WALKER CORPORATE LAW GROUP, PLLC » VC Issues

Fundraising 101: Checklist for Entrepreneurs

Scott Edward Walker — Thu, 10 May 2012 01:59:57 +0000

I’ve been a corporate lawyer for 18+ years, and there are certain fundamental mistakes that I’ve seen entrepreneurs repeatedly make in connection with fundraising. Accordingly, I thought it would be helpful to provide a simple checklist tailored to first-time entrepreneurs. I’ve also included links to prior posts for a detailed discussion.

1. Do your homework and determine which investors are the right fit for your startup (see post here).

2. Hustle and build relationships in order to get warm introductions to those investors (see post here).

3. Optimize for people, not valuation (see post here).

4. Only raise money from friends and family as a last resort (see #1 in post here).

5. Get references and speak with other entrepreneurs and founders who have done deals with your prospective investors (see post here).

6. Limit your pitch deck to 10 slides or less, tell a story and demo your product (see post here).

7. If it’s a seed round, issue convertible notes (see post here).

8. Don’t solicit investors via Facebook, LinkedIn or Twitter (see posts here and here).

9. Only raise funds from “accredited investors” (see post here) and make sure your lawyers file a Form D with the SEC and applicable state commissions (see post here).

10. Don’t pay anyone a commission for raising funds for you unless they are a registered broker-dealer (see post here).

Convertible Note Seed Financings: Econ 101 for Founders

Scott Edward Walker — Mon, 23 Apr 2012 02:38:49 +0000

This post is the second part of a three-part primer on convertible note seed financings. Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed certain basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

This part 2 will address the economics of a convertible note seed financing and the three key economic terms: (i) the conversion discount, (ii) the conversion valuation cap and (iii) the interest rate.

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? and (ii) what happens if the maturity date is reached prior to the note’s conversion to equity?

[Note: This post was originally published on TechCrunch.]

What Is a Conversion Discount?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. A conversion discount (or “discount”) is a mechanism to reward the noteholders for their investment risk by granting to them the right to convert the amount of the loan, plus interest, at a reduced price (in percentage terms) to the purchase price paid by the Series A investors.

In other words, the founders are saying to the investors, in effect, if you take this risk and give us money today, we’ll reward you by giving you “20% off” at our Series A round down the road (20% being the usual discount, as discussed below). For example, if the investors in a $500,000 convertible note seed financing were granted a discount of 20%, and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price (referred to as the “conversion price”) of $0.80 per share and thus receive 625,000 shares ($500,000 divided by $0.80), which is 125,000 shares more than a Series A investor would receive for its $500,000 investment and a 1.25x return on paper ($625,000 divided by $500,000). (The foregoing example does not include accrued interest on the loan, which is typically about 5%-7% annually, as discussed below.)

Discounts generally range from 10% (on the low side) to 35% (on the high side), with the most common being 20%. In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that granted a discount to investors was 67% in 2010 and 83% in 2011; and the median discount was 20% in both 2010 and 2011.

As discussed in part 1 of this series, one of the significant advantages of issuing convertible notes, as opposed to shares of preferred stock, is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round. Clearly, a greater discount can be offered to early investors who are assuming more risk, particularly where the startup is closing its financing on a rolling basis over an extended period of time (as is the trend).

Moreover, a note can include a discount that increases over time – e.g., (i) 1.5% per month up to 25%; or (ii) 10% if the Series A round closes within 6 months, 15% if it closes between 6 and 12 months, and 20% if it closes after 12 months. In the Fenwick Survey, the percentage of convertible note seed financings that included a discount which increased over time was 25% in 2010 and 5% in 2011.

Finally, founders should be aware that investors will sometimes push for the issuance of warrants in lieu of a discount. In a seed round, this makes no sense and only creates more paperwork and, accordingly, higher legal fees. In the Fenwick Survey, the percentage of convertible note seed financings that included the issuance of warrants was 0% in both 2010 and 2011.

What is a Conversion Valuation Cap?

A conversion valuation cap (or “cap”) is another mechanism to reward the noteholders for their investment risk (and for their efforts in increasing the value of the startup as a result of introductions, advice, etc.). Specifically, a cap is a ceiling on the value of the startup (i.e., a maximum dollar amount) for purposes of determining the conversion price of the note — which (like a discount) thereby permits investors to convert their loan, plus interest, at a lower price than the purchase price paid by the Series A investors.

Using the example above, let’s assume the cap were $5 million and the pre-money valuation in the Series A round were $10 million. If the noteholders invested $500,000 and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price of $0.50 per share ($5,000,000 divided by $10,000,000) and thus receive 1,000,000 shares ($500,000 divided by $0.50), which is 500,000 shares more than a Series A investor would receive for its $500,000 investment and a 2x return on paper ($1,000,000 divided by $500,000), not including any accrued interest on the loan. Notice that if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return, as noted above.

If we bump-up the pre-money valuation to $20 million and the cap remains at $5 million, you can see how the noteholders are rewarded (and protected): their $500,000 loan now converts at an effective price of $0.25 per share ($5,000,000 divided by $20,000,000) and they would thus receive 2,000,000 shares ($500,000 divided by $0.25), which is 1,500,000 shares more than a Series A investor would receive for its $500,000 investment and a 4x return on paper ($2,000,000 divided by $500,000), not including any accrued interest on the loan. Again, if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return.

As you can see, noteholders with a 20% discount and no cap would receive 625,000 shares whether the pre-money valuation in the Series A round were $10 million, $20 million or $50 million. This is why sophisticated investors vehemently argue that a note without a cap (i) misaligns the interests of the founders and the investors; and (ii) penalizes investors for their efforts in helping the startup increase its value. The math can be tricky, but the bottom line is that noteholders without a cap do not share in any increase in the value of the startup prior to the Series A round.

Accordingly, as discussed in detail in part 1, a cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock); however, the beauty of a cap is that it is not a valuation for tax purposes — which facilitates the financing by allowing the founders to grant different caps to different investors.

In the Fenwick Survey, the percentage of convertible note seed financings that included a cap was 83% in 2010 and 82% in 2011; and the median valuation cap was $4 million in 2010 and $7.5 million in 2011.

How Do the Discount and the Cap Interrelate?

If the convertible note includes both a discount and a cap, the applicable language will typically provide that the conversion price will be the lower of (i) the price per share determined by applying the discount to the Series A price per share; and (ii) the price per share determined by dividing the cap by the Series A pre-money valuation. As reflected in the examples above, the reason the conversion price is the “lower of” (not the “higher of”) is because the lower the conversion price, the more shares the noteholders are issued upon conversion.

In the first example above where the discount was 20%, the cap was $5 million and the pre-money valuation was $10 million, we saw that the conversion price was (i) $.80 when we applied the discount to the Series A price and (ii) $.50 when we divided the cap by the pre-money valuation. Accordingly, the conversion price would be $.50 (the lower of) for purposes of computing the number of shares issued to the noteholders upon conversion.

Now watch what happens if we drop the pre-money valuation to $6 million: Applying the discount, the conversion price, of course, stays the same at $.80; but when we divide $5 million (the cap) by $6 million (the pre-money valuation), we get $.83, which is obviously higher than $.80 — and thus the discount applies, not the cap. This is a bit counter-intuitive because the pre-money valuation exceeds the cap by $1 million. Notice, however, that unless the pre-money valuation were greater than $6,250,000, the cap would not be triggered ($5,000,000 divided by $6,250,000 equals $.80).

If this weren’t confusing enough, there is one other complex issue that founders need to be aware of with respect to discounts and caps: the additional liquidation preference that is created. Indeed, this is a particular problem, and could result in a substantial windfall to investors, in a large convertible note financing with a low conversion price.

For example, in a $2 million convertible note financing with a 50% discount (or a 50% conversion cap ratio), the noteholders would receive $4 million worth of shares of Series A Preferred Stock upon conversion (not including accrued interest), which would include whatever liquidation preference is attached to the shares (typically 1x). Accordingly, the noteholders would receive an extra $2 million of liquidation preference.

There are several different approaches to solving this issue, the most elegant of which is to convert the notes into a different series of preferred stock (e.g., Series A-1), with a liquidation preference per share equal to the conversion price; however, for purposes of this post, it’s enough for founders simply to be aware of this issue and how it relates to discounts and caps.

What is the Typical Interest Rate and How Do the Investors Get Paid?

The third and final piece of the economics puzzle is the interest rate component. Again, a convertible note is a loan and typically requires the startup to pay simple (not compounded) interest on the amount of the loan. Interest rates on convertible notes have historically been in the range of 7%-10% annually, but recently have dropped to the 5%-7% range. In the Fenwick Survey, the median annual interest rate in convertible note seed financings was 6% in 2010 and 5.5% in 2011.

As alluded to in the examples above, the interest is not paid in cash on a periodic basis like a typical loan, but instead accrues (or accumulates), and then the total amount of interest due is added to the loan amount and converted into shares of preferred stock upon the closing of the Series A round. For example, if the interest rate were 5% in a $500,000 convertible note seed financing and the Series A closing occurred on the one-year anniversary of the convertible note closing, the investors would convert an additional $25,000 ($500,000 x .05).

Each state has its own laws (called “usury” laws) that limit the maximum interest rate that may be charged on a loan. In California, for example, unless an exemption applies, the maximum annual interest rate for a non-consumer loan is the higher of (i) 10% or (ii) 5%, plus the rate charged by the Federal Reserve Bank of San Francisco on advances to member banks on the 25th day of the month prior to the date of the loan (or, if earlier, the date of the written loan commitment).

Everything You Ever Wanted to Know About Convertible Note Seed Financings (But Were Afraid To Ask) – Part 1

Scott Edward Walker — Mon, 09 Apr 2012 20:35:19 +0000

Introduction

We are in the golden age of seed financing. Venture capital funds, seed funds, super angels, angel groups, incubators, and “friends and family” are all playing the seed financing game and investing early in startups in an attempt to land the next Facebook.

As a result, the pendulum has swung dramatically in the founders’ favor, and the issuance of convertible notes for seed financing has never been more prolific. Indeed, as a corporate lawyer for 18+ years, I have seen this development first-hand.

This post is the first part of a three-part primer on convertible note seed financings. Part 1 will address basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

Part 2 will discuss the two most significant issues for founders in connection with the issuance of convertible notes: (i) the valuation cap and (ii) the discount (and how they interrelate).

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? (ii) what happens if the maturity date is reached prior to the note’s conversion to equity? and (iii) what securities laws do founders need to worry about in connection with the issuance of convertible notes?

[This post was originally published on TechCrunch.]

What is a Convertible Note?

A convertible note is short-term debt that converts into equity. In the context of a seed financing, the debt typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. In other words, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.

Why Can’t a Startup Issue Shares of Common Stock to Investors?

It can. In fact, many incubators like Y Combinator and TechStars are issued shares of common stock for their initial investment (usually about $20,000). Friends and family are also often issued shares of common stock. Most sophisticated investors, however, will not accept shares of common stock for their investment and will push hard for shares of preferred stock, with special rights (as discussed below).

In addition, the issuance of shares of common stock creates three potential problems. First, the founders risk substantial dilution because it is often difficult for the founders and the investors to agree on a valuation for the startup and, accordingly, to agree on the percentage ownership the investor will receive. For example, if a startup is merely two guys and an idea, how much equity should an investor receive for a $100,000 investment? 10%? 25%? 50%?

Second, there may be tricky tax issues depending upon the timing of the investment. For example, if two co-founders are issued shares of common stock for a nominal purchase price upon incorporation, and investors pay substantially more for their shares of common stock at the same time or shortly thereafter, the IRS may impute a much higher value on the shares issued to the founders and deem the excess amount over the purchase price a form of compensation — and therefore taxable to the founders as ordinary income.

Third, the issuance of shares of common stock may cause potential problems with respect to stock option grants because the underlying value of the shares of common stock (i.e., the “strike” or “exercise” price) will have been established. The goal, of course, regarding option grants is to price the options as low as possible so that the option recipients are incentivized and are able to adequately share in the increased value of the company that they help create. A high strike price undermines that goal.

How Does the Issuance of Convertible Notes Address These Problems?

One of the key advantages of issuing convertible notes is that the valuation issue is kicked down the road until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round). Accordingly, the issuance of convertible notes disposes of the foregoing three problems. Again, a convertible note is a loan (debt, not equity). A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

What are Some of the Other Advantages of Issuing Convertible Notes?

Speed, simplicity and cost. Indeed, a startup could close a convertible note round in a day or two by merely issuing a 2-3 page promissory note, which could cost as little as $1,500-$2,000 in legal fees (or a little more if a note purchase agreement is also executed, which is customary). On the other hand, the issuance of shares of preferred stock is complex, and it can take weeks to negotiate all the terms and documents — with legal fees in the neighborhood of $10,000 – $30,000 or more (depending upon whether the investors insist on full-blown Series A-type documentation, as opposed to stripped-down documentation like the “Series Seed,” discussed below).

Another significant advantage of issuing convertible notes is to avoid giving the investors any control. When investors receive shares of preferred stock, they are typically granted certain significant control rights, including a Board seat and veto rights with respect to certain corporate actions (such as the sale of the company) pursuant to so-called “protective provisions.” They also have certain key rights as minority stockholders under applicable State law (usually Delaware).

Convertible noteholders are rarely granted control rights (and have no minority stockholder rights). For example, in Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), convertible noteholders were granted a Board seat in only 4% of the seed financings; while preferred stockholders were granted a Board seat in 70% of such financings.

Finally, another advantage of issuing convertible notes (and probably the least understood and most important) is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round. As Naval Ravikant, a co-founder of AngelList, aptly noted in a recent interview on This Week in Startups with Jason Calacanis (at the 17:55 mark): “Convertible notes have made variable pricing possible.”

Paul Graham reached the same conclusion in his post, “High Resolution Fundraising”:

The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.

Naval and Paul are referring to the conversion valuation cap (or the “cap”), which I will discuss in detail in part 2 of this series; however, suffice it to say that the cap is designed to protect the investors by putting a ceiling on the conversion price of the note and thereby permitting investors to share in any significant increase in the value of the startup subsequent to their investment. If, for example, the cap were $5 million and the pre-money valuation in the Series A round were $10 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock at an effective price of $5 million or one-half of the price paid by the Series A investors.

Accordingly, the cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock). But the beauty of the cap is that it is not a valuation for tax purposes, which is why different investors may get different caps, unlike in a priced round (unless there were subsequent closings sufficiently far enough apart to justify different valuations). As Paul provides in his post above:

The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. So you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.

Why Do Sophisticated Investors Push for Shares of Preferred Stock Instead of Convertible Notes?

We’ve already covered one of the principal reasons: preferred stockholders are typically granted control rights, including a Board seat and certain veto rights. They are also typically granted certain additional economic rights (like Series A investors), such as pro-rata rights and a liquidation preference. In fact, in the Fenwick Survey, 9% of the preferred stock seed financings included a participating preferred liquidation preference (which is not founder friendly).

Other reasons have been articulated by a number of high-profile investors (including Fred Wilson, Mark Suster, Manu Kumar and Seth Levine), the most significant of which can be summarized as follows:

1) There are now stripped-down, preferred stock financing documents (like “Series Seed” and other standardized forms) that make a priced round just as fast and cheap as issuing convertible notes.

2) The interests of the founders and the investors are “misaligned” if the investors are issued convertible notes that are not capped. This is because it’s in the founders’ interest to maximize the company’s valuation in the Series A round, and it’s in the noteholders’ interest to minimize it. Investors are thus “penalized” for helping a startup get a higher valuation as a result of their introductions, domain expertise, etc.

3) Obtaining a fair valuation may be tricky for unsophisticated investors, but not for sophisticated ones. As Fred Wilson argues: “I can negotiate a fair price with an entrepreneur in five minutes…”

4) Noteholders must wait for the date of conversion to start the clock running for long term capital gains treatment; with shares of preferred stock, the clock starts running immediately.

Are the Series Seed and Other Standardized Forms Really as Fast and Cheap as Convertible Notes?

The Series Seed and other standardized forms have solved a huge problem: how to get shares of preferred stock into the hands of investors in a seed investment without having to draft and negotiate a full-blown set of Series A documents, with all the bells and whistles (and associated legal fees of $50,000+).

However, to say that using these forms makes a preferred stock financing as fast and cheap as a convertible note financing is a bit misleading because we are talking about non-negotiable, fill-in-the-blank forms. Obviously, any transaction will be fast and cheap if the parties utilize fill-in-the-blank forms, without any back-and-forth negotiation.

Indeed, as I have previously discussed, the fundamental problem with these standardized forms is this one-size-fits-all approach. Every financing is different, and the structure and terms are based on a number of different factors, including (i) the size of the investment; (ii) whether the startup is “hot” (and there’s a competitive environment); (iii) who the investors are; (iv) current market conditions, etc.

Simply put, it may not be in the founders’ interest to utilize these forms and issue shares of preferred stock for a relatively small investment or if the founders have strong negotiating leverage (as recently demonstrated by the $2.35 million convertible note seed financing by HealthTap) — particularly because these forms require the founders to grant certain control rights (and additional economic rights) to the investors, as discussed above. Nor does the issuance of preferred stock allow for the extraordinary flexibility that the issuance of convertible notes permits (also discussed above).

As Naval Ravikant profoundly pointed out in his recent interview with Jason Calacanis (at the 19:19 mark):

Venture capital used to be the bundling of advice, control and money. And now people have come along, like Y Combinator and TechStars and AngelPad and so on, to say ‘we’re the advice’; and then people have come in, like Yuri Milner at Start Fund, and say “we’re money – we just want to give you money” and the control provision has gone away. So you’re starting to see the whole ecosystem become unbundled.

VC Term Sheets – Investors’ Option to Walk

Scott Edward Walker — Wed, 14 Sep 2011 22:06:51 +0000

Introduction

This post originally appeared in the “Ask the Attorney” column I am writing for VentureBeat; it is part of my ongoing series regarding venture capital term sheets. Here are the issues I have addressed to date:

In today’s post, I examine the non-binding and conditional language in term sheets.

The Investors’ Right to Walk

VC Term Sheets Are Non-Binding. It is important for founders to understand that VC term sheets are usually deemed to be “non-binding” (other than perhaps a few provisions, such as the “no-shop” provision and legal fees and expenses). What does this mean? It generally means that investors may walk away from the deal at any time prior to the execution of the definitive agreements. Indeed, this is what recently happened to SEOMoz, as Rand Fish (its co-founder and CEO) eloquently describes in his post, “Misadventures in VC Funding: The $24 Million Moz Almost Raised.”

VC Term Sheets Are Conditional. In addition to being non-binding, VC terms sheets are also expressly subject to certain conditions being met (so-called “conditions precedent”). For example, most term sheets will provide that they are “conditioned upon the completion of due diligence satisfactory to the investors.” What does this mean? It means that investors may walk away from the deal at any time prior to the execution of the definitive agreements if a specific condition (such as satisfactory diligence) has not been met.

Why Are Investors Granted This Option to Walk? It’s called the “golden rule” — he who has the gold, makes the rules. From the investors’ perspective, they do not want to be committed to invest in a startup until they are comfortable that there are no significant legal or business problems; and they are generally not going to expend the time and money to determine if there are significant problems until the startup has committed to them (that is, by agreeing to a “no shop”).

What Are the Key Issues for Founders? There are a number of issues founders should focus on regarding the non-binding and conditional aspects of term sheets.

First (and needless to say), founders should do extensive due diligence on the investors prior to executing a term sheet to ensure that they are dealing with trustworthy and reputable investors (both the firms and the individuals involved), and that there’s no history of them walking away from deals. I have previously discussed this issue in detail, and the importance of choosing solid investors, in my post “Doing Deals In The New Decade: 7 Tips For Entrepreneurs” (see tip #1).

Second, founders should only agree to pay the investors’ legal fees and expenses if the deal actually closes. Otherwise, if the investors choose to walk, the company is on the hook for both the investors’ legal fees and the company’s. (Talk about a nightmare – no deal and a pile of legal fees.)

Third, as previously discussed, founders should push hard to knock-out the no-shop provision so that they can move quickly if they think their investors are getting cold feet — and talk to other investors that they have hopefully kept “warm” on the sidelines. Indeed, some very pro-entrepreneur investors, like Fred Wilson, do not require no-shop provisions (see rule #4 in Fred’s post “Competing To Win Deals”).

Fourth, founders should button-down all of the key issues in the term sheet. Once a startup has executed a term sheet, it has lost all of its negotiating leverage. A common mistake founders make is not negotiating the major terms of their employment agreements in the term sheet (particularly the termination provisions).

Fifth, founders should push to knock-out any unusual conditions. Keep in mind that investors have an implicit duty to negotiate in good faith. Accordingly, even though the term sheet is “non-binding,” a Court will hold investors liable if they have acted in bad faith (not to say that suing your prospective investors is good business). This is why it is important to limit the number of conditions in the term sheet and to ensure that they are narrowly drafted.

Finally (and this will only work if the founders have extraordinary leverage), founders should add an expense reimbursement or “reverse break-up” fee to the term sheet requiring the investors to reimburse them for their expenses (including legal fees) and/or pay liquidated damages in the event the investors walk through no fault of the company. This is common in the M&A world and hopefully will find its way into VC term sheets.

Conclusion

I hope the foregoing is helpful. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott

Should I Use My Investor’s Lawyer?

Scott Edward Walker — Thu, 01 Sep 2011 03:10:43 +0000

Introduction

This post was originally part of the “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles). Thanks, Scott

Question

We’re a startup based in Palo Alto, and we just received a Series A term sheet for a $725,000 investment. The investor is kind of insisting that we use his lawyer at a big Valley firm to represent us. He said that he doesn’t need a lawyer, and this will save us a lot of money. We’re first time entrepreneurs, and we don’t know if this is standard practice and what we should do. Any advice would be appreciated.

Answer

Welcome to the world of the Silicon Valley! This is not uncommon, but I still cringe when I hear it (probably because I was trained at two big law firms in New York City and this kind of stuff typically doesn’t happen there).

I think a good startup lawyer has two important roles: (1) to watch his client’s back – that is, to make sure his client is protected from a legal standpoint and doesn’t get blind-sided; and (2) to act as a consigliere – that is, to provide strong, disinterested business advice (to the extent necessary).

As the late, great attorney Craig Johnson wrote in the book The Silicon Valley Edge: A Habitat for Innovation and Entrepreneurship:

Although start-up lawyers in Silicon Valley draft documents and follow form books . . . , they usually play a much larger role in the businesses being started. They are often dealing with people with very limited or no business experience. These people need help in defining and pursuing their business goals. . . . How should the founders divide the initial stock ownership? Who should be on their board of directors? Which financing sources should they consider? At what valuation and on what terms?

Accordingly, in the context of negotiating your term sheet, a good startup lawyer will sit down with you and walk you through all of the key legal provisions in the term sheet to make sure you fully understand their ramifications. For example, he will explain to you how the liquidation preference works and run spreadsheets, if necessary, to show you how much money you will receive based on different sale scenarios; he will explain to you how the option pool works, including the founders’ significant dilution; and he will discuss what protective provisions are and other tricky legal terms, such as drag-along rights and anti-dilution provisions.

But more importantly, a good startup lawyer will also discuss with you the business terms, including the structure of the deal. Because this is only a $725K investment, a good lawyer will recommend structuring the investment as a convertible note or a “Series Seed” financing, rather than a full-blown Series A. Indeed, this is what will save you money on legal fees. Moreover, he will impress upon you the importance of talking to other investors (if you haven’t already done so) in order to create a competitive environment.

He will also help diligence the investors to make sure you choose the right partner for your startup. Not to mention pushing back hard on unreasonable terms, such as “exploding” term sheets or certain redemption rights.

Simply put, how is the investor’s lawyer going to play this role? From a business perspective, he is beholden to the investor. If he doesn’t play ball and get the deal done on the investor’s terms, the investor will obviously stop sending him work. This is not to suggest that there’s anything nefarious or unethical going on; it’s just common sense.

Conclusion

There is too much at stake for entrepreneurs not to be represented by a smart, unbiased lawyer, who has no vested interest in the closing of a proposed financing. As I learned in New York, no matter what an investor tells you, at the end of the day it’s all business. And if an investor can convince you to use his lawyer, it’s good for his business — not yours.

Venture Capital Term Sheets – Redemption Rights

Scott Edward Walker — Thu, 07 Jul 2011 20:02:42 +0000

Introduction

In today’s post, I examine the redemption rights of investors.

Redemption Rights

What Are Redemption Rights? A redemption right is another feature of preferred stock and permits the investors to require the company to repurchase their shares after a specified period of time; it is, in effect, a “put” right – that is, the investors may elect to put their shares back to the company. As a practical matter, however, redemption rights are rarely exercised and, according to Fenwick & West’s recent VC survey, only 20% of the deals in the San Francisco Bay area included such rights.

Redemption rights are principally designed to protect investors from a situation where, after a period of time, their portfolio company is just moving “sideways” and, accordingly, is not an attractive acquisition target or IPO candidate. Investors are thus given the opportunity to exit their investment by exercising their redemption rights – which is particularly important because venture capital funds have limited lives (typically 10 years).

The problem, of course, is that a so-called “walking dead” company rarely has the cash to buy-back the investors’ shares. Moreover, there are significant restrictions under applicable State law regarding redemptions if the company does not have the legally-available capital.

What Does a Redemption Rights Provision Look Like? A redemption rights provision will typically look like this in the term sheet:

“Unless prohibited by [Delaware] law governing distributions to stockholders, the Series A Preferred shall be redeemable at the option of holders of at least [__ ]% of the Series A Preferred commencing any time after the [fifth] anniversary of the Closing, at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in [three] equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].”

What Are the Key Issues for Founders? There are several issues founders should focus on in connection with redemption rights. First, founders should push back to knock them out entirely because, as noted above, they are not the norm and rarely implemented.

If the investors insist on redemption rights, the founders should only agree if such rights cannot be exercised until at least five years after the closing. Founders should also try to limit the redemption price to an amount equal to the investment — and push back hard on any cumulative dividends.

Investors will sometimes try to add enforcement provisions to give their redemption rights some teeth; for example, the investors may require that if the company defaults (cannot pay the redemption price in cash), then the investors will have the right to elect a majority of the Board of Directors until the redemption price is paid in full and/or the Company will be required to pay the redemption price via the issuance of promissory notes. Again, the founders should push back hard.

Finally, founders should watch-out for unusual redemption rights, such as a “MAC” redemption pursuant to which investors are given the right to redeem their shares if the company “experiences a material adverse change to its business, operations, financial position or prospects.” This is a non-starter.

Conclusion

I hope the foregoing is helpful. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott

Venture Capital Term Sheets: Conversion Rights

Scott Edward Walker — Fri, 10 Jun 2011 00:15:16 +0000

Introduction

This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat; it is another installment of my ongoing series regarding venture capital term sheets. Here are the issues I have addressed to date:

In today’s post, I examine conversion rights of investors.

Conversion Rights

What Are Conversion Rights? As many of you know, VC investors are typically issued shares of preferred stock, not common stock. Indeed, preferred stock, as the name suggests, is preferable to (and more valuable than) common stock because it grants certain key rights to the holders, one of which is a conversion right.

A conversion right is the right to convert shares of preferred stock into shares of common stock. There are two types of conversion rights: optional and mandatory.

What Are Optional Conversion Rights? Optional conversion rights permit the holder to elect (not require) to convert its shares of preferred stock into shares of common stock, initially on a one-to-one basis. These rights are related to the investor’s liquidation preference.

For example, let’s assume that the Series A investor has a $5 million, non-participating liquidation preference (with a 2x multiple) representing 30% of the outstanding shares of the company, and the company is sold for $100 million. The investor would thus be entitled to the first $10 million pursuant to its liquidation preference, and the remaining $90 million would be distributed ratably to the common stockholders. If the investor, however, elects to convert its shares to common stock pursuant to its optional conversion rights (thereby giving-up the liquidation preference), it would receive $30 million.

Optional conversion rights are typically non-negotiable and will look like this in the term sheet:

“The Series A Preferred initially converts 1:1 to Common Stock at any time at the option of the holders, subject to adjustments for stock dividends, splits, combinations and similar events, as described below.”

What Are Mandatory Conversion Rights? Mandatory conversion rights require the holder to convert its shares of preferred stock into shares of common stock; it happens automatically (and thus are sometimes referred to as “automatic conversion”).

Mandatory conversion rights are always negotiable and will look like this in the term sheet (the blanks are thresholds that require negotiation, as discussed below):

“All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion rate, upon (i) the closing of a [firm commitment] underwritten public offering of Common Stock at a price per share not less than ___ times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $_______ ; or (ii) the written consent of the holders of ___% of the Series A Preferred.”

What Are the Key Issues for Founders? There are several issues founders should focus on in connection with mandatory (or automatic) conversion rights. First, founders should push for a low multiple of the Original Purchase Price (e.g., two or three times the Original Purchase Price) to create more flexibility with regard to an IPO.

Similarly, founders should push for “gross” (not “net”) proceeds and an amount in the range of $10-15 million; or, even better, “for a total offering of not less than [$10-15] million (before deduction of underwriters’ commissions and expenses).”

Sometimes experienced counsel can persuade the investors to eliminate these thresholds entirely (to avoid the possibility of having to obtain last-minute waivers when pricing the IPO); if not, the company must ensure that the thresholds are the same for all series of preferred stock.

Finally, founders should push for a majority threshold with respect to an automatic conversion upon written consent of the Series A Preferred; and if more than one series of preferred stock is issued, the holders should be required to vote as a class (otherwise a single series could block the transaction).

Are There Other Instances When Conversion Rights Arise? As I have previously discussed, conversions rights also arise in the context of pay-to-play provisions — i.e., there will be an automatic conversion from preferred stock to a “shadow” preferred or common stock if the investors do not participate in a financing; and they also may arise in the context of drag-along provisions, if the investors are required to convert to common in order to create majority approval of the particular “drag.”

Conclusion

I hope the foregoing is helpful. This is obviously a bit technical and generally requires input from experienced counsel. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott

VC Term Sheets – Pay to Play Provisions

Scott Edward Walker — Thu, 19 May 2011 22:25:03 +0000

Introduction

This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat. Below is a longer, more comprehensive version, which is part of my ongoing series on venture capital term sheets. Here are the issues I have addressed to date:

In today’s post, I examine “pay-to-play” provisions, which can be an important protection for the founders.

Pay-to-Play Provisions

What Are Pay-to-Play Provisions? Pay-to-play provisions are designed to provide a strong incentive for investors to participate in future financings. In their simplest form, such provisions require existing investors to invest on a pro rata basis in subsequent financing rounds or they will lose some or all of their preferential rights (e.g., anti-dilution protection, liquidation preferences, certain voting rights, etc.) – either by automatic conversion into a “shadow” series of preferred stock, with the applicable rights stripped-out; or by automatic conversion into common stock, resulting in the loss of all preferential rights (so-called “strongman” pay-to-play).

Pay-to-play provisions are often hotly negotiated in the context of a “down” round, particularly where a subset of existing investors is leading such round and requires the other existing investors to participate or, in effect, be punished (so-called “eve of financing” pay to play). Pay-to-play provisions can, however, be drafted to apply to any future financing, regardless of whether it is a down round or not, to ensure the future support of all investors.

What Is a Typical Pay-to-Play Provision? Here’s what a typical pay-to-play provision may look like in the term sheet (the bracketed language offers various alternatives):

[Unless the holders of [__]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors. All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose liquidation preferences] [lose the right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat, if applicable].

What Are Some Key Issues for Founders? There are several issues founders should focus on. First, founders need to understand that pay-to-play provisions will not typically be included in a Series A term sheet; this is an issue that they will generally need to raise and appropriately discuss with the investors. The conversation might begin like this: “We are looking for investors who are in for the long haul and will agree to support the company throughout its lifecycle.” This is indeed a reasonable position, and founders need to pay careful attention as to how the investors respond. (In some cases, there may be disagreement within a syndicate.)

Second, if founders get push-back from the investors, they can offer to limit the pay-to-play provisions to down rounds – the reasoning being that investors who are not willing to support the company in the event of a hiccup should not benefit from the anti-dilution protection (particularly if it’s a full ratchet) and should lose some or all of their preferential rights. This too is a reasonable position.

Third, it may be unrealistic to expect angel and certain non-lead investors (including strategic investors) to participate in future financing rounds. Accordingly, appropriate carve-outs should be negotiated and inserted into the term sheet, and the pay-to-play provisions will need to contractual (i.e., outside of the Certificate of Incorporation) because each share of the same series must have the same rights, preferences and privileges as other shares of that series in the company’s charter.

Finally, from a capitalization (and drafting) perspective, it’s simpler to have the preferred stock automatically convert into common stock rather than a new class of shadow preferred. Moreover, automatic conversion into common stock obviously provides a stronger incentive to the investors to participate in a future financing round and has the added benefit of reducing the company’s “preference overhang.”

What Are “Pull-Up” Provisions? “Pull-up” or “pull-through” provisions are designed to have the same effect as pay-to-play provisions – i.e., they are designed to provide a strong incentive for existing investors to participate in future financings. The difference, however, is that pull-up provisions act as a carrot, not a stick. Indeed, instead of existing investors being penalized, they are rewarded. Here’s how they generally play out:

In some Series B or later rounds, the existing investors do not have the voting power to change the terms of the outstanding series of Preferred Stock to put in place an “eve of financing” pay-to-play (as discussed above). Accordingly, they structure the new round as a pull-up financing, which permits the existing investors (e.g., the holders of the Series A Preferred) to convert or exchange shares of Series A Preferred into a new series of Preferred Stock (e.g., Series A-1) which is similar to the Series A, but convertible at a much better rate (reflecting the new valuation of the company) and with additional sweeteners (e.g., full-ratchet anti-dilution, senior in liquidation, etc.).

Conclusion

I hope the foregoing is helpful. This is obviously a complicated issue and warrants input from experienced counsel in connection with the negotiation of a Series A term sheet. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott

VC Term Sheets – Drag-Along Provisions

Scott Edward Walker — Fri, 06 May 2011 03:40:43 +0000

Introduction

In today’s post, I examine “drag-along” or “bring-along” provisions, which can be very tricky.

Drag-Along Provisions

What Are Drag-Along Provisions? Drag-along provisions grant the investors the right to compel the founders and other stockholders to vote in favor of (or otherwise agree to) the sale, merger or other “deemed liquidation” of the company. Investors view such provisions as an important protection, particularly if they seek to exit their investment and sell the company for a price less than the amount of their liquidation preference.

If the founders have strong negotiating leverage, they can push back and knock-out the drag-along provisions; if not, they should push to insert certain reasonable protections (as discussed below), which will make such provisions less draconian.

What Is a Typical Drag-Along Provision? Here’s what a typical drag-along provision may look like in the initial draft of the term sheet:

The holders of the Common Stock shall be required to enter into an agreement with the holders of the Series A Preferred that provides that all such holders of Common Stock and the remaining holders of the Series A Preferred will vote their shares in favor of a transaction in which 50% or more of the voting power of the Company is transferred or any other Deemed Liquidation and which is approved by the holders of 50% of more of the outstanding shares of Series A Preferred, on an as-converted basis.

What Are Some Key Issues for Founders? There are several key issues founders should focus on. First, the founders should require a higher threshold than a majority of the Preferred Stock to trigger the drag-along (e.g., 2/3 of the Preferred Stock) and also perhaps Board approval (though recent Delaware case law may make this problematic). Founders should also push for approval by a majority of the Common Stock. If the investors object, a reasonable compromise would be to allow the investors to convert their Preferred Stock to Common Stock to create a majority (which would lower the liquidation preference).

Second, to avoid a situation where the founders receive no consideration because they are forced to vote in favor of a transaction at a sales price less than the aggregate liquidation preference, the founders should push for a minimum sales price to trigger the drag-along (e.g., a price greater than 2 times the aggregate liquidation preference). Obviously, the investors will push back hard on this.

Third, founders should push for certain limitations with respect to the representations, warranties and covenants they are required to make in the definitive acquisition agreement. For example, founders should push for what is called “several” (not joint) liability – to avoid a situation where they are liable for misrepresentations of any other sellers; and they should also push to limit their liability to their pro rata portion of any claim and, in any event, to an amount not in excess of the cash (or the value of the consideration) they actually receive.

Exhibit A: FilmLoop. Michael Arrington of TechCrunch reported a few years back on how drag-along rights can play-out in the real world when he reported on the FilmLoop story. As Mike pointed out:

The FilmLoop founders made it clear that they thought they had a good chance at success and did not want to sell. However, ComVentures’ ownership percentage, plus certain rights they have (called “drag along rights”), can force the other investors and the company founders to sell.

Mike also added some solid advice for founders at the end of his post: “make sure you read those drag along and liquidation preference clauses carefully before signing.” And I would also add — get input from experienced corporate counsel because such clauses can indeed be complicated.

Conclusion

Drag-along provisions are an important housekeeping tool to avoid a situation where a few minority stockholders are holding-up a transaction approved by a super-majority of the stockholders — thus requiring, for example, a freeze-out merger; in fact, it is good practice for companies to include a similar provision (and a waiver of dissenter’s rights) in its stock option agreements. However, a drag-along provision that is designed to grant the investors the unilateral right to force a sale without the founders’ approval is a big red flag.

Should We Execute the “Series Seed” Documents with No Negotiations?

Scott Edward Walker — Thu, 21 Apr 2011 20:07:44 +0000

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Below is a longer, more comprehensive version. Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998. Many thanks, Scott

Question

We’ve gotten commitments for a seed investment of $600,000, and the lead investor advised us that to save time and money on legal fees we should use the Series Seed documents, which he said are just fill-in-the-blank forms, with no negotiations. Have you heard of the Series Seed documents and, if so, do you think this makes sense?

Answer

The so-called Series Seed documents are a stripped-down set of preferred stock financing documents, which were designed for seed investments by Silicon Valley lawyer Ted Wang (with an assist from venture capital firm Andreessen Horowitz). The goal, as Ted notes on his site, was to “[create] a simple set of documents for early stage investment.”

The problem Ted was attempting to address was how to get shares of preferred stock into the hands of investors in a seed investment without having to draft and negotiate a full-blown set of Series A documents, with all the bells and whistles (and associated legal fees of $50,000+). In short, Ted has solved this problem – and for that I tip my hat off to him. Moreover, a number of investors have been quite vocal in their support of the Series Seed documents and have begun utilizing them, particularly in Silicon Valley.

But the issue, of course, is whether the documents are fair from the entrepreneur’s perspective. Indeed, if entrepreneurs are going to be required to simply sign form financing documents with no negotiations, they obviously must be comfortable with what they are signing. So let’s examine the terms of the Series Seed documents.

The Good News. The good news for entrepreneurs is that, first, the number of documents (and pages) for a preferred stock financing have been reduced dramatically, including the removal, among other things, of anti-dilution provisions, registration rights and a legal opinion. Preferred Stock financings are thus much quicker and cheaper.

Second, the liquidation preference is 1X non-participating, which is very pro-entrepreneur; and third, the company’s obligation to reimburse the investors’ lawyers is a flat fee of $10,000.

The Bad News. The bad news is that, unlike in connection with the issuance of convertible notes, the founders must give-up certain control rights to the investors, including a Board seat and veto rights with respect to certain corporate actions pursuant to protective provisions. For a $600,000 seed investment, this may not make sense and is the fundamental problem with using fill-in-the-blank forms. Other issues include the four-year vesting requirement and the 30-day no-shop provision (which some VC’s, like Fred Wilson, do not require).

The bottom line is that if you are a “hot” startup with strong negotiating leverage, you’re better off issuing convertible notes to avoid the foregoing issues and to kick the valuation issue down the road to the Series A round. Needless to say, the pendulum has recently swung dramatically in the entrepreneurs favor (particularly in Silicon Valley), and most of the hot startups are issuing convertible notes in seed rounds, not equity.

For example, in January of this year, Yuri Milner and SV Angel announced that their Start Fund would offer all Y Combinator companies $150K in convertible notes; and last August, Paul Graham tweeted that: “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

Conclusion

In conclusion, the Series Seed documents may be a good starting point in certain situations; however, agreeing to close on a set of form documents without negotiation may not be in your best interest — particularly if you have a hot startup.

VC Term Sheets – Protective Provisions

Scott Edward Walker — Thu, 07 Apr 2011 20:15:10 +0000

Introduction

Today’s post relates to protective provisions, which is something VC investors almost always require in a priced round (i.e., equity issuance).

Protective Provisions

What Are Protective Provisions? Protective provisions grant the investors the right to veto or block certain corporate actions. Accordingly, even if the Board of Directors authorizes a particular action, the consent of a certain percentage of the preferred stockholders would be required prior to the company taking such action. The rationale for these provisions is to protect the investors (who are usually the minority stockholder following a Series A financing) from the majority stockholders.

What Are the Standard Protective Provisions? The following protective provisions are viewed as fairly standard and non-controversial (and are actually the provisions agreed-to in FourSquare’s Series B financing led by Andreessen Horowitz):

(a) a sale of the company or other “Liquidation Event”;

(b) any amendment to the company’s Certificate of Incorporation or Bylaws so as to alter or change the powers, preferences or special rights of the shares of Preferred Stock so as to affect them adversely;

(c) any increase or decrease (other than by conversion) in the total number of authorized shares of Preferred Stock or Common Stock;

(d) the authorization or issuance of any equity security having a preference over, or being on a parity with, any series of Preferred Stock with respect to dividends, liquidation or redemption;

(e) the redemption or purchase of shares of Preferred Stock or Common Stock (subject to certain exceptions);

(f) any declaration or payment of any dividends or any other distribution on account of any shares of Preferred Stock or Common Stock; or

(g) any change in the authorized number of directors of the company.

What Are Some of the Non-Standard/Controversial Protective Provisions? Investors will often push for additional protective provisions, such as the following:

(a) any hiring, firing or change in the compensation of any executive officers;

(b) the entering into any transaction with any director, executive or employee of the Company;

(d) any change in the principal business of the company or the entering into any new line of business; or

(e) any purchase of a material amount of assets of another entity.

Founders should push back on the foregoing provisions and should indeed be able to knock most (if not all) of them out if they have strong negotiating leverage.

What Are Some of the Other Key Issues? There are two other issues founders should focus on. First, the founders should require a minimum threshold of outstanding shares of Preferred Stock in order for the protective provisions to remain in place. Thus, language should be inserted into the term sheet providing that the protective provisions would only be applicable “so long as [25]% of the originally issued Series A Preferred remains outstanding.”

Second, founders need to watch-out for high voting thresholds, particularly upon a Series B or later financing round. Indeed, founders are often able to negotiate a single vote for all investors (i.e., the Series B or later investors would not have a separate vote for their respective protective provisions); however, the requisite consent percentage should generally not be higher than 66 2/3% to avoid the scenario where an investor holding a small percentage of shares effectively has veto rights.

Conclusion

Protective provisions are found in nearly all term sheets for VC equity financings. Even the so-called “Series Seed” documents, a stripped-down set of forms designed for equity seed investments, contain protective provisions. This is why, among other reasons, I strongly advise founders doing a seed financing to issue convertible notes with a cap; it’s quicker, cheaper and less onerous. As Chris Dixon, the startup guru, so aptly puts it: “Like it or not, the seed investment world runs on trust and reputation – not legal documents.”

VC Term Sheets – Board Control

Scott Edward Walker — Thu, 24 Mar 2011 20:33:47 +0000

Introduction

Today’s post relates to the composition of the Board of Directors and specifically addresses the issue of who should control the Board following a Series A financing.

The Board of Directors

What is the Board of Directors? The Board of Directors is a corporation’s governing body, and its role is to oversee, monitor and authorize all of the corporation’s significant activities, including the appointment of its CEO. Accordingly, control of the Board means, in effect, control of the corporation.

The composition of the Board is thus an important and indeed sensitive issue to founders. Sadly, we’ve all heard the horror stories of founders being “fired” from the company they founded.

Traditional Board Composition. It has traditionally been rare for the founders to control the Board following a Series A financing (despite the fact that Series A investors generally acquire a 20-40% stake in the venture). Sometimes the investors push to control the Board; however, usually there is a “compromise” in which neither the investors nor the founders technically control the Board.

Thus, in a five-member Board, two directors would be appointed by the investors, two would be appointed by the founders and one director would be independent (jointly appointed by the other directors). Similarly, in a three-member Board (which is more common these days), one director would be appointed by the investors, one would be appointed by the founders and there one be one independent.

Today’s Frothy Environment. The pendulum has recently swung dramatically in the founders’ favor (particularly in Silicon Valley), giving the founders extraordinary negotiating leverage with investors if they have a “hot” startup. One area where founders have exercised such leverage is in connection with Board composition.

As Paul Graham, co-founder of Y Combinator, recently wrote:

“Founders retaining control after a series A is clearly heard-of. And barring financial catastrophe, I think in the coming year it will become the norm.”

Accordingly, if you have the leverage, founders should push hard to maintain control of the Board post-closing. The entrepreneur-friendly VC’s obviously know what’s happening in the marketplace and are likely to capitulate and agree to a provision in the term sheet akin to the following:

“Immediately following the Closing, the Board shall consist of three members. Holders of a majority of the Series A Preferred shall be entitled to elect one member, which member shall be designated by [Investor A], [who initially shall be __________]. Holders of a majority of the Common Stock shall be entitled to elect one member, which member shall initially be __________ [the Company’s Founder]. Holders of the Preferred Stock and Common Stock, voting as a single class on an as-converted basis, shall elect the remaining director.”

It would also be prudent for the founders to require the investors to actually name their representative on the Board – to avoid a situation where some unknown junior staffer takes the seat (as opposed to the heavyweight partner who can clearly add value).

Conclusion

Founders should push to control the Board following a Series A financing. Indeed, any concerns the investors raise are minimized by their protective provisions (i.e., veto rights), which I will discuss next week. And remember: all terms are negotiable – no matter what anyone tells you. Cheers, Scott

VC Term Sheets – Dividends

Scott Edward Walker — Thu, 03 Mar 2011 22:59:59 +0000

Introduction

This post originally appeared as part of the “Ask the Attorney” series I am writing for VentureBeat. Below is a longer, more comprehensive version, which is part of my series on venture capital term sheets. Here are the issues I have addressed to date:

Today’s post relates to dividends and how to protect the company from over-reaching by the investors.

What Is a Dividend?

A dividend is, in essence, a distribution of the company’s profits to its shareholders, which is generally made in cash or stock. Cash dividends are obviously rare in early-stage companies because there are usually no profits (or cash) to distribute; and, if there were, they would generally be re-invested in the growth of the company. Stock dividends are problematic due to their dilutive effect.

There are two types of dividends: non-cumulative and cumulative. With a non-cumulative dividend, if the Board of Directors does not declare a dividend during a particular fiscal year, the right to receive the dividend extinguishes for such year. With a cumulative dividend, the dividend is calculated for each fiscal year and the right to receive the dividend is carried forward until it is paid or the right is terminated; in short, it accumulates (and sometimes investors also request compounding).

Cumulative Dividends as a Protective Device

Cumulative dividends are relatively uncommon (10% or less of financings); however, investors sometimes push for some form of cumulative dividend as a protective device to provide a minimum annual rate of return on their investment (e.g., 7-10%) – and it is thus tied-into the liquidation preference. If the company capitulates on this issue, it must make clear in the term sheet that cumulative dividends will only be payable if there is a liquidation event (e.g., the sale of the company) and forfeited in the event of an IPO or upon the conversion of preferred stock into common stock (because the protection is not needed in such cases).

This provision would look like something like this in the term sheet: “The Preferred Stock will carry an annual __% cumulative dividend [compounded annually], payable solely upon a liquidation [or redemption]….”

Provisions Most Favorable to the Company

A dividend provision most favorable to the company would look something like this: “Dividends will be paid on the Preferred Stock on an as-converted basis only if, when and as paid on the Common Stock.”

This is favorable to the company because the investors’ only right to a dividend is to participate with the common stockholders when and if declared by the Board. Typically, however, investors will be given a limited preference to be paid first if a dividend is declared. That provision would look something like this:

“Annual [8%] non-cumulative dividends on the Preferred Stock will be payable only if and when declared by the Board, and prior and in preference to any declaration or payment of any other dividends.”

Conclusion

Dividends are generally not a huge issue in connection with the negotiation of a VC term sheet; however, as discussed above, founders need to watch-out for mandatory cumulative dividends, as well as stock dividends that could be extremely dilutive to them. Next week we’ll look at Board control.

What Is a Price-Based Antidilution Adjustment?

Scott Edward Walker — Fri, 18 Feb 2011 00:52:31 +0000

Introduction

This post originally appeared as part of the “Ask the Attorney” series I am writing for VentureBeat. Below is a longer version. Please shoot me any questions in the comments section or, if you prefer confidentiality, via email at swalker@walkercorporatelaw.com.

Question

My co-founder and I have a question regarding the term sheet we just received from a VC. We don’t understand what a price-based antidilution adjustment is and what it’s meant to address. The exact language under that section reads as follows: “Subject to standard and customary exceptions, the conversion ratio for Preferred Stock shall be adjusted on a broad weighted average basis in the event of an issuance below the Preferred Stock price, as adjusted.” Could you please explain? Thanks!

Answer

A price-based antidilution adjustment is a mechanism to protect investors in the event that the company sells securities at a price lower than the price of the securities purchased by such investors; it is complicated and can be devastating to the founders.

You first must understand that upon the issuance of preferred stock to an investor in a Series A round, the investor has the right (and the obligation, in certain instances) to convert the preferred stock into common stock, and conversion ratio is set at one-for-one. The formula for determining the conversion ratio is (i) the original issuance price of the preferred stock divided by (ii) the conversion price (which originally is the price paid).

For example, assume that XYZ Inc. raises $2 million in a Series A round at an $8 million pre-money valuation, and the VC receives 2 million shares of preferred stock at $1 per share; the conversion ratio is 1 (1 divided by 1). Now let’s assume a Series B round 18 months later in which XYZ raises another $2 million from a new VC, but at a pre-money valuation of $5 million. Each share of Series B Preferred Stock is thus priced at $.50, and 4 million new shares must be issued to the Series B VC to raise the same $2 million.

XYZ thus issued twice as many shares in the down round to generate the same amount of cash. As a result, the Series A VC’s ownership is diluted (so are the founders!), and this is what a price-based antidilution adjustment is designed to address. The position of the Series A VC is that it valued the company too high and therefore should be able to “recover” its overpayment by adjusting the conversion ratio.

There are two basic types of price-based antidilutions adjustments: (i) “full ratchet” (or “ratchet”) and (ii) “weighted average.”

Full Ratchet. A full ratchet antidilution adjustment is draconian to the founders (and other holders of the company’s common stock) and thus is relatively rare. This type of adjustment “ratchets” down the conversion price to the lowest price at which stock is issued after the issuance of the investor’s preferred stock – regardless of the number of shares issued. In the example above, the conversion price would be $.50, the conversion ratio would be 2 (1 divided by .50), and the Series A investor would receive twice as many common shares upon conversion. Note that the same conversion ratio would result even if the company issued just one share for a price of $.50.

Weighted-Average. By use of complicated formulas, a weighted-average antidilution adjustment takes into account both (i) the lower price and (ii) the actual number of shares issued in the down round; it is therefore more moderate and indeed more accurately reflects the dilutive effect. Accordingly, the greater the number of shares that are issued at a lower price the more significant the adjustment to the conversion ratio.

There are two categories of weighted-average formulas: broad-based and narrow-based.

In a broad-based weighted-average formula, the dilutive issuance is weighted against the fully diluted capital stock of the company (i.e., it assumes conversion of all preferred stock, warrants, stock options and other convertible securities). In a narrow-based weighted-average formula, the dilutive issuance is only weighted against the outstanding securities and does not include convertible securities. A broad-based formula thus compares a dilutive issuance to a larger pie making the issuance appear less significant and therefore more appealing to the founders.

Conclusion

Based on the foregoing, the language in your term sheet (i.e., “adjusted on a broad weighted average basis”) is generally the best you’re going to get with respect to this issue. Good luck.

What Are Exploding Term Sheets and No-Shop Provisions?

Scott Edward Walker — Thu, 10 Feb 2011 02:31:19 +0000

Introduction

This post originally appeared as part of the “Ask the Attorney” series I am writing for VentureBeat. Below is a longer, more comprehensive version. Please shoot me any questions in the comments section or, if you prefer confidentiality, via email at swalker@walkercorporatelaw.com.

Question

We just got a term sheet from a VC and we were hoping you could help us understand certain timing provisions. In the last paragraph, there is language about the term sheet expiring “at 5:00pm on the day following the date hereof if not accepted by the company prior to such time.” Also, in a section called “No Shop” there is language that the company “shall not negotiate with or enter into any agreement with any other person…for a period of 90 days following the date hereof.” We’ve been talking to a bunch of VC’s and don’t want to lock ourselves in. Are these provisions customary?

Answer

As I noted in my post 7 Negotiating Tips for Entrepreneurs, in order to obtain negotiating leverage in any transaction, including a VC financing, you need to create a competitive environment (or the perception of one). As a result, VC’s can be played-off of each other, and you can get the best possible terms.

No VC, however, wants to be a stalking horse. If a venture capital firm offers you a term sheet, they want you to sign it — not shop it. That’s why a term sheet will often include language about it expiring if not signed by a certain date – commonly referred to an “exploding term sheet”; and that’s why most term sheets include language prohibiting the company from negotiating with other parties for a period of time once it has been executed – commonly referred to as a “no shop” or “exclusivity” provision. Let’s look at each of those in the context of your question.

Exploding Term Sheets. An exploding term sheet like yours is a huge red flag. What a way to start a relationship – a relationship that could last 5-10 years. Basically, you’ve been given 24+ hours to sign the term sheet, which is ridiculous (and which I assume has already passed). My advice is to just ignore this paragraph or, better yet, immediately call the VC and advise him/her that you’re going to need a little time to review the term sheet with your lawyer and to check references (i.e., to speak to a few of the CEO’s at the VC’s portfolio companies).

This will slow the process down in a respectful manner – and you should be diligencing your investors in any event (as I discuss in tip #1 of my post Doing Deals with the Big Boys: 10 Tips for Entrepreneurs). If that creates a problem for the VC, I strongly suggest you find another VC.

No Shop Provisions. I can understand that your VC doesn’t want to expend time and money for legal fees, etc. after the term sheet has been executed only to have you shop the deal to another VC; however, 90 days is way over the top. You should push back hard on this and try to limit it to a few weeks (with 30 days being a reasonable compromise).

And if you have a lot of leverage (e.g., lots of VCs interested in your company), you may be able to knock this provision out entirely — like Michael Robertson, Founder of MP3.com, did in his deal with Sequoia a few years back. Michael is a brilliant, serial entrepreneur and he discusses his no-shop provision in this recent video interview (starting at 44:38):

This is an important issue because if your VC walks away after you sign the term sheet (which happens from time to time), your company will be considered damaged goods and it will be difficult for you to find another investor. Accordingly, if you get any indication that your VC is getting cold feet, you want to be able to move quickly to re-kindle discussions with other investors, if possible.

Moreover, the no-shop provision is not reciprocal – meaning your VC can be out in the marketplace talking to other startups while negotiating your definitive agreements and can walk away from your deal with no legal recourse.

Some pro-entrepreneur VCs, like Fred Wilson, do not require no-shop provisions. Indeed, Fred noted 10 deal rules he follows in a relatively recent post. Here is #4:

Don’t pressure the entrepreneur to make a decision. Don’t issue exploding term sheets. Don’t put no shops into your term sheets. Those kinds of things are signs of insecurity. I prefer to tell people that we’ll have an exclusive relationship when the deal closes and not before then. If someone wants to leave me at the altar, better it happens then than after we are married.

Those are the kind of VCs you should partner with, but they’re hard to find.

Conclusion

The big take-away here (which Michael also discusses in his video) is that every term is negotiable – no matter what anyone tells you. That’s why creating negotiating leverage is so critical.

How Do I Swim Safely in the VC’s Option Pool?

Scott Edward Walker — Wed, 15 Sep 2010 20:02:31 +0000

Introduction

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Below is a longer, more comprehensive version. Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998. Many thanks, Scott

Question

My co-founder and I have been talking to some VC firms on Sand Hill Road, and I think we’re pretty close to getting at least one term sheet. I read your post a few weeks ago about how one of the common mistakes startups make dealing with VC’s is focusing too much on valuation. You also mentioned that there are other important terms that affect the economics of a financing, including the size of the option pool. Can you please explain that. Our company never issued any options, and my co-founder and I each own 50% of the shares. Will the VC firms require an option pool and, if so, how will that affect us? Thanks!

Answer

As I discuss in my post “Issuing stock options? Here’s what you need to know,” the issuance of stock options by startups is quite common because options give key employees an opportunity to benefit directly from any increase in the company’s value (creating substantial upside potential), without requiring any cash outlays by the company. Options are thus an important tool to attract talented employees.

Accordingly, the VC firms will require your company to establish a large pool of unallocated options for future employees. In fact, you will probably see language in the term sheet similar to this (with the blanks filled-in): “The price per share is based upon a fully-diluted pre-money valuation of $_________ and a fully-diluted post-money valuation of $________ (including an employee pool representing __% of the fully-diluted post-money capitalization).”

As I discussed in my post “How Do I Value My Startup?”, the pre-money valuation (or “pre”) is the value of the company prior to the VC investment, and the post-money valuation is equal to the pre plus the amount of the investment.

For example, if you and the VC negotiate a pre of $6 million, and the VC has agreed to invest $2 million, then the post-money valuation would be $8 million. Accordingly, absent an employee option pool, the VC would own 25% of your company post-money ($2 million divided by $8 million), and you and your co-founder would own 75%.

Now let’s turn our attention to the parenthetical language: “including an employee pool representing __% of the fully-diluted post-money capitalization.” This is the language that most entrepreneurs do not understand and which has the effect of substantially diluting you and your co-founder, but not the VC. (Note that it’s a little confusing in the term sheet because the dilution results from the way the price per share of the company is calculated.)

Indeed, venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation. Here’s how it works: the post-money valuation of the company is divided by the “fully diluted” number of shares outstanding (which means the total number of shares, options and warrants that have been issued by the company), plus all of the shares or options that will be issued in the future as part of the employee pool.

Using our example above, if the employee pool were 20% of the fully-diluted post-money capitalization (which is fairly typical, though sometimes higher), you and your co-founder would only own 55% of the company post-money (75% minus 20%); the VC would still own 25%; and 20% would allocated to the employee pool. All of the dilution is thus borne by the founders

Moreover, as a result of the employee pool, the founders’ ownership went from 75% to 55% – which is a 26.7% decrease. How did that happen? Because of the language “post-money capitalization.” In other words, the 20% employee pool is calculated as if the VC’s shares of preferred stock have already been issued to the VC.

It actually gets worse because if your company were sold prior to a Series B financing, all of the unissued and unvested options would be cancelled, and the VC would thus share the additional sale proceeds proportionally with you and your co-founder (even though those options came out of your pocket).

Here are a couple of steps to mitigate this issue: You will never be able to negotiate the option pool out of the deal; nor will you be able to require the VC’s to dilute equally with the founders. What you can do, however, is negotiate a higher pre-money valuation to account for the option pool dilution. Indeed, Jeffrey Bussgang, a VC at Flybridge Capital Partners, notes in his book “Mastering the VC Game,” that he has come-up with a new term called the “promote” to address the option pool issue and explains (on pps. 131-132) that:

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a “6 on 7” deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, “Jeff – their price was better. My company is worth more than $7 million”.

At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic. That’s why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”. The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation. It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.

Moreover, as the guys at VentureHacks advise in their solid post “The Option Pool Shuffle,” you should present a hiring plan to the VC that sizes the pool as small as possible. For example, “[i]f your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.”

Conclusion

The foregoing is obviously frustrating to entrepreneurs – but is merely more evidence of the “golden rule”: He who has the gold makes the rules. The bottom line is that entrepreneurs must fully understand the economics of a VC financing, which include liquidation preferences and the option pool, prior to negotiating a term sheet. Experienced legal counsel can certainly add value in this regard.

How Do I Value My Startup?

Scott Edward Walker — Wed, 01 Sep 2010 18:58:05 +0000

Introduction

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998. Many thanks, Scott

Question

I’m the founder of a mobile apps startup, and we’re starting to get some incredible traction. I’ve been bootstrapping the venture for the last year, but I’d really like to raise about $2 million to scale this thing. If a VC invests $2 million, what percentage of the company will he own?

Answer

It depends upon the value of your company prior to the investment (commonly referred to as the “pre-money valuation” or “pre”). For example, if the pre were $4 million, the VC would get one-third ($2,000,000 divided by $6,000,000); on the other hand, if the pre were $1 million, the VC would get two-thirds ($2,000,000 divided by $3,000,000).

As you can see, the VC’s percentage ownership is calculated by dividing the amount of its investment by the post-money valuation of the company (which is equal to the pre plus the amount of the investment).

The real issue then is — how do you determine the value of your company prior to the investment? Let’s look at that.

I come from the M&A world in New York, where the valuation of target companies was more science than art. Indeed, targets were valued based upon a number of different methodologies, the most significant of which is the discounted cash flow method (DCF). As discussed in this excellent article from the Darden Graduate School of Business, DCF basically estimates the net present value of the target’s future cash flow, discounted to reflect the Weighted Average Cost of Capital or “WACC” (which, in simple terms, is the risk).

In the startup world, however, DCF doesn’t work because there is little or no historical financial data and projected cash flow is thus pure speculation. Accordingly, the valuation of startups is highly subjective and is more art than science. To put it bluntly: your startup is worth whatever the market says it’s worth, which was starkly demonstrated during the dot-com bubble and subsequent crash.

So what does this all mean in practical terms? It means you need to get out there and effectively pitch a handful of VC’s in your space and get them excited about your venture. By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other. This is akin to what investment bankers do when they’re selling a company: they create a competitive environment (or the perception of one) to drive-up the purchase price and to provide negotiating leverage.

As legendary investor John Doerr, a partner at Kleiner Perkins, notes in the video I posted on Monday, “Helping Entrepreneurs Succeed: John Doerr”: “Valuations and how way to negotiate them? I think the best thing to do is to talk to two or three venture capital groups at once – at the same time; not ten, but three.”

That being said, you should be aware of the following caveats:

Creating a competitive environment and playing VC’s off of each other is very tricky and best done with the help of an experienced lawyer and/or consultant.

At the end of the day, you will still need to convince the VC’s that you can deliver a 10X return (i.e., that they will make 10 times their investment). VC’s will thus take into account certain significant factors such as the quality of your management team, the size of your market, etc.

As I have previously discussed, startups often make the mistake of focusing too much on valuation. Indeed, there are other important terms that affect the economics of a financing, including the liquidation preference and the size of the option pool.

Conclusion

I hope the foregoing was helpful. And if you’re wondering how to get a meeting with a VC, I briefly discussed this issue in my post “Ask the Attorney: What Are the Most Common Mistakes Startups Make Dealing with VC’s?” (see #1). In a nutshell, you need to hustle and build relationships so that you can get a “warm” introduction — i.e., an introductory phone call/email from a middleman or woman whom the VC trusts and respects; it takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

Helping Entrepreneurs Succeed: John Doerr

Scott Edward Walker — Mon, 30 Aug 2010 19:46:03 +0000

To Our Clients & Friends: Welcome to our weekly series entitled “Helping Entrepreneurs Succeed.” Each week, we post a short video clip of a successful entrepreneur, investor or business leader on a variety of topics to help entrepreneurs succeed.

This week, we present legendary investor John Doerr, a partner at Kleiner Perkins. Eric Schmidt calls John “one of Google’s best board members”; and Jeff Bezos noted that “Doerr (and Kleiner) is the center of gravity in the Internet.” In this interesting, one-minute clip from 2005 (courtesy of Stanford University’s Entrepreneurship Corner), John discusses how to negotiate valuations with VC’s and related issues.

I included this clip as a supplement to my blog post today on VentureBeat in which I advised entrepreneurs that: “[Y]ou need to get out there and effectively pitch a bunch of VC’s in your space and get them excited about your venture. By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.” Many thanks, Scott

What Is a Liquidation Preference?

Scott Edward Walker — Wed, 25 Aug 2010 20:19:11 +0000

Introduction

Question

I’m the co-founder and CEO of an e-commerce startup, and I’ve been meeting with different VC firms regarding an initial round of funding. I’ve started doing some reading on term sheets and the issues we will need to address, and I’m a little confused with some of the VC terminology. Could you please explain to me what a liquidation preference is and how we should negotiate it. Thanks!

Answer

Welcome to the world of venture capital. A liquidation preference is one of the essential components of preferred stock and is generally considered to be the second most important deal term in a VC investment (the first being the company’s valuation prior to the investment, commonly referred to as the “pre-money valuation” or “pre”).

Let’s start with the basics: A VC investor will be issued shares of preferred stock, not shares of common stock. Preferred stock, as the name suggests, is preferable to common stock because it grants certain key rights to the preferred stockholders – making it far more valuable than common stock. One such right is a liquidation preference.

The word “liquidation” is broadly defined in the VC documentation to include not only the actual liquidation of the company (i.e., the disposition of the company’s assets) upon dissolution or bankruptcy, but also the sale of the company (whether via stock, assets or merger) to a third party or a change of control.

The word “preference” flows from “preferred” and means that the shares of the preferred stock will have a priority over (i.e., will be treated better than) the common stock in the event of a liquidation. For example, in bankruptcy, once the company’s creditors have been paid off, any remaining assets would be distributed to the holders of the preferred stock prior to the holders of the common stock.

Similarly, if the company were sold, the proceeds of the sale would be distributed first to the holders of the preferred stock and then to the holders of the common stock, based upon the terms of the liquidation preference.

There are three types of liquidation preferences:

Straight (or Non-Participating) Preferred – this liquidation preference is most favorable to the company/founders. Upon the sale of the company (or any other liquidation), the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders. Alternatively, the preferred stockholders could choose to convert their preferred stock to common stock and simply be treated the same as the common stockholders (i.e., share ratably in the proceeds).

Participating Preferred – this liquidation preference is most favorable to the investor (and is sometimes referred to as “double-dip preferred”). Similar to straight preferred, the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders; however, the preferred stockholders would then also be treated like common stockholders and would share ratably in the remaining proceeds – thus, in effect, being paid twice (or “double”). Indeed, issuing participating preferred has the same economic effect as issuing a promissory note and shares of common stock (or a warrant) to the investor.

Capped (or Partially) Participating Preferred – this liquidation preference is often viewed as an intermediate approach. The preferred stockholders have the same rights as participating preferred (i.e., return of investment, plus share ratably in the reminder), but their aggregate return is capped; once they have received the capped amount, they no longer have the right to share in the remaining proceeds with the other common stockholders.

Fully participating preferred is the exception (about 20% of the deals today) — particularly in the Series A round of funding. You should thus push hard for a straight preferred liquidation preference and settle for capped participation as a fallback position. Remember, whatever you agree to with your initial investors will carry forward to future rounds; that’s why fully participating preferred should be avoided.

As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.). Watch out for this one! It means the preferred stockholders are entitled to a multiple of their original investment (e.g., double or triple the amount) before the common stockholders get anything.

Based on the foregoing, it is imperative that, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios. For example, if your company were sold for $40 million, and the VC had invested $5 million for one-third of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million.

The VC would thus receive 50% of the sale proceeds even though it only owned one-third of the company.

Conclusion

I hope the foregoing is helpful. My colleague, Susan Morgan, has actually created proprietary software to help entrepreneurs create spreadsheets relative to liquidation preferences and the amount of proceeds they would receive under different sales scenarios. Indeed, liquidated preferences (particularly when they are stacked onto different series of Preferred Stock) can be quite difficult to understand – until it’s too late.

“Ask the Business Attorney”: What Are the Most Common Mistakes Startups Make Dealing with VC’s?

Scott Edward Walker — Wed, 28 Jul 2010 19:00:22 +0000

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version. Please feel free to call me directly if you have any questions (415-979-9998). Thanks, Scott

Question

My co-founder and I are crushing it, and we’re getting ready to approach VC’s for some cash. We’re both first-time entrepreneurs, and we don’t want to make any rookie mistakes. What are some of the common mistakes that you’ve seen guys like us make dealing with VC’s?

Answer

Obviously, that’s a pretty broad question. Here are five quick ones:

1) Cold Calls. One of the classic rookie mistakes is cold-calling or emailing a VC you don’t know personally; in short, you’re wasting your time. The only way you will get a meeting with a VC is through a “warm” introduction – that is, an introductory phone call or email from a middleman (or woman) whom the VC trusts and respects.

The ideal middleman is a successful entrepreneur whom the VC has backed; investors can be good middlemen; and lawyers, accountants or recruiters may also be helpful. As the guys at Venture Hacks so aptly put it in their book Pitching Hacks: “Getting an introduction is a test of your entrepreneurial skills.”

2) Not Doing Your Homework. Startups often make the mistake of not doing their homework regarding the different VC firms. Prior to approaching middlemen to make introductions, you first need to do some research and figure-out which VC firms are a good fit for your startup based on a number of different factors, including (i) their space/industry focus, (ii) their investment criteria, (iii) their fund size, (iv) their geographic focus, (v) their “sweet spot” and (vi) their track record.

You also need to do your homework (including speaking to other founders) with respect to the particular partners with whom you are interested in working, including determining their reputation, domain expertise and capacity to take-on a new deal. (See paragraph #3 of my post “Angel Financings: Legal Tips for Entrepreneurs – Part 1.”)

3) Requesting an NDA. Another classic rookie mistake is asking a VC to sign a Non-Disclosure Agreement (“NDA”); it ain’t going to happen. VC’s are inundated with business plans and executive summaries and are constantly talking to entrepreneurs whose ideas may be similar to yours. Indeed, there is no way a VC is going to risk getting sued as a result of funding a startup with a similar idea or business plan to yours. Moreover, they would need to hire a lawyer to review and negotiate NDA’s – which from their perspective is a waste of time and money.

To the extent you have any “secret sauce” or proprietary technology that you’re concerned about disclosing, you should just not share it with the VC. (I discuss NDA’s in detail in my post “Ask the Business Attorney: Non-Disclosure Agreements.”)

4) Obsessing Over Valuation. Another common mistake startups make is focusing too much on valuation. Obviously, the pre-money valuation (or “pre” as it is commonly referred to) of the company is an important deal term; however, inexperienced startups make the mistake of obsessing over pre – and will often a sign a term sheet with the VC firm that gives them the highest pre.

This is the wrong approach for two significant reasons: first, there are other important terms that affect the economics of a financing, including the size of the option pool and the liquidation preference; and second, a top-notch VC firm (like a Sequoia) can add extraordinary value to a venture. Thus, even if they come in with a lower pre than another VC firm, a smaller piece of a huge pie is better than a bigger piece of a little pie.

As Alan Salzman and John Doerr note in Chapter 7 of the book, Startup and Emerging Companies: “Unfortunately, those actively involved with start-up companies encounter numerous instances in which the focus on [valuation] is somewhat out of balance and tends to prejudice the discussions with venture capitalists.”

5) Not Retaining Strong Counsel. Finally, rookies often make the mistake of trying to negotiate VC term sheets (or some of the key investment terms) without having spent the time to fully understand them and/or retaining strong, experienced counsel. Needless to say, term sheets are complex and a potential minefield for first-time entrepreneurs. Moreover, the VC guys (and gals) spend their careers negotiating term sheets and know every term (including every nuance) inside out.

Accordingly, startups need to be smart (and demonstrate a certain level of credibility with the VC’s) by getting a good corporate lawyer involved early on, among other things, to coach and prepare them for their preliminary negotiations with the VC’s. As I note in the comments to Mark Suster’s post, “Want to Know How VC’s Calculate Valuation Differently from Founders?”: a good corporate lawyer will also run spreadsheets/models to show the founders how the purchase price will be disbursed (i.e., the waterfall) in different M&A exit scenarios.

Conclusion

I hope the foregoing is helpful; and if you’re interested, Sachin Agarwal, co-founder of Posterous, wrote an excellent post regarding the “personal side” of dealing with VC’s: “If you can’t buy your investor a beer, don’t take their money.” You should check it out.

Webinar for Entrepreneurs: Venture Capital Term Sheets (Plus More)

Scott Edward Walker — Fri, 16 Apr 2010 01:03:03 +0000

Introduction

My colleague, Susan Morgan, conducted a webinar yesterday with respect to venture capital term sheets for the “CFO University,” which is group of Chief Financial Officers convening monthly webinars via CFOwise. As I have previously discussed, Susan recently joined our team and has strong financing experience, including 7+ years at Fenwick & West in Silicon Valley where she closed more than 30 financings. (You can learn more about Susan’s background on her bio page.) In conjunction with the webinar, Susan also wrote a brief post on convertible notes. You can see the webinar and read the post below. Many thanks, Scott

Webinar: Venture Capital Term Sheets

CFO University: VC Term Sheet and Deal Point Discussion

Guest Speaker: Susan Morgan of Walker Corporate Law Group, PLLC

Date: April 14, 2010, 9:09 am (Denver Time)

Summary: This webinar runs for about 55 minutes and covers all of the key venture capital terms, including liquidation preferences, dividends, redemption rights, conversion rights and anti-dilution provisions.

Link: Please click the following link to play the webinar (you can start at the 3:30 mark):
https://cfowise.webex.com/cfowise/ldr.php?AT=pb&SP=MC&rID=11196707&rKey=ebb4537ffb730d0b

Why I Recommend Convertible Notes for Entrepreneurs by Susan Morgan

The vast majority of startup entrepreneurs obtain their first few morsels of financing from friends and family, founder infusions and/or (with some luck) small, but sophisticated angels. These infusions may aggregate up to $500,000 or less, and every penny is desperately needed by the entrepreneur to reach the “next stage” of development – which would then allow the entrepreneur to obtain more serious capital from more institutional investors. At the point in time in which these initial small infusions are made, the company is often unknown, their products undeveloped and their markets unrealized. What then is the best financing structure for these initial investments? I would argue that it is convertible promissory notes (or “Bridge Financing”).

The alternative to a Bridge Financing – issuing the first round of preferred stock – requires (i) the valuation of the company for pricing the stock and (ii) the determination and documentation of all of the rights, preferences and privileges of the stock. How do you price the company at this stage? Any metric you use can easily produce a number that turns out to be “way off the mark” when the company later completes its development (or whatever progress it has made using the initial funds), and then seeks to obtain subsequent funding. Accordingly, the founders could be substantially diluted at this early stage.

At the “second funding” stage (the so-called “Series A” round), a larger institutional angel or VC will evaluate the company’s progress and determine a valuation (and price per share) for the more substantial infusion that they are proposing to make. The rights, preferences and privileges of the preferred stock will also be negotiated at this stage, and the Bridge Financing notes will simply convert to the preferred stock on those terms. The advantage for the entrepreneur, of course, is that the documentation for the Bridge Financing is far simpler and therefore much cheaper than that of the preferred round. With a Bridge Financing, the shares will thus be priced much later on when the company has more to show, yielding a potentially higher, more realistic price for the funds infused.

So, what is to induce the early stage investors to invest in the convertible notes? Typically, they are offered “equity sweeteners” in the form of either (i) conversion at a discount (generally from 10% to 40% discount) or (ii) warrants to purchase shares in the future (preferred or common shares). These are somewhat equivalent economically, and usually either one or the other is used.

As my colleague Scott Edward Walker discusses in his post on types of angel financing, the disadvantage of issuing convertible notes is that the founders’ interests and the angels’ interests may not be aligned because it’s in the angels’ interest for the Series A valuation to be low. Indeed, angels who think they can make a significant contribution to a venture (e.g., as a result of their introductions or domain expertise) want to share in the increase in value they are creating. Accordingly, if angel investors do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation — which is obviously not in the founders’ interest and is heavily negotiated.

Conclusion

This post obviously covers a lot of territory, but hopefully introduces entrepreneurs to some of the key issues with respect to angel and venture capital financings. If you have any questions, please shoot them to us via the comments section.

Introducing Susan Morgan and Kudos to Ted Wang re the Series Seed Documents

Scott Edward Walker — Wed, 24 Mar 2010 05:09:33 +0000

Introduction

I am pleased to welcome officially Susan Morgan to our team. Susan has 10+ years of sophisticated corporate law experience, including 7+ years at Fenwick & West in Silicon Valley where she closed more than 30 private financings; she is an Adjunct Professor at Golden Gate University, where she teaches a course on Business and Legal Issues in High Technology Startups; and she is a highly successful entrepreneur, having co-founded two software companies. (You can learn more about Susan’s background on her bio page.)

For Susan’s first assignment, I asked her to review and comment on the new “Series Seed” financing documents posted by Ted Wang and the related posts by Brad Feld, Fred Wilson, Yokum Taku and Jason Mendelson. Indeed, I concurred with Jason in the comments section of his post that “there will never be a standard set of seed documents” because of the lawyers and their own self-interest (as I discuss in my VentureHack’s post “Top Ten Reasons Why Entrepreneurs Hate Lawyers”). Susan, however, surprised me and actually sided with Ted and Brad and their optimism. Below are her thoughts. Many thanks, Scott

Series Seed Documents

By Susan Morgan

Much has been written recently regarding the concept of standardizing a “lite” version of first round financing. The compelling idea is that a small, early-stage “seed round” financing should not include all of the massive documentation, negotiation and legal expense that accompany a more substantial later financing round. Ah, but the problem is that each law firm (and institutional investor) has its own well-used and well-loved proprietary set of form documents which they trot out as the starting point for any financing. Because these forms are of a “one-size-fits-all” variety, they tend to include all of the complex, intricate and specialized terms that might be appropriate to negotiate in a later-stage financing, but needlessly drive up the costs and complexity of an early-stage seed round financing.

How to solve this problem? Enter the “lite” versions. Over the past couple of years, several attorneys and/or law firms have created a publicly-available, “stripped-down” set of form financing documents which eliminate some of the “less essential” terms for an early stage seed financing and thereby streamline the process and reduce costs. The most recent iteration of such documents are the “Series Seed” documents post by Ted Wang, an attorney at Fenwick & West (my former law firm). In fact, a recent post by Brad Feld lists four such sets (including Ted’s) and proposes that we “finish the job” by getting “everyone” in a room together to hammer out a single set of final terms and documents, which the entire industry can then standardize around. A nice idea, but will it work?

Jason Mendelson (Brad Feld’s partner) thinks not. In a recent post, Jason predicted a stunning failure of this effort to standardize. Why? Because Jason believes that the two constituent groups that will need to come to agreement on a standardized set of forms (i.e., lawyers and VCs) are, to some extent, inherently motivated not to do so. Lawyers like to put their own proprietary stamp on things (including these seed financing documents), and VCs tend to trust and support the lawyers they have hired to protect their interests. Jason fears that an all-day meeting with 50+ lawyers (who would all insist on being included) and any number of VCs and other parties will deteriorate into an “ego fight” – each participant insisting on including his or her own special tweaks into the documents. Jason’s fears are not entirely unfounded – he has witnessed this before in drafting sessions of the National Venture Capital Association (the “NVCA”) for their model venture capital financing documents.

So, should we abandon this effort as a potential waste of time? I don’t think so. For one, we should consider re-defining what we mean by “success.” If our only standard for success is perfect agreement on a single set of seed documents; well, then that is a very high standard indeed and we just may not reach that. But why should that be our only gauge of success? I would propose that we have already reached some measure of success! Just look at the term sheet comparison produced by Yokum Taku. There is far more agreement in terms among these term sheets than disagreement. In fact, it’s not hard to take the next step and put together a composite term sheet (with some alternative terms, as the NVCA does) that encapsulates everything in this comparison. The composite term sheet would look like this:

Seed Financing Term Sheet

Name of security:	Series __
Principal documents:	COI, SPA, IRA (or Bylaws)
Dividend preference:	Pro rata with common
Liquidation preference:	1x non-participating
Redemption rights:	None
Anti-dilution:	None or Broad-based weighted average
Board composition:	2 common; 1 preferred (with some minimum holding for preferred)
Protective provisions:	Changes in preferred only; or Changes in preferred and merger/sale of assets only; or Typical list for company-friendly VC financing
Information rights:	Unaudited annual; or add quarterly
Registration rights:	None
Right of first offer on new financings:	Yes
Right of first refusal and co-sale agreement:	None; or Assignment of company right of first refusal to investors
Drag-along:	No; or Yes (founders and preferred), triggered upon (i) majority of common, (ii) majority of preferred, and (iii) board approval
Future rights:	(2 = yes, 1 = no)
Legal opinion:	None
Legal fees:	None; or ~$10K to investor counsel

Of course, this hasn’t melded the underlying text in the documents together, but if we do no more that just get everyone (or a core subset of attorneys and VCs) to agree on this term sheet as a starting point, we have already achieved a significant milestone! In one quick stroke, we have eliminated a considerable volume of drafting and negotiating: anti-dilution provisions, registration rights provisions and legal opinions – gone. This alone would save entrepreneurs a huge chunk of legal fees. And I would propose we use that as our measure of success – i.e., how much money we save entrepreneurs.

So, I don’t know whether an all-day drafting session can get us to full standardization (or even a little closer to that goal), but it certainly seems worthwhile to keep the conversation going. As Ted so aptly put it in his comments to Jason’s post: “[L]et’s not give up just yet! Let’s talk about ‘standard seed documents’ and see where that leads. It may take years, but I’ve got a long horizon.” Who knows, maybe an all-day drafting session will yield some random pieces of conformity that will, at least, save the entrepreneurs some amount of legal fees. And that, by my definition, would be a success.

Five Mistakes Entrepreneurs Make in Dealmaking – Part I

Scott Edward Walker — Wed, 30 Sep 2009 00:10:40 +0000

I’ve been doing deals as a corporate attorney for over 15 years, including nearly eight years in the trenches at two major law firms in New York City; and during that period, I have seen certain mistakes made by entrepreneurs (and inexperienced deal guys) over and over again. The purpose of this post (which is part I of a series) is to discuss the following five basic mistakes made by entrepreneurs in connection with corporate transactions: (1) the failure to diligence the guys on the other side of the table; (2) the failure to build a strong transaction team; (3) the failure to run the negotiations through the lawyers; (4) the failure to check their emotions and to remain disciplined; and (5) blinking first. The video version of this post is set forth immediately below.

http://www.youtube.com/watch?v=lHtZY6kPq-w

Mistake #1 – The Failure to Diligence the Guys on the Other Side of the Table

Whether the entrepreneur is doing a venture capital financing, a partnering agreement with another company or is selling his company to a private equity firm – he must investigate the guys on the other side of the table. This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom he is dealing. Who are these guys? Are they good guys or are they jerks? Can they be trusted? When they say they are going to do something, do they do it? Do they add value? Remember, in certain deals (such as a venture capital transaction), the entrepreneur will be, in effect, married to these guys for a number of years. Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs or CEO’s who have done deals with the guys on the other side of the table in order to make an informed judgment as to whether they are guys with whom the entrepreneur should be doing business.

Mistake #2 – The Failure to Build a Strong Transaction Team

Every successful entrepreneur knows the importance of building a strong team, yet they often ignore this rule when putting together a transaction team. Now is not the time for the entrepreneur to being using his buddy the divorce lawyer or the attorney who wrote his will to negotiate his financing or acquisition; nor is it the time to use his bookkeeper to handle tax and accounting issues; nor is it the time for the entrepreneur to play lawyer and start pulling forms off of the Web. As I learned first-hand in New York, the quarterback of the transaction team should be a strong, experienced corporate lawyer – he’s the guy who is going to drive the deal, watch the entrepreneur’s back and help the entrepreneur build-out his team.

Mistake #3 – The Failure to Run the Negotiations Through the Lawyers

The entrepreneur should do what he does best — i.e., build companies — and leave the deal negotiating to a strong corporate attorney (or an investment banker in the acquisition context). Entrepreneurs are generally no match for sophisticated venture capitalists or private equity guys or corporate development guys who do deals for a living. Accordingly, a smart entrepreneur will stay above the fray and let his corporate attorney run the deal – and business issues can easily be handled at an all-hands meeting (whether in-person or via conference call). Experienced deal guys on the other side of the table may try to do an end-run around the entrepreneur’s lawyers, but the entrepreneur must remain disciplined and simply advise the guys that all negotiations are being run through his lawyers.

Mistake #4 – The Failure to Check Their Emotions and to Remain Disciplined

Entrepreneurs (particularly those who haven’t had much deal experience) often become emotionally wedded to a particular transaction and are unable to maintain their objectivity the further along they get in the process. Too often, an entrepreneur will fall in love with a particular deal — like the first-time home buyer — which will lead to poor decision-making and risky positions. As I saw first-hand in New York City representing big, successful private equity firms, the best deal guys are masters at taking their emotions out of transactions and being extremely disciplined. Indeed, they will generally walk from a deal if they get out of their comfort zone (e.g., with respect to the risk profile, price, etc.) — regardless of how much time and money they have expended. It is critical that the entrepreneur understand this dynamic — and that’s why it is so important to develop a game plan early on — because once the emotions start playing havoc, you have to stay disciplined and stick to your plan (your dealbreakers, etc.) and be willing to walk, if necessary.

Mistake #5 – Blinking First

There comes a point in time in just about every deal where both sides have dug into certain positions and the question becomes which side will blink first; e.g., in a venture capital financing, perhaps the issue is the liquidation preference or, in an acquisition, perhaps the issue is carve-outs to the cap on liability. Whatever the issue, the lesson for the entrepreneur is clear (albeit difficult to execute): in order to maintain negotiating leverage and credibility, the entrepreneur should not blink first. Indeed, if the entrepreneur has flatly stated that “this issue is a dealbreaker,” but then blinks and nevertheless agrees to go forward with the transaction despite not getting what he asked for, he will have completely undermined his credibility and will have his clock cleaned with respect to any other significant issues. Like poker, if your bluff gets called, it will be difficult to bluff again. Which brings us back to the important tip in #4 above: run the negotiations through an experienced corporate lawyer (or an investment banker) who does this stuff for a living.

Founder Vesting: Five Tips For Entrepreneurs

Scott Edward Walker — Fri, 11 Sep 2009 00:34:02 +0000

There have been several relatively recent blog posts with respect to the issue of founder vesting, including (i) two posts by Chris Dixon, a smart angel investor and co-founder of Hunch, here and here; and (ii) a post by Mark Suster, a successful entrepreneur turned VC (and another smart guy), here. There are also a number of solid older posts addressing this issue, including (i) Venture Hack’s post here and (ii) Brad Feld’s post here. The purpose of this post is three-fold: (i) to weigh-in from the legal side; (ii) to try to pull the foregoing posts together in an organized manner; and (iii) thereby to provide five practical tips to entrepreneurs in connection with founder vesting.

1. Impose Reasonable Vesting Restrictions Upon Incorporation to Address Issues between or among the Founders. If there are two or more founders, they should impose reasonable vesting restrictions on the stock issued to them at the time of incorporation because, in most cases, the stock has been issued not only for their services or property (e.g., technology) relating to the conception of the venture, but also for their continuing commitment and efforts. Indeed, it would be inherently unfair for one of the founders to quit the venture after a few weeks or months, but still be permitted to keep all of his stock. The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis; however, it may be appropriate (depending upon the founders’ respective contributions and relationship) (i) to impose a one-year “cliff” and/0r (ii) to vest a portion of the stock “up front.” Vesting restrictions are addressed in a restricted stock purchase agreement, which each founder would be required to execute and which would grant the company the right to repurchase any unvested shares (at the initial purchase price) at the time of the founder’s departure.

2. Impose Reasonable Vesting Restrictions Upon Incorporation to Address Issues with the Series A Investors. A vesting schedule will usually be required by the investors in connection with a Series A financing. Accordingly, it would be prudent for the founders to impose a reasonable vesting schedule upon incorporation for a second reason: if a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place. If the founders have not established a vesting schedule or a large percentage of the founders’ stock has already vested (due to either the lapse of time or the unreasonableness of the schedule), the investors will impose their own vesting schedule, which means that vesting will, in effect, force the founders to “earn” stock they think they already own. This may be a difficult pill for the founders to swallow; however, from the investors’ perspective, this is a significant issue — i.e., they believe they are paying for the founders’ long-term commitment and “sweat” — and thus one that they will rarely give-up. If a founder has strong leverage, the best deal he can likely negotiate with respect to a vesting schedule is the following: approximately 25% of his stock deemed vested at the closing of the Series A financing and the balance of the stock vesting on a monthly basis over the next three years.

3. Make an “83(b) Election”. Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock (i.e., stock subject to forfeiture) to the grant date, rather than the vesting date. As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock was purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale. Absent an 83(b) election, any subsequent appreciation of the stock would be subject to ordinary income tax rates at the time of the vesting — which could create a situation where the founder has significant tax liability, but no cash to pay it. It is therefore advisable (subject to consultation with tax counsel) for any founders receiving restricted stock to make an 83(b) election with the Internal Revenue Service (the “IRS”). Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable).

4. Push for Acceleration Upon a Change of Control. As Brad Feld aptly points out: “Acceleration on change of control is often a contentious point of negotiation between founders and VCs, as the founders will want to ‘get all their stock in a transaction – hey, we earned it!’ and VCs will want to minimize the impact of the outstanding equity on their share of the purchase price.” From the potential acquiror’s perspective, full acceleration is generally not a good thing because the founders have no incentive (i.e., “skin in the game”) going forward, and the acquiror will thus have to come out-of-pocket to re-incentive them. Accordingly, a common solution is for the founders to push for either (i) partial acceleration upon a change of control (i.e., some percentage of vesting is accelerated, with the balance continuing to vest perhaps at an accelerated rate provided the founder remains employed by the acquiror); or (ii) as Chris Dixon suggests, full vesting upon a change of control after a transition period (e.g., after the founder remains employed by the acquiror for one year). The investors will likely push back and will generally only agree to a partial acceleration in the event of a “double trigger” (e.g., a change of control and a termination without cause within one year). Founders should push back on this and require full acceleration in the event of a double-trigger. Bottom line: this issue must be resolved in the context of the negotiation of all of the significant issues and will obviously depend upon the parties’ respective bargaining power.

5. Discuss Partial Acceleration Upon a Termination Without Cause. Another potential hot button is what happens if a founder is terminated without “cause” or he quits for “good reason” (e.g., his job responsibilities have been substantially diminished). This is a tricky issue. Obviously, from an individual founder’s perspective, there should be full acceleration of all of his unvested shares if he is terminated without cause or he quits for good reason because he has, in effect, been denied the opportunity to “earn” his stock. From the investors’ and the other founders’ perspective, full acceleration is a problem for two significant reasons: (i) startups need the flexibility to make personnel changes if things aren’t working out, and it is difficult to establish “cause” or negate “good reason” from a legal perspective (and startups certainly do not want to expend time and money litigating this issue); and (ii) a replacement will likely need to be hired and additional stock/options will thus need to be issued. A compromise position, which may be amenable to all of the parties, is a partial acceleration akin to the amount of severance (e.g., six-months’ acceleration).