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

2. StageSourcesFormSize AngelFriends & Family, SBCCommon / Loan$100-2MM Venture CapitalInstitutional FirmsPreferred Stock$1-10MM Private EquityInstitutional FirmsPreferred Stock$10-50MM Growth EquityRe-Cap Stages of Financings AngelVenture Capital Private Equity Growth Equity IPO PIPEIcahn ;)

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 equity investment in the Series A. -Interest rate, maturity rate, conversion feature.

5. TYPICAL DEAL POINTS Usually some “equity kicker” – 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 3 rd : Series A 2 nd : Series B 1 st : Debt Holders 4 th : 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%! 30% 33% 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% 22.2% 40% Series B: 40% Series A: 33% x 60% = 19.8% Founders: 37% x 60% = 22.2% ISO: 30% x 60% = 18% 18% 19.8%