1. Term Sheets and Convertible Notes: Structuring the Deal
Spring Venture Fair and Forum
San Francisco
May 7-9, 2011
Term Sheets and Convertible Notes: Structuring the Deal
May 8, 2013
Jonathan S. Storper and Leslie A. Keil
and hansonbridgett.com
Hanson Bridgett LLP
425 Market Street, 26th Floor
San Francisco, CA 94105

2. Convertible Note Basics
Term:
length of time before repayment
6 months to 24 months – 5 yrs.
renegotiating is costly
Conversion: Optional or Automatic
Optional – Investors
Automatic - Company
Point of Conversion (time and rate)
Company wants automatic
Discount:
20%
Additional feature upon conversion to
yield larger % in company
Problem is it may offset new $
Discount for coming in early
Prepayment:
Company probably will spend $ and investor wants the conversion
Maybe friends and family round
Interest Rate:
Return on note 6-8% limits on % (10% limit)
Usury exceptions
Warrant Coverage:
Option to buy more shares
How much? (10-20%)
Ability to participate in next round
Security:
If you can get it
Secured / Unsecured and bankruptcy
Company pushes against it; funds may push for it
Covenants:
Promises to prevent company from going out and doing bad things
What you can do with the $
How you operate
Consents you must seek from investors
Ratios
Key Points:
Term
Conversion: Optional or Automatic
Discount
Prepayment?
Interest Rate
Warrant Coverage
Security
Covenants

3. Examples Total loaned = $1,000,000
Automatic Conversion upon “Qualified Financing”
Qualified Financing = $2,000,000
Loan converts into equity according to the following formula:
(Balance of loan + interest accrued)
Per Share price in Qualified Financing
Thus, if $2,000,000 raised in a Qualified Financing at $1.00 a share, amount loaned converts into 1,000,000 shares; if $2,000,000 raised at $0.50 a share, the amount loaned converts into 2,000,000 shares
Effect of 20% Discount:
Discount applies to the per share price at which the loan would otherwise convert.
If the $1,000,000 loan would otherwise convert at $1.00 a share, the discounted conversion price becomes $0.80 a share, yielding 1,250,000 shares on conversion rather than 1,000,000
If the $ $1,000,000 loan would otherwise convert at $0.50 a share, the discounted conversion price becomes $0.40 a share, yielding 2,500,000 shares on conversion rather than 2,000,000

4. Term Sheet Basics What is a Term Sheet? Is it Binding? No Shop NDAs
Fees
What is a Term Sheet?
Basic deal terms
Got your bridge round (convertible note)
Outline of major terms - usually preferred
These terms are “Standard” ? (negotiated)
VCs prepare; for angels usually company
Is it Binding?
Yes / No
Not usually but it’s an outline
Not easy to deviate (investors walk)
No Shop:
Binding
Keep feet to fire
Helps get deal done (30-90 days)
NDAs:
Binding
Even if deal doesn’t close
Injunctive relief
Fees:
VCs want you to pay: you want to cap
Angels – both parties pay their own fees

5. Deal Basics Type of Security Purchasers – Accredited v. Nonaccredited
Documents to get the deal done
Type of Security:
Common usually founders and F & F
Convertible debt
Straight debt and warrants
Preferred
Purchasers – Accredited v. Nonaccredited:
Accredited - $1 million net worth - $200 / 300 k
Sophisticated
- Who will you sell to? – unaccredited – not patient, more disclosure, higher cost
How much: 1. currently, for every round, often see 2 down rounds
2. build in reserves, add time for this market (early stage
Documents to get the deal done:
Rep statement
Stock purchase
Investor rights
Registration Rights Agreement
Employment Agreements
IP Assignment
Private offering memo
Purchase agreement
Investor rights agree
Co-sale
Share
Securities filings

6. Dividends When paid Noncumulative v. Cumulative When paid:
Delegated by Board
Investors want a preference for receipt prior to the founders
Set return (6-9%) 8% typical
Noncumulative v. Cumulative:
Noncumulative – expires every year
Cumulative – doesn’t expire
Used to rarely see cumulative, but now if you put off dividend then in last years, cumulative for all years!
New – mandatory dividend payments and penalties for nonpayment
New – dividends tied to product launch

7. Liquidation Preference
Liquidation Preference – change of control
What is it?
Before common
How much $ on liquidation event
Liquidation event: M&A, change control, IPO
How much?
(1x, 2x original)
Participating?
What happens after paying liquidation; participants like common
With remainder of common stock or not?
Capped?
If participating
Limitation (i.e. 3x original)
Trigger
Change in control – sometimes license (let’s say exclusive)
Events (winding up and dissolving; sale; IPO, merger / acquisition)
What is it?
How Much?
Participating?
Capped?
Trigger

8. Examples
Assume a Series A Preferred round that raises $1,000,000 based on a $2,000,000 pre-money valuation $1 + $2 = $3
1/3 = 33%
Thus, upon the closing, the preferred investors will own 33% on a fully diluted basis
Assume a sale for $10,000,000
Liquidation Preference = 1x non-participating
Preferred investors get $1,000,000 if they do not convert to common
Preferred investors get $3,333,333 if they convert to common
Liquidation Preference = 1x participating
Preferred investors get $4,000,000 if they do not convert to common ($1,000,000 + $3,000,000)
Liquidation Preference = 1x participating capped at 3x
Preferred investors get $3,000,000 if they do not convert to common

9. Conversion Optional Automatic Ratio 1:1
Conversion – Right of investor or requirement of company to convert from preferred to common
Optional:
At investor election; certain time or event
Automatic:
Company requirement (IPO clears out cap table; majority vote; on sale – drag them along)
Ratios:
Starts at 1 to 1; can be adjusted up if you have to

10. Antidilution What is it? Weighted Average
Antidilution: Investor protection on pricing
Typical provision
Protection for in down round
Someone buys in for less
Investor protection for pricing
Add just the conversion price
Ratchet: - Harsh – price guaranty (ratchet) (1990s);
Coming back (1st year down round)
It’s worse for management
Carve-outs: Negotiations – over carve out
Options to employees (usually common);
Stock to preferred vendors, landlords, advisors
Incentive pool (Employees/Incentive)
Dividend stock or strategic partners
What is it?
Weighted Average
Narrow- includes preferred and common
Broad- includes preferred, common, options, warrants, others
Ratchet
Carve-outs
Weighted average
Narrow – includes preferred and common; worse for management
Broad – includes preferred common options, warrants, others; better for management

11. Difference Between Broad and Narrow Weighted Average
The definition of Stock Outstanding
Broad: includes Common, Preferred, options, warrants, etc.
Narrow: includes only the Preferred
The more narrow, the larger the adjustment to the conversion price = greater punitive to Founders

12. Example: Ratchet Assume:
$1,000,000 raised in Series A at $1.00 per share
Pre-money valuation = $3,000,000
Series A converts to common on a 1:1 basis
Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total)
$500,000 raised one year later in Series B at $0.50 a share
Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis
Thus, Series B owns 20% of the Company on as-converted basis (i.e., 1,000,000 out of 5,000,000 total)
No anti-dilution protection, Series A owns 20% of Company after the sale of the Series B (1,000,000 shares out of 5,000,000 total). 
Full ratchet anti-dilution protection, then the conversion price for the Series A Preferred is reduced from $1.00 per share to $0.50 per share.
Thus, full ratchet means that upon conversion, Series A entitled to receive 2,000,000 shares of common stock rather than 1,000,000 shares of common stock. 

13. Weighted Average Formula
AP = OP x CSO + (NM/OP)
CSO + AS
AP= Adjusted conversion price (after the application of weighted avg anti-dilution)
OP= Old conversion price (before the application of weighted avg anti-dilution)
CSO= Number of shares of Common Stock Outstanding immediately prior to dilutive issuance [the difference between Broad and Narrow]
NM= New Money raised as a result of the dilutive issuance
AS= Number of Additional Shares issued in the dilutive issuance

14. Example: Broad Based Weighted Average
Assume:
$1,000,000 raised in Series A at $1.00 per share
Pre-money valuation = $3,000,000
Series A converts to common on a 1:1 basis
Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total)
$500,000 raised one year later in Series B at $0.50 a share
Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis
Broad-based weighted average anti-dilution provision:
$1.00 x 4,000,000 + ($500,000/$1.00) = $0.90
4,000, ,000,000
Thus, the adjusted conversion price is $0.90 and the conversion ratio is adjusted to 1:0.9
Upon conversion, Series A with broad based weighted average protection would be entitled to receive 1,111,111 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection and 2,000,000 shares with full ratchet protection). 
This will have a much less punitive effect on the company's founders and management than a full ratchet anti-dilution provision

15. Example: Narrow Based Weighted Average
Assume:
$1,000,000 raised in Series A at $1.00 per share
Pre-money valuation = $3,000,000
Series A converts to common on a 1:1 basis
Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total)
$500,000 raised one year later in Series B at $0.50 a share
Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis
Narrow-based weighted average anti-dilution provision:
$1.00 x 1,000,000 + ($500,000/$1.00) = $0.75
1,000, ,000,000
Thus, the adjusted conversion price is $0.75 and the conversion ratio is adjusted to 1:0.75
Upon conversion, Series A with narrow based weighted average protection would be entitled to receive 1,333,333 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection, 1,111,111 with broad-based weighted average protection and 2,000,000 shares with full ratchet protection). 
More punitive effect on the company's founders and management than broad based weighted average, but still less than a full ratchet anti-dilution provision

16. Redemption Mandatory – 5 years (investors may give this up) Optional
Redemption – (go to company and require buyback)
Mandatory: Companies don’t like / want a partner
Optional:
Option on activity, time, event
Price - price paid + dividends not paid + return

17. Board of Directors Total number Number elected by common
Number elected by preferred
Outside directors?
Advise at least 5
Angels elect as group
Series A won’t yield control
How much do they own
3 in CA (engaged and not too many)
Odd #
Put the big names on advisory board and not make Board too large
They will ask for compensation depending on role

18. Protective Provisions
Voting In General
What Protective Provisions Cover
Senior securities
Liquidation, change of control
Amendments of Articles, Bylaws
Change rights of preferred
Information Rights
Change in corporate purpose
How long are they in effect?
Early round: minority but keep watch as dilution occurs
Preferred votes as though they converted
Majority or more
Preferred wants to vote as separate class (each new round!)
Don’t get handcuffed in running your business

19. Registration Rights Demand Piggyback S-3 Registration Rights:
Don’t try and negotiate
Standard
Right to common stock that preferred converts into and get them registered
Terminates when you can sell without registration
Demand:
Triggering events force registration
Investor has right to demand registration after time (1 year after IPO); (rights to cut back or delay by company)
Need flexibility
Piggyback:
Onto management
Right of investor to piggyback onto the company pool – company pays cost, including lawyer
Right to register – investor wants transferability
Company will want right to limit
S-3:
Short form
More for public companies (can use year after IPO)
Less expensive
Issues: # of shares, investors
Legal and accounting expenses which
Company will want to avoid
Company will want amount of securities to be greater than a certain amount (say $1 mil) to avoid frivolous regulation and associated expenses

20. Miscellaneous Right of First Offer (Right to make first offer)
Right of First Refusal (Right to make last offer)
Co-Sale (Right to participate
in the sale)
Exceptions – certain amount
of shares each year; family
members; estate planning
purposes
Closing Conditions
Right of First Offer:
If 50% or more of Series A preferred is outstanding Company issues stock then Investor has pro rata RTS (as converted basis)
If you go sell, investor gets rights to buy up to current % ownership
Right of First Refusal:
Series A investors must allow other Series A to buy
Investor gets right to buy founder shares on same terms
Co-Sale:
Right to participate in sale
Tag along – right of investor to sell when others sell (pro rata)
Drag along – company forces sale of shareholders who don’t agree
Closing Conditions:
Before investors close they may require milestones (contracts, patents, NDA, management lockup, board seat)

21. Angel Killers No Term Sheet Variance from Term Sheet
Hiding the Ball/Due Diligence Surprises
Cap Table Problems
Management Structure/Team
Material Contracts & Agreements
Board composition
No Clear Exit Strategy
Too Many Cooks
Lack of IP
Material Contracts & Agreements:
Not signed or in default

22. The End