INNOVIT - Negotiating VC Terms_062024.pptx

planning for VC investment - legal issues

1. Roger Royse @rroyse00 INNOVIT Negotiating VC Terms

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3. Market Issues 3

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11. Positioning for Outside Capital 11

12. Structuring for Capital Business Model Choice of Law Choice of Entity Cap Table Vesting Debt 12

13. VC Considerations QSBS VC’s LPA will not allow investment in a passthrough Tax exempt investors want to avoid UBTI Foreign investors want to avoid ECI VC wants to be able to manage losses No K-1’s showing losses 13

14. The Glass Box Company 14

15. The Cap Table Common stockholders Option pool Warrants Convertibles (debt and SAFEs) Pre and post money 15

16. SAFEs and Convertible Notes Convertible Notes Debt obligations that convert to preferred stock SAFE Convertible equity Conversion feature Valuation Cap Sets a maximum valuation at which note will convert Discount Early investors get a discount to the preferred price Change of Ownership Investors convert to common or get a multiple on a sale of the company prior to a priced financing round 16

17. Pre Money vs Post Money SAFEs Pre Money – cap based on value of the company before SAFE (and other SAFEs) and option pool Company friendly SAFE holders share option pool and other SAFEs dilution Cannot predict what percent SAFE will get until conversion Post Money – based on value after financing Y Combinator form Parties have certainty as to percentages Founders take option pool dilution SAFEs do not dilute each other 17

18. Diligence Issues IP Rights Patents Invention Assignments Licenses and ownership Data security Employment Claims ( Homejoy ) Tax Claims Regulatory Litigation Claims by prior employer Entrenched Management Material Agreements 18

19. Staged Financings Enough to get to next valuation event 2X 1 to 2 years Up vs Down rounds 19

20. Pitch Deck Market Size Team Product Go To Market Strategy Financials Financial Plan 20

21. The Executive Summary One page Team Industry Market Traction IP Funds raised NOT valuation 21

22. Negotiation Basics 22

23. “Avoid venture capital unless you absolutely need it.” Randy Komisar, venture capitalist* *Straight Talk For Startups 23

24. Should You Take Venture Capital? Must give up Equity No near-term cash flow Risky Illiquid Can the business scale? Explosive growth Huge market 24

25. Which VC Should I Approach? Thematic Investors bet on their thesis of what is next Domain Investors focus on an industry that they know well Quant Investors focus on data People Investors bet on the jockey, not the horse Tech investors bet on the horse 25

26. Venture Capital Economics 2/20 Formula 2% management fee on committed capital 20% carried interest 7-to-10-year terms LPS want 2 1/2 to 3 times investment return VC fund must earn 3 to 4 times investment to return that amount 26

27. Venture Capital Economics – Expected Performance 50% lose money 20% – 30% are singles or doubles The rest must be home runs (10X to 100X) 27

28. General VC Fit Large potential market First Mover or first to market advantage Long term scale over short term profits Not able to service debt Traction! 28

29. Venture Capital Economics – Management Venture capital will participate in management Board seats Board Observer Management rights letter (for VCOC exemption) Seven-to-ten-year term (and longer) Precludes small investments Board meetings Management 29

30. Venture Capital Metrics Team Domain expertise Technical co-founders Technology or product Solve problems, address pain points Customer validation Market size Must be a huge market 30

31. Picking a VC Reputation Likelihood of closing Stage of fund Size of fund How much dry powder? Is there a fund 2, fund 3 etc.? Are they litigious? Deal with decision makers 31

32. Entrepreneur VC Fit Network Temperament Advice See the published email from the CEO of CircleUp to an investor at for an example of a VC/Founder relationship that did not work out 32

33. Company VC Fit Capital intensive business? Follow on funding? Time to exit 33

34. Series A is the New Series B Series Seed Pre-Seed Series A-1, A-2 34

35. Types of Funds Micro VC – angels with other people’s money Seed Stage Fund – early, first institutional money Mid Stage – B and beyond Late Stage 35

36. Syndicates Lead or Co-Lead and followers Party rounds 36

37. Other Parties Lawyers CPA Banker/Broker/Finders Mentors and Advisors 37

38. Strategic Venture Capital Can you pivot? Will it affect customers? Follow on investors Change in management Strategic agreements Confidentiality ROFR, right of first look, right of first offer Strategic objectives Less operational involvement 38

39. The Term Sheet 39

40. Term Sheets Valuation Preferences Participation Board participation Protective provisions Transfer restrictions Redemption rights Dividends Anti Dilution Information Registration Rights Costs and fees 40

41. Priced Rounds Preferred Stock Valuation Methods Score Card Venture Capital Method Berkus Method Cayenne Calculator Risk Factor Summation Negotiation 41

42. The Priced Round More Valuation Methods (Patents + People) x $1 Million Comparables Discounted Cash Flow Market Multipliers Discount to Public Companies 42

43. Participation Participating preferred stock returns its investment and then shares pro rata in proceeds of a sale Non-participating convertible preferred stock either gets a return of its investment or its pro rata share of proceeds Participation may be capped at a multiple of the investment Conversion to common – auto-conversion and majority vote 43

44. Dividends Preferred will have a dividend preference. A cumulative dividend on preferred shares must be paid before any other dividends on common. If the company can't pay out a cumulative dividend in a year, the amount is carried forward. Common in private equity deals, not in venture Non-cumulative is only paid when as and if declared. 44

45. Liquidation Preference Who gets paid first and how much? 45

46. Example of Liquidation Preference 1X Nonparticipating convertible preferred $1,000,000 invested for 10% Ex 1: Exit (sale) of company for $5,000,00 Ex 2: Sale for $20,000,000 46

47. Board Representation Size of board Founder-friendly boards Role of the Board Observers Indemnification Insurance 47

48. Board Rights Indemnification D&O Insurance Right to designate 48

49. Protective Provisions Class vote or majority vote Delaware law Separate vote for later investors Do the interests of different investors diverge? 49

50. Protective Provisions Standard: Right to veto or block certain corporate actions Sale of the company Amendment to the company’s certificate or bylaws so as to adversely alter or change the rights of preferred stock Increase or decrease in the number of authorized shares of preferred or common Authorization or issuance of equity security having a preference over, or being on a parity with, preferred stock Redemption of shares of preferred stock or common stock Declaration or payment of dividends Change in the authorized number of directors of the company 50 Other: Hiring, firing or change in the compensation of officers Any transaction with any director, executive or employee of the company Incurrence of indebtedness in excess of $[____] Change in the principal business of the company or the entering into any new line of business Any purchase of a material amount of assets of another entity Option plan increase

51. Information Rights Financial statements and other information Thresholds 51

52. Registration Rights Requires a company to list the shares publicly so that the investor can sell Demand rights Piggyback rights S-3 rights 52

53. Common Restrictions: Co-Sale Rights, ROFR, Drag Along Co Sale and Tag-Along Rights – right to participate in a sale Right of First Refusal – right of company (first) and investors (second) to require shares to be offered to each of them before a third-party sale Drag Along – right to force shareholders to sell in an exit Board, common and preferred approvals Small shareholder carveout 53

54. Founder Vesting Term, milestones, commencement Acceleration Single and double triggers Fire the Founder 54

55. Pro Rata Rights Right to maintain, right to participate Major investors Limited by amount of money company wants to raise 55

56. Option Plan Increased pre money 409A valuations Extended exercise periods for NSOs 56

57. Redemption Rights Feature of Preferred Stock Right to put stock to company, usually after a period of time and over time Is effectively a right to force a sale of the company 57

58. Anti-Dilution Broad-based weighted average Narrow-based weighted average Full ratchet 58

59. Exclusivity No-shop 30 to 60 days 59

60. Nonbinding 30 day no-shop Confidentiality Is it really nonbinding? 60

61. Planning for Later Rounds Overly favorable terms Valuation planning and down rounds Reverse splits Cap tables Changes in company management 61

62. Corporate Venture Capital Strategic objectives Less operational involvement Right of first refusal, right of first offer, right of first look 62

63. Troubled Company Terms Forced conversion to common Full ratchet Uncapped participating preferred Insider rounds Low valuations Down rounds Trigger anti dilution protection unless waived Pay to play requires existing investors to invest on a pro rata basis in subsequent rounds or they lose preferential rights (anti-dilution, liquidation preferences, voting rights) 63

64. Successful Exits IPO Sale or Acquisition 64

65. Unsuccessful Exits Zombie Companies In re Trados Inc. Shareholder Litigation Bankruptcy or Insolvency Reorganizations Fire Sales Management carveouts Fiduciary duties: shareholders, optionees, preferred and creditors? 65

66. Other Unsuccessful Exit Issues Tax Liability Personal Liability Tax Employment Fiduciary Claims Securities Law Claims Contractual Pierce the veil and creditor claims Serial Entrepreneurs and failed companies 66

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