venture capital financing
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© 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 1
Majda Barazzutti
November 13, 2013
The Venture CapitalFinancing Process:
The Legal Perspective
© 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 2
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
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
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
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
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
Warrants
“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
Series Seed
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
Venture Capital Identify the Right VC Due Diligence The Risk of “Finders”
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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
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
“Clean Up”
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
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
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 post-financing 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
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
Liquidation Preferences Liquidation Preference: 1x or more Participating Preferred:
Full participation 19% Capped participation
14% Non-participating 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
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) Investor can force Company to repurchase shares
after x years – beware of redemption premium Guaranteed exit path for VC if Company is
“successful enough” 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
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
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
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
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 Retain same percentage ownership
“Price-Based” changes: Dilutive Financing (financing at lower price per share) 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
Anti-Dilution Protect investors if company issues equity at a
lower valuation than preferred Full Ratchet 3% Weighted Average: Broad Base: more favorable
92% Weighted Average: Narrow Base: less favorable to
company4%
© 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 23
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
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
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
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
Bottom Line (Almost) anything can be negotiated Pick your battles: Liquidation �
Preferences, Protective Provisions, �Board Control
Make sure you understand what you’re signing
© 2013 Valla & Associates, Inc., P.C. www.vallalaw.com 28
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.comPhone: +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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