37 Offices in 18 Countries
Venture Capital:
Fundraising, Founders and
IP Strategy in Silicon
Valley
Richard Horton
Silicon Valley – Sydney
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Squire Sanders
• Dual qualified US – AU attorney
• 13 years in Silicon Valley
• Squire Sanders1,300 lawyers globally
39 offices in 19 countries
2 in Silicon Valley (Palo Alto, San Francisco)
Top-20 global legal practice
Practicing law in more than 140 jurisdictions, in more than 40 languages
United States/Latin America: 16 offices, ~540 lawyers
• Represent many major SV funds and numerous startups
• Global venture capital and M&A expertise
3
US Venture Capital industry
• About 30 billion dollars invested in 2011 (about 4,000 deals in US) vs. 120 billion 1999 – 45% SV
• Internet and Software are leaders (nearly 50% in 2011) – ultimate start up business
• Cleantech – capital inefficiency issues
• Second coming of internet due to new infrastructure
• Return to fundamentals: capital efficiency
4
Investments by Industry Q4 2011 –
PWC/NVCA MoneyTree Report
5
Australian Explosion and Silicon Valley
• Explosion of AU incubators, accelerators, co-working spaces etc
Replicate Y Combinator
• Huge number AU IT/software graduates
• Many AU gov’t grants (CA, R&D tax credit etc)
• Silicon Valley ex-pats (Aussie Mafia too)
• Relevance of Silicon Valley?
AU VC and Angel community very small
AU vs. global opportunity
US Parochialism
Flip?
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Australian Explosion and Silicon Valley
• US-centric approach
• Australian American Free Trade Agreement
• The Future in Australia?
More to remain HQ’d in Australia as venture and entrepreneurial community grows
Several new VC funds in Australia online soon (Australian and offshore)
Too many first time entrepreneurs currently
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US Venture Capital industry
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Plan for Success
• Venture capital is a mature industry
Well known set of deal terms and variations
Need a lawyer with experience
• Most VCs hate legal complexity
• Standardization
• Expensive mistakes
LLC (unless very simple and conversion path to C corporation)
– Angel may require
Nevada incorporation
• Question mark re Australian startup reputation for corporate
compliance
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Sources of Capital for Startup Business
• Self Funding
“Bootstrapping” and “Organic Growth”
Smart money is good money
• Angel/Super Angel
Many sophisticated Angels in SV from dot com era and subsequently
Higher risk, pre-VC money
Can be good and bad
• Traditional VCs
Specialize in subject-matter (semi-conductors; cleantech; life
sciences)
Pressure to perform for LPs
Homerun game
Looking for exit
10
Sources of Capital for Startup Business
• Confidential information
• Don’t “shop” the deal too broadly
• Be prepared: you never know who you will meet when
Have an “elevator” pitch
Have a powerpoint of Business Plan
• Understand the fund’s decision process
Keep competitive till the end if possible
• Corporate Investment/Strategic Investment Usually equity investment by large corporation and significant
grant of rights
Strategic’s key motivation
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Process to Signing a Deal – The Term
Sheet
• Term Sheet
Non-binding
But must have legal advice
• Legal Documents
Based on term sheet
Usually 2-4 weeks, depending on due diligence findings and any “clean up”
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Due Diligence
• Initial due diligence
• Continues in earnest after signing of term sheet
• DD process (approx 1 to 2 months)
• Due diligence
• May have a material impact on valuation
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Key Terms - Valuation
• Primary issue in fundraising
• Too low
• Too high no good either
• Pre-money vs. Post-money?
• Convertible notes and bridge financings
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Key Terms - Valuation
• AcmeCo example
Pre-money valuation $8,000,000
– Founders – 3,000,000 shares of common stock – 75%
» Consideration?
– Drug and software IP/technology?
– Earnout (repurchase)
– Share option pool – 1,000,000 common stock – 25%
Amount to be raised – $4,000,000 => Post-money valuation of
12m
– 2,000,000 Convertible Preference Shares @ $2 each
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Key Terms – Valuation (example)
Capitalization (Cap table)
13.33%
Capitalization
Pre-Money
Post-Money
Founder’s Common Stock 3,000,000 shares 3,000,000 shares
Outstanding Preferred Stock 0 shares -- 2,000,000 shares
Outstanding Stock Options
Reserved Options 200,000 shares 5.00% 200,000 shares
800,000 shares 20.00% 800,00 0 shares
4,000,000 shares 6,000,000 shares
Valuation: (Series A Preferred Purchase
Price = $2.00 per share) $8.0 million $12.0 million
75.00% 50.0%
33.33%
% %
3.33%
100.00% 100.00%
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Key Terms – Liquidation Preference
• Convertible Preference Shares
• Liquidation Preference***
• Non-participating Preferred vs Participating Preferred
• Precedential value
• Non-participating Preferred (NPP)
• Participating Preferred (PP)
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Effect of Liquidation Preference in
Merger
Preferred Investment Amount 5,000,000$
Percentage purchased 30%
Sale Price of Company 25,000,000$
Participating
Preference Only Converted Preferred
Sales Price 25,000,000$ 25,000,000$ 25,000,000$
Amount to Preferred
Liquidation Pref 5,000,000$ 5,000,000$
--------------- --------------- ---------------
Amount after Preference 20,000,000$ 25,000,000$ 20,000,000$
Percentage of Balance 30% 30%
As Converted 7,500,000$ 6,000,000$
--------------- --------------- ---------------
Total to Preferred 5,000,000$ 7,500,000$ 30% 11,000,000$ 44%
Common Stock 20,000,000$ 17,500,000$ 70% 14,000,000$ 56%
Non Participating Preferred
In this climate Founders may need a massive exit to make any money….
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Key Terms
• Drag Along Rights
Investors can force vote for a merger
• Dividend Preference
Fundamentally, startups can’t pay dividends
Cumulative dividends
• Protective Provisions
Authorize more shares of that series (i.e. authorize future
investors)
Authorize series with more senior rights
Change rights of that series
**Merger/sale of assets
Changes to option plan (ESOP)
Limits on changes to number of members of Board of Directors
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Key Terms
• Board level protective provisions?
• Board of Directors
Observer rights only?
• Participation Rights/Pre-emptive Rights**
• Right of First Refusal**
• Co-Sale (Tag Along)
• Anti-dilution protection for Investor
Full Ratchet
Weighted average
• “Pay to play”
• Exclusions
Option pool of limited size
Mergers/acquisitions
Warrants for banks/leasing companies
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Effect of Anti-Dilution Formulas
• Merger Returns
Series A % of Company and
valuation thereof post - money
Assumes 4,000,000 additional shares of Series B
Preferred Stock issued at the following per share
prices:
$1.50
$0.75
Example A: Preferred without antidilution
protection
20.0% ($3.00 MM) 20.0% ($1.50 MM)
Example B: Weighted average antidilution
formula protection
21.9% ($3.36 MM) 25.5% ($2.06 MM)
Example C: Full ratchet antidilution protection 25.0% ($4.00 MM) 40.0% ($4.00 MM)
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Calculating Anti-Dilution
One, not “the” approach
:
X Co + $ = C1
X + Y
Application to Issuance of 4,000,000 Shares of
Series B Preferred at $1.50 per share:
(5,200,000 2.00) + $6,000,000 = $1.78
5,200,000 + 4,000,000
Where: X = number of shares of common stock outstanding or deemed to be outstanding (including
common stock equivalents) prior to new issuance
Each share of Series A converts into Common at
ratio of $2.00 or 1 to 1.12.
$1.78
Co = old conversion price Post Series B Common Equivalents:
C1 = new conversion price % With
Weighted
Average
% Without
Antidilution
Protection
$ = aggregate consideration received for
new shares issued
Common (including
options)
39.05% 30.0%
Y = number of new shares issued Series A 21.9 20.0
Series B 39.05 . 40.0
100.0 100.0%
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Key Terms
• Founder Vesting - Retention and Golden handcuffs
Vesting = 4 years (1 year cliff)
83b election - critical
Accelerated vesting?
“Founders Preferred Stock”
• Key Management/Employees: Employee share option pool
Usually options vest as above (25% after year 1; 1/36th per month thereafter)
• Redemption – The Living Dead
Forced liquidity when company hasn’t gone public
Amount (all at once or percentage)
• Information rights
• Registration rights
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Documents for Funding
• Preferred Stock Purchase Agreement
Schedule of Exceptions
Due Diligence
• Investor Rights Agreement
• Co-Sale/ROFR Agreement
(sometimes combined with Investor Rights Agreement)
• Restated Articles of Incorporation
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Convertible Notes
• Convertible notes?
Quicker, cheaper since not shareholder
Avoids valuation discussion/debate?
– warrant coverage
Same terms and shares as subsequent funding?
Cap or Discount (priced?)
Problems (multiple liquidation preference)
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IP Strategy
• Must have an IP Strategy
US very sophisticated regarding IP
Patents quintessential right (most important)
Infringement searching
Investor understanding of patents very varied, but valued
• IP ownership
• Patent protection
1 year grace period from first publication
• Prior employer rights
S2870 California Labor Code
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IP Due Diligence Issues
• Licensing Mistakes
• In-Licenses
• Out-Licenses
• Failure to secure branding rights
• Unplanned use of Open Source software
• IP rep and warranty issues
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Key to Success
• Understand the process and risk
• Focus on goals
Timing and appropriateness of investment
Management team
• Knowing the limits of negotiations by using experienced
counsel