An introductory crash course on the typical legal and business terms involved with, and negotiated in, venture capital fundraising including SAFE, Convertible Note, Series Seed and Series A financings.

1. Venture Capital
Financings 101
(SAFEs, Convertible Notes,
Seed and Series A)
BARDIA MOAYEDI
July 12, 2019

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Where will you get the money? How much money do you need?

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Friends and Family
Angel Investors (Fools?)
Incubators/Accelerators
Venture Capital
Strategic Investors
Venture Debt/Commercial Banks
Government Grants
FINANCING SOURCES

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“Sweat” Equity and Bootstrapped
• Founders and initial employees receive shares of common stock in exchange for assignment
of intellectual property and time and effort in developing the business.
• Founders and initial employees fund the company until investment (i.e. “bootstrapped”).
Friends and Family
• Accredited Investors?
 Networth of at least $1M (not including primary residence) or annual income at least $200,000 each
year for the last two years and this year.
• Non-accredited but are they Sophisticated Investors?
Vendor discounts and payment terms
Sources of Initial Capital

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Traditional Angels
• High net worth individuals investing personal funds in early-stage companies to fill gap between
formation and venture investment ($50k to $1M investments).
• Large groups can be difficult to manage and often there isn’t a “lead” that will continue to support the
company.
Angel groups (Sand Hill Angels, Tech Coast Angels, Golden Seeds, Investors’ Circle)
• Large groups of angel investors that centralize pitching, due diligence and investment process.
Angel List
• Companies post executive summary and proposed term sheet and wait for indication of interest.
“Super” Angels and “Micro” VCs.
Crowdfunding
• Selling small amounts of equity to many investors.
• Jobs Act has loosened regulations limiting investments by non-accredited investors, but many risks and
administrative costs.
Angels, “Super” Angels, Angel Groups & Crowdfunding

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Incubators make a one-time small initial investment in each company in the program.
• Ranges from $15,000 to $150,000.
• Investment structures vary depending on the incubator, but many invest in common stock or
preferred stock (usually 1% to 10% of the company) at a low valuation, some do convertible
debt, SAFEs or some combination.
• Investment terms and amount are usually standardized.
• Access to advisors, VCs, strategics and super angels.
Incubators also arrange for discounts and credits towards services
(Amazon Web Services, RackSpace, PayPal, TriNet, law firms).
Many incubators are funded by VC firms and super angels.
Incubators/Accelerators

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So who are these “VCs” anyway. . .
Courtesy: www.vcstarterkit.com

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VCs are long-term investors who take a very active role in their portfolio companies.
• VCs usually don’t expect a return on that investment for 7-10 years, on average.
VC firms are typically structured as limited partnerships with one or more funds managed
by a group of investment professionals (general partners).
• Investors in VC funds (limited partners) are typically pension funds, insurance companies,
endowments, foundations, family offices, and high net worth individuals.
• Limited Partnerships are “pass-through” entities like LLCs.
Fund sizes range from micro ($25M to $50M) to mega (NEA Fund 17: $3.6B).
VCs typically focus investments on a particular stage of company (seed, early, late) and
industry (B2B SaaS, consumer, biotech, etc.).
In addition to capital, VCs bring managerial and technical expertise and network.
Venture Capital - So who are these “VCs” anyway. . .

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VCs look for team, product/technology and market potential
Typically a VC’s first investment in a company is in preferred stock. Some will do SAFEs/convertible
notes initially, but not many.
VCs will insist on one or more seats on the Board, separate voting rights and often restrictive
operational pre-approval rights.
VCs expect to make follow on investments in portfolio companies, whether in the form of convertible
loans between equity financings or in subsequent equity financings.
VC firms make money on investments when portfolio companies are sold or they can sell stock on
public markets through an IPO.
Some statistics: VCs receive an average of 200 executive summaries each month.
• Less than 5% will be invited to meet with the VC’s partners.
• 2% will reach the due diligence phase, and less than 1% will be offered a term sheet.
• About 0.3% of those submitting executive summaries will ultimately obtain VC funding (source:
techcrunch.com; medium.com/vcdium).
Venture Capital – What are they looking for?

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Generally larger companies, often in the same industry.
Invest because of a strategic interest in the company’s business so that it may
complement its own growth.
Purchase equity on terms similar to VCs, but with a “commercial element” such as license
agreement, marketing or distribution arrangement, collaborative development agreement,
preferred pricing arrangements, and/or a right to negotiate to acquire the company.
Strategic Partners/Corporate Venture Capital

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Incubators: Want a kick-start and exposure and don’t mind giving away a relatively large piece of
the company (1-10%) for a relatively small investment.
Angels: If only need a smaller amount of capital and do not want to give away control, but willing
to herd cats.
VCs: Need to raise significant capital and want guidance and expertise of VC. Harder to attain
Strategics: Need cash and desire to form a relationship with a larger player in the industry.
So… Incubators, Angels, VCs or Strategics?

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Working capital loans (typically lines of credit, equipment financing, A/R financing, growth
capital) secured by assets, IP, A/R and cash accounts kept at bank.
Commercial bank loans often have shorter term (1 to 2 years) and may have specific
purposes, such as equipment finance.
Often onerous terms and covenants will apply (such as meeting certain financial metrics).
SBA loans – require personal guarantees.
A Few More Options… Commercial Bank Loans

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Loans provided by banks and finance companies that specialize in lending to early stage
companies.
Debt is secured by companies assets, IP, equipment and bank accounts.
Venture debt is typically available only following VC investment. Bank not loaning against
the credit worthiness of the company, but rather betting the VCs will keep funding the
company
Lenders generally require warrants to participate in the upside.
Because of the higher risk involved, interest rates are generally higher than offered by
commercial banks
“Sweet-spot” range of funding is from $3M – $6M. Usually 3 year term.
A Few More Options… Venture Debt

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Governments may provide capital for startups.
• Grants are usually "free money" in that they do not need to be paid back and they don't cost
any equity.
Certain types of scientific research and development are eligible. Federal initiatives, like
Defense Advanced Research Projects Agency (DARPA), National Science Foundation
(NSF) and the Small Business Innovation Research program, award grants to hi-tech small
businesses or startups to carry out R&D and bring innovative technological products to
market.
Some states give grants to boost hiring and economic development.
Availability limited and application process can be time-consuming.
A Few More Options… Government Grants

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Convertible Debt/SAFEs
• Debt or instrument that converts into preferred stock in future equity financing.
• So called “bridge” loan/financing because it bridges to the next financing.
• Benefits: quick, simple and avoids the need to do a priced equity round at a time when the company’s value is low or
has not increased from prior round.
• Typically discounts and capped valuation apply on conversion.
• May be convertible into existing or new equity security upon an acquisition event or be repaid at a premium.
• Notes may be secured or unsecured – usually depends on stage of the company.
Equity
Common Stock (rare)
– No special rights unless by contract
– Typically priced low
Preferred Stock
– Special rights in charter and financing documents
– Price reflects premium placed on those rights
INVESTMENT STRUCTURES

16. Convertible Note Financings
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Short term loan to company
• Investors purchase promissory notes from the Company with a stated principal amount,
interest rate and maturity date (typically 12 – 24 months).
• Interest rate typically ranges from 6-8% per annum.
Loan automatically converts into the same equity issued in next round of financing
(“Qualified Financing”)
• Notes typically convert at a discount to the Qualified Financing price per share.
• Discount typically ranges from 10-30% with 15-20% being the current market norm.
• Sophisticated investors will ask for both a percentage discount and a valuation cap.
• Alternatively, warrants can be issued in lieu of a conversion discount.
Notes pay a premium (1.5X - 2X) if Company is acquired before notes convert
What is a Convertible Note Financing?

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Discount to price per share paid by other investors in the Qualified Financing
Example:
• Investor holds a note for $100,000 (including interest) with a 20% conversion discount
• In a Qualified Financing, shares of Series A sold at $1.00 per share to VC
• Note would convert at $0.80 per share into Series A (i.e. $1.00 minus 20% discount)
• Investor receives 125,000 (100,000 ÷ $0.80) Series A shares compared to 100,000 shares
received by new Series A Investors for the same $100,000 investment
Conversion Discount

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Discount Usually 10% to 30%
As the time increases between the investment and the Qualified Financing, the discount
may increase
• Incentivizes quicker Qualified Financing
• Accounts for risks taken by earlier investors in bridge round
Factors in setting a conversion discount
• Anticipated length of time until a Qualified Financing
• The length of time the funds will last
• Risk
• Ultimately, investor appetite
Setting a Conversion Discount (Percentage Discount)

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Valuation Cap
• Note converts at a price determined by dividing the valuation cap by the company's fully-diluted
shares just before the Series A financing.
• Companies should aim to set a high valuation cap at or near the anticipated Series A valuation.
• Note converts at the more favorable price per share for the investor between the discount rate
and the valuation cap.
Example – Convertible Note with 20% Discount and $10 million valuation cap
• Company raises Series A at $20 million valuation and there are 20 million shares outstanding
so the Series A price per share is $1.00.
• 20% conversion discount = $0.80 pps ($1.00 minus 20% discount)
• $10 million valuation cap = $0.50 pps ($10M ÷ 20M shares)  Investor converts @ Cap
Setting a Conversion Discount (Valuation Cap)

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Documentation (2-3 primary documents, 15-30 pages total)
TERM SHEET
CONVERTIBLE NOTE PURCHASE AGREEMENT
- Minimal representatons and warranties
- Closing mechanics
FORM OF CONVERTIBLE NOTE
- Customized for each investor
- Includes deal terms (i.e. discount/cap)
SECURITY AGREEMENT (if applicable – usually not)
SUBORDINATION AGREEMENT (if applicable – usually not)
FORM OF WARRANT (if applicable – usually not)

22. Simple Agreement for Future Equity
(SAFEs)
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• Relatively new structure; conceived and promoted by Y Combinator.
• Structure is similar to a convertible note financing except that the security purchased by the
investor is a contractual obligation and not debt (there is no interest or maturity date).
• Conversion Discount
• Valuation Cap
• Change of Control Conversion
• Attempts to solve the “maturity date” and other issues that may arise in convertible notes.
• Documentation (1 primary document; <10 pages total).
Simple Agreement for Future Equity (SAFEs) – Basic Elements

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• Not widely adopted by investors outside the Y Combinator (“YC”) ecosystem or Silicon Valley.
• SAFEs are generally more Company friendly that investors like.
– No interest rate
– No maturity date
– Not debt so no real investor protection (i.e. protections afforded to creditors/lenders)
– Not equity so no stockholder rights
• YC refreshed the SAFE template in early 2019 to make them more investor friendly.
SAFEs – Issues to Consider

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Pros & Cons of Various Seed Financing Structures:
Convertible Debt SAFEs Series Seed Preferred Stock
Pro Con Pro Con Pro Con
Most Common /
Battle Tested
Debt can mature without
ability to pay
No interest accrual or
maturity date
May meet investor
resistance
Valuation issues settled
up front / no “punting”
Valuation could be too
low and Series A VC can
use to their advantage
Relatively fast negotiation
& closing
Debt that is accruing
interest while the Note is
outstanding
Even faster negotiation &
closing
No maturity or expiration
date
Investor is truly “buying-
in” and becoming a
stockholder
Usually comes with Board
seat
Relatively inexpensive
legal cost to produce
documents compared to
Seed
Valuation cap provision
raises valuation issue
debt structure sought to
avoid
One document and lower
legal costs than
convertible note financing
No time pressure of
maturity date
No maturity or expiration
date
Punts valuation
discussions down the
road
Punts valuation
discussions down the
road
Raises many of the same
issues as full-blown
Series A financing
Only requires Board
consent to approve
Only requires Board
consent to approve
Board consent and SH
consent required to
amend Charter
Likely most expensive
and time consuming

26. Overview of Preferred Stock Financings
(Series Seed and Series A)
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Preferred Stock is a “Hybrid Security”
• Preferred Stock is equity with rights, preferences and privileges superior to those of Common Stock.
• Convertible into Common Stock at 1:1.
• Blend of Debt and Common Stock.
• Gives Investors Downside Protection (Like Debt).
– Via Liquidation Preference and Antidilution Protection
• Investors Get Other Significant Rights.
– Voting protective provisions
– Board seats
• Beauty of the structure is that there is still (theoretically at least) an alignment of interests because the
Preferred Stock converts to Common Stock on a successful exit (and the Investor protections go away).
Preferred Stock Basics – Series Seed and Series A

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Key Elements
• Valuation
• Often regarded as the most important issue
• Very subjective; valuation is an art, not a science
• Liquidation Preference
• Expressed as a multiple of the investment (1x – 3x)
• Participating v. Non-Participating
• Dividends (usually not included in Series Seed)
• When, and if, declared
• Cumulative v. Non-Cumulative
• Special voting rights separate from the Common Stock (less rights provided to Series Seed)
• Need Preferred Stock approval to amend the Charter/Bylaws, issue new stock, sell the company, etc.
• Anti-dilution protections (not usually included in Series Seed)
• Full Ratchet v. Broad Based Weighted Average
Preferred Stock Basics – Series Seed and Series A

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Key Elements continued…
• Management Rights (i.e. one or more Board seats)
• Drag-Along Rights (not usually included in Series Seed)
• With “drag-along,” preferred investors can compel common stockholders to participate in sale of the Company
• Who can “drag” who and under what terms and conditions
• Information Rights, Pro Rata Rights, ROFR and Co-Sale Rights
Preferred Stock Basics – Series Seed and Series A

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Overview of Phases
• Identifying the Right Source (4-6 weeks)
• Term Sheet (2-3 weeks)
• Due Diligence (3-5 weeks)
• Finalize Documents (about 5 principal documents/agreements not including term sheet) (2-5 weeks)
• Closing the Investment (about 4-6 weeks from signing the term sheet)
Key Items
• The more detailed/negotiated the Term Sheet, the fewer issues will remain at the time of documentation
• Spend the time now while you have it to clean up your corporate records and streamline diligence
• Find trusted advisors and legal counsel experienced in representing companies in VC financings that will
provide you with practical guidance
Preferred Stock Timeline – Series Seed and Series A