Entrepreneurial Finance

1. Business, Law, and Innovation Entrepreneurial Finance Lecture 5 Spring 2014 Professor Adam Dell The University of Texas School of Law

2. Stages of Financings Private Equity Growth Equity Angel Venture Capital PIPE Icahn ;) IPO Stage Sources Form Size Angel Friends & Family, SBC Common / Loan $100-2MM Venture Capital Institutional Firms Preferred Stock $1-10MM Private Equity Institutional Firms Preferred Stock $10-50MM Growth Equity Re-Cap

3. So How Do I Finance My Startup? • By any means necessary. • Most use friends & family $ • Some get angel funding, often by getting into an incubator. We have 2 great ones in Austin:

4. Angel Investment • Loan or do I sell a piece of my company? • Best approach is a convertible promissory note • Borrow $100k, which you promise to pay back • But if you raise your Series A, the loan converts into an equityinvestment in the Series A. • Interestrate, maturityrate, conversionfeature.

5. TYPICAL DEAL POINTS • Usually some “equitykicker” • Like a small piece of the company or discount upon conversion into next round • 20% discount to the price of the Series A • Easy to structure, can do them quickly, no real rights other than as a debtor to the company. • It’s still the sale of a “security”, but they are simple. • What if equity financing does not occur? • Board observer? • Information rights (e.g., financials)? • Equity Kicker • Conversion feature (e.g., triggered upon next round of financing of at least $1,000,000) • Mandatory or discretionary conversion?

6. SERIES A ROUND EQUITY FINANCING • What is the company worth? - More art than science - More often than not driven by the market (how competitive the deal is) - Factors: space, team, traction, revenue (often very little), IP, partners, customers • How much money does the company need?

7. PREFERRED OR COMMON? • Attributes of preferred stock (still behind creditors) • Common stock deal prices stock options for employees • Common stock - no negotiation on terms (pari passu with the founders)

8. PREFERRED OR COMMON? (CONTINUED) • No protective provisions for investors • Preferred deal is much more common

9. ATTRIBUTES OF SERIES A PREFERRED • Anti-Dilution Provision • Grant of additional equity to protect your investment • Protection from a down round • Protection from the company granting additional equity to others. • Weighed-Average Anti-dilution (standard) vs. • Full Ratchet Anti-dilution (harsh)

10. ATTRIBUTES OF SERIES A PREFERRED • Dividend “when, as and if declared” • Noncumulative v. cumulative • % • Priority on dividend payments • Liquidation preference • “Participating Preferred” • Money back x 3, or • Money back, then pro-rata with founders

11. ATTRIBUTES OF PREFERRED STOCK • Liquidation Preference Sale / Merger / Acquisition / Liquidation 1st: Debt Holders 2nd: Series B 3rd: Series A 4th: Common

12. MORE ATTRIBUTES OF SERIES A PREFERRED STOCK • Merger or asset sale treated as a liquidation • Consent of Series A Preferred required (50%, 66 2/3%, or more) • Must decide whether to treat merger or asset sale as a liquidation (“cram down”)

13. MORE ATTRIBUTES OF SERIES A PREFERRED STOCK • Redemption (or not) • Beginning year 6, then year 7 and 8 • Purchase price + accrued dividends (if any)

14. MORE ATTRIBUTES OF SERIES A PREFERRED STOCK • Conversion • Convertible at any time by dividing Purchase Price by Conversion Price (1:1 basis) • Automatic conversion on IPO • Adjustment to conversion price (“full ratchet”) • excludes options for employees and warrants for service providers • Very lengthy provision but price of new equity issuances is key

15. MORE ATTRIBUTES OF SERIES A PREFERRED STOCK • Pro Rata Investment Rights • Right to maintain ownership levels in future rounds of financing. • If a VC owns 15% of the company, then during a subsequent round of financing, the VC has the “right” to invest up to 15% of the total $s raised in that round.

16. MORE ATTRIBUTES OF SERIES A • Voting Rights - generally 1:1 • Protective Provisions • Sale of the company • Create new class of securities • Amend Certificate of Incorporation/Bylaws • Redeem shares • Change number of Board members • Amended and Restated Certificate of Incorporation vs. Certificate of Designation

17. SERIES A TRANSACTION DOCUMENTS • Series A Preferred Stock Purchase Agreement • Reps/warranties from company (capitalization, IP, contracts, etc.) • Rep/warranties from investors (“accredited investor,” no distribution under securities laws, Rule 144, etc.) • Schedule of Investors

18. SERIES A TRANSACTION DOCUMENTS (CONTINUED) • Investors’ Rights Agreement • Demand registration rights • S-3 registration rights • “Piggyback” registration Rights • Financial information rights • Right of First Offer • Right of First Refusal (among Preferred SHs)

19. SERIES A TRANSACTION DOCUMENTS (CONTINUED) • Stockholder Agreement • Includes founders • Right of first refusal for sales by founders (first, to the company and then to the shareholders) • Right of co-sale if ROFR is not exercised • Voting Agreement (for Board seats) • Indemnification Agreement

20. POINTS TO CONSIDER • Size of the option pool (20%, 30%??) • Board observer rights? • Stock Restriction Agreements for founders (vesting provisions) • Employment Agreement for founders • Form of investment - individually or through LP? • Tax issues?? • Exit strategy

21. Series A (Dilution) Series A – Raise $5m @ $10m pre-money Pre Money: $10m Post Money: $15m Series A Investor bought: 33% of the company Founders, existing (Angel) investors: diluted by 33% BUT, Series A required a 30% ISO Pool POST Series A So….Founders, existing investors: diluted by 63%! 33% 30% 37%

22. Series B (Dilution…Yes More!) Series B – Raise $20m @ $30m pre-money Pre Money: $30m Post Money: $50m Series B Investor bought: 40% of the company Founders, Angel, Series A, ISO: diluted by 40% Series B: 40% Series A: 33% x 60% = 19.8% Founders: 37% x 60% = 22.2% ISO: 30% x 60% = 18% 40% 22.2% 18% 19.8%