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Seed Financing and Term Sheets
- 3. A. Valuation
1. Comparables
– Search for comparable companies based on growth
rate, risk profile, capital structure, size and timing of
cash flows.
– Industry-specific metrics may include subscribers,
members, “clicks”, etc.
– Problem of information gaps with private companies;
difficulties with comparability of private and public
companies.
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- 4. 2.
Net Present Value
– Discounted present value of projected cash flows and
assumed terminal value; terminal value a large
component of total value.
– Assumptions and estimates critical (growth rate,
discount rate, exit multiple, etc.) to value.
– Analysis difficult for start-up companies with significant
outflows in the early years followed by speculative
projected inflows in uncertain future periods.
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- 5. 3. Venture Capital Method
– Projected terminal value, discounted to present value.
– Often adjusted for expected subsequent dilutive rounds
of financing.
– Designed to arrive at desired investment return.
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- 6. B. Debt Capitalization
1. Loans
– Fixed in principal amount, maturity, interest rate.
– First claim against assets.
– Terms capable of being modified or extended.
– Preserves equity at the cost of ongoing debt service
and specified maturity date.
– Lender control issues.
– Adequacy of capital issues.
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- 7. 2. Convertible Notes
– Debt and equity features.
– Debt: fixed principal amount, maturity, interest rate.
– Debt claims against assets.
– Principal (and sometimes accrued interest) may be converted
into equity.
– Conversion may be at the option of the holder or the
company, and may be subject to certain contingencies.
– Often convertible (sometimes at a discount) into securities
issued in first equity round raised from outside investors;
effectively postpones need for valuation until outside investors
have set a value.
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- 8. C. Equity Capitalization
1. Common Stock
– Basic unit of equity ownership.
– Entitled to share in residual assets after payment of liabilities to
creditors and lenders and claims of holders of senior equity securities.
– Entitled to dividends if, as and when declared by the board of
directors.
– Except for matters expressly governed by a vote of senior equity
securities, entitled to vote on all matters presented to stockholders.
– In special cases, common stock may be divided into classes with
disproportionate or no voting rights; often used to maintain control of
founding family shareholders or for regulatory reasons.
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- 9. 2. Preferred Stock
– Preferred stock may be a “straight” preferred (non-convertible into
common stock) or convertible into common stock at the option of the
holder or upon the occurrence of certain events.
– Preferred stock may be “permanent” (not redeemable under any
circumstances) or redeemable (at set times or at the option of the
holder or the company).
– Generally, has a preference over common stock or other junior
equity securities as to rights in liquidation and/or rights to receive
dividends.
– Liquidation event includes dissolution or winding-up of the company
and, typically, a merger or sale of the company or other transaction
involving a change of control.
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- 10. D. Term Sheet Provisions
Scope of Financing
– Size of offering
– Price per share
– Pre-money valuation
– Resulting capitalization
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- 11. Terms of New Series of Preferred Stock
1. Dividends
– Specified dividend rate not typical for venture investments; preferred
stock will generally prohibit dividends on common stock as long as
the preferred stock is outstanding or unless comparable dividends
are paid on the preferred stock and common stock
– Preferred stock with a specified dividend rate may either provide for
“cumulative” or “non-cumulative” dividends
– Cumulative dividends will accumulate, whether or not declared by
the board, and will be added to amounts payable in liquidation; in
certain cases, cumulative dividends may compound, usually either
quarterly or annually; dividends may also be payable in certain
events, such as upon conversion or upon the closing of an IPO; may
also be used to increase amount of shares issuable upon
conversion into common stock
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- 12. 2. Liquidation Preference
– Liquidation event includes dissolution or winding-up of the
company and, typically, a merger or sale of the company or
other transaction involving a change of control
– Liquidation preference generally equal to invested capital,
plus declared and unpaid dividends or, in some cases,
accrued dividends
– Liquidation preference may be a multiple of invested capital,
guaranteeing a minimum positive return if conversion into
common stock not financially superior
– A participating preferred stock will be entitled to a liquidation
preference plus the right to share with the common stock in
residual assets based on the assumed conversion of the
preferred into common stock
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- 13. 3. Convertible Into Common Stock
– Typically, preferred stock convertible into common stock at any time at the
option of the holder into a number of shares based on the following formula:
Original Issue Price
Conversion Price
– Initially, the Conversion Price is typically set equal to the Original Issue Price
so that each share of preferred stock will be convertible into one share of
common stock
– Conversion Price will be proportionally adjusted for subsequent stock splits,
stock dividends, recapitalizations and similar organic changes
– Conversion Price will also be adjusted for subsequent dilutive offerings
(offerings below the then current Conversion Price of the preferred stock);
exceptions for issuance of common stock upon conversion of existing
convertible securities, employee stock plans up to a certain amount or as
approved by the board, shares issued in correction with acquisitions or to
lenders, vendors or others in connection with various business arrangements
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- 14. − “Full ratchet” adjustment will adjust the Conversion Price
downwards to the price of any dilutive offering, regardless of
the number of shares issued in the dilutive offering
− “Weighted average” adjustment is more typical and takes into
account the price and size of the dilutive offering relative to
the previously outstanding stock
− “Broad-based” versus “narrow-based” weighted average antidilution formulas; “broad-based” will count all outstanding
options and convertible securities in the fully-diluted
calculation of shares outstanding and will result in a smaller
adjustment then a “narrow-based” formula which may include
only outstanding common stock and stock issuable upon the
conversion of the preferred stock
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- 15. 4. Mandatory Conversion Provisions
−
−
Requires conversion upon closing of a “Qualified Public
Offering”
Defined typically as an initial public offering with minimum net
proceeds to the company ($50 - $75 million) and a minimum
price to the public (representing a multiple of the preferred
conversion price)
5. Redemption of Preferred Stock
− Right of holders to require redemption by the company at
specified time or times
− Mechanism to force liquidity event after sufficient time to
implement business plan
− Corporate law prevents company from redeeming equity without
adequate “surplus”
− Remedies for failure to redeem may include additional board
seats
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- 16. 6. Preferred Stock Covenants
− Affirmative: delivery of financial and other information, access to
management and corporate records, board representation and
frequency of meetings, payment of obligations, etc.
− Negative: merger, sale or change of control transaction, sale of
assets, capital expenditures, incurrence of debt, affiliate transactions,
adoption of employee equity plans, change of business strategy,
issuance of senior or pari passu equity securities, etc.
− Covenants may require decisions by preferred shareholders, by the
board of directors or by representatives of the preferred shareholders
on the board; importance of group dynamics with multiple rounds of
financing
− Remedies problematic since preferred stock cannot be declared “due
and payable” like debt; often limited to damage claims, equitable
remedies or rights to additional board seats
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- 17. 7. Voting Rights
− Class vote on matters specifically affecting the preferred
stock; changes to the rights of the preferred stock, issuance
of additional preferred stock or senior equity securities,
election of preferred stock designees to the board, merger or
sale, etc.
− Typically, will vote on an as-converted basis with the common
stock.
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- 18. © 2014 Wilmer Cutler Pickering Hale and Dorr LLP
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- 19. Bob Schwed
Robert.Schwed@wilmerhale.com
+1 212 937 7276
Wilmer Cutler Pickering Hale and Dorr LLP is a Delaware limited liability partnership. WilmerHale principal law offices: 60 State Street,
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advised of all legal developments. Prior results do not guarantee a similar outcome. © 2014 Wilmer Cutler Pickering Hale and Dorr LLP
© 2014 Wilmer Cutler Pickering Hale and Dorr LLP