preparing for early stage financing - pedley, millin & gordinier - june 11, 2013

PREPARING FOR EARLY STAGE FINANCING

June 11, 2013

Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.

Anthony Millin, Esq. Partner Pedley, Millin & Gordinier, PPLC


Anthony Millin - Bio

Anthony Millin has a corporate and securities practice, focusing on start-up and emerging growth companies. Anthony is also a successful serial entrepreneur who has co-founded multiple companies in the United States and China, several of which have been institutionally funded. This experience in raising capital, and building and running companies, provides Anthony with valuable insights into the legal and business needs of his clients. It enables Anthony to understand a business, its goals and its challenges from the perspective of the entrepreneur.

Anthony’s legal practice includes general corporate counseling, preparation of investment materials and presentations, equity and debt financings, joint ventures, corporate governance, and mergers and acquisitions. He also has worked closely with angel investors and a range of institutional investors. Anthony serves businesses across multiple industries, including internet/technology, biotech, clean energy, education and health care. He also brings his China-based experience to assist early-stage and middle-market companies interested in conducting business in China.

Anthony also serves as Founder and Chairman of Bramley Ventures, Vice Chairman of the Board of Bethesda Green, Member of the Board of Directors of the Montgomery County Chamber Community Foundation, Co-Founder and Member of the Board of Directors of Lauren’s Light, and Member of the Advisory Board of the Maryland Clean Energy Center.

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Agenda

• Investor Packages – Creating a compelling investor package and preparing for investor

presentations

• Stages of Company – Evaluating the sources of financing and legal structures for each stage of a

company’s lifecycle

• Term Sheet – Negotiating a term sheet – a deep dive into the key legal provisions and their

impact

• Definitive Documentation – Understanding the different set of documents that comprise the “Definitive

Documentation”

• Due Diligence – Preparing for the due diligence process

• Regulatory Compliance – Complying with federal and state regulatory requirements

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Investor Packages

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Investor Package

• “Teaser”

• Non-Disclosure Agreement (NDA)

• Executive Summary

• Investor Presentation (PowerPoint)

• Financial Model

• Business Plan (Internal Document)/ Implementation Plan

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Investor Packages

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SECTIONS TO COVER IN INVESTOR MATERIAL

• Vision

• Business Summary/Executive Summary

• Market Need/Opportunity / Problem You Are Solving

• Your Solution – Your Products and/or Services

• Market

• The Competition and Your Competitive Advantage

• Marketing/Sales/Distribution Strategy

• Business Model – How Do You Generate Profit

• Current Milestones Achieved/ ”TRACTION”

• Management Team

• Financial Summary

• The Ask (Funds Seeking) and Uses


Teaser

• 1-2 pages

• Goal of a “Teaser” is to get to a meeting

• Tool for you and your advisors to easily share with prospects

• Quick to read, compelling

• Prior to an NDA - Share only information comfortable sharing more broadly

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Non-Disclosure Agreement • Most VCs and many angel groups will not sign

• How should you proceed ?

– Judgment call specific to each potential investor

– Risk Level and Risk Aversion

– Should label all your documents “Confidential”

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Executive Summary

• 5-10 Pages

• Expands on each section of the “Teaser”

• Includes detailed bios of the management team and a more detailed financial summary

• Distribute to potential investors after initial meeting

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Financial Model

• It is important to build a financial model

• Forces you to understand your underlying business model

• Investors understand that actual results will usually vary from your projections

• The key is your understanding of the assumptions that drive the Revenue, COGS and SG&A in your business

• Summary Income Statement and Cash Flow projections for 3-5 years

• Very detailed Cash Flow projections for next 12 months

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Financial Model

• Performs Sensitivity Analysis

– What if your assumptions are off by 10%, 25%, 50%

– What if the first sale takes 6 months longer than projected

– What if the pricing needs to be cut by 30%

– Understand the impact on Cash Flow

• Try to raise sufficient capital to ensure that you do not run out of cash under the more conservative set of assumptions

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Financial Model

• What items from the financial model should you include in the investor package – Teaser

• Revenue and EBITDA line for 3-5 years

– Executive Summary and Investor Presentation • Summary chart of Income Statement and Cash Flow

Statement for 3-5 years

– The more detailed financial model will be shared with potential inventors with whom you are engaged in serious discussion and/or due diligence

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Investor Presentation

• Prepare for the Presentation

– Research who you will be meeting (Investor Bios, Investor focus areas, portfolio companies relevant to your market)

– Know how much time you will have to present your company

– Customize presentation to address your audience and allotted time

– Practice, Practice, Practice !!

• Invite questions and make the presentation interactive

– Increases the likelihood that you will address the specific questions and concerns of the audience

• Be Passionate - If you are not, your audience will not be

• If you do not know an answer to a questions, it is OK to acknowledge that and follow-up later with the answer

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Stages of a Company

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Stages of Company

• Seed Stage

• Early Stage

• Growth/Expansion Stage

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Stages of Company - Seed

STAGE

SEED

Investor

• Self • Friends & Family • Angels

Objectives Include

• Complete organization structure • R&D related to building or testing product/service offering • Validation - assessment of potential/early customer interest • Develop a marketing and sales plan

Structure • Common Stock/Membership Units • Convertible Note • Series AA Preferred Stock/Membership Units

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Stages of Company - Early

STAGE

EARLY

Investor

• Angel • Institutional Angel • Venture Capital

Objectives Include

• Launch initial product and/or service • Continued product development • First commercial sales • Build Management Team, Board, Advisors

Structure • Series A Preferred Stock/Membership Units • Convertible Note

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Stages of Company - Growth

STAGE

GROWTH / EXPANSION STAGE

Investor • Venture Capital • Other Institutional Investors (PE/Hedge Fund/IB Group)

Objectives

• Scale Marketing, Sales and Distribution • Scale Operations • Expand Product Lines • Expand Geographically

Structure • Series B Preferred Stock • Series C Preferred Stock

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Term Sheet

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Term Sheet

• Term sheets can take several different forms, depending on the preferences of the Parties involved – A brief list of terms – A letter agreement – A short agreement

• Reasons for Using Term Sheets – Highlights key terms of the transaction – Enables earlier discovery of points of contention or deal breakers – While it requires additional time and cost upfront, ultimately reduces

the amount of time and expense incurred by facilitating the drafting and negotiation of the definitive transaction documents

– Makes it harder for parties to change their business positions later

• Term sheets are generally non-binding, but may include a few binding provisions

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Three Key Negotiation Areas

• VALUE OF THE COMPANY – Drives the percent of the Company you are selling in the financing

• INVESTOR RIGHTS & PREFERENCES – Drives the investors’ preferences with respect to distributions of profit or

distributions upon a liquidity event

– Drives the investors ‘ rights to participate in new issuances of securities and transfers of issued securities

• INVESTOR PROTECTIONS (CONTROL) – Drives the level of control that the investor (usually holding only a minority

interest) exerts on major actions of the Company

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Value of The Company

• Key Valuation Concepts

–Pre-Money vs. Post Money Valuation

– Fully-Diluted Basis

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Pre-Money/Post-Money

• The Pre-Money Valuation is the valuation of the Company not including the new cash to be raised

• The Post-Money Valuation is the valuation of the Company including the new cash to be raised

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Pre-Money/Post-Money

Example - Entrepreneur is raising $500,000 and the investor and entrepreneur agree on a valuation of $2 million • Is the $2 million pre-money or post-money?

– If it is pre-money, the business is worth $2.5 million upon

closing and the investor will receive 20% ($500,000/$2.5 million) of the company upon closing

– If it is post-money the business is worth $2.0 million upon

closing ($1.5 million pre-closing) and the investor will receive 25% ($500,000/$2.0 million) of the company upon closing

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Fully-Diluted Basis

• To calculate the share price or membership unit price

– Divide the value of the company by the number of shares/units issued and outstanding

• How do you account for stock options, warrants, or convertible notes that could become issued and outstanding units upon exercise or conversion ?

– Investors almost always want to avoid having their shares diluted in the future when these instruments are exercised or converted, often at a price lower than the price paid by the investor

• The investor will want the share/membership unit price calculated on a “FULLY DILUTED BASIS” – Includes the number of shares/units subject to options, warrants, convertible notes in

the denominator

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Fully Diluted-Basis - Example

• Shares issued and outstanding - 1.8 million

• Stock Option Plan: 200,000 (Includes options not yet granted, and granted but not yet vested or exercised)

• Investment Amount: $ 500,000

• Pre-money valuation: $ 2 million

Based on Shares Currently Outstanding Divide the pre-money valuation by the sum of the shares issued and outstanding 2,000,000/1,800,000 = $1.11 per share Number of shares issued in financing = $500,000/ $1.11 = 450,000 Investor will acquire an 18 % ownership interest (450,000/2,450,000 = 18%)

Fully-Diluted Basis Divide the pre-money valuation by the sum of the shares issued and outstanding plus the options in the stock option plan 2,000,000/2,000,000 = $1.00 per share Number of shares issued in financing = $500,000/ $1.00 = 500,000 Investor will acquire a 20 % ownership interest (500,000/2,500,000 = 20%)

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Rights and Preferences

• Liquidation Preference • Participating vs. Non-Participating • Dividend Rights/Preferred Return • Anti-Dilution • Preemptive Rights • Right of First Refusal & Co-Sale Rights • Drag Along Rights • Redemption Rights • Registration Rights • Information Rights

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The Liquidation Preference

• A mechanism by which the investor seeks to recoup its original investment or a multiple thereof, plus any declared and unpaid dividends, before there are any distributions to the common stockholders/unit holders

• Usually is defined to occur upon a liquidation, dissolution or winding up of the company, a merger, or a sale of the company or its assets

• Example - $1 million dollar investment:

1X Liquidation Preference = $1 million to investor before common shareholders/units holders get 1st dollar

2X Liquidation Preference = $2.0 million to investor before common shareholders/units holders get 1st dollar

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Participating vs. Non-Participating

Non-Participating Preferred Limits the investor to its Liquidation Preference (In practice, an investor will exercise its right to convert its preferred stock/units into common stock/units and give up its Liquidation Preference if it would get a larger return as a common stockholder/unit holder)

Participating Preferred with A Cap

Investor receives its Liquidation Preference plus further distributions on a pro-rata basis with the common stockholders/ unit holders up to the Cap (In practice, an investor will exercise its right to convert its preferred stock/units into common stock/units and give up its Liquidation Preference if it would get a larger return as a common stockholder/unit holder)

Participating Preferred With No Cap

Investor receives its Liquidation Preference plus further distributions on a pro-rata basis with the common stockholders/ unit holders

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Cumulative vs. Non-Cumulative

No Preferred Return 8% Non-Cumulative Preferred Return

8% Cumulative Preferred Return

The preferred stockholders/ unit holders and common stockholders/unit holders participate in dividend distributions on a pro rata basis

1st – Company must pay 8% dividend to the preferred stockholders/unit holders for the current year before making a distribution on any junior securities 2nd – Preferred stockholders/ unit holders and common stockholders/unit holders then share in dividend distributions on a pro rata basis

1st – Company must pay 8% dividend to the preferred stockholders/unit holders for the current year, and for all prior years for which a Preferred Return was accrued but not paid 2nd – Preferred stockholders/ unit holders and common stockholders/unit holders then share in dividend distributions on a pro rata basis

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Anti-Dilution Protection

• Protection to investor in the event the Company issues new shares/units at a price lower than the price paid by the investor

• Adjusts the investor’s conversion ratio for the conversion of Preferred Stock to Common Stock (from a 1:1 ratio) to increase the number of shares of Common Stock the investor receives on conversion

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Anti-Dilution Protection

• Three Forms of Anti-Dilution Protection *

– Full Ratchet - Least favorable to Entrepreneur

• Only accounts for the share/unit price of the new issuance. A single new share/ unit issued at a lower price will result in the original investor receiving such lower price on their full prior investment

– Narrow Based Weighted Average - More Favorable to Entrepreneur

• Accounts for the share/unit price of the new issuance plus the size of the new issuance relative to the number of shares / units issued and outstanding

– Broad Based Weighted Average - Most Favorable to Entrepreneur

• Accounts for the share/unit price of the new issuance plus the size of the new issuance relative to the number of shares/units issued and outstanding on a fully diluted basis

* Subject to customary exceptions

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Preemptive Rights

• The investor’s pro rata right, based on percentage equity ownership, to participate in subsequent issuances (usually only financings)

• If the investor owns 20% of Company before the subsequent financing, the investor has the right to take 20% of the subsequent financing

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Right Of First Refusal Co-Sale Right

• In the event a shareholder/unit holder receives a bona fide offer to buy its stock / units, the remaining shareholders/unit holders have a pro rata right to either acquire those shares/units on the same terms, or to sell their shares/units, on an as-converted basis pro rata, as part of such sale of such shares/units

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Drag Along Rights

• The right of a pre-requisite number (i.e., a majority) of the selling shareholders/unit holders who all agree to sell their shares/ units, to drag along the remaining shareholders in the sale of the Company

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Redemption Rights

• Right to have the company redeem investor’s shares/units

• Usually at the greater of the purchase price or the FMV as determined by a formula, the Board, or an independent appraisal of the Company

• Could be at the investors’ option or mandatory

• Payment terms are critical to Company, since Company does not know its cash situation at the time of redemption

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Registration Rights

• Grants the investor the right to either:

– Force the Company, after a period of time, to register the investor’s shares and offer them publicly, or

– Register and sell the investor’s shares as part of a registration and public offering, including a registered offering initiated by the Company or another stockholder

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Information Rights

• Right to financial information such as income statements, cash flow statements, and balance sheets

• Right to other information such as budgets and budget reconciliations, a dashboard of key metrics, and Board observation rights

• Could be on an annual, quarterly or monthly basis. Need to weigh benefits to investor vs. burden on management to produce

• Could be unaudited or audited

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Protective Provisions

• Board Representation/Voting Agreements

• Provides investors, who are minority shareholders (i.e., control less than 50%), significant control over designated actions of the Company

• Requires the approval of a majority, or supermajority, of preferred shareholders/unit holders voting as a separate class

• May also require the approval of a majority of the Directors designated by the preferred shareholders/ unit holders

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Protective Provisions

• Investors and entrepreneurs will negotiate over which protective provisions to include. Examples are: – Amending the Certificate of Incorporation and Bylaws / Operating

Agreement

– A repurchase or redemption of equity

– A material change in the nature of the Company’s business

– A change in the size of the Board

– The issuance of new equity or securities convertible into equity (pari-pasu, superior or junior to existing securities)

– The sale of all or substantially all of assets of the Company or merger into another company resulting in a change of control

– The liquidation, dissolution, and winding up of the Company

– Incurring debt above a designated amount

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Definitive Documentation

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Form of Securities

• Corporation

– Common Stock

– Preferred Stock (Rights & Preferences/Protections)

• Limited Liability Company

– Common Units

– Preferred Units (Rights & Preferences/Protections)

• Corporation and Limited Liability Company

– Convertible Note (Secured or Unsecured)

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Form of Securities

• Common Stock/Units

– Founders, Friends and Family

• Convertible Note

– Friends and Family, Angel

• Preferred Stock

–Angel, Institutional Angel, Venture Capital

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Common Stock

• A security that represents an equity ownership interest • First form of stock issued upon creating a new

corporation • Conveys some basic rights – vote, right to dividends and

proceeds of sale • Usually comes with restrictions – e.g., restrictions on

transfer • Right to the assets of the company upon liquidation,

after distributions to the holders of debt and preferred equity

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Convertible Note

• Debt instrument, with interest that usually accrues

• Bypasses the need for upfront agreement on valuation

• Can be secured or unsecured; subordinated

• Convertible into a company’s stock /units:

– Automatically, at the time the company closes on its next qualified round of equity financing

– If no such round occurs, at pre-agreed upon terms

– Anytime prior to maturity, upon a vote of a majority of the convertible note holders

• If no conversion, repayable along with accrued interest, upon its maturity

• Provides investor with a discount to the next round (may also include warrants)

• Relatively simple legal structure, lower transaction cost

• Priority status over common and preferred shareholders/unit holders

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Convertible Note With A “CAP”

• A Convertible Note is often the first non-friends and family investment

• Comes into the Company during a period of very high risk (market risk, execution risk, technology/product risk and financing risk)

• To compensate for all of the risk, many investors now negotiate a “CAP” on the conversion price (Negotiating maximum conversion value upfront)

• Protects investor in event of rapid value growth prior to conversion • Investor will usually have the option to convert at the lower of:

• A negotiated discount (i.e., 20%) to the next equity round • The agreed-upon valuation cap

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“CAP” - EXAMPLE

• A Company with 1 million shares of common stock/units outstanding

• Issued a $500,000 convertible note, with a conversion discount of 20% and a conversion cap of $6 million

• The start-up was able to raise $15 million at a pre-money valuation of $45 million in its next round of financing

$ 6 million

Cap 20%

Discount No Cap or Discount

Valuation $6 million $36 million $45 million

Per Share Price $6.00 $36.00 $45.00

Shares Upon Conversion 83,333 13,889 11,111

% Of Company (Post) 5.9% 1.0% 0.8%

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Preferred Stock

• Security that represents an equity ownership interest

• Rights and preferences (priorities): – Over the common stock related to the assets

and profits of a company – Rights in the event of issuance of new equity

or existing shareholders sale of equity

• Protective provisions that limit actions that can be taken by the Company without preferred stockholder approval

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Common Stock/Units

• Common Stock

– Stock Purchase Agreement or Subscription Agreement

– Stockholders Agreement

• Common Membership Units

– Membership Unit Purchase Agreement or Subscription Agreement

– Amended and Restated Operating Agreement

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Convertible Note

• Convertible Promissory Note Purchase Agreement

• Convertible Promissory Note(s)

• Pledge & Security Agreement (If Secured)

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Preferred Stock/Units

• Series Seed/Series AA (Limited Rights and Protections) – Stock Purchase Agreement – Investor Rights Agreement – Amended and Restated Certificate of Incorporation

• Series A Membership Units – Membership Unit Purchase Agreement or Subscription Agreement – Amended and Restated Operating Agreement

• Series A Preferred, Series B Preferred, Series C Preferred – Stock Purchase Agreement – Investor Rights Agreement – Right of First Refusal and Co-Sale Agreement – Voting Agreement – Amended and Restated Certificate of Incorporation

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Due Diligence

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Due Diligence

• A comprehensive review of a company's business

• Components of Due Diligence – Legal Due Diligence

– Business Due Diligence

– Financial Due Diligence

• Time to complete due diligence - Two weeks to two months depending on the size of the investment, the group making the investment, the stage of the company, and the level of preparation by the Company

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Due Diligence on Investor

• Early investor becomes an important partner in the success of the Company

• Company should conduct due diligence on the investor

– Understand investor’s expertise, track record, value beyond money being provided

– Speak to other CEO’s funded by investor to learn how the investor was to work with (in both good times and bad times)

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Preparation Of Documents

• Documents will include: – Organizational Documents

• COI, Bylaws, Operating Agreement, Stockholder Agreement, Good Standing Certificate, Qualifications)

– Ownership • Capitalization Table (Ownership) • Share Certificates

– Corporate Document • Minutes from Board and shareholder meetings

– Financial (Up to 3 years if available) • Tax Returns, Financial statements (Income Statement/ Cash flow

Statement/Balance Sheet)

– Customers/Suppliers /Strategic Partnerships • Names; Copies of agreements • Contact information for reference checks

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Preparation Of Documents

• Documents will include (continued): – Intellectual Property

• List of all Intellectual Property (Patents/Trademarks/ Copyrights)

– Insurance policies – People

• Organization chart • Bios of key managers

– Agreements • Copies of all prior financing agreements (debt & equity) • Copies of all other material agreements

– Marketing collateral and marketing and sales strategies – Detailed product or service descriptions and information – Business plans

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Preparation Of People

• Make sure all key members of the team who will interact with investors are prepared for the process

• If Investors plan to contact a few key customers and/or partners

– Let the customers and/or partners know that they may be contacted by investors

– If there have been issues with a customer, explain the situation to the investor ahead of time

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Regulatory Compliance

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Regulatory Compliance

• Ability to raise money from individual investors regulated by the Securities Act of 1933 (the “Securities Act”) and certain state securities laws (“Blue Sky Laws”)

• Security Filings will be required with the Securities and Exchange Commission, and unless the financing falls under a self-executing state exemption, with state security agencies

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Contact Information

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Anthony Millin, Esq. Partner Pedley, Millin & Gordinier, PLLC 4520 East West Highway, Suite 700 Bethesda, Maryland 20814

Tel: (240) 235-1101 Cell: (301) 908-0005 Fax: (240) 235-1097 Email: [email protected] Web: www.pedleymillin.com

mailto:[email protected]

http://www.pedleymillin.com/

preparing for early stage financing - pedley, millin & gordinier - june 11, 2013

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