Business, Law, and Innovation
Entrepreneurial Finance
Lecture 5
Spring 2014
Professor Adam Dell
The University of Texas School of Law
Stages of Financings
Angel
Venture Capital
Private Equity
Growth Equity
IPO
PIPE
Stage
Sources
Form
Size
Angel
Friends & Family, SBC
Common / Loan
$100-2MM
Venture Capital
Institutional Firms
Preferred Stock
$1-10MM
Private Equity
Growth Equity
Institutional Firms
Preferred Stock
Re-Cap
$10-50MM
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 POINTS
Usually 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)?
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
1st: Debt Holders
2nd: Series B rd
3 : Series A
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-money
Pre Money: $10m
Post Money: $15m
Series A Investor bought: 33% of the company
Founders, existing (Angel) investors: diluted by 33%
BUT, Series A required a 30% ISO Pool POST Series A
So….Founders, existing investors: diluted by 63%!
33%
30%
37%
Series B (Dilution…Yes More!)
Series B – Raise $20m @ $30m pre-money
Pre Money: $30m
Post Money: $50m
Series B Investor bought: 40% of the company
Founders, Angel, Series A, ISO: diluted by 40%
40%
22.2%
19.8%
18%
Series B: 40%
Series A: 33% x 60% = 19.8%
Founders: 37% x 60% = 22.2%
ISO: 30% x 60% = 18%