deal structures for early stage financing
TRANSCRIPT
DEAL STRUCTURES FOR EARLY STAGE FINANCING
September 27, 2011
Anthony MillinLerch, Early & Brewer, Chtd.
www.lerchearly.com
Common Stock – Founders, and Friends and Family RoundConvertible Note – Friends and Family, and Angel RoundPreferred Stock
Overview
© Lerch, Early & Brewer 2011
Common Stock
A security that represents an equity ownership interest in a corporation.
Is the first form of stock issued upon creating a new company.
Stock purchase agreement or subscription agreement. Issued to the founders, and often to friends and family
investors Conveys some basic rights to the holder.
The right to vote (although there could be a class of non-voting common stock).
The right to share in dividend distributions (profits) and the proceeds of a sale of a company (appreciation).
Right to the assets of the company upon liquidation, after distributions to the holders of debt and preferred equity.
© Lerch, Early & Brewer 2011
A Convertible Note
A convertible note is a debt instrument, with interest that usually accrues.
Frequently issued to angel investors, and is sometimes used in a friends & family round.
Is convertible into a company’s preferred stock: Automatically, at the time the company closes on its first
preferred round of financing that meets a minimum dollar threshold, or if no such round occurs, at an agreed upon time prior to maturity.
Upon a vote of a majority of the convertible note holders.
If there is no automatic conversion, and no election to convert is made, the convertible note is repayable along with accrued, but unpaid interest upon its maturity.
© Lerch, Early & Brewer 2011
Benefits Of A Convertible Note Structure
Relatively simple legal structure, and enables a lower transaction cost. Note Purchase Agreement and Promissory Note
Provides the investor with priority status over common and preferred shareholders with respect to the assets of the company.
Bypasses the need for the parties to agree on the current value of the company.
© Lerch, Early & Brewer 2011
A Convertible Note With A “CAP”
The cap ensures that if the issuing company is very successful, the convertible note investors still will own a material percentage of the company
Offers protection in situations when there is: A significant jump in the value of the company for the first
preferred round, and a considerable amount of capital is raised.
Investor will usually have the option to convert at either: A negotiated discount (i.e., 20%) to the first preferred round The agreed-upon valuation cap.
Investor is compensated for investing during a period when market risk, execution risk, technology/product risk and financing risk are usually the highest.
© Lerch, Early & Brewer 2011
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 first preferred round of financing. $ 6
million Cap
20%Discount
No Cap or Discount
Valuation $6 million $36 million
$45 million
# of Shares 83,333 13,889 11,111
% Of Company (Post)
5.9% 1.0% 0.8%
© Lerch, Early & Brewer 2011
Preferred Stock
Is a security that represents an equity ownership interest in a corporation.
Comes with a set of rights and preferences (priorities) over the commons stock related to the assets and profits of a company.
Comes with a set of protective provisions that limit actions that can be taken by the Company without preferred shareholder approval.
The first preferred round is called Series A Preferred, the second preferred round is called Series B Preferred, followed by Series C Preferred, etc.
Typically issued on pre-money fully diluted basis. Agreements include:
Stock Purchase Agreement Investor Rights Agreement Right of First Refusal and Co-Sale Agreement Voting Agreement Amended and Restated COI
© Lerch, Early & Brewer 2011
Price Per Share on a Fully Diluted Pre-Money Basis
Pre-Money - value of your business before taking into account the new money to be invested.
Fully Diluted- accounts for the total number of shares that would be outstanding if all possible sources of conversion, such as stock options, convertible notes and warrants were exercised.
Enables investor to avoid having its shares diluted later on when these instruments convert, often at a price lower than the price paid by investor.
© Lerch, Early & Brewer 2011
Shares Currently Issued And Outstanding Vs. On A Fully Diluted-basis
Shares outstanding: 3 million; Stock Option Plan: 500,000; Investment Amount: $ 3.5 million; Pre-money valuation: $ 7 million ; Post-money valuation: $10.5 million.
Based on Shares Currently Outstanding
Divide the pre-money valuation ($7 million) by the sum of the shares outstanding (3 million) = 7,000,000/3,000,000 = $2.33 per share. (16.5% difference).
Fully-Diluted Basis
Divide the pre-money valuation ($7 million) by the sum of the shares outstanding (3 million) plus the stock option plan pool (500,000) = 7,000,000/3,500,000 = $2.00 per share
© Lerch, Early & Brewer 2011
The Liquidation Preference
A mechanism by which the investor seeks to recoup its original investment or a multiple thereof, plus any declared and unpaid dividends, before there are any distributions to the common stockholders.
Usually is defined to occur upon a liquidation, dissolution or winding up of the company, a merger, or a sale of the company or its assets.
Example - $3.5 million dollar investment:1X Liquidation Preference = $3.5 million to investor before common shareholders get 1st dollar.
2X Liquidation Preference = $7.0 million to investor before common shareholders get 1st dollar.© Lerch, Early & Brewer
2011
Participating vs. Non-Participating Preferred
Non-Participating Preferred
Limits the investor to its liquidation preference.
(In practice, an investor will have and exercise its right to convert its preferred stock into common stock and give up its Liquidation Preference if it would get a larger return as a common stockholder).
Participating Preferred
Investor receives further distributions along with the common stockholders after receiving the Liquidation Preference.
© Lerch, Early & Brewer 2011
Dividends – No-Coupon vs. Cumulative vs. Non-Cumulative
13
Dividend Right – No Coupon
6%Non-Cumulative Dividend
6% Cumulative Dividend
The holders of the preferred stock have a right to participate, pro rata, with holders of common stock, when and if dividends are declared by the Company.
Before the company can pay any dividends on its common stock in any particular year, it must pay dividends scheduled for the preferred stockholders for such year.
If no dividend is declared and paid in 2011 and 2012, in 2013 the company must first pay a 6% dividend to the preferred shareholders for 2013 before a payment is made to common stockholders.
Before the company can pay any dividends on its common stock in any particular year, it must pay all scheduled but unpaiddividends for the preferred stockholders.
If no dividend is declared and paid in 2011 and 2012, in 2013 the company must first pay a 6% dividend for each of 2011, 2012 and 2013 to the preferred shareholders before a payment is made to common stockholders.
© Lerch, Early & Brewer 2011
Rights, Preferences, Protections Conversion Rights – The investor’s right to convert to common stock,
at its option, or automatically upon the vote of a majority of preferred stockholders or a qualified IPO - based on a ratio (initially 1 for 1, as then adjusted).
Preemptive Right– The investor’s pro rata right, based on percentage equity ownership, to participate in subsequent financings. If the investor owns 20% of Company before the subsequent financing, it typically has the right to take at least 20% of the subsequent financing.
Registration Rights – The investor’s right to force the company, after a period of time, to register the investor’s shares and offer them publicly, or to include them as part of a registration and public offering made by the Company or a Management Stockholder.
Redemption Rights – The investor’s right to require the company redeem its shares at a point in the future (i.e. 5 years) normally at the greater of the purchase price or the FMV (which can be determined by a formula, the Board, or an independent appraisal of the business).
Rights, Preferences, Protections
Voting Rights – Right of the preferred shareholder to vote with the holders of common shares (except as limited by law), on as converted basis, in addition to specific voting rights granted to the preferred shareholders. Preferred shareholders typically have the right to vote as a separate class for one or more directors as well as with respect to Protective Provisions.
Rights of First Refusal / Co-Sale Rights - In the event a common shareholder has a bona fide offer to buy its common stock, the preferred shareholders have a pro rata right to either acquire those shares on the same terms, or to sell their shares, on an as converted basis, as part of such sale of the common shares.
Drag Along Rights - The right of a pre-requisite number (i.e. majority) of the shareholders, who agree on a proposed sale of the company or its assets to require the remaining shareholders to participate in the transaction.
Information Rights – Right to financial and other information relating to the company, such as quarterly and annual income statements, balance sheets, cash flow statements. Information could also include budgets and budget reconciliations, a dashboard of key metrics as well as notices of material litigation.
© Lerch, Early & Brewer 2011
Rights, Preferences, Protections
Protective Provisions - Require the approval of a majority, or supermajority, of preferred shareholders before an action is taken by the company. There are a number of protective provisions. Examples include: Amending the Certificate of Incorporation and Bylaws. A repurchase or redemption of shares of stock. A material change in the nature of the company’s business. A change the size of the Board. The issuance of new, superior securities. The liquidation, dissolution, and winding up of the Company.
© Lerch, Early & Brewer 2011
Speaker
Anthony Millin is an attorney who works with start-up and emerging growth businesses on equity and debt financings, recapitalizations, and mergers and acquisitions. His practice also includes formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. www.lerchearly.com/team/anthony-l-millin
(301) 657-0746. [email protected]
© Lerch, Early & Brewer 2011
For more information
Lerch, Early & Brewer, Chtd.3 Bethesda Metro Center, Suite
460Bethesda, MD 20814
(301) 986-1300www.lerchearly.com
Thank you for your participation© Lerch, Early & Brewer 2011