venture capital financing
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DESCRIPTIONA 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.
- 1.November 13, 2013Majda Barazzutti 2013 Valla & Associates, Inc., P.C. www.vallalaw.com1
2. The Venture Capital Financing Process: The Legal Perspective 2013 Valla & Associates, Inc., P.C. www.vallalaw.com2 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.com3 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.com4 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.com5 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.com6 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.com7 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.com8 9. Alternatives: Strategic Investors Stage of Product Development: ScalabilityAims DifferNot Interested in Helping the Company GrowConflict of Interest: greater returns from commercial rights than growthExpertiseCould affect future VC financings 2013 Valla & Associates, Inc., P.C. www.vallalaw.com9 10. Venture Capital Identify the Right VC Due Diligence The Risk of Finders 2013 Valla & Associates, Inc., P.C. www.vallalaw.com10 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.com11 12. Clean Up Prior to Investing: Document Employees Founders Relationships Securities filings Confidentiality and Invention Agreements Prepare for VCs due diligence 2013 Valla & Associates, Inc., P.C. www.vallalaw.com12 13. Sample Term Sheet Binding Provisions: No Shop Confidentiality Applicable lawALL other provisions are not bindingSee examples: NVCA (http://www.nvca.org) 2013 Valla & Associates, Inc., P.C. www.vallalaw.com13 14. A Typical Term Sheet Valuation/Number of Shares/PriceLiquidation PreferenceRedemptionConversionAntidilutionVoting RightsProtective ProvisionsVesting of founders' stock 2013 Valla & Associates, Inc., P.C. www.vallalaw.com14 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.com15 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.com16 17. Liquidation Preferences Liquidation Preference: 1x or more Participating Preferred: Full participation Capped participation Non-participating19% 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.com17 18. Redemption Optional (Company call): Company can repurchase stock at original price (plus dividends) if Investors dont convert to Common after x yearsMandatory (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 premiumBut, Company must have funds legally available22% of all VC financings in 2012, 35% in down rounds 2013 Valla & Associates, Inc., P.C. www.vallalaw.com18 19. Voting rights/Protective provisions Preferred usually votes with Preferred on an as converted basisVote by Series/ClassUsually right to vote on x directorsApplicable law provides for rights for certain events (merger or creation of senior preferred stock)Investors often add additional actionsTerminate 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.com19 20. Voting rights/Protective provisions Amend Articles / Certificate (or Bylaws)Alter rights, preferences of Series A, affect Series AIncrease or decrease authorized shares PreferredStockMerger / acquisition, sale of substantially all assetsLiquidation / dissolutionDeclare or pay dividendChange authorized number of Board Directors 2013 Valla & Associates, Inc., P.C. www.vallalaw.com20 21. Conversion Preferred always has a conversion to Common feature, but loses all preferred privilegesOptional Conversion Holders can convert to Common at any timeAutomatic 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.com21 22. Conversion Conversion Ratio is initially 1:1Anti-dilution protection: conversion price adjustment, not automaticEvent-Based changes: Stock splits, stock dividends, reverse stock splits Price-Based changes: Dilutive Financing (financing at lower price per share) Retain same percentage ownershipExclusionsPay 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.com22 23. Anti-Dilution Protect investors if company issues equity at a lower valuation than preferredFull Ratchet Weighted Average: Broad Base: more favorable Weighted Average: Narrow Base: less favorable to company 2013 Valla & Associates, Inc., P.C. www.vallalaw.com3% 92%4%23 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.com24 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 rightsPiggy-backS-3Expenses 2013 Valla & Associates, Inc., P.C. www.vallalaw.com25 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.com26 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.com27 28. Bottom Line (Almost) anything can be negotiated Pick your battles: Liquidation Preferences, Protective Provisions, Board Control Make sure you understand what youre signing 2013 Valla & Associates, Inc., P.C. www.vallalaw.com28 29. Thank you! In bocca al lupo! Valla & Associates, Inc., P.C. 1990 N. California Blvd., Suite 1060 Walnut Creek, CA 94596 USAE-mail: email@example.com Phone: +1 925 705 7623 Fax: +1 925 705 7629www.vallalaw.com 2013 Valla & Associates, Inc., P.C. www.vallalaw.com29