Deal Structures For Early Stage Financing

1. Deal Structures For Early Stage Financing Anthony Millin February 28, 2013

2. Introduction Three different forms of financing structures • Common Stock – Founders, Friends and Family • Convertible Note  –  Friends and Family, Angel • Preferred Stock – Professional Angel, VC

3. Common Stock • A security that represents an equity ownership interest • First form of stock issued upon creating a new corporation • Issued to the founders & friends and family investors • Stock purchase agreement or subscription agreement • Conveys some basic rights – vote/dividends/proceeds of sale • Can come with restrictions – restrictions on transfer • Right to the assets of the company upon liquidation, after distributions to the holders of debt and preferred equity

4. A Convertible Note • Debt instrument, with interest that usually accrues • Frequently issued to angel investors / also used in friends and family • Can be secured or unsecured • Convertible into a company’s stock: • Automatically, at the time the company closes on its next qualified round of equity financing • If no such round occurs, at pre-agreed upon terms • Anytime prior to maturity, upon a vote of a majority of the convertible note holders • If no conversion, repayable along with accrued, but unpaid interest upon its maturity

5. Benefits Of A Convertible Note Structure • Relatively simple legal structure/ lower transaction cost • Note Purchase Agreement and Promissory Note; (Pledge and Security Agreement) • Priority status over common and preferred shareholders • Provides investor with a discount to the next round (may also include warrants) • Bypasses the need for upfront agreement on valuation

6. Convertible Note With A “CAP” • Often the first non-friends and family investment • Period of very high risk (market risk, execution risk, technology/product risk and financing risk) • To compensate for all of the risk, many investors now negotiate a “CAP” on the conversion price (Negotiating maximum value upfront) • Protects investor in event of rapid value growth prior to conversion • Investor will usually have the option to convert at the lower of: • A negotiated discount (i.e., 20%) to the next equity round • The agreed-upon valuation cap

7. EXAMPLE • A company with 1 million shares of common stock outstanding • Issued a $500,000 convertible note, with a conversion discount of 20% and a conversion cap of $6 million • The start-up was able to raise $15 million at a pre-money valuation of $45 million in its next round of financing

8. Preferred Stock • Security that represents an a equity ownership interest • Rights and preferences (priorities) • over the common stock related to the assets and profits of a company • rights in the event of issuance of new equity/shareholders sale of equity • Protective provisions that limit actions that can be taken by the Company without preferred stockholder approval • Series A Preferred, Series B Preferred, Series C Preferred, etc. • Stock Purchase Agreement • Investor Rights Agreement • Right of First Refusal and Co-Sale Agreement • Voting Agreement • Amended and Restated COI • Series Seed / Series AA (Limited Rights and Protections) • Stock Purchase Agreement • Investor Rights Agreement • Amended and Restated COI

9. Three Key Levers of Negotiation • Value of the Company • Pre-Money, Fully Diluted Value placed on Company • $5 million/1 million=$5/share vs. $5 million/1.5 million = $3.33/share • Investor Rights & Preferences • Liquidation Preference (1x / Participating vs. Non Participating) • Dividend Rights (Cumulative vs. Non-Cumulative) • Preemptive Rights, Information Rights • Right of First Refusal & Co-Sale Rights / Drag Along Rights • Investor Protections (Control) • Approval of a majority of the preferred stock required before an action is taken by the company • Amending COI / Redemptions / Change in Business / Size of Board / Dissolution / Issuance Of Equity or Debt

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