1. Funding Early Stage Companies
Chris Hazlitt | Bryan Cave HRO
September 6, 2012

2. Financing Transactions: The Parties
Investors
Invest in private companies, expect value to increase
Sell/distribute stock later
Principal concerns:
Return on Investment
Control
Liquidity
Companies / Founders
Need cash for R&D, operations, funding growth
Valuation
Equity vesting
Legal Counsel
Flexibility
Liability
Ease of Administration

3. Common Financing Options
Seed
1st Round
2nd Round
3rd Round
Subordinated Debt
Factoring Facility
Commercial Bank
Senior Debt

4. Considerations Valuation/Size of Round Structure
Liquidation Preference
Board Composition
Conversion Rights/Auto-conversion
Anti-dilution
Redemption
Protective Provisions
Registration Rights
Information Rights
Co-Sale/Right of First Refusal

5. Valuation/Size of Round
“Pre-Money”
Negotiated valuation
Amount Raised
target ownership
dilution
“Post-Money”
equal to pre-money + amount raised

6. Prior Stockholders (founders)
Typical Structure
Prior Stockholders (founders)
COMPANY
BEFORE
common stock
AFTER
COMPANY
common stock
Prior Stockholders
Investor preferred stock

7. Liquidation Preference
When it comes into play
Dissolution, Winding up
Sale of Company (merger/asset sale)
Order of payment
Creditors
Preferred Stockholders
Common Stockholders

8. Liquidation Preference – Types
Non-Participating
First to Preferred
Then to Common
Participating
Then to Common and Preferred (as a single class)
Capped Participating
Second to Common and Preferred (to a point, as a single class)
Third to Common

9. Board Composition Negotiated Usually VC gets a guaranteed Board Seat
VC and Founders worry about Board control
Rights in Certificate; voting agreement identifies particular individuals
Capitalization
Voting on change of control
Stockholder meetings rarely occur

10. Conversion/Auto-Conversion
Shares of Preferred Stock are generally convertible at any time to Common Stock
Why:
Economics
Voting
Shares of Preferred Stock automatically convert on
IPOs of a certain size and/or valuation
Vote of Preferred (series or class)
Conversion Rate
Initially 1:1
Adjusts for stock splits
Adjusts for anti-dilution

11. Anti-dilution/Conversion Rate Adjustments
What it does:
Reduce my effective purchase price
When:
Upon a dilutive financing or other dilutive event:
down round
strategic issuance
failure to reach milestones (less common)

12. Anti-dilution – Full Ratchet
If the Company issues stock below my old conversion price, then my conversion price equals the price at which new stock is sold.
In other words, after investor buys investor always get the lowest stock purchase price made available to a subsequent investor.
This lowers the conversion price and raises the number of shares investor receives.

13. Anti-dilution - Weighted Average
If the Company issues stock below my old conversion price, then my new conversion price equals my old conversion price times a fraction that represents the amount of dilution I actually experienced.
This results in less of an adjustment than a full ratchet.

14. Redemption
What is it?
A “put” right, typically. Could be a “call” right, but never used in a venture deal
What price?
Typically at “cost”
Occasionally “cost” + some accruing dividend (6 – 8%)
Occasionally, higher of “cost” or “fair market value”
When?
Typically at least 5 years from purchase
Occasionally on an event of default (such as breach of material covenants)

15. Protective Provisions
Special votes (blocking rights) in addition to those provided by law Typically include:
(i) alters rights of preferred; amend or waive provisions of Certificate in manner adverse to preferred
(ii) increase or decrease authorized preferred or common stock
(iii) create senior or pari passu series of stock
(iv) redeem or repurchase any stock
(v) merger or sale of company
(vi) increase or decrease the authorized size of board
(vii) pay dividends on junior stock
Can be class- or series-specific; different thresholds; factors:
(i) capitalization
(ii) relative cost
(iii) trust

16. Registration Rights – Securities Laws
General Principle:
All securities must be sold pursuant to:
A registration; or
An exemption from registration
What about resale?
Still need a registration or an exemption from registration

17. Information Rights Annual Quarterly Monthly (major investors)
Business Plan (major investors)
Visitation

18. Right of First Refusal & Co-Sale Rights; Drag-Along Rights
Right to purchase from founder or early investor
Controls stockholder base
Co-Sale Rights:
Right to sell with founder
Keeps founder from exiting the Company and allows investors to participate in a “sweetheart” deal
Drag-Along Rights:
Right to require stockholders to vote in favor of a sale of the Company that is approved by the preferred stockholders (and the board)
Avoids small stockholders from blocking a deal by exercising dissenters rights

19. Is There Another Way? Convertible Debt
where valuation is not established;
limit negotiations now
converts into preferred equity upon future financing
conversion price discounted to future equity share price (e.g., 20% to 50%) and often with a cap on the maximum effective valuation represented by the conversion price
optional conversion into common prior to exit
doesn’t start capital gains clock 19

20. Show Stoppers Equity ownership Documentation of who owns what
Poor cap table management
Stock issuances and consideration documented (cash, technology, etc.)
Stock restrictions in place: vesting and transfer restrictions (repurchase rights, first refusal rights and acceleration)
Third-party finders used to sell securities
Unregistered finders can create rescission rights 20

21. Show Stoppers Who owns the Intellectual Property???
NDAs, invention assignments, development logs
Public disclosure before patents are filed 21

22. Show Stoppers
Unreliable financial systems:
Data
Reports
Statements

23. Show Stoppers Undiscovered Liabilities:
Employment issues or labor disputes
Unpaid taxes
Unknown liens, suits, or encumbrances
Unfunded benefits

24. KEYS TO A SUCCESSFUL FINANCING
Full and transparent disclosure
Confidence and a plan
Anticipate questions
Know your answers
Be honest – admit your vulnerabilities, but explain how you’ll overcome them

25. KEYS TO A SUCCESSFUL FINANCING
But, if you don’t know the answer,

26. KEYS TO A SUCCESSFUL FINANCING
But, if you don’t know the answer,
DON’T FAKE IT

27. Chris Hazlitt