Venture Capital Deal Structure

Prof. Dell, Spring 2009

FORM OF TRANSACTION

• Debt or Equity?

• Distinction between the two types of investments

• Series A Preferred Stock or Convertible Promissory Note?

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 Date

Conversion feature

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?

TYPICAL DEAL POINTS (CONTINUED)

• What if equity financing does not occur?

• Board observer?

• Information rights (e.g., financials)?

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)

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)

PREFERRED OR COMMON? (CONTINUED)

• No protective provisions for investors

• Preferred deal is much more common

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)

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

ATTRIBUTES OF PREFERRED STOCK

• Liquidation Preference

Sale / Merger / Acquisition / Liquidation 3rd: Series A

2nd: Series B1st: Debt Holders

4th: Common

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”)

MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

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

MORE ATTRIBUTES OF SERIES A PREFERRED STOCK

• Conversion– Convertible at any time by dividing Purchase

Price by Conversion Price (1:1 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

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.

MORE ATTRIBUTES OF SERIES A

• Voting Rights - generally 1:1

• 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

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

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)

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

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

Series A (Dilution)

Series A – Raise $5m @ $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%!

30%

33%

37%

Series B (Dilution…Yes More!)

Series B – Raise $20m @ $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%

22.2%

40%Series B: 40%

Series A: 33% x 60% = 19.8%

Founders: 37% x 60% = 22.2%

ISO: 30% x 60% = 18%18%19.8%