Download - Funding Your Startup - Successful Contracting. A crash course in angel and venture capital funding
SVOD 2013Funding Your Start-up
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Funding Your Start-Up:Successful Contracting
Theresia GouwAccel Partners
Ilya StrebulaevStanford GSB
SVOD 2013Funding Your Start-up
The Venture Capital Cycle:
IPOM&A
Failure
VC Investment
Angels
Self-funding by founders
“Family and friends” round
SVOD 2013Funding Your Start-up
• Division of future payoffs
• Learning–A/VC about E–E about A/VC
• Resolving future problems and agency conflicts
The purpose of contracting between E and A/VC
p. 3
SVOD 2013Funding Your Start-up
• Active monitoring
• Formal monthly financial reports
• Staging of investments
• Major reviews of progress/milestones
• Stock grants/stock options
• Vesting of the stock options over a multiyear period
• Dilution of E’s stake in subsequent rounds if the firm does not perform
Resolving future problems
p. 4
SVOD 2013Funding Your Start-up
• Example: E owns 7.5M common shares
• VC offers $10M of Series A convertible preferred for 25% of the company
• Liquidation preference: –Series A Preferred is paid first one times the original purchase price–The balance of any proceeds is distributed to Common Stock
• Optional conversion:–Series A Preferred converts 1:1 to Common Stock at any time at option of holder
Most commonly used VC contract:Convertible preferred stock
p. 5
SVOD 2013Funding Your Start-up
Convert or do not convert? VC payoff
p. 6
No Conversion Conversion
Conversion Point
0 10 20 30 40 50 60 70 800
5
10
15
20
25
Exit Payoff/Liquidation Payoff ($Million)
Conv
ertib
le P
refe
rred
Sto
ck P
ayoff
($
Mill
ion)
Common Stock(Converted)
Preferred Stock(Unconverted)
SVOD 2013Funding Your Start-up
Payoff diagrams: Who gets what
p. 7
0 3 5 8 1113161821242629313437394244475052555760636568707376780%
10%20%30%40%50%60%70%80%90%
100%
Venture Capitalist's Payoff Entrepreneur's Payoff
Exit Payoff/Liquidation Payoff ($Million)
Payo
ff (
Porti
on o
f Pro
ceed
s)
Venture Capitalist's Payoff
Entrepreneur's Payoff
SVOD 2013Funding Your Start-up
• Seniority over Common Stocks–Downside protection
• Incentives–E get more in better states of the world
• Signaling–More optimistic E likely to take the offer
• Preventing “Take the money and run” scenario–E do not have incentives to sell too early
• Tax reasons
Why VCs prefer convertible preferred stocks
p. 8
SVOD 2013Funding Your Start-up
• As minority shareholders, VCs need protection
• Anti-dilution provisions
• Corporate governance
• Vesting of founder and employee stocks
• Dividends restrictions
• Redemption rights
Additional contract features that protect VCs
p. 9
SVOD 2013Funding Your Start-up
• Voting rights –Voting rights vs. cash flow rights
–Voting with Common Stock shares on an as-converted basis
–Increase or decrease of authorized Common Stock shares shall be approved by majority of Preferred and Common, voting together
–Majority of Series A Preferred should consent to:• Liquidation/exit• Amending By-Laws• Issuing any new securities• Paying any dividends• Changing the size of the Board of Directors
Corporate governance
p. 10
SVOD 2013Funding Your Start-up
• Board composition–The Board shall consist of five members
–Series A Preferred elect two Board members
–Founders or their representative elect two Board members
–One independent director, who is mutually acceptable to VC and E
–Each board committee will have at least one Series A Preferred nominee
Corporate governance
p. 11
SVOD 2013Funding Your Start-up
• Vesting: Shares or options are earned over time
• Step vesting: –Typically occurs over three to five years at annual/quarterly/monthly increments
• Cliff vesting:–Vesting occurs at one time
• Example:–30% after one year–Remaining 70% vesting quarterly over next four years
Vesting and employee restrictions
p. 12
SVOD 2013Funding Your Start-up
• Vesting is needed to align interests between Es and investors
• Ex ante vs. ex post–Getting a better vesting contract for the founders/first employees (e.g. single trigger) seems better for Es–Down the line, other key employees would prefer the same contract
• Can affect acquirer’s valuation / exit outcome
Economics of vesting
p. 13
SVOD 2013Funding Your Start-up
• Restrictions on founders and investors selling their shares–Transfer restrictions: preventing sales of founders’ stock without permission of investors–Tag-along rights: the right of investors to participate in any of such sales–Right of first refusal: investors can buy first at the price offered to other parties–Right of first offer: Investors will be first to be offered shares
• Non-competition, non-solicitation, and non-disclosure for executive officers
Vesting and employee restrictions
p. 14
SVOD 2013Funding Your Start-up
• Convertible notes without cap–Angel’s stake in the company is a constant (in good outcomes)
–The higher the pre-Series A valuation, the less the angel investor owns post-Series A round
–Despite the company doing better
–Misalignment of interests between angels and entrepreneurs
Contracting with AngelsThe World of Convertible Notes
p. 15
SVOD 2013Funding Your Start-up
• Cap: Main provision invented to limit the dilution of note holders–They now can benefit from higher valuation in Series A round
• Holders of capped convertible note convert at the lower of: –The (discounted) Series-A price or–The capped price
• The cap effectively makes seed round (partially) a valuation round
Convertible notes: Cap
p. 16
SVOD 2013Funding Your Start-up
Angel’s ownership value after a $10M Series A round
p. 17
0
5
10
15
0 5.00 10.00 15.00 20.00 25.00 30.00 35.00
Ange
l's O
wne
rshi
p Va
lue
After
Ser
ies
A ($
Mill
ion)
Pre-Money Valuation
Cap of $5 Million
Cap of $10 Million
Cap of $20 Million
No Cap