Business, Law, and Innovation

Entrepreneurial Finance

Lecture 5Spring 2014

Professor Adam Dell

The University of Texas School of Law

Stage Sources Form SizeAngel Friends & Family, SBC Common / Loan $100-2MM

Venture Capital Institutional Firms Preferred Stock $1-10MM

Private Equity Institutional Firms Preferred Stock $10-50MMGrowth Equity Re-Cap

Stages of Financings

Angel Venture Capital Private EquityGrowth Equity

IPO PIPE Icahn ;)

So How Do I Finance My Startup?

• By any means necessary.

• Most use friends & family $

• Some get angel funding, often by getting into an incubator. We have 2 great ones in Austin:

Angel Investment

• Loan or do I sell a piece of my company?

• Best approach is a convertible promissory note

- Borrow $100k, which you promise to pay back - But if you raise your Series A, the loan converts into an equity

investment in the Series A. - Interest rate, maturity rate, conversion feature.

TYPICAL DEAL POINTSUsually some “equity kicker”

– Like a small piece of the company or discount upon conversion into next round – 20% discount to the price of the Series A

Easy to structure, can do them quickly, no real rights other than as a debtor to the company. -It’s still the sale of a “security”, but they are simple.

What if equity financing does not occur?

Board observer?

Information rights (e.g., financials)?

•Equity Kicker•Conversion feature (e.g., triggered upon next round of financing of at least $1,000,000)•Mandatory or discretionary conversion?

SERIES A ROUND EQUITY FINANCING

• What is the company worth?- More art than science- More often than not driven by the market (how competitive the deal is)- Factors: space, team, traction, revenue (often very little), IP, partners, customers

• How much money does the company need?

PREFERRED OR COMMON?

• Attributes of preferred stock (still behind creditors)

• Common stock deal prices stock options for employees

• Common stock - no negotiation on terms (pari passu with the founders)

PREFERRED OR COMMON? (CONTINUED)

• No protective provisions for investors• Preferred deal is much more common

ATTRIBUTES OF SERIES A PREFERRED

• Anti-Dilution Provision– Grant of additional equity to protect your investment– Protection from a down round– Protection from the company granting additional equity to

others.

– Weighed-Average Anti-dilution (standard)vs.

– Full Ratchet Anti-dilution (harsh)

ATTRIBUTES OF SERIES A PREFERRED

• Dividend “when, as and if declared”– Noncumulative v. cumulative– %

• Priority on dividend payments• Liquidation preference

– “Participating Preferred”– Money back x 3, or– Money back, then pro-rata with founders

ATTRIBUTES OF PREFERRED STOCK

• Liquidation Preference

Sale / Merger / Acquisition / Liquidation 3rd: Series A

2nd: Series B1st: Debt Holders

4th: Common

MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Merger or asset sale treated as a liquidation – Consent of Series A Preferred required (50%,

66 2/3%, or more)– Must decide whether to treat merger or asset

sale as a liquidation (“cram down”)

MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Redemption (or not)– Beginning year 6, then year 7 and 8– Purchase price + accrued dividends (if any)

MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Conversion– Convertible at any time by dividing Purchase

Price by Conversion Price (1:1 basis)– Automatic conversion on IPO– Adjustment to conversion price (“full ratchet”)

• excludes options for employees and warrants for service providers

– Very lengthy provision but price of new equity issuances is key

MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Pro Rata Investment Rights– Right to maintain ownership levels in future

rounds of financing.– If a VC owns 15% of the company, then during

a subsequent round of financing, the VC has the “right” to invest up to 15% of the total $s raised in that round.

MORE ATTRIBUTES OF SERIES A

• Voting Rights - generally 1:1• Protective Provisions

– Sale of the company– Create new class of securities– Amend Certificate of Incorporation/Bylaws – Redeem shares– Change number of Board members

• Amended and Restated Certificate of Incorporation vs. Certificate of Designation

SERIES A TRANSACTION DOCUMENTS

• Series A Preferred Stock Purchase Agreement– Reps/warranties from company (capitalization, IP,

contracts, etc.)– Rep/warranties from investors (“accredited

investor,” no distribution under securities laws, Rule 144, etc.)

• Schedule of Investors

SERIES A TRANSACTION DOCUMENTS (CONTINUED)

• Investors’ Rights Agreement– Demand registration rights– S-3 registration rights– “Piggyback” registration Rights– Financial information rights– Right of First Offer– Right of First Refusal (among Preferred SHs)

SERIES A TRANSACTION DOCUMENTS (CONTINUED)

• Stockholder Agreement– Includes founders– Right of first refusal for sales by founders (first, to the

company and then to the shareholders)– Right of co-sale if ROFR is not exercised

• Voting Agreement (for Board seats)• Indemnification Agreement

POINTS TO CONSIDER

• Size of the option pool (20%, 30%??)• Board observer rights?• Stock Restriction Agreements for founders

(vesting provisions)• Employment Agreement for founders• Form of investment - individually or through LP?• Tax issues??• Exit strategy

Series A (Dilution)

Series A – Raise $5m @ $10m pre-moneyPre Money: $10mPost Money: $15mSeries A Investor bought: 33% of the companyFounders, existing (Angel) investors: diluted by 33%BUT, Series A required a 30% ISO Pool POST Series ASo….Founders, existing investors: diluted by 63%!

30%

33%

37%

Series B (Dilution…Yes More!)

Series B – Raise $20m @ $30m pre-moneyPre Money: $30mPost Money: $50mSeries B Investor bought: 40% of the companyFounders, Angel, Series A, ISO: diluted by 40%

22.2%40%

Series B: 40%Series A: 33% x 60% = 19.8%Founders: 37% x 60% = 22.2% ISO: 30% x 60% = 18%18%19.8%