37 Offices in 18 Countries

Venture Capital:

Fundraising, Founders and

IP Strategy in Silicon

Valley

Richard Horton

Silicon Valley – Sydney

richard.horton@squiresanders.com

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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

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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

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Investments by Industry Q4 2011 –

PWC/NVCA MoneyTree Report

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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

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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