Technology Schematic of the Enterprise

1
Venture Capital Deal Structure Prof. Dell,
Spring 2011
2
FORM OF TRANSACTION

• Debt or Equity?
• Distinction between the two types of investments
• Series A Preferred Stock or Convertible
  Promissory Note?

3
CONVERTIBLE PROMISSORY NOTE

• Still a sale of security
• No voting rights, dividend distributions or
  inspection rights - only a creditor of the
  company with priority on liquidation.
• Easy to structure - speed of transaction
• Interest Rate
• Maturity DateConversion feature

4
TYPICAL DEAL POINTS

• Equity Kicker
• Amount of warrant coverage, or
• Discount upon conversion into next round of
  equity financing
• Conversion feature (e.g., triggered upon next
  round of financing of at least 1,000,000)
• Mandatory or discretionary conversion?

5
TYPICAL DEAL POINTS (CONTINUED)

• What if equity financing does not occur?
• Board observer?
• Information rights (e.g., financials)?

6
SERIES A ROUND EQUITY FINANCING SOME BUSINESS
POINTS

• Valuation of the technology company
• Management team
• Market space
• How much money does the company need (or want)?
• Percentage ownership of the company (on a
  fully-diluted basis, including option pool)

7
PREFERRED OR COMMON?

• Attributes of preferred stock (still behind
  creditors)
• Common stock deal prices stock options for
  employees (ISOs issued for FMV)
• Common stock - no negotiation on terms (pari
  passu with the founders)

8
PREFERRED OR COMMON? (CONTINUED)

• No protective provisions for investors
• Preferred deal is much more common

9
ATTRIBUTES OF SERIES A PREFERRED

• Anti-Dilution Provision
• Grant of additional equity to protect your
  investment
• Protection from a down round
• Protection from the company granting additional
  equity to others.
• Weighed-Average Anti-dilution (standard)
• vs.
• Full Ratchet Anti-dilution (harsh)

10
ATTRIBUTES OF SERIES A PREFERRED

• Dividend when, as and if declared
• Noncumulative v. cumulative
• Priority on dividend payments
• Liquidation preference
• Participating Preferred
• Money back times 3, or
• Money back, then pro-rata with founders

11
ATTRIBUTES OF PREFERRED STOCK

• Liquidation Preference

Sale / Merger / Acquisition / Liquidation
1st Debt Holders
2nd Series B
3rd Series A
4th Common
12
MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Merger or asset sale treated as a liquidation
• Consent of Series A Preferred required (50, 66
  2/3, or more)
• Must decide whether to treat merger or asset sale
  as a liquidation (cram down)

13
MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Redemption (or not)
• Beginning year 6, then year 7 and 8
• Purchase price accrued dividends (if any)

14
MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Conversion
• Convertible at any time by dividing Purchase
  Price by Conversion Price (11 basis)
• Automatic conversion on IPO
• Adjustment to conversion price (full ratchet)
• excludes options for employees and warrants for
  service providers
• Very lengthy provision but price of new equity
  issuances is key

15
MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Pro Rata Investment Rights
• Right to maintain ownership levels in future
  rounds of financing.
• If a VC owns 15 of the company, then during a
  subsequent round of financing, the VC has the
  right to invest up to 15 of the total s
  raised in that round.

16
MORE ATTRIBUTES OF SERIES A

• Voting Rights - generally 11
• Protective Provisions
• Sale of the company
• Create new class of securities
• Amend Certificate of Incorporation/Bylaws
• Redeem shares
• Change number of Board members
• Amended and Restated Certificate of Incorporation
  vs. Certificate of Designation

17
SERIES A TRANSACTION DOCUMENTS

• Series A Preferred Stock Purchase Agreement
• Reps/warranties from company (capitalization, IP,
  contracts, etc.)
• Rep/warranties from investors (accredited
  investor, no distribution under securities laws,
  Rule 144, etc.)
• Schedule of Investors

18
SERIES A TRANSACTION DOCUMENTS (CONTINUED)

• Investors Rights Agreement
• Demand registration rights
• S-3 registration rights
• Piggyback registration Rights
• Financial information rights
• Right of First Offer
• Right of First Refusal (among Preferred SHs)

19
SERIES A TRANSACTION DOCUMENTS (CONTINUED)

• Stockholder Agreement
• Includes founders
• Right of first refusal for sales by founders
  (first, to the company and then to the
  shareholders)
• Right of co-sale if ROFR is not exercised
• Voting Agreement (for Board seats)
• Indemnification Agreement

20
POINTS TO CONSIDER

• Size of the option pool (20, 30??)
• Board observer rights?
• Stock Restriction Agreements for founders
  (vesting provisions)
• Employment Agreement for founders
• Form of investment - individually or through LP?
• Tax issues??
• Exit strategy

21
Series A (Dilution)
Series A Raise 5m _at_ 10m pre-money Pre Money
10m Post Money 15m Series A Investor bought
33 of the company Founders, existing (Angel)
investors diluted by 33 BUT, Series A required
a 30 ISO Pool POST Series A So.Founders,
existing investors diluted by 63!
33
30
37
22
Series B (DilutionYes More!)
Series B Raise 20m _at_ 30m pre-money Pre Money
30m Post Money 50m Series B Investor bought
40 of the company Founders, Angel, Series A,
ISO diluted by 40
Series B 40 Series A 33 x 60
19.8 Founders 37 x 60 22.2 ISO 30 x
60 18
40
22.2
18
19.8