $1,000,000 raised in Series A at $1.00 per share– Pre-money valuation = $3,000,000– Series A converts to common on a 1:1 basis• Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total)• Assume:– $500,000 raised one year later in Series B at $0.50 a share– Pre-money valuation = $2,000,000– Series B converts to common on a 1:1 basis• Assume:– Broad-based weighted average anti-dilution provision:$1.00 x 4,000,000 + ($500,000/$1.00) = $0.904,000,000 + 1,000,000• Thus, the adjusted conversion price is $0.90 and the conversion ratio is adjusted to 1:0.9• Upon conversion, Series A with broad based weighted average protection would be entitled to receive1,111,111 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection and2,000,000 shares with full ratchet protection).• This will have a much less punitive effect on the companys founders and management than a full ratchet anti-dilution provision
  15. 15. Example: Narrow Based Weighted Average• Assume:– $1,000,000 raised in Series A at $1.00 per share– Pre-money valuation = $3,000,000– Series A converts to common on a 1:1 basis• Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000total)• Assume:– $500,000 raised one year later in Series B at $0.50 a share– Pre-money valuation = $2,000,000– Series B converts to common on a 1:1 basis• Assume:– Narrow-based weighted average anti-dilution provision:$1.00 x 1,000,000 + ($500,000/$1.00) = $0.751,000,000 + 1,000,000• Thus, the adjusted conversion price is $0.75 and the conversion ratio is adjusted to 1:0.75• Upon conversion, Series A with narrow based weighted average protection would be entitled to receive1,333,333 shares of common stock (compared to 1,000,000 shares with no anti-dilutionprotection, 1,111,111 with broad-based weighted average protection and 2,000,000 shares with fullratchet protection).• More punitive effect on the companys founders and management than broad based weightedaverage, but still less than a full ratchet anti-dilution provision
  16. 16. Redemption• Mandatory – 5 years (investors may give this up)• Optional
  17. 17. Board of Directors• Total number• Number elected by common• Number elected by preferred• Outside directors?• Advise at least 5• Angels elect as group
  18. 18. Protective Provisions• Voting In General• What Protective Provisions Cover– Senior securities– Liquidation, change of control– Amendments of Articles, Bylaws– Change rights of preferred– Information Rights– Change in corporate purpose• How long are they in effect?
  19. 19. Registration Rights• Demand• Piggyback• S-3
  20. 20. Miscellaneous• Right of First Offer (Right to make first offer)• Right of First Refusal (Right to make last offer)• Co-Sale (Right to participatein the sale)• Exceptions – certain amountof shares each year; familymembers; estate planningpurposes• Closing Conditions
  21. 21. Angel Killers• No Term Sheet• Variance from Term Sheet• Hiding the Ball/Due Diligence Surprises• Cap Table Problems• Management Structure/Team• Material Contracts & Agreements• Board composition• No Clear Exit Strategy• Too Many Cooks• Lack of IP
  22. 22. The End

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