Startups, Venture Capital and Angel Funding in a Reopened Economy

© 2020 Haynes and Boone, LLP
Idea to IPO
Startups, Venture Capital and
Angel Funding in a Reopened
Economy
#startup #ideatoipo
Roger Royse
@rroyse00

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

Economic Indicators – The Economist May 22, 2021
3

4
ALL
Gross domestic product, % change on a
year ago
Industrial
productio
n, %
change
on a year
ago
Consumer prices % change on
a year ago
Unemploy
ment rate,
%
Country latest quarter* 2021* 2022* latest latest
year
ago 2021* latest
United
States
+0.4Q1 +6.4 +6.0 +3.7 +16.3Ma
y
+5.0May +0.1 +3.1 5.8May
China +18.3Q1 +2.4 +8.5 +5.2 +8.8May +1.3May +2.4 +1.6 5.0May*
Japan -1.6Q1 -3.9 +2.2 +2.9 +15.8Apr -0.1May +0.0 -0.2 2.8Apr
Britain -6.1Q1 -5.9 +5.8 +5.5 +27.5Apr +2.1May +0.5 +3.0 4.7Mar*
Canada +0.3Q1 +5.6 +5.4 +4.2 +2.0Mar +3.6May -0.4 +2.2 8.2May
Euro
area
-1.3Q1 -1.3 +4.3 +4.3 +39.3Apr +2.0May +0.1 +1.7 8.0Apr
Last updated: 14:24 (GMT) - Monday June 21st 2021
Output, prices and unemployment
Trade, exchange rates, budget balances and interest rates

Franklin Templeton
5

Franklin Templeton
 RECESSION INDICATORS: STRONG…TO QUITE STRONG
 ClearBridge Investments: The economic growth forecast is climbing, and the
second quarter is likely to be one of the strongest periods in modern history.
 Data as of May 31, 2021
Source: ClearBridge Investments, BLS, Federal Reserve, Census Bureau,
ISM, BEA, American Chemistry Council, American Trucking Association,
Conference Board, and Bloomb
 https://www.franklintempleton.com/financial-
professionals/article?contentPath=html/ftthinks/common/clearbridge-
investments/recession-indicators-strong-to-quite-strong-u.htmlerg
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7

8

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10

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12

13

M&A
14

M&A Europe
15

M&A North America
16

SPACs (Special Purpose Acquisition Company)
 Publicly traded vehicle (SEC registered)
 Blind pool capital: acquire a single business
 Investors purchase a Unit (common share & warrant)
 Capital held in trust for up to 2 years (limited time to deploy capital)
 Investor option: redemption rights & upside potential (stock price / warrant)
 A business combination
17

SPAC structure
18

SPAC numbers
19
Year # of SPAC IPOs
Average IPO Size
(mn)
Gross Proceeds (mn)
2021 345 $311.9 $107,596
2020 248 $336.1 $83,361
2019 59 $230.5 $13,600

SPAC stats
20

Mobility
21

State Migration
22

State winners and losers
23

 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 purchasers’ accredited
investor status
24
Accredited Only Equity Crowdfunding

 Crowdfunding (Title III of the JOBS Act)
 Private company may sell up to $5 million of securities in a 12-month period
 Testing the Waters allowed
 Individual investments in all crowdfunding issuers in a 12-month period are
limited to:
 If either their annual income or net worth is less than $107,000, then the greater of:
 $2,200 or
 5% of the lesser of their annual income or net worth
 If both their annual income and net worth are equal to or more than $107,000,
then:
 10% of the lesser of their annual income or net worth
25
Reg CF Equity Crowdfunding

CHINA
 Tightening US export controls (and non compliance)
 Concern over Chinese expansion
 Hong Kong protests
 Uyghurs in Xinxiang
 Foreign Investment Risk Review Modernization Act (“FIRRMA”)
 Committee on Foreign Investment in the United States (“CFIUS”) restricts Chinese
investment in U.S. technology companies.
 FIRRMA broadened the authority of CFIUS to review, modify or bar foreign investments,
even non-controlling foreign investments, in U.S. companies with critical technology,
infrastructure or access to sensitive personal data of U.S. persons.
 Critical technology includes any technology for which certain categories of U.S. export
license would be required.
 Notification to CFIUS became mandatory, rather than voluntary as it had previously been.
26

China- 2
 Export Control Reform Act (“ECRA”)
 Restricts exports of new and emerging technologies and of foundational technologies.
 Artificial intelligence, geospatial images, semi conductors etc
 Military applications
 Effect on investment
 net U.S. direct investments from China into the United States in 2019 were $4.3
billion, down from the $18.0 billion level registered in 2016
27

China Trade
28

ESG Investing (Source – Sonen Capital http://www.sonencapital.com/impact/methodology/)
29

Ethical Business Practices for portfolio companies
 Environmental, Social and Governance (ESG)
 Policies and compliance procedures
 AML and anti-corruption
 KYC
30

Distributed Ledger
 Supply chain
 Volatility in crypto
 SEC
 NFTs
 Non fungible tokens
 Ethereum
 Digital ownership (art)
31

NFTS Explained (https://www.theverge.com/22310188/nft-explainer-what-is-
blockchain-crypto-art-faq)
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Successful sectors
 Ecommerce Ag-Tech
 Online services Ed-Tech
 Food safety Cyber Security
 Precision medicine Supply Chain
 Housing Transformative Tech
 AV Energy Tech

Summary: Post Covid
 Remote employees and taxes
 Employment tax environment
 Federal covid relief
 Planning for uncertain economic times
34

Remote Employees and taxes
 Payroll taxes
 Mere payment of wages to an employee located in a state may trigger withholding
and unemployment taxes
 Income and sale tax nexus
 Employees located in a state may create nexus
 Sales into a state may create nexus
 Business tax and licensing
 States may have economic nexus requirement
 Trade secret
 Reasonable measures to protect trade secrets

 DOL/FLSA: Economic Realities Test
 Focus is on the economic reality of the relationship.
 Right to control is important but not dispositive.
 ABC Test
 The worker is free from the control and direction of the hiring entity in connection
with the work;
 The worker performs work that is outside the usual course of the hiring entity’s
business; and
 The worker is customarily engaged in an independently established trade,
occupation, or business of the same nature.
 IRS: The Control Test
 State law Tests
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Is my new worker an “employee”?

Employment tax enforcement
 AB-5 Gig Economy worker laws
 ABC test
 AB-2257 exemptions
 EDD enforcement
 Federal law
 The Biden plan for strengthening worker organizing, collective bargaining, and
unions
 Worker Flexibility and Small Business Protection Act (S.4738) creates an ABC test
with no exemptions

 Salary or Hourly
 Exempt or not Exempt from FLSA coverage
 Bonuses (Discretionary or Mandatory)
 Stock Options or Equity?
38
Compensation

 Noncompete Agreement
 Nondisclosure Agreement
 NonSolicitation Agreements
 Trade Secrets or IP of former employer
 Appropriate Background Check
39
Covenants

 Confidentiality and Nondisclosure Agreement
 Noncompete Agreement
 Nonsolicitation Agreement
 PIAIA or CIAIA
 California Labor Code § 2870
 Employee’s Time
 No Employer Facilities
 Not Related to Employer’s Business
 Doesn’t Result from Work Performed for Employer
40
Employee agreements

 1 employee: immigration, workers’ comp, independent
contractors, overtime, and unemployment insurance.
 15 employees: disability rules (ADA) and discrimination statutes
(Title VII).
 20 employees: age discrimination laws (ADEA).
 50 employees: family and medical leave (FMLA).
 100 employees: EEO-1 reporting obligations (EEOC).
 Local ordinances may add requirements for paid sick and
medical leave.
41
How do our legal obligations
grow as we add employees?

 What efforts has the Plaintiff made to truly keep the information
secret?
 Policy of confidentiality. Were employees advised of policy?
 Has the alleged secret been published?
 Is the secret reverse-engineerable through legitimate means? (i.e.
can one skilled in the art make the same machine by taking it
apart?)
 Is the information, alleged to be secret, available through other
means? Or is it generally known in the trade or ascertainable
through reasonable diligence?
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Key Defenses to Trade Secret Claims

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Any information, such as a formula, pattern, program, device, method or
technique, that has value because the trade secret is not generally
known to the public and which is subject to reasonable efforts to maintain
its secrecy.
 Choose trade secret or patent?
 Claims include theft of customer lists, financing information, etc.
 Frequent battle ground for litigation between employee who leaves to
start competing venture with former employer.
Trade Secret

 Trademark may be your most valuable asset.
 Research existing names and logos.
 Brand your company strategically and legally.
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Trademarks

Federal Covid Relief
 PPP Loan
 Forgiveness
 Effect on M&A
 SBA Actions
 Employee Retention Tax Credit
 COVID-Related Tax Relief Act of 2020 (“COVIDTRA”)
 Deduction of PPP funded expenses
 CA conformity

Employee Retention Tax Credit
 Credit against payroll taxes for wages paid to employees from March 13, 2020 through
June 30, 2021.
• Credit against payroll taxes equal to 70% of wages (wages up to $10,000) per
employee per quarter.
• Businesses with 500 or fewer employees: The same credit is available for all wages
whether employees are working or not.
• Businesses with more than 500 employees: The credit is available only for employees
not working.
• Business must have experienced full or partial shutdown as a result of the order to limit
travel, meetings, and commerce due to COVID-19, or lost 20% or more of quarterly
gross receipts (compared to the same quarter in 2019).
• Businesses that received a PPP loan are eligible to claim the credit, as long as the
claimed wages weren’t paid by PPP.
• Companies with 500 or fewer employees can request advance payment of the credit up
to 70% of the average quarterly payroll for the same quarter in 2019.
46

FINANCINGS
 The venture market is hot
 Are you ready for venture
 Should you take venture
 VC economics
 Positioning for venture
47

Cap Table
 Common Stock
 Options
 Warrants
 Convertibles
 Preferred Stock
48

Capitalization
49
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 %

SAFEs and Convertible Notes
 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
50

Effect of Valuation Caps
51
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 %

The UNSAFE
 Valuation Caps + SAFE = Unknown Dilution
Pre–Money – SAFEs take dilution of other SAFEs
Post-Money – SAFEs do not dilute for other SAFEs
https://safegenie.io/ is a tool that helps project pre money SAFE valuation
52

Other Diligence Issues
 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
53

Staged Financings
 Enough to get to next valuation event
 2X
 1 to 2 years
 Up vs Down rounds
54

Pitch Deck
 Market Size
 Team
 Product
 Go To Market Strategy
 Financials
 Financial Plan
 NOT VALUATION
55

Executive Summary
 Team
 Projections
 Market
 Industry
 IP and Patents
56

Term Sheets
 Valuation
57

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
58

Money –The Priced Round
 More Valuation Methods
 (Patents + People) x $1 Million
 Comparables
 Discounted Cash Flow
 Market Multipliers
 Discount to Public Companies
59

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
60

Dividends
 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.
61

Liquidation Preference
 Who gets paid first and how much?
62

Example of Liquidation Preference
 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
63

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
65

Protective Provisions
 Class vote or majority vote
 Delaware law
 Separate vote for later investors
 Do the interests of different
investors diverge?
66

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
67

Information Rights
 Financial statements and other information
 Thresholds
68

Registration Rights
 Requires a company to list the shares publicly so
that the investor can sell
 Demand rights
 Piggyback rights
 S-3 rights
69

Transfer Restrictions
 Right of First Refusal (ROFR)
 Lock Ups
 Co-Sale Rights
 Drag Along
 Buy Sell
 Rule 144
70

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
71

Founder Vesting
 Term, milestones, commencement
 Acceleration
 Single and double triggers
 Fire the Founder
72

Pro Rata rights
 Right to maintain, right to participate
 Major investors
 Limited by amount of money company wants to raise
73

Option Plan
 Increased pre money
 409A valuations
 Extended exercise periods for NSOs
74

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
75

Anti-Dilution
 Broad-based weighted average
 Narrow-based weighted average
 Full ratchet
76

Exclusivity
 No-shop
 30 to 60 days
77

NonBinding
 30 day no shop
 Confidentiality
 Is it really nonbinding?
78

Planning for later rounds
 Overly favorable terms
 Valuation planning and down rounds
 Reverse splits
 Cap table management
 Fire the CEO
79

Corporate Venture Capital
 Strategic objectives
 Less operational involvement
 Tight of first refusal, right of first offer, right of first look
80

CONTACT US
81
Roger Royse, Partner
Haynes and Boone, LLP
+1.650.687.8820
Roger.Royse@haynesboone.com
Twitter @rroyse00

AUSTIN
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Suite 1300
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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
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T +52.55.5249.1800
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NEW YORK
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ORANGE COUNTY
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T +1 949.202.3000
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PALO ALTO
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T +1 650.687.8800
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SAN ANTONIO
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San Antonio, TX 78205
T +1 210.978.7000
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SHANGHAI
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Finance Center, Tower 2
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THE WOODLANDS
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82

Startups, Venture Capital and Angel Funding in a Reopened Economy

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