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VENTURE CAPITAL AND THE REPRESENTATION OF START UPS

VENTURE CAPITAL AND THE REPRESENTATION OF START UPS. Paul V. Rogers Covington & Burling February 27, 2006. I. Overview. Choice of Entity Capital Structures and Venture Financings Employee Incentives Intellectual Property Issues Management Issues Exits or Liquidity Events.

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VENTURE CAPITAL AND THE REPRESENTATION OF START UPS

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  1. VENTURE CAPITAL AND THE REPRESENTATION OF START UPS Paul V. Rogers Covington & Burling February 27, 2006

  2. I. Overview • Choice of Entity • Capital Structures and Venture Financings • Employee Incentives • Intellectual Property Issues • Management Issues • Exits or Liquidity Events

  3. II. How I Got Here • History Major in College • 3 years at Manufacturers Hanover • Hale and Dorr – Boston (14 years) • Covington & Burling – DC (6.5 years)

  4. III. Practice Differences • NY – Wall Street • Financial Institutions • Fortune 500 • Outside of NYC • Businesses • Smaller Financial Institutions

  5. Practice Differences (cont’d.) • Venture “Clusters” • Silicon Valley • Boston • Virginia • Seattle • North Carolina • New York

  6. IV. Characteristics of Clients • Entrepreneurial • Very Driven – 100 mph • Crusaders or Prophets • Financial Incentives • Cool Technology • Short Time Horizons

  7. V. Characteristics of Venture Capitalists • Very Competitive • Pressured on Returns to Limited Partners • Risk v. Reward • Willing to lose entire investment for multiple return • 1-2x Return Not Interesting • 4-10x Return • Focus Issues • Positive • Negative • Also Have Short Time Horizons

  8. VI. Cheat Sheet for a Lawyer for Start Up • Ongoing • Capital Stock • Classes • Ownership • Restrictions • Intellectual Property • Protection of Ownership • Proper Licensing • In or Out • Venture Financing • Economic Return • Control Issues • Liquidity

  9. VII. Choice of Entity • Corporation • Subchapter S • Limited Liability Company • Partnership • Considerations in Choosing Entity • Types of Stockholders • Number of Stockholders • Financing Sources • Liquidity • Taxes • Liability

  10. VIII. Capital Structures and Venture Financings • Indebtedness • Loans • Principal Amount • Interest Rate • Payment Terms • Sources • Angels • Friends/Relatives • Founders (really equity)

  11. Capital Structures and Venture Financings (cont’d.) • Convertible Debt • Interest bearing • Payable on date certain • Convertible into equity • Option of holder or issuer • Designated or undesignated security • Pricing • Subordinated to other Indebtedness • Sources • Similar • Valuation Issues

  12. Capital Structures and Venture Financings (cont’d.) • Stockholders’ Equity • Preferred Stock • Convertible • Non-convertible • Common Stock • Voting • Non-voting • Additional paid in capital • Amount paid for shares less par value • Retained earnings/accumulated deficit • Treasury Stock

  13. Capital Structures and Venture Financings (cont’d.) • Common Stock – General • Voting (Can be Non-Voting) • Dividends (Junior Status) • Liquidation (Junior Status) • Percentage Ownership • No preferences • Rare to Have Classes

  14. Capital Structures and Venture Financings (cont’d.) • Preferred Stock – General • Redeemable • Date certain • Occurrence of event (e.g., IPO) • Classic or Straight (usually no short term redemption) • Convertible • Participating

  15. Debt Security Equity Security DEBT EQUITY LOANS/NOTES REDEEMABLE PREF. STOCK CLASSIC/STRAIGHT PREF. STOCK CONVERTIBLE NOTES CONVERTIBLE PREF. STOCK CONVERTIBLE & PARTICIPATING PREF. STOCK COMMON STOCK

  16. Preferred Stock (Debt Equivalents)Redeemable and Straight, or Classic • Return of capital • Interest rate or dividend • Premium upon repayment • Voting

  17. Convertible Choice of economic rights – preferred or common Pay $1,000,000 for 20% = convert if company worth more than $5,000,000 Participating “Cake and eat it, too” Receive $1,000,000 plus 20% of remainder X. Preferred Stock (Equity Equivalents) Convertible and Participating Stock

  18. Convertible and Participating Stock (Cont’d.) • Dividends • Voting Rights • Conversion Features • Redemption

  19. EXAMPLES • Redeemable/Straight or Classic Preferred • Investment - $1,000,000 • Percentage Ownership – Often 0% as not participating (can receive participation through warrants for common stock) • Liquidation at $50,000,000 • Return - $1,000,000 invested (often plus an interest rate) – assumes 1x liquidation preference

  20. Examples (cont’d.) • Convertible Preferred Stock • Investment - $1,000,000 • Percentage Ownership – 20% • Liquidation at $50,000,000 • Return – a choice: $1,000,000 invested (often plus a dividend rate) or $10,000,000 (assumes 1x liquidation preference)

  21. Examples (cont’d.) • Participating Preferred Stock • Investment - $1,000,000 • Percentage Ownership – 20% • Liquidation at $50,000,000 • Return - $10,800,000 • $1,000,000 invested (often plus a dividend rate) plus 20% of $49,000,000 – “cake and eat it too” security (assumes 1x liquidation preference)

  22. XI. Other Venture Investment Issues • Control • Board of Directors • Special Approvals • Stock Transfer Restriction • Rights of First Refusal on Future Financings • Registration Rights • Drag Alongs • Financial Reporting

  23. XII. Employee Incentives • Cash • Salary • Bonus • Stock Options • Incentive • Non-Qualified Stock Options • Vesting • Pricing • Exercise • Tax/Securities Law

  24. Employee Incentives (cont’d.) • Restricted Stock • Pricing • Payment • Vesting • Tax/Securities Laws • Other Equity Incentives

  25. Employee Incentives (cont’d.) • Founders’ Stock • Cheap (Penny Shares) • Restrictions • Rights of First Refusal • Rights of Co-Sale

  26. XIII. Intellectual Property • Assignment of Existing Intellectual Property • Licensing/Acquisition of Third Party Rights • Invention Assignment Agreements • Prior Employer’s Rights • Former Employees • Demand Letters • General • Exit Event

  27. XIV. Management Issues • Board of Directors • Powers • Membership • Nominations • Officers • State Law • Powers

  28. Management Issues (cont’d.) • Contractual Rights • Limits on • Changes to Capital • Changes to Certificate of Incorporation and By-Laws • Mergers & Acquisitions • Incurrence of Indebtedness • Revisions to Business Plan • Management Changes • Capital Expenditures

  29. Management Issues (cont’d.) • “Who is the Client” Issues • Corporate “Divorces” • Founder v. Founder • Control Issues • Buyouts

  30. Management Issues (cont’d.) • Board v. Management • Cause v. Without Cause • Stock Vesting

  31. XV. Liquidity Events • Sale • Merger • Receive Stock or Cash from Acquiror • Stock Purchase • Generally Cash • Asset Sale • Usually Cash • Tax Issues • Liability Issues

  32. Liquidity Events (cont’d.) • Considerations • Number of Stockholders • Securities Laws • State Corporation Laws • I.P. Rights • Licenses

  33. Liquidity Events (cont’d.) • Initial Public Offerings • Sale to Public • Usually only Issuer Shares • Valuation Event for Stockholders • Future Source of Liquidity • Lock Ups • Rule 144 • Registration Rights

  34. Liquidity Events (cont’d.) • Liquidation • Sell Assets • Wind Down • Pay Employees/Landlord • Bankruptcy • Comparatively Rare

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