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Earlier Stage Investments

December 2015

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Agenda • Deal structures • General solicitation • “Accredited investor” crowdfunding

• Matchmaking sites and syndicate investments

• Crowdfunding • Regulation A offerings

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Deal Structures

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Equity investments versus convertible debt investments

• Equity investments • Investors purchase shares of stock representing a known ownership percentage • Requires investors and company to negotiate a current valuation of the company • Equity holders have residual interest in company after creditor claims • More to negotiate, more documentation, higher legal fees

• Convertible debt investments • Investors “loan” money in exchange for the right to receive shares of stock in the

future representing an unknown ownership percentage • Defers negotiation of valuation of the company to the future • Debt holders have priority interest in company above equity holders • Less to negotiate, less documentation, lower legal fees

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Equity investments • Two-tiered capital structure

• Common stock for founders, employees and consultants • Low valuation allows company to provide attractive equity incentives • Often issued upon the exercise of stock options • Often issued subject to vesting conditions • “Plain vanilla” equity security with rights defined by statute

• Preferred stock for investors • High valuation allows company to raise capital with least dilution • Issued in one or more series at different prices over time • Highly negotiated rights

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Equity investments (cont’d)

• Series seed preferred stock rights • Pre-money valuation (investor ownership/founder dilution) • Liquidation preference and participation rights • Voting rights (board seat and corporate governance) • Conversion rights • Pre-emptive rights • Additional contractual rights (e.g., same rights provided to investors in next financing)

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Valuation • Pre-money valuation + amount raised = post-money valuation • Amount raised / post-money valuation = investor ownership % (founder

dilution) • e.g., raising $2 million on a $6 million pre-money valuation (resulting in a

$8 million post-money valuation) yields a 25% investor ownership and 25% founder dilution

• Pre-money valuation is theoretical enterprise value of the company prior to the financing, but . . . • In reality, pre-money valuation is driven by amount raised and required investor ownership • Supply (of both angel capital and investment opportunities in specific sector) and demand (for

both angel capital and investment opportunities in specific sector) drive cost of capital • Competition among investors is most significant source of founder leverage

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Liquidation preference and participation • Liquidation preference

• The right of Series Seed Preferred to be paid a portion of the acquisition proceeds before any amount is paid to common stockholders, i.e., a preferential return of capital

• Usually 1x the original issue price • Series Seed Preferred will convert to common stock if its pro rata percentage of acquisition

proceeds exceeds its liquidation preference

• Participation rights • Right of Series Seed Preferred to participate in remaining acquisition proceeds (on as-

converted basis along with common stock) after liquidation preference is satisfied • “Double dip”: participating preferred stockholder enjoys preferential return of capital in

liquidation preference and then enjoys pro rata share of remaining proceeds

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Voting rights • Board representation

• Series Seed Preferred right to elect one or more directors • Voting agreement required if lead investor does not control majority

• Protective voting provisions • Preferred votes with common on an as-converted basis on all matters • Preferred votes separately on specified matters

• Any change to the Series Seed Preferred rights • Any change to size of board of directors • Any creation of a senior security (i.e. next round of financing) • Any acquisition of the company

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Conversion rights • Series Seed Preferred has right to voluntarily convert to common stock at any time • Conversion rate is initially 1-for-1, adjusted for stock splits and stock dividends • Many Series Seed Preferred do not include price-based adjustments to conversion

rate for subsequent dilutive issuances • Upon conversion, Series Seed Preferred loses all preferential rights of a preferred

stockholder (e.g., liquidation preference) but also avoids any limitations applicable to preferred stockholders (e.g., no participation rights)

• Preferred stockholders to become common stockholders for sharing of acquisition proceeds

• Non-participating (or capped participating) Series Seed Preferred will convert to common stock when its pro rata share of acquisition proceeds exceeds its liquidation preference (or capped participation)

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Pre-emptive rights • Series Seed Preferred has right to invest its pro rata share in future

financings • Ability of angel investor to maintain its ownership percentage (with

increased investment) as company raises financing over time • May require minimum threshold of stockholdings to be eligible (i.e.

pre-emptive rights only enjoyed by “major investors”) • May be waiveable by majority-in-interest of Series Seed Preferred on

behalf of all Series Seed Preferred

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Additional contractual rights • Series Seed Preferred have right to receive same rights provided to

investors in next financing • Registration rights • Price-based antidilution adjustments to conversion rate • Rights of first refusal and co-sale rights on proposed founder dispositions • Pre-emptive rights (if not provided in Series Seed Preferred financing) • Dividend preference • Redemption rights

• Series Seed Preferred investors defer negotiation on additional rights and merely piggyback off negotiations of next round investors

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Convertible debt investments • Debt-like features

• Bears interest at fixed rate • Has stated maturity date • Repaid at acquisition before any acquisition proceeds go to equity holders

• Equity-like features • Converts into preferred stock at next round of financing • Equivalent to a “prepaid investment” in next round of financing • Investor piggybacks off the negotiation of valuation and preferred stock rights by

next round’s investors

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Convertible debt investments (cont’d)

• Convertible promissory note provisions • Interest rate • Maturity date • Conversion discount • Valuation cap • Alternatives upon acquisition • Alternatives upon maturity

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Interest rate; maturity date • Interest rate

• AFR – 10% • Insignificant element of investor’s return profile, which is entirely based upon equity

upside following conversion

• Maturity date • 12 months – 36 months • Provides investor with some leverage and ability to influence company if next round

of financing does not occur within contemplated timeframe

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Conversion discount • Converts into equity at the next round of financing

• If no conversion discount, note is converted into Series A at the same price per share paid by Series A investors

• If 10% conversion discount, note is converted into Series A at 90% of the price per share paid by Series A investors

• e.g. if Series A is sold to investors at $1.00 per share, note holder receives one share of Series A preferred for every $0.90 invested

• Conversion discount rewards note investor for investing prior to Series A

• Note investor enjoys all of the same rights (including liquidation preference and participation rights) that Series A investor negotiates for itself

• Conversion discount may be implemented via (1) discounted issuance of Series A (resulting in liquidation preference in excess of capital raised), (2) undiscounted issuance of Series A-1 at 90% of Series A price (resulting in liquidation preference equal to capital raised), or (3) undiscounted issuance of Series A plus additional shares of common stock (resulting in liquidation preference equal to capital raised)

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Valuation cap • Noteholder’s ownership percentage is inversely related to Series A

valuation • The higher the Series A valuation, the smaller the ownership interest the note holder receives • e.g., $1m convertible note investment converts into 10% of company with post-Series A

valuation of $10m, but same $1m convertible note investment converts into 1% of company with post-Series A valuation of $100m

• Valuation cap guarantees note investor a minimum ownership percentage • Valuation cap negotiated at time of note investment specifies maximum valuation at which note

converts into Series A • e.g., $1m convertible note investment with $9m valuation cap converts into 10% of company

even if post-Series A valuation is $100m

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Alternatives upon acquisition • Premium repayment

• Note repaid at 2x or 3x original principal amount, senior in right to any distribution of acquisition proceeds to stockholders

• Conversion into default preferred stock • Note converted into a “default” series of preferred stock (sometimes denominated as Series AA Preferred

Stock) with rights, privileges and preferences set forth in a summary term sheet attached to convertible debt investment agreements

• Conversion valuation may be specified in summary term sheet or be valuation cap • Allows noteholder to participate in acquisition proceeds as an equityholder

• Conversion into common stock • Note converted into common stock immediately prior to acquisition • Conversion valuation may be specified in convertible debt investment agreements or be valuation cap • Allows noteholder to participate in acquisition proceeds as an equityholder

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Alternatives upon maturity • Repayment upon demand

• Noteholders (either individually or by the action of a specified requisite percentage-in-interest of noteholders) may demand repayment of 1x principal plus accrued interest

• Remain outstanding • Note remains outstanding and continues to accrue interest until a conversion or

repayment event occurs

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General Solicitation

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General solicitation • General solicitation and general advertising are permitted for offerings

under Rule 506(c) of Regulation D • No dollar limit on size of financing • No limit on number of investors • No required disclosures • Resale limitations (i.e. no resale without registration or an exemption from registration) • Securities may be sold to accredited investors only • Company must take reasonable steps to verify accredited investor status (non-exclusive list of

methods includes tax returns, bank statements, credit agency reports, etc.) • Company may use third party verification (broker-dealer, investment advisor, attorney or CPA) • No “bad actors” at company (including > 20% stockholders), promoters, investment managers

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Rule 506(c) summary • Amount of offering: unlimited • By? Rule 506(c) can be used by reporting and non-reporting issuers, so long as issuer and other

covered persons are not subject to bad actor disqualification • Who can invest? Accredited investors only • What is the investor cap? None • Is an intermediary required? Not technically required; easier for an issuer to conduct a Rule

506(c) offering on its own • Manner of offering: involves general solicitation • Reporting following the offering: filing of a Form D • Bad actor disqualification: the issuer will be required to obtain information from all covered

persons • Documentation: there may or may not be an offering memorandum; the investors will sign a

securities purchase agreement with the issuer; each investor will make payment to the issuer directly generally

• State blue sky: securities sold pursuant to Rule 506(b) are “covered securities”

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Rule 506(b) vs. Rule 506(c) Sep. 23, 2013 – Dec. 31, 2014

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Rule 506(b) vs. Rule 506(c) Sep. 23, 2013 – Dec. 31, 2014

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Accredited Investor Crowdfunding

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“Accredited investor crowdfunding” • Many “matchmaking portals” rely on Rule 506(b) to conduct internet-based

offerings solely to accredited investors • These offerings are structured such that the matchmaking portal makes an

offer only to accredited investors with which the portal has established or has a pre-existing substantive relationship

• Issuer specific or offering specific information is not generally available and is made available only to “members” or on a password-protected basis to those investors known to the portal

• An accredited investor crowdfunded offering relies on the guidance provided in pre-JOBS Act no-action letters (IPONet, Lamp Technologies, etc.) and affirmed recently in C&DIs on general solicitation, as well as in a recently issued no-action letter, CitizensVC

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“Accredited investor crowdfunding” (cont’d)

• Many matchmaking portals use the feeder fund or syndicate investing approach

• A well-known investor or investor group will lead the deal, invest a significant amount, monitor the negotiations of the term sheet, participate in diligence, and post-investment monitor the deal

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“Accredited investor crowdfunding” (cont’d)

• Data from a leading matchmaking platform, AngelList, shows that almost all of the deals completed through the site are private

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Crowdfunding

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Regulation Crowdfunding • Amount of offering: up to $1 million in a 12-month period through crowdfunding • By? Issuers that are not reporting companies, not funds, and not subject to

disqualification • Who can invest? Accredited and non-accredited investors • Is there an investor cap? An investor is subject to an investment limit on amounts

invested in any 12-month period through crowdfunding equal to: • The greater of: $2,000 or 5% of the lesser of the investor’s annual income or net worth if either

annual income or net worth is less than $100,000; or • 10% of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of

$100,000, if both annual income and net worth are $100,000 or more • Is an intermediary required? Yes. An issuer can only engage in crowdfunding

through a broker-dealer or a funding portal, and can use only one intermediary for an offering

• Manner of offering: the offering must be conducted only through the platform

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Regulation Crowdfunding (cont’d) • Offering disclosure requirements: an issuer that elects to engage in a

crowdfunded offering will be required to prepare initial disclosure about the issuer and the offering on Form C

• Form C requirements resemble the Form 1-A requirements for a Regulation A offering and include a discussion of:

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• Use of Proceeds; • The Targeted Offering Size; • Offering Price; • Business; • Directors and officers; • Beneficial Ownership and Capital

Structure;

• Indebtedness; • Related party transactions; • Exempt offerings; • Risk factors; • Transfer restrictions; and • Management’s Discussion and

Analysis.

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Regulation Crowdfunding (cont’d) • Financial Statement Requirements: in addition, a Form C must include certain

financial statements prepared in accordance with U.S. GAAP. Audited financial statements must be conducted in accordance either with AICPA standards or PCAOB standards. Requirements depend on the target offering size as follows:

• $100,000 or less: the amount of total income, taxable income and total tax or equivalent line items, as reported on the federal tax forms filed by the issuer for the most recently completed year (if any), certified by the principal executive officer of the issuer, and the financial statements of the issuer, also certified by the principal executive officer. If financial statements of the issuer are available that have either been reviewed or audited by a public accountant independent of the issuer, then, these financial statements must be provided instead of the materials described in the preceding sentence.

• More than $100,000 and less than $500,000: financial statements of the issuer reviewed by a public accountant independent of the issuer. If financial statements of the issuer are available that have been audited by a public accountant independent of the issuer, the issuer must provide those instead of the reviewed statements.

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Regulation Crowdfunding (cont’d) • More than $500,000: financial statements of the issuer audited by a public accountant independent of the

issuer; provided, however, that for issuers that are first-time issuers, offerings that have a target offering amount of more than $500,000 but not more than $1 million, financial statements of the issuer reviewed by a public accountant independent of the issuer. If audited statements are available, those must be provided instead.

• Advertising: an issuer’s ability to advertise or promote the offering is limited to certain offering notices (basic offering details) and certain communications with potential investors made through the platform

• Intermediary restrictions and requirements: the intermediary is subject to educational and other obligations and limitations

• Reporting following the offering: until an issuer terminates its reporting obligations, it is required to file amendments for material changes (C/A), periodic updates (C-U) and annual filings (C-AR)

• Transfer restrictions: securities sold in such an offering are subject to certain transfer restrictions for one year

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Regulation A

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Regulation A • The SEC adopted final rules which:

• Amend and modernize existing Regulation A. • Create two tiers of offerings:

• Tier 1 for offerings of up to $20m ($6m for selling stockholders); or • Tier 2 for offerings of up to $50m ($15m for selling stockholders).

• Set issuer eligibility, disclosure and reporting requirements. • Impose additional disclosure and ongoing reporting requirements, as well as an

investment limit, for Tier 2 offerings, and, given these investor protection measures, makes Tier 2 offerings exempt from certain blue sky requirements.

• Became effective June 19, 2015

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Regulation A (cont’d) • Amount of offering: Tier 1 up to $20 million in 12-month period, Tier 2 up to $50 million in 12-month

period • By? Eligible issuers are non-reporting issuers, organized in and with their principal place of business in the

United States or Canada, other than funds, blank check companies, issuers subject to various disqualifications

• Who can invest? Accredited and non-accredited investors • What is the investor cap? A non-accredited natural person is subject to an investment limit and must limit

purchases to no more than 10% of the greater of the investor’s annual income and net worth, determined as provided in Rule 501 of Regulation D (for non-accredited, non-natural persons, the 10% limit is based on annual revenues and net assets). The investment limit does not apply to accredited investors and will not apply if the securities are to be listed on a national securities exchange at the consummation of the offering

• Is an intermediary required? No • Manner of offering: the offering may involve “testing the waters” • Offering disclosure requirements: an issuer must prepare and file with the SEC and have qualified an

offering statement on Form 1-A.

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Regulation A (cont’d) • Part I (Notification) requires certain basic information regarding the issuer, its eligibility,

the offering details, the jurisdictions where the securities will be offered, and sales of unregistered securities.

Part II (Offering Circular) Part II contains the narrative portion of the Offering Circular and requires disclosures of basic

information about the issuer; material risks; use of proceeds; an overview of the issuer’s business; an MD&A type discussion; disclosures about executive officers and directors and compensation; beneficial ownership information; related party transactions; and a description of the offered securities.

This is similar to Part I of Form S-1 and an issuer can choose to comply with Part I of Form S-1 in connection with its Offering Circular. An issuer that chooses to list its securities concurrent with the completion of a Regulation A

offering will be required to use Part I of Form S-1 in connection with the Offering Circular Other Tier 2 issuers also are likely to use Part I of Form S-1 as well

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Regulation A (cont’d) • Financial statement requirements: differ for Tier 1 and Tier 2 offerings:

• Tier 1 and Tier 2 issuers must file balance sheets and other required financial statements as of the two most recently completed fiscal year ends, or for such shorter time as they have been in existence, subject to certain exceptions.

• The financial statements for an issuer in a Tier 2 offering are required to be audited by an independent auditor that need not be PCAOB-registered, except as noted below.

• An issuer in a Tier 2 offering that seeks to have a class of securities listed on a national securities exchange concurrent with the Regulation A offering must include financial statements audited in accordance with PCAOB standards by a PCAOB-registered firm.

• Advertising: an issuer may solicit any investors (not subject to the requirements applicable to EGCs, for example); materials may be used both before and after the offering statement is filed

• Intermediary restrictions and requirements: an issuer can conduct a Regulation A offering with or without a financial intermediary

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Regulation A (cont’d) • Reporting following the offering: Tier 1 issuers would have no ongoing reporting obligation, other

than to file an exit report on Form 1-Z within 30 days after the termination or completion of a Regulation A-exempt offering. Tier 2 issuers will be subject to ongoing reporting. Tier 2 issuers would be required to file:

• Annual reports on Form 1-K (120 calendar days after the issuer’s fiscal year end); • Semi-annual reports on Form 1-SA (90 calendar days after the end of the first six months of

the issuer’s fiscal year); • Current reports on Form 1-U; • Special financial reports on Form 1-K and Form 1-SA; and • Exit reports on Form 1-Z.

• Bad actor disqualification: the issuer will be required to obtain information from all covered persons

• State blue sky: securities sold pursuant to Tier 1 will be subject to state blue sky requirements; securities sold pursuant to Tier 2 will be “covered securities”

• Transfer restrictions: securities sold pursuant to Regulation A are not “restricted securities”

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Market Trends

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Market Trends