Startup Voice

Thursday, August 30, 2012

Convertible Promissory Notes: Investor’s Perspective

Unlike venture capitalists, who commonly dictate their own terms and present their own term sheet, angel investors are typically on the receiving end of a term sheet from the company in which they have expressed an interest. Sometimes even, there is no term sheet and the angel investor is presented directly with transaction document(s) (e.g., a convertible promissory note or a convertible promissory note and note purchase agreement).

Of course, as you will hear me repeat again and again, I would discourage anyone from making an investment without the help of legal counsel in navigating the negotiation and review of the documentation for it. Attorneys that specialize in financing work will be able to point out underwater rocks and provide invaluable negotiation advice. In this post, we’ll discuss five points that you should pay attention to in your transaction documents:

Preferred Preferences and Privileges. When purchasing a note, you are postponing the negotiation of the rights, preferences and privileges of the shares of preferred stock into which your note will convert and deferring it to investors who come after you. This saves everyone time and money and allows a bridge financing to be completed in short order using just a few short documents. However, that also means that you, as a bridge investor, have to be comfortable that you are leaving the negotiation of your rights in good hands. The typical way to control this is by setting the amount which must be raised by the company in its “Qualified Financing” high enough that the investors in such Qualified Financing will be serious market players, most likely venture capitalists. On the other hand, the threshold should not be so high, that your note never converts. Striking a healthy balance is key. (Mechanics of note conversion are covered in detail in another post.)
Maturity. As a debt instrument, a note should always specify a maturity date—in other words, a final date by which the note must be repaid. The probability is high that, if there has not been a Qualified Financing forcing conversion of the note prior to the maturity date, on maturity the company will not have the necessary funds to repay the note. I recommend a contingency plan, which provides that if there has not been a Qualified Financing prior to maturity, on maturity the note converts into [fill in the blank] based on a [fill in the blank] formula. For instance, the note can convert into common stock, such that the note holder holds 55% of all common stock and takes over the company. That’s aggressive and really only works with one larger investor, but I’ve seen it done (by east coast investors). Or, more typically, the note can convert into preferred stock with a pre-negotiated (and likely punitive) valuation. The conversion can be automatic or at the discretion of the investor. There are many ways that a contingency plan can be structured, but I do believe it wise to negotiate this up-front, rather than waiting for the note to mature and for the company to default on repayment.
Amendment of the Note. You should know and care about who can amend the terms of your note. Will your consent be required, or will a “majority-in-interest” of the notes (which you may not control) be able to approve amendments? If only a majority-in-interest is required, is there a provision that protects you as a minority holder against changes which impact you in an adverse and disparate manner from the other note holders? Relatedly, what other decisions can be made by a majority-in-interest? Finally, are you able to determine, based on the information provided to you, whether you will control a majority-in-interest vote and if not, which investors or what combination of investors will control it?
Prepayment. You should also pay attention to whether your note be prepaid without your consent. Seems like a minor point, but it can be very important. You may have negotiated the best conversion terms or the most lucrative multiplier in the event of a change of control, but if your note can be prepaid without your express approval, you stand to lose your negotiated upside and have to settle for accrued interest instead, which is certainly not why you entered this high risk game in the first place.
Negative Covenants; Notice Rights. Do you have the right to weigh in on or veto certain acts of the company? For instance, if the company raises money at a low valuation or a small amount that does not trigger conversion, will you have a vote? What about if the company wants to acquire assets of another company (thus spending a lot of the cash it raised in the bridge financing)? Whether you should be entitled to consent rights depends on your investment amount. If you can’t negotiate for negative covenants, you may at least wish to ask to be notified prior to an action being taken. At least you will not be left out of the loop entirely. Unlike a company’s shareholders, note holders are not entitled to statutory notice rights. Therefore, bridge investors have to negotiate for their own notice rights, if those are important to them.

Of course, what we’ve covered here just brushes the tip of the iceberg, but I do hope you find it helpful.

Happy investing!

Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Tuesday, August 28, 2012

Legal Due Diligence: Investor’s Perspective

In the perfect world, anyone making an investment should retain highly qualified and specialized legal counsel to assist with the transaction. Attorneys that work on financings every day will know exactly how to approach the legal due diligence process and will be invaluable guides, scouring the company’s legal documents to protect the investor’s rights and pointing out to the investor any red flags and fixes.

However, we do not live in the perfect world, and some angel investors out there will consider their investment amount too small to engage legal counsel, and will venture out on their own.

If you are in that boat, you should at least conduct your own due diligence. At a bare minimum, there are 3 things you should request from the company in which you are investing, before you sign on the dotted line and before you initiate the wire (or write that check):

Charter Documents. A company’s charter documents are, depending on its jurisdiction of incorporation, its articles or certificate of incorporation and its bylaws. It is important to see charter documents to make sure that you are investing in a real corporation, not a corporation that the founders are planning on forming, and not in a general partnership or a limited liability company.
Cap Table. The cap table that you request should contain, in addition to the obvious, founder vesting schedules and all other convertible notes (or other convertible securities) of the company. (I’ve written about cap tables more extensively in a prior post.) If you are not sure how your convertible note converts into shares of the company’s stock and what percent of the company you stand to own, I would urge you even more strongly to consult an attorney.
IP Assignment. There are two types of inventions assignment agreements to looks for: one for pre- and one for post- formation.
- Most founders will begin generating intellectual property for their company before it is incorporated. Unless there is an agreement assigning all their inventions to the company, the inventions belong to the founders personally. Therefore, the first type of IP assignment agreement to look for is one assigning pre-formation IP to the company. Relatedly, if the company claims to have any patents and trademarks, check to see that they are registered in the name of the company. Many founders will forget to effectuate the transfer with the patent and trademark office, and this is something that should be done before your money goes in.
- Once a corporation is formed, there should be in place an inventions assignment agreement with each founder which covers all inventions developed by such founder during the life of the company. Usually, this is an agreement that goes with a consulting agreement or an offer letter, but because many companies are unfunded at the time of incorporation and the founders do not enter into consulting agreements or offer letters with themselves, at the very least a free-standing inventions assignment agreement should be in place.

Beyond the documents mentioned above, if the amount that you are investing is upwards of $100,000, I would strongly recommend having your counsel conduct full legal diligence review.

Happy investing!

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Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

Sunday, August 26, 2012

Seed Financing: Equity or Debt?

Many early-stage companies that have succeeded in finding one or more interested seed investors are faced with a pleasant dilemma: should they document the initial investment as a bridge financing (or sale of convertible debt) or as an equity financing (or sale of shares in the company)? Let’s discuss some important factors to consider in making this decision. For more information about promissory notes, read my post dedicated to this topic.

Cost and Timing. The cost of documenting a middle-of-the-road bridge financing is generally going to be significantly lower than the cost of documenting a middle-of-the road equity financing.

The reason is that bridge financings, as the name suggests, are designed to tide a company over until it raises an equity round, and therefore, it leaves much of the negotiation and documentation of material terms to be done at the time of such equity round.

A very simple note financing (for $10,000 to $50,000) might entail just one document – a promissory note. On the other hand, in a preferred stock equity financing, at the very least an amended and restated certificate of incorporation is required, as well as a stock purchase agreement, and usually a shareholders agreement (or some combination of investors rights agreement, right of first refusal and co-sale agreement, and voting agreement).

A financing that requires less negotiation and fewer documents, can be completed on a shorter timeline. Therefore, on average, a bridge financing allows a company to take in money faster than an equity financing.

Control. Depending on the investor and the amount of the investment, a company may have to give up a measure of control when taking in capital. Control comes in several forms: control by equity holders and control at the board of directors level. A venture capitalist purchasing a significant stake in a company will usually require both, a board seat and special protective provisions that give him veto power as a shareholder over important company decisions. Even if special protective provisions are not negotiated, by law shareholders must approve certain decisions, which adds an administrative burden on the company.

A bridge financing for a small investment amount will generally allow a company to keep the most control. The founders will continue to control the entire board of directors, without having to add the bridge investor to the board. In addition, because a promissory note does not constitute a direct equity ownership and the holders of a promissory note do not become shareholders until the note converts, a company does not have to submit matters which require shareholder approval to the note holders.

Note, however, that a more sophisticated bridge financing, might include negative covenants, which would specify company acts or decisions which expressly require approval of the bridge investors irrespective of the fact that they are not shareholders. Bridge financings with a lower investment amount (< $100,000) will usually not include negative covenants.

Dilution. Before the first outside investment, founders amongst themselves own 100% of the company. With investment comes dilution—by issuing shares to the investors the founders’ share in the company decreases.

In the best-case scenario, using promissory notes will result in less dilution to the founders long-term than selling equity. In the worst, it will be the same. The determining factor, of course, is the company valuation. External factors like market conditions aside, and speaking for companies in the first several years from their formation, the later that a company is valued, the higher generally its valuation will be. In an equity financing, investors purchase shares based on a company’s valuation at the time of their investment. If the company isn’t very far along, doesn’t yet have a product, or has a product in beta and has not demonstrated traction, chances are its valuation will be low ($1,000,000 to $2,000,000) and even a small investment will significantly dilute the founders.

On the other hand, bridge investors are not purchasing shares at the time of their investment, and the number of shares that their investment will convert into will be determined based on the formula specified in the note. If a company can negotiate for the note principal and interest to convert into shares of the company’s preferred stock at a discount (of 15%-30%) of the price for such stock in the company’s next equity round, that will result in the least dilution for the company.

Many investors, however, will ask to cap the maximum valuation at which their notes will convert. In other words, even if a company’s first preferred stock financing is at a valuation of $10,000,000, if the bridge investors negotiated a valuation cap of $5,000,000 in their notes, their notes will convert into the number of shares equal to the (a) principal and accrued interest on the note, divided by (b) a price per share determined as (i) $5,000,000, divided by (ii) all of the shares of the Company outstanding at the time of the conversion.

The conversion cap has become an industry standard for even the smallest bridge financings. However, in my experience, the conversion cap does not generally reflect a company’s valuation at the time of the financing, but rather a valuation that’s somewhere midway between the valuation today and the expected valuation at the next equity financing. Therefore, even a promissory note with cap is frequently less dilutive than a priced seed equity round.

Is it any wonder that given how all these factors play out, convertible notes have become the standard investment tool for low-value seed-stage investments?!

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Thursday, May 3, 2012

Startup Hiring - Typical Equity Compensation Ranges for Early-Hires

Very frequently I am asked by my early-stage clients what the "typical" equity compensation percentage is for... [insert the position they are currently trying to fill]. Since this is a topic of interest to many, I thought I would lay out some general rules of thumb.

Before I do so, however, let me preface this with a disclaimer that:

all generalizations, rules of thumbs, and industry practices are imperfect and flawed by definition;
no two companies are the same, so do what's right by your employees and consultants;
each individual contributor is different and may warrant a different percentage under a special set of circumstances; and
the ranges listed are only typical, if at all, for early-stage company (not a company with a $100,000,000 valuation).

So, provided below are merely benchmarks which may prove useful in creating your startup's own compensation scheme:

Chief Executive Officer	–	5-8%
C-Level Executive/VP	–	2-3%
Independent Director	–	1%
Advisory Board Member	–	0.15%/year
Lead Engineer	–	0.5 - 1%
Senior Engineer	–	0.33% - 0.66%
Junior Engineer	–	0.2% - 0.33%

Happy company-making to all!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Saturday, March 3, 2012

Cap Tables for Startups

Capitalization tables (referred to in the industry as “cap tables”) are not difficult to grasp. But first-time entrepreneurs are often caught off-guard when they are asked to produce a cap table by a prospective investor (or his lawyer) doing diligence on the company.

In this post, we’ll talk about cap tables, their purpose, and what should be included in a cap table both for internal and external viewing.

1. Purpose of a Cap Table.

A cap table is, first and foremost, an essential internal document of any corporation. It sets out ownership of the corporation, in terms of the numbers of shares (by class and series) and in terms of percentages that those shares translate into. Ownership percentages matter (1) any time a vote of the equity holders is required, (2) for calculation of dividends, and (3) in the event of a sale or liquidation of the company, where they are used to calculate distribution of proceeds.

In addition, a cap table is one of the first documents that a company will be asked to produce in diligence. Prospective investors will request a cap table because they need to understand what the shares they purchase represent in terms of percent ownership of the company. This goes back to voting control and to upside in a sale of the company. Investors (or their analysts) will run waterfall analyses using different potential valuations of the company on a sale to make sure the investment has a realistic chance of being a lucrative one. (Click here for more information about waterfall analysis.) The cap table with waterfall analysis (or with numbers based on future financing rounds) is usually referred to as a pro forma cap table.

2. Structure of a Cap Table.

A cap table is most frequently maintained in Excel, and is structured in several tabs. The first tab is a Cap Summary and looks something like this:

When speaking to prospective investors prior to a signed term sheet, a cap table request can be legitimately satisfied with a PDF of this tab alone. As you can see, the cap summary provides enough detail to enable investors to create pro formas and run waterfall analyses, without giving away potentially confidential or at the very least sensitive ownership information.

The full cap table kept by the company would have additional tabs for each of the issued classes and series of stock (e.g., Common Stock, Series A Preferred Stock, Series B Preferred Stock), a tab for the stock plan, and a tab for outstanding promissory notes with interest calculations, if any. Such tabs would break-down the ownership of the shares by stockholder, include vesting provisions for stock subject to vesting, and list stock certificate numbers and dates of issuance.

Most importantly, these tabs would have percent ownership calculations on a by-class, by-series and on a fully-diluted basis. This becomes especially important when a particular decision of the company requires the consent of the shares comprising at least 50% of the Common Stock, 55% of the Series A Preferred and Series B Preferred voting together as a class, 66 2/3% of the Series A Preferred, and 50% of the Series B Preferred. Having stock ownership laid out in a well-organized, easy-to-understand manner, allows an easy identification of the minimum necessary stockholders necessary to secure the required vote.

Happy company-making to all!

Inna

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Tuesday, February 14, 2012

Speaking VC Speak: Waterfall Analysis

In evaluating an investment, investors will usually run what is known as a waterfall analysis. In layman's terms, they have to analyze their take if this company is sold for... $50,000,000, $100,000,000, $200,000,000, etc. When they compare this against what they think the company is likely to sell for, with room for error, they have an idea what multiple of their investment in the company they potentially stand to gain from such investment.

Let's use an example to illustrate this analysis. Suppose investors are purchasing $5,000,000 of participating preferred stock capped at 3x of their investment. For simplicity, let’s assume that the stock purchased by investors is the only preferred stock outstanding in this company. Let’s assume further that after the purchase, investors will own 5% of the company, on a fully diluted basis.

In our example, in a $50,000,000 sale, investors get $7,250,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $45,000,000], which isn't a bad return given that in our example the investors invested based on a $100,000,000 valuation.

If the same company sells for $100,000,000, on the other hand, the valuation at which the investors invested, investors get $9,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $95,000,000]. In case you are wondering why the investors get back more than they invested even if the valuation of the company doesn't change, the answer lies in the participating liquidation preference.

Let's now consider a $200,000,000 exit. At this price, the investors receive $14,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $9,750,000], an almost 3x return on their investment.

What about if the company in our example sells for $350,000,000, a much better outcome for the investors? In that case, the investors’ return is $17,500,000 [5% of $350,000,000 because they would be above their cap for participating with the common stock and would opt for a return on a converted to common stock basis].

A basic understanding of waterfall analysis can be helpful for an entrepreneur in discussions with prospective investors.

Happy company-making to all!

Inna

LEGAL DISCLAIMER

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Monday, January 16, 2012

Documenting Startup Expenses by Founders

Before a fledgling company is infused with funds from angels or VCs, it typically has to rely on its founders to fund startup expenses and subsequent operations. This is commonly known as bootstrapping. I am often asked about what the proper way is, from a legal perspective, to document these early capital infusions by founders.

First and foremost, founders must keep very good records of company expenses, and never comingle their own funds with the funds of the company. The right way to fund your company in the early days is, as soon as the company has a bank account, to place the funds committed to the venture into the company's bank account and make purchases and payments from that account whenever possible. If a founder does make a purchase on behalf of the corporation on his own credit card, which is what he must do before the company is incorporated and has a bank account, there should be evidence of reimbursement from the company, so that there is no possibility of the corporate veil being pierced.

There are several ways to document initial investment by a founder into his company, and we'll walk through each one:

Purchasing Equity. One way to document a capital infusion into a startup by its founder is by having the founder pay for his equity in cash.

However, if such purchase is not carefully structured, it can create some awkwardness around the capital structure of the company and the price of common stock. For example, if a founder wants to invest $100,000 and decides to buy 4,000,000 shares of common stock (a good starting number for a solo founder), he is effectively setting the price of common stock at $0.025, which is too high by a factor of... 25x for a very early-stage start-up. Setting the price this high this early may serve as an obstacle to attracting quality employees and consultants. On the other hand, issuing himself 40,000,000 shares at $0.0025 per share is too many shares and isn't appropriate for a company just starting out.

The other argument against this approach is: no matter how much you invest into your venture at the start, you cannot own more than 100% of it (although you can certainly own less). So if there is another way for you to purchase your shares (such as by using only a small part of the cash infusion for this purpose or by transferring IP to the company), why not provide additional consideration for the money that you, as the founder, invest?

A note for foreign entrepreneurs: If you hail from a country with which the United States maintains a treaty of commerce and navigation, and you would like to apply for E-2 classification to come to the U.S. on an investor visa, one of the requirements will be to demonstrate a "a substantial amount of capital in a bona fide enterprise in the United States." This investment "must be subject to partial or total loss if the investment fails." In other words, the investment should be made in the form of equity and not debt. In this case, the founder could use the bulk of the investment funds to purchase preferred stock to reflect such founder's investment.
Debt with Repayment. Another way to document startup investment by the founder is by a simple debt instrument, a loan obligation from the company to the founder. This does not provide a lot of upside for the founder on his investment, just the interest. On the other hand, the founder is going to get his upside through his equity stake, which is unrelated to his financial investment. Documenting startup investment by the founder on a promissory note is just a way for the founder to be repaid the money that he invested (with interest) sooner than waiting for the company to achieve a liquidity event. This mechanism can be used whether the founder invested $2,000 or $200,000 thousand into the venture.
Debt with Conversion. Sometimes founders prefer to have their initial investment convert at the time of the first VC round into preferred stock (of the series sold in that round). This especially makes sense for founders who don't need to have a quick return of their investment.

There are several advantages to holding preferred stock. First, when the company has an exit, there is a possibility, depending on the valuation of the company and the liquidiation preference of preferred stock, that the preferred holders as a group will receive a larger portion of the consideration in the sale than the holders of common stock. In fact, the holders of common stock sometimes receive nothing or next to nothing in a sale, while the preferred holders get their entire or almost entire liquidation preference.

Holders of preferred stock are entitled to various other rights, such as a right of first refusal on new issuances, antidilution protection, information rights, etc. And preferred shares are not subject to vesting and therefore won't be repurchased if and when the founder leaves the company.

Lastly, investors like to see founders have some skin in the game. A respectable initial investment by the founder, convertible into preferred stock tells investors that this founder is serious about the venture and is willing to put more than just his time (and personal happiness) on the table.

Happy company-making to all!

Inna

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.