© Copyright 2016 by K&L Gates LLP. All rights reserved.

Presented by Stan Lewandowski, Esq.stan.lewandowski@klgates.com 650.798.6743June 23, 2016

Silicon Valley Startup: Idea to IPOUnderstanding Terms in Venture Capital Financings

These materials have been prepared solely for educational purposes. The presentation of these materials does not establish any form of attorney-client relationship with the author or K&L Gates. Particular legal issues should be addressed through consultation with your own legal counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. © K&L Gates LLP 2016.

Circular 230 DisclosureTo ensure compliance with requirements imposed by the IRS, please be advised that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed within.

klgates.com 2

3

INTRODUCTIONS§ Stan Lewandowski, Esq., Partner (Corporate/M&A)

(650) 798 6743 & stan.lewandowski@klgates.com

§ Practices in the Silicon Valley office of K&L Gates

§ Advised clients (issuers and investors) in more than 100 closed angel and venture capital financings

klgates.com 4

THE STARTUP LIFECYCLE§ Idea

§ Sketches, rough prototype§ Proof of concept

§ MVP or MVVP§ Building

§ Capital raising§ Scaling§ Maturity and exit

klgates.com 5

PREPARING YOUR COMPANY FOR INVESTMENT – BUSINESS LEADERSHIP§ Term sheet is an early test of your business

acumen and leadership§ Your lawyer will help you but you need to be

knowledgeable and the leader!§ Be prepared on legal matters; it helps your

credibility§ Know your stockholders

§ Have a credible intellectual property position

§ Be prepared to justify your financial projections

klgates.com 6

TERM SHEET AND ITS ROLE§ AKA LETTER OF INTENT (LOI),

MEMORANDUM OF UNDERSTANDING (MOU)§ Sets out the key terms of a transaction agreed on in

principle by the parties

§ Outlines the timetable and obligations of the parties during negotiations

§ Contains some legally binding terms (confidentiality, exclusivity, transaction expenses and more)

klgates.com 7

TYPES OF EARLY STAGE FINANCINGS§ Seed Financing:

§ Amount raised: ~$50,000 up to $1M§ Instruments: convertible promissory notes, SAFEs

and KISSes (visit Idea to IPO YouTube channel at https://www.youtube.com/watch?v=qvQdTrXhMCU)

§ Series Seed and Series A Financings

§ Series B and beyond

klgates.com 8

CONVERTIBLE PREFERRED STOCK§ What is it?

§ Stock – equity position in a company

§ Preferred – has rights, preferences and privileges superior to those of common stock

§ Convertible – into shares of common stock

klgates.com 9

MAIN TRANSACTION DOCUMENTSIN A VC FINANCING§ 5 transaction documents:

• Amended and Restated Certificate of Incorporation• Series ___ Stock Purchase Agreement• Investors’ Rights Agreement• Right of First Refusal and Co-Sale Agreement• Voting Agreement

§ Sometimes IRA, ROFR/Co-Sale and Voting combined into one agreement

§ National Venture Capital Association Model Documents (www.nvca.org)

klgates.com 10

PRE-MONEY & POST-MONEY VALUATIONS§ Pre-Money Valuation = Agreed Upon Value of

Company Prior to Investment

§ Post-Money Valuation = Pre-Money Valuation + Invested Amount

klgates.com 11

SAMPLE CAPITALIZATION – STARTUP, INC.§ Common Stock

§ Authorized: 10M shares§ Outstanding: 4M owned by founders§ Stock Option Pool: 1M shares

§ 200K granted, none exercised§ 800K available for grant

§ No preferred stock authorized§ Ownership: founders own 100% on an outstanding share

basis and 80% on a fully-diluted basis§ Fully-diluted (FD): 4M + 1M = 5M

klgates.com 12

PRE-MONEY VALUATION§ Determination of Price Per Share

§ Price = Pre-Money Valuation/Fully-Diluted Capitalization

§ Pre-Money: $8M§ Stock Option Pool: 1M shares§ Investment of $3M§ Fully-Diluted Shares: 5M

§ Price = $8M/5M Shares = $1.60/Share

klgates.com 13

PRE-MONEY VALUATION§ Impact of Option Pool - Example I

§ Price = $8M/5M Shares = $1.60/Share

klgates.com 14

Shares %Founders (CS 4M 58.2%Stock Option Pool (CS) 1M 14.5%Investor 1.875M 27.3%

PRE-MONEY VALUATION§ Impact of Option Pool - Example II

§ Price = $8M/4.5M Shares = $1.78/Share

klgates.com 15

Shares %Founders (CS 4M 64.6%Stock Option Pool (CS) 0.5M 8.1%Investor 1.685M 27.3%

PRE-MONEY VALUATION - QUIZ§ If $5M of new money is invested at a pre-money

valuation of $10M, what percentage of the company will the investor own post-investment?

§ % Owned = Amount Invested/(Pre-Money Valuation + Amount Invested) OR

§ % Owned = Shares Issued to Investor/ Post-Money Shares (F/D)

klgates.com 16

LIQUIDATION PREFERENCE§ Purpose is to provide investors with preferential

rights to proceeds in a “liquidation”§ An acquisition of the company is a “liquidation”

§ Initial amount - 1X or a greater multiple of initial investment§ Non-participating – preferred gets initial amount only§ Participating preference gets initial amount plus participates

in the remainder of the proceeds with the common stock without limitation or with a limit (cap)

§ Preferred stock may always convert to common stock and share in proceeds as a common stock holder

klgates.com 17

LIQUIDATION PREFERENCE – EXAMPLE I§ Startup, Inc. is acquired for $40M

§ Series A LP invested $4M in Series A, participating, no cap

§ Series A owns 50% and common stock owns 50% of the outstanding shares

klgates.com 18

LIQUIDATION PREFERENCE – EXAMPLE I§ Distribution:

§ $4M to Series A (initial 1X); $36M remaining to be

distributed

§ $18M to Series A; $18M to common stock (50% of $36M = $18M)

§ Series A receives a total of $22M ($4M initial + $18M = $22M); Common stock gets $18M (50% of $36M)

klgates.com 19

LIQUIDATION PREFERENCE – EXAMPLE II§ Startup, Inc. is acquired for $40M§ Series A LP is for $4M, participating, 3X cap on Series A

preference (Series A owns 50% and common stock owns 50% of the outstanding shares)

§ Distribution:§ $4M to Series A (initial 1X); $36M remaining to be distributed§ $18M to Series A; $18M to common stock but Series A capped

at 3X or $12M (3 x $4M)§ Conversion to common stock scenario – 50% of $40M is $20M;

Series A may convert to common stock at any time§ Series A will elect to convert so it will receive $20M as compared

to $22M in a no cap situation

klgates.com 20

DIVIDENDS§ Cumulative

§ Accrues each year whether or not paid§ Accrued dividends payable as part of the liquidation preference§ Not commonly seen in financing deals

§ Non-cumulative§ No accrual§ In most of the VC financing deals

klgates.com 21

ANTI-DILUTION PROTECTION§ Purpose is to adjust investors conversion price if

stock is sold at a lower price in a down round§ Conversion ratio increases - means investors

will get more common stock upon conversion§ Weighted average rather than full ratchet (more

customary)§ "Ratchet" conversion price reduced all the way

to new sales price (less customary)§ Exclusions

klgates.com 22

BOARD OF DIRECTORS - CONTROL§ Control of Series A Company

§ Board of Directors - 1 vote per member but can be more in Delaware§ Preferred stock protective provisions§ Common stock protections

§ Board tends to be 3 to 5 persons; if a 5-person board, then:§ 2 represent preferred stock § 2 represent common stock

§ Selection of 5th director is critical§ Selected by other directors§ Selected by outstanding shares§ Industry expert, independent

klgates.com 23

PROTECTIVE PROVISIONS§ Purpose is to require investor approval for

certain corporate actions§ Amend Certificate/Articles/Bylaws§ Create new series/reclassify old series§ Merger/sale of assets/liquidation§ Declare/pay dividend§ Change size of board§ Budget and spending§ Others – avoid business micromanagement

§ Approval percentage§ Majority (or 2/3) of all Preferred Stock, or Series

klgates.com 24

PREEMPTIVE RIGHTS – RIGHT OF FIRST OFFER§ Purpose is to provide investors the right to keep

their ownership percentage in the company through additional investment

§ Exclusions (common stock issued upon exercise of stock options and more)

klgates.com 25

RIGHT OF FIRST REFUSAL AND CO-SALE§ Purpose is to provide investors the right to

purchase founder’s shares if the company does not purchase shares on the same terms the founder is permitted to sell

§ Carveouts: gifts to immediate family

§ Exclusions: minimal sales allowed (~1-10%)

klgates.com 26

DRAG ALONG RIGHTS§ Purpose is to provide investors with control over

having liquidity through an M&A§ Requires certain common stock holders to vote

in favor of an acquisition § Board and preferred stock approve the

transaction§ Acquiror not affiliated with any major investor§ Base valuation for the acquisition (no less than

$30M in the term sheet)

klgates.com 27

REDEMPTION§ Very rare in early stage deals

§ Usually put right in 3-5 years after closing

§ Redemption over a certain fixed period, in annual installments, usually at per share price paid by investor

klgates.com 28

OTHER AGREEMENTS AND ANCILLARIES§ Management Rights Letter

§ A Venture Fund with ERISA L.P.s must invest 50% of assets in operating companies and obtain “management rights” that give the fund the right to participate substantially in, or substantially influence the conduct of, management of the portfolio company.

§ Rights are light, such as access to management if not on the Board, access to information, etc.

§ Indemnification Agreement

§ Confidentiality, Invention Assignment and Non-Competition Agreement

klgates.com 29

THANK YOUFor Further Questions Please Contact:

Stan LewandowskiPartner, K&L Gates LLP

(650) 798-6743E-mail: stan.lewandowski@klgates.com

klgates.com 30