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

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p Va

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ies

A ($

Mill

ion)

Pre-Money Valuation

Cap of $5 Million

Cap of $10 Million

Cap of $20 Million

No Cap