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Convertible Note Basics Term: length of time before repayment 6 months to 24 months – 5 yrs. renegotiating is costly Conversion: Optional or Automatic Optional – Investors Automatic - Company Point of Conversion (time and rate) Company wants automatic Discount: 20% Additional feature upon conversion to yield larger % in company Problem is it may offset new $ Discount for coming in early Prepayment: Company probably will spend $ and investor wants the conversion Maybe friends and family round Interest Rate: Return on note 6-8% limits on % (10% limit) Usury exceptions Warrant Coverage: Option to buy more shares How much? (10-20%) Ability to participate in next round Security: If you can get it Secured / Unsecured and bankruptcy Company pushes against it; funds may push for it Covenants: Promises to prevent company from going out and doing bad things What you can do with the $ How you operate Consents you must seek from investors Ratios Key Points: Term Conversion: Optional or Automatic Discount Prepayment? Interest Rate Warrant Coverage Security Covenants
Citation preview
Term Sheets and Convertible Notes: Structuring the Deal
Spring Venture Fair and Forum San Francisco May 7-9, 2011 Term
Sheets and Convertible Notes: Structuring the Deal May 8, 2013
Jonathan S. Storper and Leslie A. Keil and hansonbridgett.com
Hanson Bridgett LLP 425 Market Street, 26th Floor San Francisco, CA
94105 Convertible Note Basics
Term: length of time before repayment 6 months to 24 months 5 yrs.
renegotiating is costly Conversion: Optional or Automatic Optional
Investors Automatic - Company Point of Conversion (time and rate)
Company wants automatic Discount: 20% Additional feature upon
conversion to yield larger % in company Problem is it may offset
new $ Discount for coming in early Prepayment: Company probably
will spend $ and investor wants the conversion Maybe friends and
family round Interest Rate: Return on note 6-8% limits on % (10%
limit) Usury exceptions Warrant Coverage: Option to buy more shares
How much? (10-20%) Ability to participate in next round Security:
If you can get it Secured / Unsecured and bankruptcy Company pushes
against it; funds may push for it Covenants: Promises to prevent
company from going out and doing bad things What you can do with
the $ How you operate Consents you must seek from investors Ratios
Key Points: Term Conversion: Optional or Automatic Discount
Prepayment? Interest Rate Warrant Coverage Security Covenants
Examples Total loaned = $1,000,000
Automatic Conversion upon Qualified Financing Qualified Financing =
$2,000,000 Loan converts into equity according to the following
formula: (Balance of loan + interest accrued) Per Share price in
Qualified Financing Thus, if $2,000,000 raised in a Qualified
Financing at $1.00 a share, amount loaned converts into 1,000,000
shares; if $2,000,000 raised at $0.50 a share, the amount loaned
converts into 2,000,000 shares Effect of 20% Discount: Discount
applies to the per share price at which the loan would otherwise
convert. If the $1,000,000 loan would otherwise convert at $1.00 a
share, the discounted conversion price becomes $0.80 a share,
yielding 1,250,000 shares on conversion rather than 1,000,000 If
the $ $1,000,000 loan would otherwise convert at $0.50 a share, the
discounted conversion price becomes $0.40 a share, yielding
2,500,000 shares on conversion rather than 2,000,000 Term Sheet
Basics What is a Term Sheet? Is it Binding? No Shop NDAs
Fees What is a Term Sheet? Basic deal terms Got your bridge round
(convertible note) Outline of major terms - usually preferred These
terms are Standard ? (negotiated) VCs prepare; for angels usually
company Is it Binding? Yes / No Not usually but its an outline Not
easy to deviate (investors walk) No Shop: Binding Keep feet to fire
Helps get deal done (30-90 days) NDAs: Binding Even if deal doesnt
close Injunctive relief Fees: VCs want you to pay: you want to cap
Angels both parties pay their own fees Deal Basics Type of Security
Purchasers Accredited v. Nonaccredited
Documents to get the deal done Type of Security: Common usually
founders and F & F Convertible debt Straight debt and warrants
Preferred Purchasers Accredited v. Nonaccredited: Accredited - $1
million net worth - $200 / 300 k Sophisticated - Who will you sell
to? unaccredited not patient, more disclosure, higher cost How
much: 1. currently, for every round, often see 2 down rounds 2.
build in reserves, add time for this market (early stage Documents
to get the deal done: Rep statement Stock purchase Investor rights
Registration Rights Agreement Employment Agreements IP Assignment
Private offering memo Purchase agreement Investor rights agree
Co-sale Share Securities filings Dividends When paid Noncumulative
v. Cumulative When paid:
Delegated by Board Investors want a preference for receipt prior to
the founders Set return (6-9%) 8% typical Noncumulative v.
Cumulative: Noncumulative expires every year Cumulative doesnt
expire Used to rarely see cumulative, but now if you put off
dividend then in last years, cumulative for all years! New
mandatory dividend payments and penalties for nonpayment New
dividends tied to product launch Liquidation Preference
Liquidation Preference change of control What is it? Before common
How much $ on liquidation event Liquidation event: M&A, change
control, IPO How much? (1x, 2x original) Participating? What
happens after paying liquidation; participants like common With
remainder of common stock or not? Capped? If participating
Limitation (i.e. 3x original) Trigger Change in control sometimes
license (lets say exclusive) Events (winding up and dissolving;
sale; IPO, merger / acquisition) What is it? How Much?
Participating? Capped? Trigger Examples Assume a Series A Preferred
round that raises $1,000,000 based on a $2,000,000 pre-money
valuation $1 + $2 = $3 1/3 = 33% Thus, upon the closing, the
preferred investors will own 33% on a fully diluted basis Assume a
sale for $10,000,000 Liquidation Preference = 1x non-participating
Preferred investors get $1,000,000 if they do not convert to common
Preferred investors get $3,333,333 if they convert to common
Liquidation Preference = 1x participating Preferred investors get
$4,000,000 if they do not convert to common ($1,000,000 +
$3,000,000) Liquidation Preference = 1x participating capped at 3x
Preferred investors get $3,000,000 if they do not convert to common
Conversion Optional Automatic Ratio 1:1
Conversion Right of investor or requirement of company to convert
from preferred to common Optional: At investor election; certain
time or event Automatic: Company requirement (IPO clears out cap
table; majority vote; on sale drag them along) Ratios: Starts at 1
to 1; can be adjusted up if you have to Antidilution What is it?
Weighted Average
Antidilution: Investor protectionon pricing Typical provision
Protection for in down round Someone buys in for less Investor
protection for pricing Add just the conversion price Ratchet: -
Harsh price guaranty (ratchet) (1990s); Coming back (1st year down
round) Its worse for management Carve-outs: Negotiations over carve
out Options to employees (usually common); Stock to preferred
vendors, landlords, advisors Incentive pool (Employees/Incentive)
Dividend stock or strategic partners What is it? Weighted Average
Narrow- includes preferred and common Broad- includes preferred,
common, options, warrants, others Ratchet Carve-outs Weighted
average Narrow includes preferred and common; worse for management
Broad includes preferred common options, warrants, others; better
for management Difference Between Broad and Narrow Weighted
Average
The definition of Stock Outstanding Broad: includes Common,
Preferred, options, warrants, etc. Narrow: includes only the
Preferred The more narrow, the larger the adjustment to the
conversion price = greater punitive to Founders Example: Ratchet
Assume:
$1,000,000 raised in Series A at $1.00 per share Pre-money
valuation = $3,000,000 Series A converts to common on a 1:1 basis
Thus, Series A owns 25% of the Company on as-converted basis (i.e.,
1,000,000 shares out of 4,000,000 total) $500,000 raised one year
later in Series B at $0.50 a share Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis Thus, Series B owns 20%
of the Company on as-converted basis (i.e., 1,000,000 out of
5,000,000 total) No anti-dilution protection, Series A owns 20% of
Company after the sale of the Series B (1,000,000 shares out of
5,000,000 total). Full ratchet anti-dilution protection, then the
conversion price for the Series A Preferred is reduced from $1.00
per share to $0.50 per share. Thus, full ratchet means that upon
conversion, Series A entitled to receive 2,000,000 shares of common
stock rather than 1,000,000 shares of common stock. Weighted
Average Formula
AP = OP xCSO + (NM/OP) CSO + AS AP= Adjusted conversion price
(after the application of weighted avg anti-dilution) OP= Old
conversion price (before the application of weighted avg
anti-dilution) CSO= Number of shares of Common Stock Outstanding
immediately prior to dilutive issuance [the difference between
Broad and Narrow] NM= New Money raised as a result of the dilutive
issuance AS= Number of Additional Shares issued in the dilutive
issuance Example: Broad Based Weighted Average
Assume: $1,000,000 raised in Series A at $1.00 per share Pre-money
valuation = $3,000,000 Series A converts to common on a 1:1 basis
Thus, Series A owns 25% of the Company on as-converted basis (i.e.,
1,000,000 shares out of 4,000,000 total) $500,000 raised one year
later in Series B at $0.50 a share Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis Broad-based weighted
average anti-dilution provision: $1.00 x4,000,000 +
($500,000/$1.00) = $0.90 4,000, ,000,000 Thus, the adjusted
conversion price is $0.90 and the conversion ratio is adjusted to
1:0.9 Upon conversion, Series A with broad based weighted average
protection would be entitled to receive 1,111,111 shares of common
stock (compared to 1,000,000 shares with no anti-dilution
protection and 2,000,000 shares with full ratchet protection). This
will have a much less punitive effect on the company's founders and
management than a full ratchet anti-dilution provision Example:
Narrow Based Weighted Average
Assume: $1,000,000 raised in Series A at $1.00 per share Pre-money
valuation = $3,000,000 Series A converts to common on a 1:1 basis
Thus, Series A owns 25% of the Company on as-converted basis (i.e.,
1,000,000 shares out of 4,000,000 total) $500,000 raised one year
later in Series B at $0.50 a share Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis Narrow-based weighted
average anti-dilution provision: $1.00 x1,000,000 +
($500,000/$1.00) = $0.75 1,000, ,000,000 Thus, the adjusted
conversion price is $0.75 and the conversion ratio is adjusted to
1:0.75 Upon conversion, Series A with narrow based weighted average
protection would be entitled to receive 1,333,333 shares of common
stock (compared to 1,000,000 shares with no anti-dilution
protection, 1,111,111 with broad-based weighted average protection
and 2,000,000 shares with full ratchet protection). More punitive
effect on the company's founders and management than broad based
weighted average, but still less than a full ratchet anti-dilution
provision Redemption Mandatory 5 years (investors may give this up)
Optional
Redemption (go to company and require buyback) Mandatory: Companies
dont like / want a partner Optional: Option on activity, time,
event Price - price paid + dividends not paid + return Board of
Directors Total number Number elected by common
Number elected by preferred Outside directors? Advise at least 5
Angels elect as group Series A wont yield control How much do they
own 3 in CA (engaged and not too many) Odd # Put the big names on
advisory board and not make Board too large They will ask for
compensation depending on role Protective Provisions
Voting In General What Protective Provisions Cover Senior
securities Liquidation, change of control Amendments of Articles,
Bylaws Change rights of preferred Information Rights Change in
corporate purpose How long are they in effect? Early round:
minority but keep watch as dilution occurs Preferred votes as
though they converted Majority or more Preferred wants to vote as
separate class (each new round!) Dont get handcuffed in running
your business Registration Rights Demand Piggyback S-3 Registration
Rights:
Dont try and negotiate Standard Right to common stock that
preferred converts into and get them registered Terminates when you
can sell without registration Demand: Triggering events force
registration Investor has right to demand registration after time
(1 year after IPO); (rights to cut back or delay by company) Need
flexibility Piggyback: Onto management Right of investor to
piggyback onto the company pool company pays cost, including lawyer
Right to register investor wants transferability Company will want
right to limit S-3: Short form More for public companies (can use
year after IPO) Less expensive Issues: # of shares, investors Legal
and accounting expenses which Company will want to avoid Company
will want amount of securities to be greater than a certain amount
(say $1 mil) to avoid frivolous regulation and associated expenses
Miscellaneous Right of First Offer (Right to make first
offer)
Right of First Refusal (Right to make last offer) Co-Sale (Right to
participate in the sale) Exceptions certain amount of shares each
year; family members; estate planning purposes Closing Conditions
Right of First Offer: If 50% or more of Series A preferred is
outstanding Company issues stock then Investor has pro rata RTS (as
converted basis) If you go sell, investor gets rights to buy up to
current % ownership Right of First Refusal: Series A investors must
allow other Series A to buy Investor gets right to buy founder
shares on same terms Co-Sale: Right to participate in sale Tag
along right of investorto sell when others sell (pro rata) Drag
along company forces sale of shareholders who dont agree Closing
Conditions: Before investors close they may require milestones
(contracts, patents, NDA, management lockup, board seat) Angel
Killers No Term Sheet Variance from Term Sheet
Hiding the Ball/Due Diligence Surprises Cap Table Problems
Management Structure/Team Material Contracts & Agreements Board
composition No Clear Exit Strategy Too Many Cooks Lack of IP
Material Contracts & Agreements: Not signed or in default The
End