Venture Capital Financing

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A legal perspective on VC financing in the United States. Article published by Majda Barazzutti, senior counsel of Valla & Associates law firm with offices in the San Francisco Bay Area and New York.

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Venture Capital Financing

  1. 1. November 13, 2013 Majda Barazzutti © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 1
  2. 2. The Venture Capital Financing Process: The Legal Perspective © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 2
  3. 3. Financing is a Staged Process     Common Stock  Bootstrapping  Friends and Family  Angels: Equity, Warrants, Convertible Notes “Series Seed” Series A Preferred (B, C, etc.) Liquidity Event © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 3
  4. 4. Structure the Initial Process Correctly    Securities Laws Filings Price must be the same: Tax Consequences of Valuation at Early Stages Protection of IP © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 4
  5. 5. U.S. vs. Italian Process       Informal Private No statutory auditors No minimum capital requirements No legal impediments to ongoing losses Limited bankruptcy laws risks © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 5
  6. 6. Convertible Debt      Bridge loan before financings Useful when the company does not have a satisfactory valuation Risks of repayment feature No minimum capital but insolvency changes the rules Better include a provision to force conversion © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 6
  7. 7. Warrants     Warrants: option to purchase company shares at a price within a set period “Kicker” to increase the potential investment value Warrants increase in value as the value of the underlying shares increase in relation to the exercise price Usually issued with bridge financing © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 7
  8. 8. Series Seed     “Open source”, simpler, standard No antidilution, redemption, dividend protection, price based anti-dilution, registration rights Will acquire same rights as the next series of Preferred Smaller financings © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 8
  9. 9. Alternatives: Strategic Investors  Stage of Product Development: Scalability  Aims Differ  Not Interested in Helping the Company Grow  Conflict of Interest: greater returns from commercial rights than growth  Expertise  Could affect future VC financings © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 9
  10. 10. Venture Capital Identify the Right VC  Due Diligence  The Risk of “Finders”  © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 10
  11. 11. Preferred Stock (Series)  Why Preferred?    Liquidation Preference Preserve a low common stock value for option grants (ratio 1:4 to 1:8):  Common Stock was bought at cheap price, $0.10 to founders.  If Common were sold at same time at $5.00 to VC, tax consequences for founders. No limits to Preferred/Common ratio © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 11
  12. 12. “Clean Up”  Prior to Investing:      Document Employees Founders Relationships Securities filings Confidentiality and Invention Agreements Prepare for VC’s due diligence © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 12
  13. 13. Sample Term Sheet  Binding Provisions:    No Shop Confidentiality Applicable law  ALL other provisions are not binding  See examples: NVCA (http://www.nvca.org) © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 13
  14. 14. A Typical Term Sheet  Valuation/Number of Shares/Price  Liquidation Preference  Redemption  Conversion  Antidilution  Voting Rights  Protective Provisions  Vesting of founders' stock © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 14
  15. 15. Valuation/Price   Pre-money/Post-money valuation: Option pool shuffle How are your shares valued?        8M pre-money valuation, 6M shares outstanding $8M pre-money ÷ 6M existing shares = $1.33/share, right? WRONG: The share price is $1.00 WHY? Read the term sheet: “The $8 million pre-money valuation includes an option pool equal to 20% of the postfinancing fully diluted capitalization.” $8M pre-money ÷ (6M existing shares+2M options )= $1/share. Pre-money valuation includes a large unallocated option pool for new employees -- lowering pre-money valuation Hence, develop a hiring plan © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 15
  16. 16. Dividends      No expectation of dividends, but: Cumulative Dividends: __ % cumulative dividend accrues over time, whether or not the company declares it - PLUS participation with Common Stock on an as-converted basis. Non-cumulative Dividends: “An amount equal to $[_____] per share of Series A Preferred when, as and if declared by the Board” PIK (payment-in-kind) dividends. Company option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value. Usually payable on liquidation or redemption, not conversion © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 16
  17. 17. Liquidation Preferences   Liquidation Preference: 1x or more Participating Preferred:       Full participation Capped participation Non-participating 19% 14% 67% Preferred has the option to convert into Common Interaction of various series: First pay B, then A, then all; all participate equally, etc. Deemed Liquidation: good times and bad times; IPO? © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 17
  18. 18. Redemption  Optional (Company call):   Company can repurchase stock at original price (plus dividends) if Investors don’t convert to Common after x years Mandatory (Investors Put)   Guaranteed exit path for VC if Company is “successful enough”   Investor can force Company to repurchase shares after x years – beware of redemption premium But, Company must have funds legally available 22% of all VC financings in 2012, 35% in down rounds © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 18
  19. 19. Voting rights/Protective provisions  Preferred usually votes with Preferred on an “as converted basis”  Vote by Series/Class  Usually right to vote on x directors  Applicable law provides for rights for certain events (merger or creation of senior preferred stock)  Investors often add additional actions  Terminate if Series holds less that minimum % of original purchase (5-20%)  Voting Switch - gain majority from an event of default © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 19
  20. 20. Voting rights/Protective provisions  „ Amend Articles / Certificate (or Bylaws)  Alter rights, preferences of Series A, affect Series A  Increase or decrease authorized shares Preferred  Stock  Merger / acquisition, sale of substantially all assets  Liquidation / dissolution  Declare or pay dividend  Change authorized number of Board Directors © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 20
  21. 21. Conversion  Preferred always has a conversion to Common feature, but loses all preferred privileges  Optional Conversion  Holders can convert to Common at any time  Automatic Conversion – must convert to Common if:  IPO at least $ __(size + price)  2/3 of preferred (or majority) elect to convert © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 21
  22. 22. Conversion  Conversion Ratio is initially 1:1  Anti-dilution protection: conversion price adjustment, not automatic  “Event-Based” changes: Stock splits, stock dividends, reverse stock splits   “Price-Based” changes: Dilutive Financing (financing at lower price per share)   Retain same percentage ownership Exclusions Pay to Play: must keep “paying” (participating pro rata in future financings) in order to keep “playing” (not have his preferred stock converted to common stock, lose antidilution) © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 22
  23. 23. Anti-Dilution  Protect investors if company issues equity at a lower valuation than preferred  Full Ratchet Weighted Average: Broad Base: more favorable Weighted Average: Narrow Base: less favorable to company   © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 3% 92% 4% 23
  24. 24. Exclusions from Dilution  Carve-outs from anti-dilution:  Options grants to employees, consultants (negotiate all or only authorized pool)  Warrants to lenders (approved by majority vs. unanimous board approval)  Warrants to service providers, strategic partners  Shares issued in mergers / acquisitions  Exercises or conversions of current stock or grants © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 24
  25. 25. Other Terms:      Vesting of founders’ stock, acceleration Right of first refusal: new issuance and transfers by founders Employee pool Co-sale agreement (drag along, tag along) : force a sale Registration rights  Demand registration rights  Piggy-back  S-3  Expenses © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 25
  26. 26. Other Terms:       No-shop agreement Information rights Confidentiality Indemnification Counsel expenses up to ___ Lock-up provisions © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 26
  27. 27. Financing Documentation     Legal and business due diligence Draft definitive agreements (purchase agreement, Certificate of Incorporation, voting agreement, investor rights agreement) Prepare closing deliveries (Schedule of Exceptions) Consents, opinions, government filings © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 27
  28. 28. Bottom Line    (Almost) anything can be negotiated Pick your battles: ƒ Liquidation Preferences, Protective Provisions, ƒ Board Control Make sure you understand what you’re signing © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 28
  29. 29. Thank you! In bocca al lupo! Valla & Associates, Inc., P.C. 1990 N. California Blvd., Suite 1060 Walnut Creek, CA 94596 USA E-mail: majda.barazzutti@vallalaw.com Phone: +1 925 705 7623 Fax: +1 925 705 7629 www.vallalaw.com © 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 29

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