Term Sheet [R]Evolution: Notes, Caps, & Other Josh Cook

LETS TALK ABOUT ME

> 2,000 company clients> 950 venture financings annually>60 venture fund formations annuallyOh, by the way, we have been #1 firm in Dow Jones survey 3 years in a row and #1, #2 or #3 in every year the survey has been done. (true story)

And, of course, 500 deals

for

My mantras . . .

REMOVE FRICTIONS

DO ONLY WHAT WE MUST

FAST AND EFFICIENT

DON’T INNOVATE ON SEED STAGE LEGAL

ANCIENT HISTORY

Several years ago . . .• Very few angel investors• Many companies start with $3-5M Series A• 4-6 weeks close• Board seat and negotiated investor rights• $50K legal fees for both sides• Fewer “forms”• Lucite deal toys () and velobound closing books ()

AND NOW?

• Lots of seed deals and even more angel investors• Sub $1M with varying “caps” or valuations• Close within days and floating or rolling closes over

months• No board seat and limited investor rights• $5-15k legal fees• “Preferred forms” for YC, Techstars, seriesseed, and

varying institutional angels • No Lucite toys () and no velobound books ()

THE BASICS

Two types of investments• Convertible Notes• Series Seed Preferred Stock Rule of thumb:• > $1M tend to be Series Seed• < $1M tend to be convertible note

THE LINGO (NOTES)

Material Note terms:• The “cap” and discount• Other stuff:

– Conversion triggers– Sale of company treatment

• Participation rights (i.e. preemptive rights, the ROFO, or Pro Rata Rights)

• Maturity• Interest

THE LINGO (SERIES SEED)

Material Series Seed terms:• “pre-money” valuation• Sale of company treatment (i.e. preference, almost

always “non participating”)• Participation rights • Most Favored Nations – ie don’t treat me worse than

the next guy(Notice I left out board seat and protective provisions)

notes can suck

why notes can suck

Do you know what you own? (Hint: You don’t)

• Confusion about how these convert: pre- or post-money?

• New investors may ask you to do something different from your NPA with the company

Other Issues

“Phantom preference” or “preference premium” on conversion• $1M convert with 50% discount, can mean

noteholders end up with $2M in preference(Pro tip: there are some ways to solve this)

Other Issues

Full Ratchet (search “Full ratchet mark suster” for more detail)• Hasn’t been an issue recently since valuations have

generally been going up

No Stockholder Rights( But you do have creditor rights: you can allege things like fraudulent conveyance instead of appraisal rights)(With acquihires it really doesn’t matter)

NOTES STILL COOL FOR SOME REASONS

• Paperwork still simpler (although only just slightly)• Less governance overhang

– Investors generally accept no board seat and few or no veto rights

• Avoids valuation for 409A purposes – – Valuation firms don’t see a “cap” as a valuation (as they

would treat a valuation in a preferred equity round)• Investors are accustomed to them now

I’m a Series Seed Fanboy

Certainty around ownership !!! (Pro Tip: That’s a really good thing)

Paperwork about as simple as convertible debt

Investors have rights as “stockholder” (but remember that stockholders stand behind creditors (noteholders) in line for payment)

But Series Seed has issues . . .

• Investors tend to want to negotiate board seats and protective provisions (when they otherwise wouldn’t if it were a convertible note)

• Can make for complicated cap table if raising at multiple valuation (compared to multiple caps with notes)

Context

CONTEXT CONTEXT CONTEXT

remember:high failure rate for

many of these companies

Thanks for the photo Dave

Worth Repeating

REMOVE FRICTIONS

DO ONLY WHAT WE MUST

FAST AND EFFICIENT

DON’T INNOVATE ON SEED STAGE LEGAL

Don’t sweat the small stuff

KEEP IT SIMPLE AND ACTIONABLE- dave mcclure

Who gives a sh*t about interest?How do lengthy reps and warranties protect you? (Hint: They don’t. But get some basics, IP and litigation.)

Maturity only kinda matters

STANDARD DOCS ARE YOUR FRIEND500 startups YC SERIESSEED Angelpad AngelList

OTHER INVESTORS ARE YOUR FRIENDS Piggyback off their efforts. Talk to the anchor investors.

MOST LAWYERS CARE TOO MUCHFind one that can address your goals without driving up costs.

SO WHAT MATTERS?

Conversion Triggers for NotesMFN – For both Notes and Series SeedCompany Sale – What are your rights and what are EXPECTATIONS?Participation rights – Try to lock these in (Pro tip: Harder for the 25k and under crowd)

Conversion

• Ask what happens in three events:– Equity financing – most important to trigger to a “qualified financing.”

No need to solve for a non qualified financing (although you’ll see that in many forms). Company typically incentivized to want to convert you. They can ask.

– Sale of company – ask for either multiple return (2x or 3x) or ability to convert. (Maybe both – we’ll talk about that in acquihire protections.)

– Maturity – There a some nuances here in corner cases worth considering.• But generally, you don’t want the company to pre pay when you don’t want

them to – either before or after maturity.• Most deals 18-24 months

Despite what I said We SHOULD Innovate In Legal

• Don’t be an “early adopter,” but be an active lurker• Capped deals – that’s a relatively recent change• Seriesseed.com forms • “Convertible Security” (http://bit.ly/OGgJnF)• Others:

– AngelList– Clerky– Eshares– Digital signature services

Josh Cook, Gunderson Dettmer650-463-5267

jcook@gunder.com @joshcook

Gunderson Dettmer LLP @gundersonlawwww.gunder.com