2. Sources of Capital
Self Funding
Angel
Venture Capitalists (VCs)
Corporate Investment (Strategic Investment)
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3. Capital Structure of Typical Start Up
Founders: Common Stock
(Vesting over time)
Employees: Common Stock Options
(With vesting over 4 years)
Investors: Convertible Preferred Stock
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4. Angel Investors = High Net Worth
Individuals with High Risk Appetite
Early stage preference
Usually “one and done”
Terms offered by company rather than
investors
Less sophisticated on terms and value
Less “value-added”
Endangered species?
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5. How to Approach Angels
Individuals (network)
Other successful entrepreneurs
Organized Groups (TIG, Atlantis, PAN, CAP,
CHAP)
One signature for all dealings
Follow-on investments possible
Better preparation for institutional rounds
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6. Venture Capital Requirements
25-30% Internal Rate of Return
Market Size / Position
Management Team
“Bet on Jockeys, not Horses”
Clear Exit Strategy
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7. Current Venture Capital Environment
Plenty of Capital in the System?
$28 billion committed in 2008 (21% decline)
Investors More Cautious with Deals
Potential Exits Uncertain and Delayed
Valuations Declining
Have We Bottomed Out?
Terms Heavily Negotiated
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8. 4 Principles of Term Sheets
Valuation
1
Exit Strategy
2
3 Down-Side Protection
4 Control
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12. Acquisition
Liquidation Preference
Multiple of Liquidation Preference
Preferred gets multiple times investment back before Common gets any money
Participating Preferred
Preferred gets investment back first, remaining proceeds shared between
Common and Preferred pro-rata
Limited or Capped Participation
Preferred gets investment back first, remaining proceeds shared between
Common and Preferred until Preferred reaches a multiple of investment (usually
2x – 5x) and remainder goes to Common
Non-Participating Preferred
Preferred gets investment back first, remaining proceeds go to Common
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13. Effect of Liquidation Preference
Hi-Tec, Inc. has 2,000,000 shares of Series A
Preferred outstanding that was purchased for
$1.00 per share and 2,000,000 shares of
Common Stock outstanding.
It has just been acquired for $15M. How is
the money divided?
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14. Effect of Liquidation Prefere nce
4x Multiple of Liquidation Preference
with Full Participation:
1. Preferred receives 4x liquidation preference ($8M).
2. The remaining $7 million is split pro rata between the
Common and Preferred ($3.5 million each).
Total return
Preferred 11.5 million
Common 3.5 million
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15. Effect of Liquidation Preference, cont.
1x Liquidation Preference
Participation Capped at 4x:
1. Preferred receives liquidation preference ($2M).
2. The remaining $13M is split pro rata between the
Common and Preferred until Preferred receives $8M (i.e.
$6 million each).
3. The remaining $1M goes to the Common Stock holders.
Total return
Preferred 8 million
Common 7 million
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16. Effect of Liquidation Preference
Non-Participating Preferred:
1. Preferred receives liquidation preference ($2M).
2. The remaining $13M goes to the Common, but because
the Common holders will receive more than the
Preferred holders, the Preferred holders will convert
into Common and all holders will be treated equally.
Total return
Preferred 7.5 million
Common 7.5 million
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17. Liquidation Preference Summary
Current Trends
Multiple Liquidation Preferences
15% of financings
1x – 2x = 70% (down from 80% in Q407)
2x – 3x = 20%
>3x = 10% (up from 0% in Q407)
Participating Preferred
57% of financings
51% were uncapped (up from 41% in Q407)
Source: Fenwick & West LLP – Trends in Terms of
Venture Financings in the San Francisco Bay Area (Fourth Quarter 2008)
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20. Down-Side Protection
Anti-Dilution Protection
Ratchet (Largest adjustment)
Conversion price of Preferred adjusted down to price of dilutive issuance
Broad based weighted average (Least adjustment)
Conversion price of Preferred adjusted down based on a weighted average of
outstanding securities, including options and warrants
Narrow based weighted average (Medium adjustment)
Conversion price of Preferred adjusted down based on a weighted average of
outstanding capital stock – does not include options and warrants
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21. Down-Side Protection
Don’t Forget Exclusions
Option pool of limited size
Mergers / acquisitions
Warrants for banks / leasing companies
Strategic transactions
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22. Anti-Dilution Calculation
Facts:
Hi-Tec, Inc. has:
3,000,000 shares of Common Stock,
5,000,000 shares of Series A Preferred Stock
Options to purchase 2,000,000 shares of Common Stock outstanding.
The Series A Preferred Stock was sold at $1.00 per share.
Hi-Tec, Inc. now would like to issue 4,000,000 shares of Series B
Preferred Stock at $0.50 per share.
How is Series A Preferred Stock affected?
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23. Anti-Dilution Calculation, cont.
Ratchet:
Series A initially converts to Common on a 1:1 ratio based on
its purchase price $1.00/$1.00.
After the issuance of Series B, the conversion price is
ratcheted down to $0.50.
The new conversion ratio is calculated as follows: $1.00/$0.50
(or 1:2). So, for every 1 share of Series A converted, the holder
will receive 2 shares of Common.
So, the 5,000,000 shares of Series A will convert into
10,000,000 shares of Common Stock.
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24. Anti-Dilution Calculation, cont.
Broad-Based Weighted Average:
Formula: (all outstanding securities) x Conversion Price + Amount Raised
All outstanding securities + New Securities Issued
Calculation: (3,000,000 + 5,000,000 + 2,000,000) x $1.00 + $2,000,000 = 0.8571428
3,000,000 + 5,000,000 + 2,000,000 + 4,000,000
Conversion Ratio: $1.00 ÷ $0.8571428 = 1.166
So, the 5,000,000 shares of Series A will convert into
5,833,333 shares of Common Stock.
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25. Anti-Dilution Calculation, cont.
Narrow-Based Weighted Average:
Formula: (Common + Preferred) x Conversion Price + Amount Raised
Common + Preferred + New Securities Issued
Calculation: (3,000,000 + 5,000,000) x $1.00 + $2,000,000 = 0.8333333
3,000,000 + 5,000,000 + 4,000,000
Conversion Ratio: $1.00 ÷ $0.8333333 = 1.2
So, the 5,000,000 shares of Series A will convert into
6,000,000 shares of Common Stock.
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26. Down-Side Protection - Summary
Current Trends
Ratchet = 2%
Weighted Average = 98%
No Anti-Dilution Protection = 0%
Source: Fenwick & West LLP – Trends in Terms of
Venture Financings in the San Francisco Bay Area (Fourth Quarter 2008)
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27. A Tale of Two Term Sheets
Two companies financed under exactly the same conditions
Initial Capitalization
3,000,000 founders shares
2,000,000 shares initially reserved for options
Series A Financing
Raises $5M at a $5M pre-money valuation
Series B Financing
Raises $2M at a $5.5M pre-money valuation (and adds 1M shares to
option pool)
Series C Financing
Raises $21M at a $63M pre-money valuation (and adds 1M shares
to option pool) at a $84M post-money valuation
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28. Key Financing Terms
Company A
Narrow-based weighted average anti-dilution
protection
Participating Preferred capped at 4x Liquidation
Preference
Company B
Ratchet Anti-Dilution
4x Participating Preferred with no cap
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29. Cap Tables Following Last Financing
Company A Company B
Common 3,000,000 Common 3,000,000
Options 4,000,000 Options 4,000,000
5,000,000 5,000,000
Series A Series A
(6,000,000) (10,000,000)
Series B 4,000,000 Series B 4,000,000
Series C 5,666,666 Series C 7,000,000
Common Ownership: 13.24% Common Ownership: 10.71%
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30. Payout Scenarios
$40M acquisition?
Company A: $1.6 million (or 4%)
Company B: -0-
$100 million acquisition?
Company A: Approximately $10.5 million (or 10.5%)
Company B: -0-
$200 million acquisition?
Company A: Approximately $23.7 million (or 11.85%)
Company B: Approximately $9.4 million (or 4.7%)
$500 million acquisition?
Company A: Approximately $66.2 million (or 13.24%)
Company B: Approximately $41.6 million (or 8.32%)
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31. Down-Side Protection - Redemption
Forced liquidity: Zombie companies
Timing: 5-7 years
Amount (all at once or percentage)
Forced exercise during certain period or
“any time” after target date
Statutory limits on share repurchase
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33. Control
Board of Directors
Key Rights
Appoint and fire officers
Set policy/Make major decisions
Issue options
Number of directors
Investors: Election of BOD members by
“series” or “class” vote
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34. Control
Protective Provisions
Must obtain approval of the Preferred to:
Authorize additional shares of stock
Create a new series of stock with equal or
greater rights
Complete a merger/sale of assets
Change the size of Board of Directors
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35. Control
Typical Additional Investor Rights
Information Rights
Co-Sale Rights
First Refusal Rights
Preemptive Rights
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36. Hutchison Law Group
Serving the Southeast’s life science
and technology communities.
Represent companies of all sizes,
with a strong focus on emerging
growth companies from inception
through exit.
Serve clients along the Southeast
corridor from Maryland to Florida.
Extraordinary depth and experience
in law, technology and business.
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37. Questions?
(and hopefully answers)
Glen Caplan
Hutchison Law Group
gcaplan@hutchlaw.com
919.829.4303
www.linkedin.com/in/glencaplan
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