Funding 101 for Tech Entrepreneurs

© 2020 Haynes and Boone, LLP
Idea to IPO
Funding 101 for Tech Entrepreneurs
#startup #ideatoipo
1
Roger Royse
@rroyse00

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

 Investors are partners
 Stage your financing
 Most funding is dilutive
 Your valuation might have little to do with what you are worth
 Valuation is not your biggest issue
 Avoid early mistakes
 Take cheap money over expensive money
 Common stock is for service providers
 Get a data room
 Do the cleanup ahead of time
3

 Founders – savings, IRAs, credit cards, mortgage equity
 Debt Financing
 Government Grants
 Friends and Family
 Angels or Seed Investors
 Incubators
 Pitch Competitions
 Institutional (VC or Private Equity)
 Alternative Financing:
o Rewards-Based Crowdfunding
o JOBS Act Crowdfinancing
o ICOs, STOs, IEOs
o Royalty Financing (SEALS)
4

 77% of startups rely on personal savings (and their parents) for their initial
funds
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Source: Wells Fargo/Gallup Small Business Index

 Angels - $25,000
 Angel Groups - $250k to $750k
 Early stage VC - $1.5 M and up ($3m to $5M)
 Later Stage VC - $10M and up
6

 Smart Money
 Chemistry
 Commitment
 Deep Pockets
 Network
7

 Bank Debt
 Security
 Personal Guarantees
8

 Free Money from the Government
https://www.usa.gov/grants
https://www.aprise.org/
https://www.sba.gov/funding-programs
SBIR program
STTR grants
9

 38% of startup founders raised money from their
friends and family
 $23,000 was the average amount invested by
friends and family per startup
10

 Angels, VCs, crowdfunding, private equity, etc.
 How much to raise?
 Milestones
 Burn rate
 Target runway
 Equity percentage and valuation
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 Team
 Projections
 Market
 Industry
 IP and Patents
13

 Market Size
 Team
 Product
 Go To Market Strategy
 Financial projections
 NOT VALUATION
14

 Mission
 Problem to be solved
 Solution (aspirin, not vitamins)
 Opportunity
 Competition (or alternatives)
 Product
 Business Model
15

 VC or Institutional Investor
 Preferred Stock
 Valuation Methods
 Score Card
 Venture Capital Method
 Berkus Method
 Cayenne Calculator
 Risk Factor Summation
 Negotiation
16

 More Valuation Methods
 (Patents + People) x $1 Million
 Comparables
 Discounted Cash Flow
 Market Multipliers
 Discount to Public Companies
17

 Kickstarter, Indiegogo
 Marketing effect of offering
 Tax issues
 FTC or state law liability

 Crowdfunding (Title III of the JOBS Act)
 The company issuer may sell up to $5million of securities in a 12-month
period
 Individual investments in all crowdfunding issuers in a 12-month period are
limited by income or net worth tests.
 Platforms
 WeFunder
 Republic
 StartEngine

 Rule 506 now provides for two different types of private offering:
 Rule 506(b) is essentially the same as the old Rule 506, providing an exemption for
non-public offerings but prohibiting general solicitation
 Rule 506(c) is a new exemption that allows general solicitation, but with certain
restrictions and filing requirements
 Rule 506(c): issuers can offer securities through means of general solicitation
as long as:
 All purchasers are accredited investors; and
 The issuer takes “reasonable steps” to verify the accredited investor status
 Crowdfunding
 AngelList
 SeedInvest
 FundersClub
 CircleUp
 OurCrowd

 The JOBS Act included legislation to create what is nicknamed “Regulation
A+”, an upgrade to Regulation A
 The new Regulation A keeps the allowance of non-accredited investors, and
features two kinds of Regulation A offerings, called “Tiers”:
 Tier 1, with a $20 M maximum, does not preempt state law registration, but has low
federal compliance burdens
 Tier 2, with a $75 M maximum, preempts state law registration, but has high
federal compliance burdens including ongoing semi-annual, annual, and current
disclosures

 An ICO is a fundraising mechanism in which new projects sell their underlying
crypto tokens in exchange for bitcoin and ether.
 Similar to an Initial Public Offering (IPO) in which investors purchase shares
of a company.
 Based on tech like ERC20 Token Standard
 Investors send funds (usually bitcoin or ether) to a smart contract that stores
the funds and distributes an equivalent value in the new token
 Often “pre-sold” to raise money to build the platform
 Tokens may have “utility” or security
 Traded on exchanges

 Alternative to regular loans and equity financing
 Company receives a specific amount of money from an investor in exchange
for a percentage of the company's future revenues over a certain period of
time, up to a specific amount.
 Investment can be considered an "advance" to the company, and the periodic
percentage payments can be considered "royalties" to the investors.

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 Angels
 Angel Groups
 Angel Funds
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 The Good:
 Connections to VC funding
 Mentorship
 Risk capital
 The Bad
 Hostage takers
 Whiners
 Demanders
 The Ugly
 Potential plaintiffs
 Disturbers
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 Convertible Notes
 Debt obligations that convert to preferred stock
 SAFE
 Convertible equity
 Conversion feature
 Valuation Cap
 Sets a maximum valuation at which note will convert
 Discount
 Early investors get a discount to the preferred price
 Change of Ownership
 Investors convert to common or get a multiple on a sale of the
company prior to a priced financing round
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 Short term
 Secured?
 Subordinate?
 Interest
 Fixed repayment
 Discount
 Valuation Caps
28

 Simple agreement for future equity
 Pre and Post Money
 Pro Rata Rights
29

 Watered down preferred stock
 Justifies low common stock price
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31
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)
Fully Diluted % Issued %

 Post Money SAFEs
 Valuation caps and excessive dilution
 Securities law violations
 Cap Tables
32

 Investor goals
 Cooperation and Accessibility
 Control
 Terms and Valuation
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Venture Capital

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40

41

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“Avoid venture capital unless you absolutely need it.” Randy
Komisar, venture capitalist*
*Straight Talk For Startups
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 Must give up Equity
 No near term cash flow
 Risky
 Illiquid
 Can the business scale?
 Explosive growth
 Huge market
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 Thematic Investors bet on their thesis of what is next
 Domain Investors focus on an industry that they know well
 Quant Investors focus on data
 People Investors bet on the jockey, not the horse
 Tech investors bet on the horse
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 2% management fee on committed capital
 20% carried interest
 7 to 10 year terms
 LPS want 2 1/2 to 3 times investment return
 VC fund must earn 3 to 4 times investment to
return that amount
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 50% lose money
 20% – 30% are singles or doubles
 The rest must be home runs (10X to 100X)
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 Large potential market
 First Mover or first to market advantage
 Long term scale over short term profits
 Not able to service debt
 Traction!
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 Venture capital will participate in management
 Board seats
 Board Observer
 Management rights letter (for VCOC exemption)
 Seven to ten year term (and longer)
 Precludes small investments
 Board meetings
 Management
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 Team
 Domain expertise
 Technical co-founders
 Technology or product
 Solve problems, address pain points
 Customer validation
 Market size
 Must be a huge market
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 Reputation
 Likelihood of closing
 Stage of fund
 Size of Fund
 How much dry powder?
 Is there a fund 2, fund 3 etc.?
 Are they litigious?
 Deal with decision makers
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 Network
 Temperament
 Advice
 See the published email from the CEO of CircleUp to an
investor at for an example of a VC/Founder relationship
that did not work out
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 Capital intensive business?
 Follow on funding?
 Time to exit
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 Business Model
 Choice of Entity
 Cap Table
 Vesting
 Debt
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 Series Seed
 Pre-Seed
 Series A-1, A-2
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 Micro VC – angels with other people’s money
 Seed Stage Fund – early, first institutional money
 Mid Stage – B and beyond
 Late Stage
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 Lead or Co Lead and followers
 Party rounds
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 Lawyers
 CPA
 Banker/Broker/Finders
 Mentors and Advisors
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 Can you pivot?
 Will it affect customers?
 Follow on investors
 Change in management
 Strategic agreements
 Confidentiality
 ROFR, right of first look, right of first offer
 Strategic objectives
 Less operational involvement
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 Expensive (fees and warrant coverage)
 Secured by IP
 Less dilution
60

 Limited Liability Company (LLC)
 S Corporation (S Corp)
 C Corporation (C Corp)
 Foreign Corporation
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1. Operating Agreements
2. S Elections
3. Suspended Losses
4. 704(c) Allocations
5. Venture Capital
6. QSB Stock
7. Stock Option Plans
8. LLC Debt
9. Reorganizations
10. Fringe Benefits
11. Audits and Liabilities
12. Contingent Allocations
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General Requirements
 Original issue
 Five-year holding period
 100% post-Sept. 27, 2010
 C Corporation issuer
 Up to $10 million or 10 times basis exclusion
 1045 Rollover treatment
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1. QSBS
2. VC’s LPA will not allow investment in a
passthrough
1. Tax exempt investors want to avoid UBTI
2. Foreign investors want to avoid ECI
3. VC wants to be able to manage losses
1. No K-1’s showing losses
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 Vesting
 Equal Percentages
 Subjective
 Formula

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FAST Model
Valuation
Milestones and
Deliverables
Vesting Stock v.
Options

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 Who should vest
 How long?
 Acceleration?
 Change of control
 Termination without cause
 Double and single triggers
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VC will require unvesting shares so vesting period could be 8 years
Fund life can be 7 to 10 years
Most exits are M&A - Fewer and longer IPOs
Extended Option exercise periods
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Special class of common that has super voting rights
Facebook, Google Snap
May be negotiated away in institutional round
70

 Right of First Refusal (ROFR)
 Lock Ups
 Co-Sale Rights
 Drag Along
 Buy Sell
 Rule 144
71

 Common Stock
 Options
 Warrants
 Convertibles
 Preferred Stock
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73
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%

 IP Rights
 Patents
 Invention Assignments
 Licenses and ownership
 Data security
 Employment Claims (Homejoy)
 Tax Claims
 Regulatory
 Litigation
 Claims by prior employer
 Entrenched Management
 Material Agreements
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 Valuation
75

 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
76

 Preferred will have a dividend preference.
 A cumulative dividend on preferred shares must be paid
before any other dividends on common.
o If the company can't pay out a cumulative dividend in a
year, the amount is carried forward.
o Common in private equity deals, not in venture
 Non-cumulative is only paid when as and if declared.
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 Who gets paid first and how much?
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 1X Non participating convertible preferred
 $1,000,000 invested for 10%
 Ex 1: Exit (sale) of company for $5,000,00
 Ex 2: Sale for $20,000,000
79

 Size of board
 Founder-friendly boards
 Role of the Board
 Observers
 Indemnification
 Insurance
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 Financial statements and other information
 Thresholds
84

 Requires a company to list the shares publicly so
that the investor can sell
 Demand rights
 Piggyback rights
 S-3 rights
85

 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
86

 Term, milestones, commencement
 Acceleration
 Single and double triggers
 Fire the Founder
87

 Right to maintain, right to participate
 Major investors
 Limited by amount of money company wants to raise
88

 Increased pre money
 409A valuations
 Extended exercise periods for NSOs
89

 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
90

 Broad-based weighted average
 Narrow-based weighted average
 Full ratchet
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 30 day no shop
 Confidentiality
 Is it really nonbinding?
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 Overly favorable terms
 Valuation planning and down rounds
 Reverse splits
 Cap table management
 Fire the CEO
94

 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)
95

 IPO
 Sale or Acquisition
96

 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and
creditors?
97

 Tax Liability
 Personal Liability
 Tax
 Employment
 Fiduciary Claims
 Securities Law Claims
 Contractual
 Pierce the veil and creditor claims
 Serial Entrepreneurs and failed companies
98

 Dead on Arrival: How to Avoid the Legal Mistakes that Could Kill Your Startup,
Roger Royse
 Straight Talk For Startups, Randy Komisar and Jantoon Reigersman
 The Startup Checklist, David S. Rose
 Angel, Jason Calcanis
 Venture Deals, Feld and Mendelson
 The Startup Game, William Draper
 Secrets of Sand Hill Road, Scott Kupor
 How to be the Startup Hero, Tim Draper
 Make Elephants Fly, Steve Hoffman
 Getting to Wow, Bill Reichert
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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
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