How to Prepare Your Startup for Venture Capital Investment - Part 1

© 2020 Haynes and Boone, LLP
T 11/16/21 How to Prepare Your Startup for Venture
Capital Investment - Part 1
#startup
1
Roger Royse
@rroyse00

Venture Capital
2

VC Funding at Record High
 Global Venture Funding Hits All-Time High In First Half Of 2021, With
$288B Invested
 Crunchbase News July 7, 2021
3

Q3 2021 Numbers
4
US VC deal activity at new record
$238 Billion so far in 2021; total volume in 2020 was $166 billion
Impact Capital up to $5.3 billion from $3.7 billion
Angel Seed and first financings
Angel - $2.5 billion 2020; $2.7 billion so far in 2021
Seed - $8.7 billion; $8.6 billion so far in 2021
Half of all 2021 deals exceed $10 million
Late stage: $111 billion to $172 billion so far in 2021
PitchBook-NVCA Venture Monitor

Executive Summary
 Team
 Projections
 Market
 Industry
 IP and Patents
5

Pitch Deck
 Market Size
 Team
 Product
 Go To Market Strategy
 Financial projections
 NOT VALUATION
 Get a professional designer!
6

Pitch
 Mission
 Problem to be solved
 Solution (aspirin, not vitamins)
 Opportunity
 Competition (or alternatives)
 Product
 Business Model
7

Money –The Priced Round
 VC or Institutional Investor
 Preferred Stock
 Valuation Methods
 Score Card
 Venture Capital Method
 Berkus Method
 Cayenne Calculator
 Risk Factor Summation
 Negotiation
8

Money –The Priced Round
 More Valuation Methods
 (Patents + People) x $1 Million
 Comparables
 Discounted Cash Flow
 Market Multipliers
 Discount to Public Companies
9

Rewards-Based Crowdfunding
 Kickstarter, Indiegogo
 Marketing effect of offering
 Tax issues
 FTC or state law liability

SAFEs and Convertible Notes
 Convertible Notes and SAFEs
 Debt obligations that convert to preferred stock
 Conversion feature – automatic, optional, prepayment
 Valuation Cap
 Sets a maximum valuation at which note will convert
 Discount
 Early investors get a discount to the preferred price
 Change of Ownership
 Investors convert to common or get a multiple on a sale of the
company prior to a priced financing round
 Shadow Preferred
 Pre and Post Money
 MFN
11

Convertible Debt
 Short term
 Secured?
 Subordinate?
 Interest
 Fixed repayment
 Discount
 Valuation Caps
12

SAFEs
 Simple agreement for future equity
 Pre and Post Money
 Pro Rata Rights
13

Effect of Valuation Caps
14
Founders 4,000,000 100% 4,000,000 100%
Stock Pool 0 0% n/a
total 4,000,000 100% 4,000,000 100%
Company sells a $1,000,000 SAFE with a $4,000,000 pre money valuation cap
That means that the SAFE will take 20% of the capitalization ($1,000,000/$5.000,000)
Fully Diluted % Issued %

The UNSAFE
 Valuation Caps + SAFE = Unknown Dilution
Pre–Money – SAFEs take dilution of other SAFEs
Post-Money – SAFEs do not dilute for other SAFEs
https://safegenie.io/ is a tool that helps project pre money SAFE valuation
15

Series Seed Stock
 Watered down preferred stock
 Justifies low common stock price
16

Pre and Post Money Valuation Caps
17
Founders 4,000,000 100% 4,000,000 100%
Stock Pool 0 0% n/a
total 4,000,000 100% 4,000,000 100%
Company sells a $1,000,000 SAFE with a $4,000,000 pre money valuation cap
That means that the SAFE will take 20% of the capitalization ($1,000,000/$5.000,000)

SAFE and Conv Debt Traps
 Post Money SAFEs
 Valuation caps and excessive dilution
 Securities law violations
 Cap Tables
18

Money to Not Take
 Investor goals
 Cooperation and Accessibility
 Control
 Terms and Valuation
19

“Avoid venture capital unless you absolutely need it.” Randy
Komisar, venture capitalist*
*Straight Talk For Startups
20

Should You Take Venture Capital?
 Must give up Equity
 No near term cash flow
 Risky
 Illiquid
 Can the business scale?
 Explosive growth
 Huge market
21

Which VC should I approach?
 Thematic Investors bet on their thesis of what is next
 Domain Investors focus on an industry that they know well
 Quant Investors focus on data
 People Investors bet on the jockey, not the horse
 Tech investors bet on the horse
22

Venture Capital Economics 2/20 Formula
 2% management fee on committed capital
 20% carried interest
 7 to 10 year terms
 LPS want 2 1/2 to 3 times investment return
 VC fund must earn 3 to 4 times investment to
return that amount
23

Venture Capital Economics – Expected Performance
 50% lose money
 20% – 30% are singles or doubles
 The rest must be home runs (10X to 100X)
24

General VC Fit
 Large potential market
 First Mover or first to market advantage
 Long term scale over short term profits
 Not able to service debt
 Traction!
25

Venture Capital Economics – Management
 Venture capital will participate in management
 Board seats
 Board Observer
 Management rights letter (for VCOC exemption)
 Seven to ten year term (and longer)
 Precludes small investments
 Board meetings
 Management
26

Venture Capital Metrics
 Team
 Domain expertise
 Technical co-founders
 Technology or product
 Solve problems, address pain points
 Customer validation
 Market size
 Must be a huge market
27

Picking a VC
 Reputation
 Likelihood of closing
 Stage of fund
 Size of Fund
 How much dry powder?
 Is there a fund 2, fund 3 etc.?
 Are they litigious?
 Deal with decision makers
28

Entrepreneur VC Fit
 Network
 Temperament
 Advice
 See the published email from the CEO of CircleUp to an
investor at for an example of a VC/Founder relationship
that did not work out
29

Company VC fit
 Capital intensive business?
 Follow on funding?
 Time to exit
30

Structuring For Venture Capital
 Business Model
 Choice of Entity
 Cap Table
 Vesting
 Debt
31

Series A is the New Series B
 Series Seed
 Pre-Seed
 Series A-1, A-2
32

Types of Funds
 Micro VC – angels with other people’s money
 Seed Stage Fund – early, first institutional money
 Mid Stage – B and beyond
 Late Stage
33

Syndicates
 Lead or Co Lead and followers
 Party rounds
34

Other Parties
 Lawyers
 CPA
 Banker/Broker/Finders
 Mentors and Advisors
35

Strategic Venture Capital
 Can you pivot?
 Will it affect customers?
 Follow on investors
 Change in management
 Strategic agreements
 Confidentiality
 ROFR, right of first look, right of first offer
 Strategic objectives
 Less operational involvement
36

Venture Debt
 Expensive (fees and warrant coverage)
 Secured by IP
 Less dilution
37

Choice of Entity
 Limited Liability Company (LLC)
 S Corporation (S Corp)
 C Corporation (C Corp)
 Foreign Corporation
38

Advantages of a C Corporation
1. Operating Agreements
2. S Elections
3. Suspended Losses
4. 704(c) Allocations
5. Venture Capital
6. QSB Stock
7. Stock Option Plans
8. LLC Debt
9. Reorganizations
10. Fringe Benefits
11. Audits and Liabilities
12. Contingent Allocations
39

Qualified Small Business Stock – 1202 and 1045
General Requirements
 Original issue
 Five-year holding period
 100% post-Sept. 27, 2010
 C Corporation issuer
 Up to $10 million or 10 times basis exclusion
 1045 Rollover treatment
40
 $50 million Gross
Assets Test
 Active Business Test
 No significant
redemptions
Note: California does not follow federal income tax treatment of QSB stock under
I.R.C. § 1202.

VC Considerations
1. QSBS
2. VC’s LPA will not allow investment in a
passthrough
1. Tax exempt investors want to avoid UBTI
2. Foreign investors want to avoid ECI
3. VC wants to be able to manage losses
1. No K-1’s showing losses
41

Founder’s Equity
42
 Vesting
 Equal Percentages
 Subjective
 Formula

Advisors
43
FAST Model
Valuation
Milestones and
Deliverables
Vesting Stock v.
Options

Currency
 Options
 NSOs
 ISOs
 Extended NSOs
 RSUs
 Restricted Stock
 Phantom Plan Units
44

Vesting
 Who should vest
 How long?
 Acceleration?
 Change of control
 Termination without cause
 Double and single triggers
45

The VC’s View of Vesting
VC will require unvesting shares so vesting period could be 8 years
Fund life can be 7 to 10 years
Most exits are M&A - Fewer and longer IPOs
Extended Option exercise periods
46

Class F Supervoting Stock
Special class of common that has super voting rights
Facebook, Google Snap
May be negotiated away in institutional round
47

Transfer Restrictions
 Right of First Refusal (ROFR)
 Lock Ups
 Co-Sale Rights
 Drag Along
 Buy Sell
 Rule 144
48

Cap Table
 Common Stock
 Options
 Warrants
 Convertibles
 Preferred Stock
49

Capitalization
50
Founders 5,000,000 38% 5,000,000 45%
Stock Pool 2,000,000 15% n/a
Series A 3,000,000 23% 3,000,000 27%
Series B 3,000,000 23% 3,000,000 27%
total 13,000,000 100% 11,000,000 100%

Other Diligence Issues
 IP Rights
 Patents
 Invention Assignments
 Licenses and ownership
 Data security
 Employment Claims (Homejoy)
 Tax Claims
 Regulatory
 Litigation
 Claims by prior employer
 Entrenched Management
 Material Agreements
51

Term Sheets
 Valuation
52

Participation
 Participating preferred stock returns its investment and
then shares pro rata in proceeds of a sale
 Non-participating convertible preferred stock either gets a
return of its investment or its pro rata share of proceeds
 Participation may be capped at a multiple of the
investment
 Conversion to common – auto-conversion and majority
vote
53

Dividends
 Preferred will have a dividend preference.
 A cumulative dividend on preferred shares must be paid
before any other dividends on common.
o If the company can't pay out a cumulative dividend in a
year, the amount is carried forward.
o Common in private equity deals, not in venture
 Non-cumulative is only paid when as and if declared.
54

Liquidation Preference
 Who gets paid first and how much?
55

Example of Liquidation Preference
 1X Non participating convertible preferred
 $1,000,000 invested for 10%
 Ex 1: Exit (sale) of company for $5,000,00
 Ex 2: Sale for $20,000,000
56

Board Representation
 Size of board
 Founder-friendly boards
 Role of the Board
 Observers
 Indemnification
 Insurance
57

Board rights
 Indemnification
 D&O Insurance
 Right to designate
58

Protective Provisions
 Class vote or majority vote
 Delaware law
 Separate vote for later investors
 Do the interests of different
investors diverge?
59

Protective Provisions
Standard:
 Right to veto or block certain corporate
actions
 Sale of the company
 Amendment to the company’s certificate or
bylaws so as to adversely alter or change the
rights of preferred stock
 Increase or decrease in the number of
authorized shares of preferred or common
 Authorization or issuance of equity security
having a preference over, or being on a parity
with, preferred stock
 Redemption of shares of preferred stock or
common stock
 Declaration or payment of dividends
 Change in the authorized number of directors
of the company
Other:
 Hiring, firing or change in the compensation of
officers
 Any transaction with any director, executive or
employee of the company
 Incurrence of indebtedness in excess of
$[____]
 Change in the principal business of the
company or the entering into any new line of
business
 Any purchase of a material amount of assets
of another entity
 Option plan increase
60

Information Rights
 Financial statements and other information
 Thresholds
61

Registration Rights
 Requires a company to list the shares publicly so
that the investor can sell
 Demand rights
 Piggyback rights
 S-3 rights
62

Common restrictions: Co-Sale Rights, ROFR, Drag
Along
 Co Sale and Tag-Along Rights – right to participate in a
sale
 Right of First Refusal – right of company (first) and
investors (second) to require shares to be offered to each
of them before a third-party sale
 Drag Along – right to force shareholders to sell in an exit
 Board, common and preferred approvals
 Small shareholder carveout
63

Founder Vesting
 Term, milestones, commencement
 Acceleration
 Single and double triggers
 Fire the Founder
64

Pro Rata rights
 Right to maintain, right to participate
 Major investors
 Limited by amount of money company wants to raise
65

Option Plan
 Increased pre money
 409A valuations
 Extended exercise periods for NSOs
66

Redemption Rights
 Feature of Preferred Stock
 Right to put stock to company, usually after a period of time and
over time
 Is effectively a right to force a sale of the company
67

Anti-Dilution
 Broad-based weighted average
 Narrow-based weighted average
 Full ratchet
68

Exclusivity
 No-shop
 30 to 60 days
69

NonBinding
 30 day no shop
 Confidentiality
 Is it really nonbinding?
70

Planning for later rounds
 Overly favorable terms
 Valuation planning and down rounds
 Reverse splits
 Cap table management
 Fire the CEO
71

Troubled Company Terms
 Forced conversion to common
 Full ratchet
 Uncapped participating preferred
 Insider rounds
 Low valuations
 Down rounds
 Trigger anti dilution protection unless waived
 Pay to play
 requires existing investors to invest on a pro rata basis
in subsequent rounds or they lose preferential rights
(anti-dilution, liquidation preferences, voting rights)
72

Successful Exits
 IPO
 Sale or Acquisition
73

Unsuccessful Exits
 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and
creditors?
74

Other Unsuccessful Exit Issues
 Tax Liability
 Personal Liability
 Tax
 Employment
 Fiduciary Claims
 Securities Law Claims
 Contractual
 Pierce the veil and creditor claims
 Serial Entrepreneurs and failed companies
75

Bibliography of Essential Reading
 Dead on Arrival: How to Avoid the Legal Mistakes that Could Kill Your Startup,
Roger Royse
 Straight Talk For Startups, Randy Komisar and Jantoon Reigersman
 The Startup Checklist, David S. Rose
 Angel, Jason Calcanis
 Venture Deals, Feld and Mendelson
 The Startup Game, William Draper
 Secrets of Sand Hill Road, Scott Kupor
 How to be the Startup Hero, Tim Draper
 Make Elephants Fly, Steve Hoffman
 Getting to Wow, Bill Reichert
76

AUSTIN
600 Congress Avenue
Suite 1300
Austin, TX 78701
United States of America
T +1 512.867.8400
F +1 512.867.8470
CHARLOTTE
101 S. Tryon Street
Suite 2250
Charlotte, NC 28280
T +1 980.771.8200
F +1 980.771.8201
CHICAGO
180 N. LaSalle Street
Suite 2215
Chicago, IL 60601
T +1 312.216.1620
F +1 312.216.1621
DALLAS
2323 Victory Avenue
Suite 700
Dallas, TX 75219
T +1 214.651.5000
F +1 214.651.5940
DALLAS - NORTH
2505 North Plano Road
Suite 4000
Richardson, TX 75082
T +1 972.739.6900
F +1 972.680.7551
DENVER
1050 17th Street
Suite 1800
Denver, CO 80265
T +1 303.382.6200
F +1 303.382.6210
FORT WORTH
301 Commerce Street
Suite 2600
Fort Worth, TX 76102
T +1 817.347.6600
F +1 817.347.6650
HOUSTON
1221 McKinney Street
Suite 2100
Houston, TX 77010
T +1 713.547.2000
F +1 713.547.2600
LONDON
1 New Fetter Lane
London, EC4A 1AN
United Kingdom
T +44 (020) 8734 2800
F +44 (020) 8734 2820
MEXICO CITY
Torre Esmeralda I, Blvd.
Manuel Ávila Camacho #40
Despacho 1601
Col. Lomas de Chapultepec,
DF 11000
Mexico City, Mexico
T +52.55.5249.1800
F +52.55.5249.1801
NEW YORK
30 Rockefeller Plaza
26th Floor
New York, NY 10112
T +1 212.659.7300
F +1 212.918.8989
ORANGE COUNTY
600 Anton Boulevard
Suite 700
Costa Mesa, CA 92626
T +1 949.202.3000
F +1 949.202.3001
PALO ALTO
525 University Avenue
Suite 400
Palo Alto, CA 94301
T +1 650.687.8800
F +1 650.687.8801
SAN ANTONIO
112 East Pecan Street
Suite 1200
San Antonio, TX 78205
T +1 210.978.7000
F +1 210.978.7450
SHANGHAI
Shanghai International
Finance Center, Tower 2
Unit 3620, Level 36
8 Century Avenue, Pudong
Shanghai 200120, P.R. China
T +86.21.6062.6179
F +86.21.6062.6347
THE WOODLANDS
10001 Woodloch Forest Drive
Suite 200
The Woodlands, TX 77380
T +1 713.547.2100
F +1 713.547.2101
WASHINGTON, D.C.
800 17th Street NW
Suite 500
Washington, D.C. 20006
T +1 202.654.4500
F +1 202.654.4501
77

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How to Prepare Your Startup for Venture Capital Investment - Part 1