This document discusses key considerations for structuring convertible note deals and venture capital financing agreements. It covers topics such as:
- Key terms of convertible notes like interest rates, conversion options, and warrant coverage
- Examples of how convertible notes convert to equity in future financing rounds
- Components of term sheets such as whether they are binding and include non-disclosure agreements
- Deal basics including the type of security and documents required
- Liquidation preferences including participating vs. non-participating and whether they are capped
- Anti-dilution provisions like weighted average formulas and ratchets
- Registration rights for future equity offerings
- Board composition and investor protective provisions
- Factors that
Hansen Bridgett: Term Sheets & Convertible Notes, Structuring the Deal
1. Term Sheets and Convertible Notes:
Structuring the Deal
Hanson Bridgett LLP
425 Market Street, 26th Floor
San Francisco, CA 94105
415-777-3200
Jonathan S. Storper and Leslie A. Keil
jstorper@hansonbridgett.com and lkeil@ hansonbridgett.com
May 8, 2013
Spring 2013 Venture Fair and Forum
San Francisco
May 7-9, 2011
3. Examples
• Total loaned = $1,000,000
• Automatic Conversion upon “Qualified Financing”
• Qualified Financing = $2,000,000
• Loan converts into equity according to the following formula:
(Balance of loan + interest accrued)
Per Share price in Qualified Financing
• Thus, if $2,000,000 raised in a Qualified Financing at $1.00 a share, amount loaned converts
into 1,000,000 shares; if $2,000,000 raised at $0.50 a share, the amount loaned converts into
2,000,000 shares
• Effect of 20% Discount:
– Discount applies to the per share price at which the loan would otherwise convert.
– If the $1,000,000 loan would otherwise convert at $1.00 a share, the discounted conversion price
becomes $0.80 a share, yielding 1,250,000 shares on conversion rather than 1,000,000
– If the $ $1,000,000 loan would otherwise convert at $0.50 a share, the discounted conversion price
becomes $0.40 a share, yielding 2,500,000 shares on conversion rather than 2,000,000
4. Term Sheet Basics
• What is a Term Sheet?
• Is it Binding?
• No Shop
• NDAs
• Fees
5. Deal Basics
• Type of Security
• Purchasers – Accredited v. Nonaccredited
• Documents to get the deal done
8. Examples
• Assume a Series A Preferred round that raises $1,000,000 based on a $2,000,000 pre-
money valuation $1 + $2 = $3
1/3 = 33%
• Thus, upon the closing, the preferred investors will own 33% on a fully diluted basis
• Assume a sale for $10,000,000
• Liquidation Preference = 1x non-participating
– Preferred investors get $1,000,000 if they do not convert to common
– Preferred investors get $3,333,333 if they convert to common
• Liquidation Preference = 1x participating
– Preferred investors get $4,000,000 if they do not convert to common
($1,000,000 + $3,000,000)
– Preferred investors get $3,333,333 if they convert to common
• Liquidation Preference = 1x participating capped at 3x
– Preferred investors get $3,000,000 if they do not convert to common
– Preferred investors get $3,333,333 if they convert to common
10. Antidilution
• What is it?
• Weighted Average
• Narrow- includes preferred and common
• Broad- includes preferred, common, options,
warrants, others
• Ratchet
• Carve-outs
11. Difference Between Broad and Narrow
Weighted Average
• The definition of Stock Outstanding
• Broad: includes
Common, Preferred, options, warrants, etc.
• Narrow: includes only the Preferred
• The more narrow, the larger the adjustment
to the conversion price = greater punitive to
Founders
12. Example: Ratchet
• Assume:
– $1,000,000 raised in Series A at $1.00 per share
– Pre-money valuation = $3,000,000
– Series A converts to common on a 1:1 basis
• Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of
4,000,000 total)
• Assume:
– $500,000 raised one year later in Series B at $0.50 a share
– Pre-money valuation = $2,000,000
– Series B converts to common on a 1:1 basis
• Thus, Series B owns 20% of the Company on as-converted basis (i.e., 1,000,000 out of
5,000,000 total)
• Assume:
– No anti-dilution protection, Series A owns 20% of Company after the sale of the Series B (1,000,000
shares out of 5,000,000 total).
– Full ratchet anti-dilution protection, then the conversion price for the Series A Preferred is reduced
from $1.00 per share to $0.50 per share.
• Thus, full ratchet means that upon conversion, Series A entitled to receive 2,000,000 shares
of common stock rather than 1,000,000 shares of common stock.
13. Weighted Average Formula
AP = OP x CSO + (NM/OP)
CSO + AS
AP= Adjusted conversion price (after the application of weighted avg anti-
dilution)
OP= Old conversion price (before the application of weighted avg anti-
dilution)
CSO= Number of shares of Common Stock Outstanding immediately prior to
dilutive issuance [the difference between Broad and Narrow]
NM= New Money raised as a result of the dilutive issuance
AS= Number of Additional Shares issued in the dilutive issuance
14. Example: Broad Based Weighted
Average
• Assume:
– $1,000,000 raised in Series A at $1.00 per share
– Pre-money valuation = $3,000,000
– Series A converts to common on a 1:1 basis
• Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total)
• Assume:
– $500,000 raised one year later in Series B at $0.50 a share
– Pre-money valuation = $2,000,000
– Series B converts to common on a 1:1 basis
• Assume:
– Broad-based weighted average anti-dilution provision:
$1.00 x 4,000,000 + ($500,000/$1.00) = $0.90
4,000,000 + 1,000,000
• Thus, the adjusted conversion price is $0.90 and the conversion ratio is adjusted to 1:0.9
• Upon conversion, Series A with broad based weighted average protection would be entitled to receive
1,111,111 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection and
2,000,000 shares with full ratchet protection).
• This will have a much less punitive effect on the company's founders and management than a full ratchet anti-
dilution provision
15. Example: Narrow Based Weighted Average
• Assume:
– $1,000,000 raised in Series A at $1.00 per share
– Pre-money valuation = $3,000,000
– Series A converts to common on a 1:1 basis
• Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000
total)
• Assume:
– $500,000 raised one year later in Series B at $0.50 a share
– Pre-money valuation = $2,000,000
– Series B converts to common on a 1:1 basis
• Assume:
– Narrow-based weighted average anti-dilution provision:
$1.00 x 1,000,000 + ($500,000/$1.00) = $0.75
1,000,000 + 1,000,000
• Thus, the adjusted conversion price is $0.75 and the conversion ratio is adjusted to 1:0.75
• Upon conversion, Series A with narrow based weighted average protection would be entitled to receive
1,333,333 shares of common stock (compared to 1,000,000 shares with no anti-dilution
protection, 1,111,111 with broad-based weighted average protection and 2,000,000 shares with full
ratchet protection).
• More punitive effect on the company's founders and management than broad based weighted
average, but still less than a full ratchet anti-dilution provision
17. Board of Directors
• Total number
• Number elected by common
• Number elected by preferred
• Outside directors?
• Advise at least 5
• Angels elect as group
18. Protective Provisions
• Voting In General
• What Protective Provisions Cover
– Senior securities
– Liquidation, change of control
– Amendments of Articles, Bylaws
– Change rights of preferred
– Information Rights
– Change in corporate purpose
• How long are they in effect?
20. Miscellaneous
• Right of First Offer (Right to make first offer)
• Right of First Refusal (Right to make last offer)
• Co-Sale (Right to participate
in the sale)
• Exceptions – certain amount
of shares each year; family
members; estate planning
purposes
• Closing Conditions
21. Angel Killers
• No Term Sheet
• Variance from Term Sheet
• Hiding the Ball/Due Diligence Surprises
• Cap Table Problems
• Management Structure/Team
• Material Contracts & Agreements
• Board composition
• No Clear Exit Strategy
• Too Many Cooks
• Lack of IP