Finance for Hi-Tech Start-ups Monday, 8/16/04 Equity-stake in venture, value increases if business succeeds and drops if it doesn’t Debt-a loan, must be paid back with interest Mezzanine debt-in between debt and equity General info: o We are going to use CA law in this class Disruptive technology-redefines the market and gets rid of an old type of technology (fax machine). Changes the way people do business. Taken out: took them public When talking about investment banks o Penny stock places: does very low volume in investments o Middle market investment bank: hi-tech merging companies. Middle volume of business (30-50 million range) o Bulge bracket: Worldwide: merryl lynch, goldman sacs. They deal with millions. How big is the company: what are the annual sales Cash flow: money coming in versus money going out (not accrual accounting…just basic) o Usually you start out negative because you need to get the product out there before you start making any money. Need to make the product, and then figure out how to distribute. • Nothing happens until something makes a sale Hypothetical What should they be talking about at the meeting? o Who owns the technology? They may not own the product because they may have a contractual agreement with Micorola (what was developed during working hours) Question of fact o Who does what? Who reports to whom? o How are they going to finance this company? Who is going to own what percentage? o How much money do they need? Too much will give too many people ownership. Too little will prevent them from being able to operate o Business Plan Prove the concept: This takes a long time • Breadboard (engineering): it’s what you test the circuits on to make sure it works. • Prototype: not saleable or marketable because its too big…but getting closer. • Alpha Version • Beta version-starts to look like something that can be effectively and cheaply manufactured. o Can’t really go to a VC until you have a product to show them (further down the line) Product has to raise money or people won’t invest How are you going to manufacture (outsource or make it yourself) How are you going to distribute (hire people, exclusive distributors) How much are you going to charge? Pricing is extremely important in business plan income statement. Timeline for expenses and business plan Month 1 2 3 4 … Expenses Salary, equipment, r&d, legal fees Income (sales investment) 0 0 0 20 Cumulative (10 ) (30) (300) (150) *The amount of money they need is the greatest maximum number that they incur. Usually they don’t raise enough because they don’t know the hiccups they’ll encounter. Whats the product? Is there a need for it? What problems will it solve? Whom do you represent? You represent the entity not the individuals (because they have different interests). Need to make this clear. o Sample engagement agreements in binder o Who do you give advice to? The board of directors or the management body. Need to determine what type of business they are going to be? A Corporation or LLC, etc. What about lawyers taking equity as part of their fees? o Pros: they have a vested interest in the firm doing well o Cons: it’s a conflict of interests—ethical issue because lawyers aren’t supposed to be in business with their clients because you won’t always see the whole picture. o Closing: when the whole deal is consummated (through the documents) One of these documents is a legal opinion by counsel telling about the organization and share info. • IF the company fails then people are going to go after you because they’ll claim your legal opinion isn’t correct (shouldn’t have given it, tainted, etc) o Lawyer should give untainted advice-don’t want to be their co-investor because you have different responsibilities. To become a corporation you need to file with the secretary of state (articles of incorporation in CA). LLC has a slim paper and you check a box with who governs (partners or members) o Register name with secretary of state after researching if it’s available. Reserve the name for 60 days until you file. Debt gets paid back before equity, then preferred stock before common stock. Types of stock (Equity): o Common stock: general stock (default) o Preferred stock: during liquidation you get money before common stock, also dividends are mandatory for these people before junior stock (common stock) o Serial preferred stock: shares issued in a series. There are different terms for each series of stock (directors authorize the series). A-100,000 shares to raise $200,000 B-500,000 shares to raise $ 5 million ($10/share) • Who comes first? It’s a question of negotiation. B people will say they won’t invest unless they come first (making A subordinate). … G-chances are something went wrong if it went this high. To amend articles of association: unless articles say otherwise it is a simple majority. Introductory Quiz-read it and figure out what they are! 1) Which type of law should be selected? California, Nevada, or Delaware a. Delaware has favorable corporate law if they are going to form a corporation. i. More lenient statutes and how they are interpreted. ii. If you had a choice you’d probably want to choose Delaware b. Arguments for California: local courts i. California § 2115 says no matter where you are incorporated if most of your sales are in CA (and your company is located there-people and place) then you are going to be governed by CA law. There are exceptions…but probably for a start up you’d end up here. (only applies to corporations) 1. This doesn’t apply to llc’s…why? It just isn’t covered because llc’s are newer. 2) ??? 3) files with sec. of state 4) Must be: name of corporation, authorized capitalization, number of shares and what kind 5) May be: 6) Certificate of designation: names the terms of preferred stock and becomes part of the articles of incorporation. 7) Preemptive rights: you have the right to maintain your allocated % of the company. They are optional (in some states they are mandatory unless you deny them in the articles of association). a. If more people invest in the company the current owners have the right to invest in the new offering to keep their %. b. Good news: gives you the opportunity to keep a new purchaser from taking control of the company c. Bad news: could make it more difficult for deals to be done because you have to negotiate in the preemptive rights. i. Delays process of raising money 8) Cumulative voting: must cumulate in CA and cannot have a staggered board (in Delaware it depends). ASK ABOUT THIS! a. Staggered/Classified board: when the members are brought on board during different years (9 member board elected 3 at a time for 3 years). It organizes it in classes (protects management). % needed: 1/3 + 1 b. Straight board-when everyone comes on at the same time (not in classes) % needed: 1/9 + 1 9) Directors of a company are not personally liable unless they breach their fiduciary duties (duty of care-do business reasonably by reading documents, etc because they are the trustees of the shareholders and duty of loyalty-must put company first). a. CA corporation code: you can eliminate liability of directors of corporate acts to the extent allowed by law (doesn’t get them off the hook if they breach their fiduciary duties) b. Why is this important? Because everyone has responsibility and most won’t know this. 10) . 11) Who manages the business and affairs of the corporation? The management is responsibility of directors who appoint officers to be hired or fired. Officers do the day to day, the supervision is the directors. The directors are responsible for picking right people, compensating them correctly, firing them, etc. Directors are hired each year. 12) Transactions between a corporation and an entity in which a board member has an interest are not void, but they are voidable. a. If the director makes full disclosure and doesn’t vote on the issue and its approved then its ok. Full and fair disclosure is necessary. 13) Executive committee: boards usually have an executive committee to meet between the regularly scheduled board meetings. They will have full authority of the board. Also there will be a compensation committee (to determine compensation of board, won’t be on board), audit committee (one has to be an accountant and they will hire people to audit financial statements) 14) . Ways to own a company: o Buy stock: control company by acquiring stock 10% of public company is probably enough to control Problem with buying stocks: acquire all assets and liabilities disclosed and undisclosed. o Acquire assets: buy tangible assets, IP, contracts, receivables, etc Advantage of buying assets: only acquiring specified liabilities and assets o Statutory merger: unique to US By operation of law: on effective date the shares are converted from A to B. Doesn’t matter what happened to stock certificates. Merger v. acquisition Monday, 8/23/04 Look over blue code book and answer the pop quiz questions. What is going on with our entrepreneurs? o They are getting ready to quit jobs, etc. o They don’t know how much money they’ll need Sanford says $1 million in financing, but he’s in and out Mike says more, Sanjay says less. How do we know how much we’ll need? Do we need to know? • Yes, we don’t want to take too much (high rates or too many stockholders), but need enough to make the product. • How do you know how much you need? o You need to create a business plan: an outline of the company, financing, management, product information. See examples on the CD. Business Plan: o How much money do we need? o What is our business? o What ill will we solve? o What’s the need in the marketplace? How big is the marketplace? o How do we fill the need in the marketplace? There needs to be a problem in the marketplace that you’ll satisfy with your product. o How you are going to deal with competition? o How are you going to get this done? Who is helping you? o Distribution plans? o Finance charts and how you’ll make money. o Business plans are done by entrepreneurs or by people that you hire Neuro baby business plan: this is an overkill business plan o Executive summary o Brain information: she give lots of information on why she thinks her company will succeed. o Market size is very important because it shows how much money you can make if you had the entire market. Also it allows you to say the market is so huge that we only need .1% A business plan never loses money…companies do though. o Introduces competition Is it better to be in a market with competition or without competition? With competition because you know it works and has potential. If no one is in the market the first question is why? Is there any market really out there? They can’t make the same thing, but you want people interested in this market. o Sales projections—this is what the VC’s are interested in. o Funding requirements: put in phases (0-concept, 1-design: beta/first one, 2-development: beta/getting more sellable, 3-test) Salaries and expenses o Development timeline: sets forth specific steps what needs to be done and when o Risks and things that could go wrong o Equity pricing: Stages from idea to IPO o Appendix: 7 year financial forecast—this is probably too many years to be realistic. • 1st year with no profitsbut the loses are probably pretty accurate. Importance of Gross Profit? The difference between revenues and the cost of producing goods. Revenues: 100 Cost of Goods Sold: 60 Gross Profit: 40 • Cost of Goods Sold: how much it costs to manufacture the product o Raw materials, labor, occupancy costs (maybe) • What type of gross profit should you be shooting for in a manufacturing business. This is pretty respectable (40%). This wouldn’t be the same for internet or providing a service. • Gross profit is where you start from. From this you take away fixed and variable costs. o Fixed costs: things that don’t change-rent, salaries/executive employment costs, administrative costs. This doesn’t change no matter how many products you make. In retail they have a fixed rent and an overage (% of sales) cost. Your fixed costs become smaller and smaller as you produce/make more profits. o Variable costs: labor, benefits, manufacturing costs One way to keep variable costs lower is to automate • At the end of the day you’d hope that pre-tax you’d be making 20%. After tax it’d be around 10% profit (fair and reasonable). • Selling expense: When you make the product sale. The percentage that the salesman makes on the deal. o Marketing: putting ads on tv, promoting your product to the market. • Research and Development: important because it makes you competitive. Improve your quality to remain on top of the market. Once you come out with your product there will be competitors who will try to improve your product and capture the market. • Maximize negative amount: where the company peaks at the bottom of the well. This is how much money they will need to get in order to stay in business. o They need at least 3.489 million (assuming everything is correct) you want this to look good, but be accurate because VC’s are professionals at financing and so they know when you are bs’ing. You want your business plan to be your road map. • Use your business plan to persuade the VC’s that you know what you are talking about. Some outsourcing risks: if you outsource it is a real possibility that the other country might steal your idea. Patents: to get protection (prevent others from selling your product in a country). It’s expensive and time consuming. Takes at least a year in the US. o If someone steals your patent then you have to sue them o A patent is the right to keep other people from making, using or selling your technology. The way you do it is you file a patent application. A patent has to be new and novel and not obvious and not used in the public for more than a year. A patent is good for 20 years. Description of your product (in claims)filed with US patent office. Also include prior art (search of other similar products and say why your invention is different than the others) o The patent will probably end up protecting less then what you wanted it to. o Patents filed in the US only protect you in the US. If you have enough money you can file in every other country (EU patent office) You could enter into non-disclosure agreements, but you still have to enforce the contract. o Will venture capitalist firms sign non-disclosure agreements? No, they will tell you to go to somewhere else. Why? Because they don’t have to (they have what you want) and if your project goes out of business and they do business with someone else you might claim they stole your idea. That’s why this is like a waltzyou give them an executive summary: you want to tell them a lot, but not enough. • Once they’ve given you a terms sheet then you know they are on board. What are the standards of disclosures in a business document? o Can’t be misleading and they need to disclose enough to keep a VC interested in your product. What’s the difference between a business plan, an offering, and a prospectus? o Business Plan: For a company not yet in operation (angel investors and VC’s). A road map for executives and directors. A business plan will also be used to raise capital. Selling securities o Offering circular: For a specific issue. It’s more formalized than a business plan. It will look almost like an SEC prospectus and they will pass it out to credited investors. This is a generalized offeringsending out business plan and proposals to sell securities. Here you are exempt from the registration requirement of the 1933 act (not of the regulations). Private placements use an offering circular. Just because we are doing a private placement which is exempt from the registration requirement of 33 doesn’t mean the other regulations don’t applythey do. Not a public offering (exemptions) is in SEC 33 § 4. Blue sky laws also apply: state regulations based on the merit system (must be fair and equitable) • Substantive regulations, but there was a lot of corruption. • The states have differing regulations. o Prospectus: For an offering to the public. The securities act of 1933 talks about the prospectus. Must comply with the requirements of the 1933 act. The SEC act has numerous regulations (inter-state sells, etc). The 1933 act is based on disclosurenot substantive. It just makes sure you disclose everything you should so that investors can make an informed decision. o for a public filing you need to work with the SEC and file a memo describing what blue sky laws will be applicable to you. What if the company Microla brings a claim stating that the patent was actually there’s because it was created during their work time. o If you get involved in a patent law suit it’s a time consuming process and your company will run out of money and die before you can settle it. Black Ink Systems Business plan Why Package: Nile Electronics confidential offering memo: Venture capitalists bet on jocky’s not horses. o Business plans are to make money. o VC’s read the executive summary first and if they want more information then they’ll contact you. o 7 year financial prospect is really unrealistic underwriting agreements with banks….once cleard by SEC the underwriters buy shares at wholesale and sell at retail. The difference is the spread (which is their gross revenue/profit). o Green shoe option: gives the underwriters the options to taken an additional 15% of issued shares to cover over allotment. Standards of disclosures in a business plan: o If using as part of offering circular you better state everything a rx investor would ned to know about the company even though it’s a private placement. o Will only be offering to accredited investors—high earnings and some experience o If not accretited then limited to 35 people that you can offer to in a private placement. o Standards of disclosure are along form S-1 for registration. Maybe not the financial statements requirements. Who is involved? Any conflicts, what k’s do you have? What problem are you solving. Warrant vs. option? o Warrant: Vested. o Option: May occur in the future. Investors are looking for IRR (rate of return)=Annual increase in their investments. They want their investment value (IRR) to be worth 40% more at the end of the year. Types of financing: o Preferred Stock: preferred over common stock (sr. to common stock). They get rights to dividends first and on liquidation the sr. stock gets paid first. o There are classes of preferred stock. Debt, common stock, preferred stock, warrants, options. o Frequently an investor wants to put his money into debt. Debt is paid off first. o Equity is junior to debt. Debt: o Given in notes Can be convertible or it may have warrants attached. You want warrants because on a note you can only have so much interest. Can’t get 40% IRR out of a note. Warrant is the option to buy stock at a certain price at a certain time. Can exercise at any point during that time period. Investment tool. Investors want warrants because they want to exercise if company does well. Convertible means that you are changing the debt into equity at the conversion price. You can convert all or part of the debt you have. Investors want a convertible option because it could mean a lot of money if the company is successful. Stock option: usually employee options that don’t vest right away. Employee incentive tool. Monday, 8/30/04 How do you decide who gets what in business ownership? What is the interest of each? o What’s the easiest way? Split it equally. o How do you value their contribution? There is no scientific way to do it. o Experienced management team is what venture capitalists look for. Is that the case here? No, there doesn’t seem anyone with start-up experience. Entrepreneurs are a very different breed. They may or may not fit into a large corporate structure. However, they know how to make due with very little. o They determine this through negotiation. They don’t have a track record; they don’t have a company already. Management by committee (everyone agreeing) means no management at all. You need to decide who is the chief…who is calling the shots. They want a stock option plan and are looking into long term employment agreements. o Employment agreement: Explains job title and services. Includes covenants not to compete: Puts limits on what you can do after you leave a company (no matter for what reason). These are very oppressive. • In CA—not enforceable unless they are rx (geographically and in time) and unless entered into in connection with sale of business or assets. o Generally 3 years is a top (maybe 5) • In most other states you can have general non-competition clauses. • Board of Directors assign duties to management. Employment terms: • Without a term, contracts are at-will. • Contracts, even with a term, are terminable by the employer. They may have to pay damages, but they can still get out of it. • Compensation • Termination clauses o For cause: whatever you define cause as being. Importance: if fired for cause, that’s it. It ends the agreement. o By employee: If the employee quits, the company really doesn’t have any options (can’t sue for damages—one way contract). Can possibly sue for an injunction for trade secrets For good reason: she’ll continue to get paid out for the rest of her contract. • Proprietary rights: employees assign all rights • Arbitration clause: o Companies don’t like juries because they are uncertain. • Governing Law: internal laws of the state (because they might point to another state) • Confidentiality agreement • IP agreement • Other employment contracts: to prevent interference with business contracts. o Courts are harsh when companies knowingly breach other contracts. • Injunctive relief: preventative—you don’t just have to rely on damages (money), which are hard to prove. What’s the difference between an employment agreement and a consulting agreement? • Consulting: usually it’s a particular task (narrow scope) o Independent contractor so you won’t have to withhold for this consulter. o You can’t just call everyone a consultant because it gives the company benefitsthis is tax fraud. • Employment: does what needs to get done (broader scope) o Tax withholdings Duty of care and duty of loyalty only apply to directors. Should we have employment agreements for our entrepreneurs? o In a start up situation—you really don’t know how people are going to work together. o Best advice—don’t want employment agreements because everything is up in the air. Investors want an employment agreement because they don’t want people leaving or taking ideas. Employees like it because they want protection against termination Employers like it to protect their IP rights. o They can have terms of employmentbut in start up environment you don’t want an employment agreement. Terms of employment: include confidentiality. Randall and Sanjay worked for a big electric companydoes that company own the rights to the marble box? Stock options: to align the interest of the employee/employer. The options vest in the future—after they have worked for a while (retain employees) Warrants: vested As stockholders-you are able to get access to annual reports and company information. Repurchase agreements: If employee leaves the company has a right to repurchase the stocks (if a privately held company) o Why? Because you don’t want them to keep the stocks while working for your competitor. o What price? What the company and the employee agree on. There is no market. So its just a fair valuehire an appraiser. Appraiser takes account of these based on the agreement reached. o If a public companyyou have a market value so you don’t need to privately value. Book value= net worth (determined by GAPP) o Assets over liabilities Assets (plants, equipment, patents)they are the value that you paid for them minus depreciation. o Assets 2.5 million-Liabilities 1.5 million= 1.0 million (book value) o But book value isn’t what you want to sell based off of because there is more to a company (sales, employees, etc). Banks sale 1-3% their book value Operating earnings= EBITDA (earnings before interests, tax, depreciation and amortization)some multiple of this will be the fair value. Use multiple of other similarly situated companies. Hard to value ITDA. PE (price earnings)= after tax next income * some multiple (future earnings) o Might make money on this, but only on the basis of trading (not valuing) Employee Stock Option Warrant Right to buy Yes Yes Vesting Yes after time. Cliff vests: where it vests after 1 year and then on monthly increments. Vests immediately because its part of another deal (when you are purchasing other stocks) Stock option plan: o Will set forth the terms o Companies like to issue shares at fair market price because they don’t want to lose money and there is a tax issue. If you get a stock for .50 that’s worth 1.00 the other .50 is taxable. Therefore, its not a good idea to discount the stock. o Shareholders must approve stock options You have to issue shares at market price (determined by the board). Unless you own 10% or morethe value has to 110% of market price. o Plan lays out the general provisions. How you pay for it and exercise the option Read Item 22 article ISO Non ISO Fair Market Value Yes Maybe notcan offer at a discount Taxable consequences Option: $1.00 Market: $1.00 No taxable income until you sell it. 9.00 ordinary, taxable income before you can sell the stock (no market). Additional 5.00 4 years later value: 10.00 Gain: 9.00 2 years later: 15.00 Gain: 14.00 taxable income. This is a bad double whammy. You would never really want to exercise before you can sell it. Accounting for options: present lawno expense (presently) for giving options. Now FASB (federal accounting standards board) wants to expense options, but this is unpredictable so you can’t do this. o What they use to project what the value will be is the black-scholes model. Monday, 9/13/04 LLC v. Corp. o LLC: transparent for purposes of federal and state income taxes. LLC is treated as though it were a partnership. For tax purposes only: it’s a pass through entity…it’s not treated as a person. It’s taxed entirely at the ownership level in proportion to the ownership %. If the LLC made 100 dollars and you owned 10%. You would be taxed at 10.00 whether or not you made the money. CA has endeavored to make it more like a corporation with limited liability. • Partnerships are personally liable (joint & several liability) No federal tax at the entity level. There is a little bit of nominal state tax. The big differencetax neutral. You can decide whether you want a board, what kind of stock, etc. o Corp: double taxed (at entity and shareholder levels) o Why is it relevant about taxation at a corporate level? What’s the advantage of an LLC? If you know that you are going to have loses (start-up company) because of limited sales during product development, to the extent that there is capital loses you can offset it during taxes (write it off to the extent of 100,000). The taxes are offset in the future for everything over 100,000. You can convert an LLC into a corporation very easily. • LLC can’t go public (can’t have more than 100 shareholders), but they can convert. • Principle disadvantage: Can’t have ISO’s (incentive stock options) o You’d much rather have ISO’s because of tax incentives. California v. Delaware: o Delaware has laws that are corporation friendly. However, in CA. you still pay the Cal. taxes and the rules apply if its your principal place of business. No tax advantagesactually disadvantages because you are double taxed (in Del and Ca). Court of chancerythey are highly regarded in corporate law…they are experts. • They have committees that stay ahead of the curve and make legislative changes. o There are so many decisions that the law is pretty much settled. There is consistency and investors can rely on the rights. No material difference to be an LLC in Delaware and then convert to a CA corporation. o California Doesn’t allow staggered boards unless they are publicly held. Section 2115: says if a majority of your business and shareholders are in Cal. then, no matter where you incorporate, you will be treated as a CA. corporation and will have to follow the rules for CA and Delaware. • But who cares? No one will complain unless it gets too big and doesn’t sign onto the agreement. • Doesn’t apply to LLC’s…it’s written for corporationsstatute hasn’t been amended. LLC’s can have the same items as corporations (debentures, stocks, shareholders) What’s going on in our company? o Founders have decided how they are going to divide up the company. o How much money do they need? Anxst & Anxst says that 1.6 million will be the maximum amount lost. (Maximum cash flow deficit in month 15…break even in month 24) • For start up companies we are talking about cash flowthat’s what is important. o How did they come up with a dollar a share and come up with the ownership percentages? They sat down and negotiated. o Can’t go anywhere until they have enough money…but 100,000 is enough to get started. o Bridge loan—gets you from where you are now, to where you can get financing. Anxst and anxst thinks it will talk .5 million to get through beta stage. So 100,000 extra thousand from uncle is not enough to get to .5 million. “Warrants as a kicker”• warrant is in addition to paying back the loan. The warrant increases the initial rate of return because they have already vestedoption to buy stock at a certain time. Immediately vested. • Warrant is a financial tool because initial investors are taking a huge risk. o If you buy a GM bond you are taking a debt risk because they have the balance sheet to pay it off. They have a rating by a bond rating agency (likelihood of getting your money back as an investor). The higher the rating, the lower the interest that GM has to pay. BBB rating—junk bonds might sell at a discount. • 1,000 bond you can buy for 850 which increases your return (at 8%) because of your return. • Taking a risk because they might not be able to pay it off. o Coupon for what you can buy the stock for. When they are traded in the market it is sold at a discount or a premium. A Microsoft bond you might have to pay 110 for, which reduces your return. You may have to pay a premium for backed bonds (those secured companies) Uncle’s bride loan—there is a note, but is it an equity risk because they don’t have any money to pay it off. Even though an item might be classified as a debt, you need to look behind it and see if there is money to pay it off with. If there is nothing behind the note then its an equity risk. If you just take a note then you aren’t getting an equity reward to go along with the equity risk; therefore he should get warrants for the equity kicker. • How many warrants should Uncle get? So he gets a 30-40% (IRR internal rate of return) return on his investment. o Professional investors want 40% IRRusually a 5 year investment horizon. 100 in year 1. By the end of the 1st year he wants 140. By end of year 2: he wants cumulatively increasing returns. 140*1.4. …at the end of year 5 he wants around 1000 (40% every year cumulative) The question then becomes what number of shares does he need to own at the end of year 5 to get his IRR back. o He uses estimates to determine the amount of sales (x) and then uses Y for EBITDA (times 6-10 for the ratio that companies will sell at), or he looks at the companies net income (Price/Earnings ratio) (times 20 for the ratio that companies will sell at) to equal his IRR. You want enough warrants for shares to meet your IRR. You are determining the value of the company in the 5 year horizon and then determine how many shares you need. EBITDA= operating income (earnings before income tax, depreciation, and amortization) • Trying to measure the power of the company to produce income. o Alpha—beta—prototype—manufactured. Beta stage comes before the prototype stage. • Big circuit boardit works, but its too big to sell. It’s the proof of concept. It’ll work, but we need more time. Prototype—getting it ready to sell…getting it small enough to sell. Security: ownership interest where profits are made through someone else’s efforts. If you put up money in a passive sense and you expect to get money back through the work of others. A security can be anything… o You need to file a form D when you issue shares. Difference between federal security act (disclosure) v. blue sky laws (dealing with stock valuation). o State Blue sky laws were an attempt to qualitatively deal with securities. Highly subjective determination. Lots of corruption. o 1933—disclosure statute. If you make full and fair disclosure then the fed’s don’t care what you are selling. o In 1933 could the federal government have preempted the state blue sky laws? Yes, if congress had wanted to because it was affecting interstate commerce and the SC would have allowed it. Why didn’t they? Politicsthey didn’t want to step on too many toes. o Today must comply with federal and state law. You need to write blue sky memos to find out what rules you need to follow to comply with each state that you are going to sell in. Most states say that if you are exempt from 33 you are exempt here, but you might have to file. Blue sky laws come into play with stock fraud. We are dealing mostly with private placements. o What is the exemption? In the absence of an exemption you must register. Section 4.2 provides exemption for private placements (shares that are not involved in public offering are exempt from registration provisions of the 33 Act) For many years—the determination of what was not a public offering was done case by case in no action letters. • If they had a relationship and there were few holders. In 1964 along came section D, which gave definitions. • Regulation D—safe harbor. If your offering meets the following standards then you are exempt from filing under 33. They’ve taken all the court decisions and codified it (found in 17 CFR) § 230.419. o If you have 1 non-accredited investor then you have to disclose and file under the 33 act. Why would you want to have an offering circular, even though you don’t need to? So that everyone knows what the deal is…so the investors can’t come back and sue. It avoids future lawsuits. You generally don’t do this with VC firms/funds because there are only 1 or 2 funds and you provide them with all the information. o As long as the investors are all accredited investors then you don’t need to file (up to upper limit of 35 unaccredited investors). Investors need to raise some money. Sanjay has friends and relatives (175) that he wants to write letters to…he shouldn’t do this because this is a public offering and they won’t be accredited and it’ll be more than 35 investors. o Not following fed rules can destroy a company because its hard to figure out who owns what…the only way to cure a security violation is to do a rescission process— send out an offering to each of them and describe the company. The company has to offer to buy back the shares. States hold a federal hearing to clear the rescission process. This has nothing to do with the vitality of the company—it has to do with following the rules and having to pay lots if you don’t. Security lawyers need to be careful because you can’t afford to deal with people that are breaking the law. Offering memorandum for Why Package… o Subordinated debt—secondary to other debts and all future debts (bank debt). The bank steps ahead (and all other senior debt) than the subordinated debt. o “The offering” is a term sheet o Good example of a private placement memo. If they had a VC firm lined up they wouldn’t have done with because the VC firm would have given them a term sheet. Here, they don’t have a VC lined up so they have to put out something very similar to a prospectus. o Memo is needed so we are sure that all private placement people get the same information. Convertible note: either get paid back or get stock. o Issuer wants this because you want the person to go away. Note + Warrant: get paid back and get stock. o Investor wants this. When valuating the company—there are a lot of factors that could impact the market/company in the next 5 years…but you need to try to take a guess at it. Gotta start somewhere. Companies invest of jockeys, not horses. Lets say you need 1000 shares to reach your IRR (at the end of the day). o In the agreement you will want to limit how many shares the company can give out. o Projecting Sales and earnings going up for 5 years…maybe this won’t happen. Maybe they’ll have a little dip and need more capital to get it back on course. If the company has a dip then the company will have to give out shares at a lower price because they aren’t hitting their numbers. How are we going to be sure that we have enough shares if there is a down route (where the shares are sold at a lower price)? An adjustment in the conversion or warrant exercise priceto give you enough shares so that at the end of the day you have enough shares. “Down round adjustment” • This is the guts of a preferred stock agreement and warrant offering. Monday, 9/20/04 Angel: investor that does early stage investments. They care a lot about high rate of return. o Have gotten more organized (investment groups)large pools of angel money. o They have experience and certain defined parameters. They will hire MBA’s to decide on which investments to make. o They too have investors—pension plans, angels, IBM, other companies who have an interest in putting money out and they will sell the sources of capital on their track record. What’s going on in session 5? They are getting more organized and they are trying to figure out how to raise the capital. o Croessus hopes to get a good return on his money…he would like to get his principal back. What steps is he taking to get his principal back? The loan is secured by all assets of the company. o He also wants his interest back—7% (a very generous rate). He could have easily asked for 12%. o This is an equity risk because there aren’t enough assets to cover the loan. There are standard rating agencies that rate the debtfor higher rated debts there is less risk and therefore lower interest. Debt risk: you know the borrower can pay the debt. Debt-equity ratio: how many times you can cover your debt. • 1:1 or 2:1the company is highly leveraged (lots of debt on the books) o When times are good there isn’t a problem because they just pay it off with the money they make (even with high interest)…but when times are bad they will go out of business if they can’t refinance. o Ch. 11 bankruptcy—you have more assets then liabilities, but you don’t have the liquidity to pay off your debts when they become due (your assets can’t be turned into cash easily—real estate, patents). This is why you look at liquidity ratio Cash item—accounts receivable, CD’s, IOU’s from government (something you can collect on in 30 days) Capitalization table: o Shareholder, shares held, %, fully diluted, % Fully diluted: all options or warrants or properties are exercised. o Liquidity event—selling the company off If you are holding a warrant at $1 and there is a sale at $10—you’ll exercise your warrant. Whether something is fully diluted depends on the exercise price. • If you were holding at $5 and the sell is at $3—you won’t exercise…no value. • You only exercise when price is “above water”—when price is hire then your warrant. “In the money” Why might you not want to exercise your warrants before a liquidity event? • Tax effects of stock options—incentive stock options and noninceentiv stock options. o Incentive stock optionsmust be an employee and there are regulations by the IRS. ISO’s—no tax incident upon exercise. If you exercise and gain on fair price nothing happens. o Non-ISO’s—for whatever reason, if you exercise you would experience lots of tax because of net gain. You don’t have any cash to pay your taxes because you can’t sell it very easily since it’s a private placement (it’s illiquid). Dilution: o Arithmetic dilution: affects the voting power o Economic dilution: accretion (increase) of stock price value. o Examples: No dilution: • 100 dollars—2 equal owners. Each has 50. • 100 dollars—2 equal owners in 4 pieces. Each still has 50. • Same thing with 1/8ths—no dilution even though you’ve increased number of shares. Dilution arithmetically, accredited economically • Investors: 100@1.00= 100/5= 20 20% • Founders: Sold another 100 shares at $5= $500 • Total: 200 shares outstanding. Here, they have been accredited because investor was willing to buy at 5…which increases the value of the entire company. o Each share is now worth 5—they made 4. o The problem has to do with voting controlfrom 100% to 50%. There are ways to get around this: supermajority, covenants, etc. Croessus- How’d they get the $1.00 valuation? That is the price that the other investors paid in the last hypothetical (nominal price) The argument is the company is worth more, now that his money is in…however that doesn’t mean he should have to pay more. o He owns 9.09% of the company. The shares aren’t above water, and they aren’t at value. He won’t exercise his shares until the company is making money. The option of buying stock at today’s price in the future has value by itself. o Publicly traded company options: use the Black-Scholes formula to value the options (measures volatility and number of shares in the market place, etc) Usually wrong, but it is a predictor. Doesn’t work for private company because there are no inputs. Thought to be useful on putting value on future options. It’s become a political football as congress and accounting profession tries to deal with whether stock options should be expensed (because of Enron) • How do you expense them? You don’t know the value of stocks in the future. • Also, start up companies need to be able to attract talent (when they don’t have money) so they use stock options. • Accounting is about predictable, repeatable treatment. The only critical element about options is about future value. How do we know how much money the company needs? o The business plan shows month by month what their expense and incomes are going to be. They are going to have a lot of expenses before they can earn $1.00. Maximum deficit is theoretically what they must raise before they become profitable. Business plans are almost always wrong because there are unexpected events that come up. There are always delays so most people will suggest you make more money. What about Uncle Croessus and his golf buddies? They are going to form a new LLC (limited liability) partnership. o LLC’s are not persons—they are see-throughs. The tax assets go right through the company to the owners, which is good because they are incurring losses and the owners want to take the losses right to their 1040’s. The coporation would accrue loss on it’s books, which it could offset on profits…but for investors this doesn’t do much because they need to offset the money right now (when they are pouring money into the company). o Anything peculiar about the partnership between the company and the LLCsecurity issue: they all need to be accredited investors because the organization was organized for the purpose of the investment. Need to look at all the investors because it was set up for that reason. How do we know: look at the title—Croessus/media stream. If they had been around a while then you just need to look at the investment vehicle itself (the partnership). o Look to the rules and regulations of the 1933 act. Regulation D—would have all the answers to doing private placements. What you need to have—what kind of disclosures? Safe harbor provisions. Try to limit to accredited investors so you don’t have to create a registration document that is modeled under the SR-1… • People still put out offering memos-so that everyone understands what the deal was and what was said and what wasn’t said. • If investors were a fund-they would put out a term sheet not a memo. o Look at confidential offering memorandum (item 6) Capital raised—some in cash, some in property o Page 5-4: they’ve raised 1.1 million less non cash items. Is this sufficient? Nope, they need 1.6-2.5 million. o What’s the alternative? How can they operate this business? They need to raise more money. o Change their management plan. o Figure out how they are going to sell it. o What is the difference between a business plan and a business model? Business plan: step by step plan Business model: how they are going to make money (business revenue) Media stream: how do you get a company name? Search with the secretary of state and reserve the name for 60 days. You also need to determine if it’s a usable name (because of trademark problems) • Corporate name: media stream llc. (this is a CA entity), can we use it in other states? Find out if the names are already used in the other states that you want to do business. o Get a name where you can use the name in lots of states. o In the future you want to expand…what do you do? Get a subsidiary with a different name. • Website: is a domain name available? • Trademark and trade names… o Federal question—need to go to US PTO (patent and trademark office). If not…figure out what else you could call this thing. • This requires a lot of time and diligence. Why do businesses fail? o They are undercapitalized o Not managed raised—don’t spend their money well. Sanford and Mike offer to put up 100,000, part in cash and part in notes. Does this raise any issues? For a corporation it requires the proper type of consideration. In California-LLC’s don’t have a requirement…you can take whatever the directors want to take. o A note isn’t that great because it’s not cash, but maybe they’ll offset it against their wages. What are the advantages and disadvantages of an LLC? o +: owners will be able to personally expense to loses. o -: can’t grant incentive stock options (ISO’s)…why? Because that’s what the statute says. If you are employee you don’t want to exercise your options before a liquidity event…why? Departing with the money. If the stock fair value is in excess of your exercise price, you have tax on the gains. • Why might someone want to do this? Because they want to pay their taxes on the low price and then when the stock goes up there won’t be huge tax liabilities. When you know you’ll hit a home run. Liquidity event: o IPO o Sale of shares—acquisition o Merger: US only—combination of 2 businesses (or more) assets and liabilities done through operation of law. File with secretary of state in each statearticles state which company is going to be the surviving company. A into B (reverse triangular) with B surviving. B into A (triangular) with A surviving. Why do you want to do a reverse triangular? B has certain contracts and rights, which require 3rd parties consents to transfer. B may have lucrative contracts that you don’t want to lose. • Government contracts can never be assigned—they can be novated. • The contracts will spell out the rights of the company and the agreements. How are you going to keep the rights of the companies without consent of 3rd partiesget around this by keeping company. o Sale of assets: shareholders sell shares to a buyer. What would the buyers objections be? You acquire all asset liabilities (known, contingent, and unknown). Buyers would rather buy the assets of the company. The company gets the money from the buyer. Buying assets and certain specified liabilities (subject to debts on balance sheet, contracts, accounts payable) and the company keeps the rest of the liabilities. • Company uses the dollars to pay off liabilities and uses excess to pay shareholders in a dividend payoffthe corporation then dissolves. • How do directors protect against future lawsuits? They would access the risk and leave behind all the debts that they knew might arise. Wait certain SOL time frames…some claims they can never get rid ofenvironmental. o Phase 1 test—analysis of the property and assets. o They will save the money or remediate the problem. Should mediastream have an offering memo? Yes, to support what the terms of the deal are. So no one can sue for securities fraud. Why an LLC? With an LLC you can manage it any way you want to. With a corporation there are very strict formalities that you must keep…minutes and board meetings, etc. Failure to follow the formalities might allow a plaintiff to pierce the corporate veil— gives personal liability to active stockholders. o Corporations protect investors so long as formalities are observed and it’s adequately capitalized. Failure to do so will allow the courts to treat it as a partnership and find personal liability. o In an LLC—you decide how things are run. Very flexible standards. Not very many piercing the corporate veil actions. o LLC laws vary by jurisdictions—limited liabilities: investor can only lose up to their amount of investments. o Modeled after corporation codes of the states—but there are some potential holes in California. Monday, 9/27/04 Business Plan= What are we going to do; Business Model= How are we going to do it o In our casenothing happens until someone makes a sale (What). How are we going to sell it? Direct to the consumer through the mail order, internet or on TV? Sell through a retailer (Wal-Mart)? Once you get involved with Wal-Mart they own you. Through a distributor who would buy big quantities and then sell it to any number of wholesalers and they would sell it to retailers? You need to understand how each of these works… Preferred stock—stock that has added benefits/perks. o Venture finance is private companies (not public companies)what they are looking for is a liquidity event. Financing the middle market company probably up through a liquidity event of some sort. o Preferred over common stock in some respects Why Preferred? Pricing protections, dilution protections, pre-emptive rights • Redemption: the right or obligation for a company to buy back it’s shares. Purchase of their own stock. o Mandatory: you must buy back my stock o Optional: the company can buy back your stock. Unlikely that VC will allow companies to have optional redemption rights. o Why would they want to buy back? Get rid of affirmative/negative covenants Financial standpoint of company: if the investor likes the interest rate w/a 10% rate, but the company wants a better rate—so it will redeem the stock so co. can get financing elsewhere. % of equity to be soldlooking at projections (skeptically or optimistically) to determine what it’ll make (some multiple of EBITDA) o they’ll have a negotiation based on projection and/or history of performance Priorities/preferences as to dividends, liquidation and redemption: o Priority is the guts of the preference o Preference on dividends: They’ll get their dividends first (before the common stock) Must declare dividends for preferred stock before common stock o Preference on liquidation: preferred stock gets paid out first Creditors/debt is first in line, then preferred stock, then common stock holders. If the company cashes out (sells all of its assets)…who gets the money? • Debt:equity ratio= 10:100they’ll get paid no matter what order they are in. • If you needed to raise 100: o All equity o 50/50 equity/debt o 25/75 equity/debtrisk is called leverage. You are taking a risk that you’ll be able to cover that debt. You rate of return will be higher because you only have to pay out 25. If things go bad, you won’t have enough to pay off your debt and the company can go bankrupt. Big risk—but higher return on equity • Debt before equity o Within debt: Secured debt (lien on all the assets) Senior Unsecured debt: bank debt • Once the bank comes in, they will usually require that the secured debt gets paid off. Subordinated debt: agreement that they take after the senior debt Mezzanine debt: has some elements of debt and equity (highest interest rates because risks go up) • Probably convertible, has warrants • Drives up their rate of return on equity o Within Equity Senior preferred stock Junior Preferred stock (subordinated preferred) • Can have various classes within • Close to common stock Common stock o Usually what they will take is provided for in the debt terms. They’ll get their par value (generally what you paid for it plus accrued and unpaid interest). However, the preferences could say they get 2.5 times that amount… Highest multiple prof has seen in 4. Usually 1 or 1.5 is normal Participating preferred: upon liquidation or redemption—the stockholder gets: par value, accrued dividends, and the rest is left over for the common (plus the preferred—acts like it was converted to common) • Get to double dip…preferred as though they were common o Is there a relationship between dividends and redemption? Does the state have any interest in amount of money spent on dividends? If you buy stock back (redeem) than you have less money to pay creditors, etc. Therefore all states have limits on how much money you can spend on dividends or redemptions. In Ca-Section 500: strict limits on how close to insolvency you can get. • If you don’t have the requisite balance on your balance sheet then you can’t do it. • You can have all these rights, but if the company doesn’t meet the requirements then the company won’t be able to give dividends or buy stock back. Negative covenants: agreement not to do something o You’d find the covenants in the term sheet. “without the consent of X of the preferred stock, the company will not assume debt in excess of y” Affirmative covenants: company will do things—hold annual meeting and give annual meeting, it will give access to the books. o This gives a close relationship between company and investor Mandatory dividends: company must declare dividends every year Optional dividends: company may declare dividends or may not (even if they’ve made a lot of monay) o Series A stock: 6% Convertible Preferred Stock with pare value of 1.00/share • Covertible—to common stock • Preferred-to liquidation, dividends, redemption • 6%--it will accrue 6% of par value every year. o Give each series a different identifying number. Venture capital representatives are actively involved—need to be actively involved because the company doesn’t have a long track record. o Not intended to be held indefinitely. Not in it for the long term… o Gets his money from a fund They have high IRR’s and they want to get out in 3-4 years. They have to return the money to the fund. • Need to be invested, have a liquidity event, and get their money out. VC’s make money by taking a %. • VC’s aren’t looking for a lifestyle business (dry cleaning, etc). o VC’s are looking for a homerun—30 IRR. 1 or 2 out of 10 will be great, 2-3 will be ok. Looking for strong management—bet on jockeys not horses. He will want board representation Term sheet is prepared by the VC firm o After hearing about the deal and checking out the research, they will present the company with a term sheet. o Comparative term sheet—what the investor would like and what mediastream would like. He who has the gold rulesthe investor version is going to prevail, unless you have 2-3 investor groups vying to do your deal. See 6-3 Purchasers • Limited number of investors because they want to remain in the definition of a private placement. Here Mediastream was created to finance the company and so you need to look through the corporation and look at the qualifications of each of the members. o Security regulations Security • Subordinated: easier to get financing later • 6% coupon—dividend: if not paid, it will accrue o their investment keeps growing every year o Cumulative or non-cumulative: cumulative will add up on the accrued amount. 500,000 too little to raise with VC • most VC firms won’t look at the deal for less than 5 million because of the transaction and opportunity costs. o Costs are the same for the offerings. Automatic conversion (to common stock) • Why does everyone agree for automatic conversion at the time at IPO? o Investor wants it because it’s a liquidity event…ability to get out. o The common stock is what goes publicthere will be a market for common stock (not preferred stock), so the company wants to clean up it’s balance sheet. o What if you have a very small IPO—the investor might say that it’s not making enough of a market to give up the preference. That’s why they define how big it must be. It’s about negotiation—would you rather have preferences or common stock. “frequently defined IPO terms” Anti-dilution: • 1:1—common to preferred • stock splits (mathematics) o adjustment so that you have the same piece of the company. o 1:2 (one share of common for 2 preferred in a 2 for 1 split) o Why would a company want to split it stocks? With a smaller company—you’d have 50,000 outstanding. If you took the value of the company and divided it by 50,000 you’d get 10,000/sharetherefore you need to split the stocks to lower the price. How much do you need to bring down the stock price to 10-15/share. Also, you need more shares to sell to the public. • Only 20% (10,000) of the company isn’t enough. Must have enough shares at the right price. • Stock combination: sold the shares at $10 a share and is now trading at .10/share. (opposite of stock split) (mathematics) o You may want to combine 10 shares into 1 so that you have a value of $1.00. • Stock dividend-same effect as a stock split (we’ll pay you a stock dividend for every share you own) (mathematics) • Re-organizations: restructuring the stock • Price adjustments: o 1 million at $1.00these people will lose some equity if you don’t adjust the price (so that their equity is still worth 1 million) 1/3 of the company o 1 million at $0.50 o Full Ratchet—in the event you sell for less that 1.00, then we get to buy all of our shares at the same price Investor wants They automatically get another million of shares (total 2 million of .50 shares) o Weighted Average—so many shares at 1.00 and so many shares at .50what’s the diluted effect. We need to get more for the 1.00. Need to get 1.33 to 1 to maintain the same value you had. Company wants weighted average Ranking: • Company wants the stock to be subordinated so that they can raise more money in the future. o They know that they’ll need another round and you want to avoid having the ranking conversation with the A round. Mandatory redemption—company doesn’t want it, but the investor wants it. • Investors will demand it. Redemption at holder’s option • If the IPO doesn’t occur, the investors want the right to make the company buy them out. Liquidation preference • Participating preferred desired by investors Voting: • Investors want it on an as converted basiskeep their power Registration rights: • The particular issuance of stock is registered in the ‘33 Act. o At the same time you need to register under the ’34 Act. • Each issuance of stock is a separate registration under the ’33 Act. • The investors want the right to: (IPO is usually just the company selling stock—primary offering. Primary and Secondary is possible—allowing some shareholders to share along with the IPO). Investors might want to have a secondary offering (where the investors are selling to the public). The company is the only person who can file the registration statement. The underwriters will create an orderly market for the stock. The shareholders will want the company to pay for the secondary offering. o Demand registration rights 1 or 2 demands—where the shareholders force the company to register their shares. (careful counsel will say “after public offering”) o Piggyback registration rights Later down the road (2 years, etc)the shareholders will jump on the registration statement. o Liquidity event is more likely to be a sale in today’s world. Monday, 10/04/04 Stockholders agreement: lays out the roles of the stockholders and the company. o Is it important? It will cover a bunch of thingsincluding a buy/sell agreement: puts restrictions on when stock can be sold (agreement). Company has right of first refusal, then other shareholders, then outside public. Why? To control who has your stock…you want to keep it in your group. Control has a value to it. Why would you want to offer it to the company first? When the company buys it back everyone else’s % increases (without having to pay for it). If one of the partners buys it—his % increases and everyone else’s decreases (a little). Who makes the decision to buy back for the company? The board—is it a good deal or not? Generally speaking it’s the price at which you could sell (sometimes it’s a formula, sometimes it’s whatever the parties agree to, determination made by investment banking firm. • Investors aren’t going to wait around while you check with the company. That’s why there is a fallback way to value the stock. It will also set forth that they’ll agree to vote for the directors. What % is required to approve corporate actions (% is figured out by looking at who is who in the company) It says how the company is going to be run. Restrictions usually have exceptions on who you can sell your stock to (offspring, heirs) Protective provisions: negative and affirmative covenants. Preemptive rights: when corporation issues more stocks, preemptive rights allow existing stockholders the right to buy more shares to keep same %. It will be bought at same price as offered to other people. o Don’t really work that well in a company that is constantly offering stocks—you have to stop the show and negotiate the new deal with the investor because otherwise you won’t know what to offer your existing stockholders. VC’s won’t stand for standing around and waiting for you to talk to your stockholders. o Professional wants it, but doesn’t need it, because of all the negative covenants. Co-Sale rights: The right to sale an equal % of stock if a certain group sells their stock. VC doesn’t want to buy control when buying into the company. Co-Sale rights say that if the company or the stockholders are going to sell 10% of their stock (1000 shares), then the VC can sell an equal % of their shares. o “Tag along rights”I get to tag along when company sells stocks. o Right of first refusal may not be accepted…but co-sale gives some power Drag-along right: it’s a call of the stockscontrolling shareholders will all agree to sell their shares to a controlling shareholder. It drags everyone else along. o VC (series B) has an investment horizon. Board of directors: wants at least 1 director on the board. o Sometimes they’ll ask for observation rights: sit in on board meetings, but don’t have voting rights. Pros: gets the information to the person Cons: privileges lost, not held to the same duties, they have undue influence. • Because it walks like a duck and talks like a duck they’ll be held to the standards of a director. Shareholders can sue for the actions of these observers. Expenses: the company will usually pay some number to cover investors legal fees Founders lock-up: after an IPO the founders who own stock can’t sell their stock until x number of days after the sale. o 33 Act provides that officers/directors/10% stockholders have a special positionthe underwriters will want these people to stay out of the market and not sell their stocks. VC’s want to control how much stock is availableorderly market. Also it looks badif I’m getting on board why are these people leaving. Option plans: VC’s will want to restrict because it dilutes the equity that they just bought. Usually it’ll be about 15%. o Vesting: when the options will expire (cliff vest)20% in the first year, etc. D&O insurance: excellent summary Enter a Venture Capitalist o Read Cap lists and shareholders’ charts very carefully. o Cap lists: shows debt and equity States stock information • Preferred Par Value: 1.60 common shares o Fully diluted tells you at any liquidity event the number of shares that will be there in the future because everyone will execute. o Serial preferred stocks: read section 400 and 500 in the blue book. Company is authorized to issue 1,000,000 common stock at .0001 par value. Also 20,000,000 series preferred stock. • Each series has certain rights, preferences, etc. Each of the rounds will have certain number of shares adding up to 20 million. • Here, we’ve subordinated A to everyone else (future classes) • Certificate of determination: where directors give a resolution which states the terms of the series. o Adopted by the board and sent to secretary of state to incorporate in the articles of incorporation. Shareholders can amend the articles Each class will have separate class votes for approval. Each class may have different approval %’s. • You’ll negotiate different things to get all the classes to pass the amendment. Some states imply par value if not stated. Why package: dirigible stock—make it as close to common as possible. Minimum number of rights. Series A—first bite at the apple…you know that we need future financing so be nice and be subordinated. o How to make sure you have enough stocks for executions? Set it aside in your articles and capitalization charts (set it aside) Mediastream is behind in revenues and more expenses then thought. Their product line is developing though. o Run rate: what your results would look live over a certain period of time. (It’s a projections—where you’ll be 1 year out) Why do August, Sept., October have high sells? Shipping for Christmas Alpha=big, Beta=getting closer, prototype=getting close to final manufacturing prototype. Article= first prototype ready to sell. Engagement agreement o States the costs and the payments that will be made. Success rate: if succeed in finding an investor then they receive a % of the amount received. Thor thinks the stocks are worth 10.00 (10 for 1 split at 1.00). Pre money valuation (implied value of company): you get an investor to give you an estimate and you multiple that by the number of fully diluted shares outstanding (1,045,000). Post money valuation: pre-money valuation + investment given (5 million). Post money= 10,450,000. 10 for 1 split—to bring the price down to 1.00 a share. o Easier to deal with for stock options and previous rounds. “The deal is in the documents” you need to look at the documents. Why the 1.6 conversion ratio? You want to raise 500,000. you could have sold series at 1.00 par value, but they gave series A a higher price valueso the conversion ratio gets you to 500,000 shares. o Series A is more valuable because of their rights and preferences. Difference between series and A and common? They have more preferences/rights. What are the distinguishing characteristics of VC financing? o They play a more active role and they want an exit date. Relationship between Series A and B? series A is subordinated to series B (it’s whatever is contracted for) o Liquidation preferences, redemption rights, coupon, dividends, etc. Pro’s and Con’s of Series B (compared to an IPO) o Pro’s of B: you’d have a hard time going IPO because you don’t have a track record (however companies still do it), fewer requirements than going IPO, prevents this company from getting orphaned (you only want to sell a certain number of shares—don’t want to get it down to a penny stock: nasdaq requires 5.00 par value). This company has only been around for a few months, questionable management. Doesn’t require Sarbanes-oxley reports—they’d have to file if they went IPO. More personal liability for going public. Benefit of market system: you have enough shares out there that you get a pretty good evaluation of what the company is worth. Without a market then brokers will lose interest (because there aren’t enough shares out there to trade). There can be a premature IPO—companies will regret o Con’s of B: don’t create national market What are the responsibilities of the directors? Duty of due care and duty of loyalty. Who is responsible for complying with federal and state securities laws? Directors are personally liable. You are hanging out thereyou are promising that everything you say is true and not misleading. o Lawyers can also be liable if they were co-conspirators. As a lawyer—you don’t want to be around if something goes down. “there are old lawyer and bold lawyers, but no old bold lawyers” Preventing conflicts of interest between investors on the board: you have duties of due care and loyalty…but in reality this isn’t the casehard to separate. o Harder to get people put on boardsincreased scrutiny. o Indemnification and D&O insurance. Investment Banker said 10 million was needed, yet they accepted 5 millions from Thor. o Problem is where do you get the next 5 million. Explain why you are going to only accept 5 million nowgets us 18 more months into this. Bankable after it closes series b? Bankable= the bank will loan them money. The bank could loan them money, but most won’t because they have no record of earnings (sometimes with the high enough rate). Bank loanscheapest money you can get. o Once you get profitability then you may be able to borrow money against your receivables. o Could be bankable if the founders guarantee the loan (co-sign with it), but not a good thing to do…only in emergency situations should you do this. Time to close a series B? 60-90 days (because of the plans, agreements, due diligence). Time to close an IPO? 60-90 days: from the time you prepare to the registration statement (financials, UW agreements, etc) it will probably take you additional 45 days. SEC has 30 days to get back to you. Then you’ll respond with amendment 1, etc. o It takes time—don’t wait till you start running out of money. Monday, 10/11/04 See Venture capital Term Sheet Preferred stock is really about: dividends, liquidation and redemption rights o Any one of these is enough to make it preferred. All you can win in a lawsuit is what you should have had 10 years ago—don’t want to have to enforce contracts because VC’s aren’t in the business of lawsuits. VC’s want IRR Pari passu—we get what they get. § 500 trumps everything else on redemption rights o limits company on what they can do. Depends on requisite capital in company. Participating preferred: gets 2 bites at the apple o 1) liquidation Preferred (par value and accrued dividends) o 2) Participating—converted to common and we participate with the common Non-participating: the second step disappears. 1,000,000 net worth (end of the day after paying off the debts) o 200,000 preferred 6%= 275,000 o Left over: 725,000 100,000 shares of common 200,000 shares of preferred Now: 300,000 shares of common so divide 725,000 by 300,000. Sale is the main way that VC’s get their money (liquidity event) o IPO is the least likely. Demand rights—who gets to drive the company public. o Company wants after IPO; investor wants to demand whenever. Registration Statements o Primary: company raising money for it’s own use (pay off debts, acquisitions) Usually IPO o Secondary: the stockholders sell the shares Demand rights come into play here. Sometimes this goes along with IPO • Investors don’t like because owners are jumping ship when they are trying to get people to buy in. o Ex/Ford was private for a long timetheir first offering was of ford family stock. Demand: make the company offer your shares to the public (whether or not your ready or not) Each investor will all have registration rights agreements—they will have an underwriter’s cutback: everyone demands in an offering, but the underwriters can cut that number back to keep price up (cut back proportionately). Session 8 info o Need more money—series C (.80 per share) o Implied pre-money valuation: what the company was valued before VC put their money in Here: 1,045,000*10 (10:1 stock split)= 10,450,000 • Or 15,450,000-5,000,000=10,450,000 o Post-money: 15,450,00 (what a knowledge buyer is willing to pay for it) Value: $1.00 per share o Clear path to profitability: we have a plan that we’ve been operating on…so we are going to make money in month X. Good reason to believe that we’ll make profit. We know what our costs are, we have contracts, etc. o Micorola competition Advantages: The market is legitimate (validates market); Micorola may want to buy the company. • On balance it’s pretty good Disadvantages: they have great assets (they can steamroll MediaStream) o Strategic alliance: an agreement between two companies to work together on advancing a company goal Marketing, distribution o Very-Chip Manufacturing—in Taiwan (outsource) Advantages: lower costs Disadvantages: licensing, demands, control, patenting issues, they can steal the idea • Laws are steal developing—getting better…but risky o Blizzard electronics is for salethey have a plant Pros: don’t need to worry about patent issues as much (same country) Cons: more expensive because it’s older o Need to do due diligence to check out the differences between outsourcing and buying company. o Conflict for Mike in introducing Silverman Wachs? Silverman is his former employer—he will have relationships and have different loyalties • He’ll have to make a full disclosure to the board o Lehman formula: A compensation formula developed by Lehman Brothers for investment banking services. The structure is as follows: -5% of the first million dollars involved in the transaction -4% of the second million -3% of the third million -2% of the fourth million -1% of everything thereafter (above $4 million) Monday, 10/18/04 Intellectual Property (see outline!) o Patents: 3 types 1) Utility Patents • Requirements: i) Patentable Subject Matter-any machine or manufacture, process or compensation of matter or a new and useful improvement (anything under the sun that is useful—broad) ii) Characteristics of that subject matter: new, useful and non-obvious iii) Statutory bars/vetos: novelty requirement (how long they wait) 2) Plant Patents: eg/new pineapple type 3) Design Patents: ornamental, not functional (bumper) Who gets the patent? The inventor. Most of the time the employer has a claim based on work product. Right to exclude others—not a right to affirmatively do it yourself. • Interesting aspect: improvements—doesn’t allow you to do it, but keeps others from doing it, so long as you have the patent. Lasts 20 years from date of application • Changed from 17 years from issuance—why? Abuses by people in filing a broad topic and delaying issuance until market developed (summary patent) o Takes about 2 years to become effective Only applies in the US. Must apply in other countries as well. Patents protect patent holders against an independent invention; copyrights/trade secrets only protect against copying (independent discoveries are ok) Patents protect invention, even though how the product is put together even though it’s publicly known. (Trade secrets if publicly known are not protected) • Why such powerful protection? o 1) encourages innovative efforts o 2) Makes it reasonable for people to invest and make the product (build a company) o 3) deemed a bargain between inventor and public-public will give some monopoly rights, but inventor will fully disclose how to make and use the invention—to put knowledge out in the public arena so that people can invent around it and improve it. Patents have to follow a standard format. • Specification: description of product (prior art, problems, why your invention is needed, purpose, what is accomplishes, best mode, preferred embodiment-best use) o Have to read this to understand how the words are used • Claims: stakes out exactly what your product/protection is o Written in a strange language o Patent is valid claim by claim—each trying to specify the invention in a different way. o Strength of patent comes in here Doctrine of equivalence Patent law is really old. • In 1982, they created a whole new type of federal appeals court: unified, strengthened patent law. Patent licenses and transferability • Exclusive v. non-exclusive Modern developments • Up until the 1980’s patents were relatively weak. • Global competition forced protections to be developed o New court developed and patents have become very important patent law is a creature of federal statutes—state law can’t modify it You infringe on a patent You have no protection unless a patent is issued o Trademarks: really become important with websites Exclusive right—mark used to identify class, good, services (usually deals with origin—who makes it) Can be a word, picture, logo Descriptive or obvious word can’t be a trademark—other people can use it • The more it’s fanciful—the more likely it’ll be a trademark • Unique will probably be protected Trademark rights are given by use (there is a registration process, but you must use it) • Presumption of validity and damages if registered. Can’t license out trademarks because the value of the trademark is keeping quality control and value. • Can license with quality and supervision requirements. • You can sell a division of your company—and then the trademark will be valid if transferred. o Copyrights Bundle of rights—negative exclusionary rights (keep others from doing it) Subject matter: works of expression (don’t cover underlying idea) • Functional applications (ring tone, computer language) are not protect-able o Must divide up How do you prove? Substantially similar creates a presumption that someone must overcome by proving they didn’t have access to the work. Extended to 70 years after death of author. Works made for hire: 95 years after last year of publication (Disney—to protect mickey mouse) • In code—narrow things If an author assigns right to movie director, after 35 years it automatically springs back to author. Independent contractors (not supervised or paid benefits) • If a true employee and within scope of employment then company owns it. • Need to get an assignment—but it only lasts temporarily Don’t need to register—international treaty says you don’t have to register, but you get better (statutory) damages if you register. o Trade secrets: creatures of state law and more recently the uniform trade secrets act Federal law does not preempt state law—they are based on different theories and procedural processes. Basis: law of agency and fiduciary duty • Not a form of property, it’s based on a breach of trust—tort (acting wrongly by breaching employment obligations) You misappropriate or misuse a trade secret (taking someone else’s rights) Trade secrets spring up automatically (springs into effect on discovery and your reasonable efforts to keep it secret) Hypo 9: o C round—down round Raised 5 million with 6,250,000 shares (.80/share) Got 2 board seats .80—purchase price and new common stock conversion Terms are found in the term sheet and in the articles of incorporation (limited things) and in a shareholders agreement (preferred stock purchase agreement) • Preferred stock purchase agreement: obligate yourself to purchase shares, inspection rights, board seat, buy-sale rights, co-sale rights, rights of first refusal. • Here, we have LLCput terms in an operating agreement o Before they incorporate—they usually become a c class business What did issuance of C round do to B shareholders? Enacted their antidiluutio rights (owners are able to recoup what they loss by selling it at a cheaper price) • They would get the money back upon conversion. o For B (to begin with): you would get 1/1 When you trigger anti-dilution you get 1/conversion rate. He’d get more common shares and more votes. • Changes the conversion rate/price. Since you vote in accordance with the number of common shares you get upon conversion it affects your voting power. Doesn’t affect dividends. Doesn’t change liquidation preference either. Shocking terms for B and C: o Redemption price is high (“put”): if the company doesn’t redeem it or automatically convert it (qualifying IPO) it has to pay twice or 1.5 times the purchase price to the investor. Section 500 of Ca. Code—states requirements for when a company can redeem. Issues Compare B and C: o Preferences-B is subordinate to C (liquidation or merger/acquisition) Liquidation measure: what you paid + accrued dividends o Mandatory redemption: (from standpoint of issuer) B shares get 1.5 times value at specified date C shares get 2 times value at specified date o Optional redemption: (from standpoint of issuer)—company can go out and redeem. Usually requires notice. Conversion price adjustments o Types of anti-dilution: Full ratchet: takes conversion price of old shares all the way down to issuance price of new shares Weighted average: usually between full ratchet and dollar. Usually side with money wins in the negotiations (they have money=power; easier to understand cash rather than value of company). o VC usually provides forms for the agreement Who is in control after C round? Thor (38.92%) Uncle Croessus—repaid note to him in terms of series C issuance. May have increased payout with 2x. Stock option plan o Are ISO’s (incentive stock option/statutory) available for an LLC? Maybe. LLC—you get/lose money based on our investment (membership interest) o Corporations have limits placed on ISO’s: $100,000 per year when they vest (Tax Code) o Benefit of ISO’s: avoids taxable income on exercise (no taxable income on exercise). You also get long term capital gain treatment on sell of shares (if you hold it for a year). Value in an option is if it is lower than trading price. o Non-ISO-have to pay tax when you exercise (painful, especially if you have to hold onto it because of contractual obligations) Taxable gain tax…maybe eventually you’ll get a capital loss. Monday, 10/25/04 We’ll have guest speakers today: o Sage Group—presenting on valuation Mark Vidergauz Dan Gardenschwartz The paper will be sent via email by tomorrow—if you don’t get it…email prof: bzweig@kayescholer.com Rolling out—nothing happens until someone makes a sale: has to be desirable and solve someone’s problem at a desirable price. Time for the rubber to meet the road. o Manufacturing o Marketing/Distribution Problem with outsourcing: people ripping off your idea and selling it cheaper than you can produce. o When you get big enough—you can build your own plant overseas. o Even if you produce it here, someone can steal your idea through reverse engineering. Locks only keep the honest people out—crooks just break in Random access code—helps protect your media chip. • Before 1994—you could get a general garage door opener and open up everyone’s garage by playing with the numbers. • Now they use random codes that change the frequencies so that you can’t figure it out. Communication problems o Getting less with global technology Language barrier, cultural barrier—hard to reduce everything to writing Experience allows people to have a better understanding of the real costs associated with manufacturing. o Outsourcing v. Keeping it in the company Difference between sales and marketing o Sales: moving product o Marketing: advertising Strategic—how are we going to position ourselves in the market? Who is our customer? Wholesaler, direct sales, etc. Strategic Alliance: enter into an arrangement with someone else to meet a need of the company. o Types: Contract—take or pay (forcing company to buy what the other one makes) • Deals with projections about sales—fairly dicey Joint Venture • MediaStream and Blizzard form a company (M Co.) and they are only going to make specific box productsprobably and LLC o They’ll each put in money, patents, licenses, and they’ll get back % of the company. o Complex contract will set forth the complicated terms of the agreement o MediaStream will probably enter into a take or pay agreement. o Subsidiary terms: Exclusive sales and distribution Plant construction agreement Financing agreement Manufacturing agreement Take or pay agreement Technology licenses Management agreement Capital contributions and capital calls: who will pay for what; who will provide workers Distributions Agreement regarding election of directors and executive management of the venture • Someone has to be responsible—in charge of the company. Confidentiality and non-disclosure Sale or transfer of an interest in the venture Termination: when the company will end Business Judgment Rule—important to keep in mind for business decisions Manufacturing is different than producing to order o Producing to order: Every time you have a demand you put in an order (small increases)high costs associated with because you have high overhead o Manufacturing: Gearing up for differing increments of products—lower price for higher volumes produced. You want to be here—plan ahead and have an idea about what your sales are going to be. Full disclosure is necessary…corporate governance—making a record of things is more important than coming up with the right answerprovides details of your decision making process (make an excellent record) o Record is more important than coming up with the right answer—courts won’t second guess if they satisfied their fiduciary duties. Option Pros Cons Other Manufacturing Build a New Plant in CA • Retain control over the process: control destiny because responsible for quality control and meeting demand requirements • Increased information about costs of manufacturing • One set of laws to worry about in terms of place of business— expands when make a purposeful availment of selling in other states • Tax incentivesdeprecciatio for the new plant • Higher costs because you are starting from scratch • No expertise in manufacturing of products: longer learning curve • Don’t have outside advice on how to create a mare efficient process • Build a New Plant elsewhere in the US • same as above, except for one set of state laws • possible lower cost of • same as above • higher costs of communication between management • living and building costs if outside of CA and the manufacturing site Build a New Plant in Mexico • probably lower costs of construction and labor costs • remain in control of process • tax advantages for owning plant and equipment • different international laws regarding labor and patents • language and cultural barriers • increased transportation and communication costs between plant and management • “Plant built to suit”-lease it back with the option to buy. Also lease the equipment. • Remain in control of manufacturing process • Risk is shifted to developer • Can determine what plant will look like and how it will run • Easier to update plant in the future with improved technology • Have the option to buy if things are successful • Developer probably doesn’t have much experience in order to offer advice • Fewer tax advantages when leasing the equipment • Depending on terms of agreement company may lose some equity in the buy option • Dependant on developer for favorable terms • Lease an existing plant, buy equipment • lower capital expenditures if plant is in working condition • own the equipment which results in depreciation benefits • don’t own the plant, so less control over the plant and fewer tax incentives • dependent on landlord for continued lease • high expenditures for new equipment. • Joint Venture with Very Chip (Taiwan) to build a plant in the US to produce Very chip products, marvel box and contract basis for others • Gain expertise from Very Chip who is an experienced manufacturer. • Mixed production and contracts for future growth options • In US-so familiar with US laws • Increased likelihood of IP infringements • Spreading out resources and not focusing on manufacturing the marvel box • Dependent on Very Chip in manufacturing and continued upkeep of the plant • Existing surplus electronics plant in the US • Lower acquisition costs • Familiarity with US laws • Electronics plant, so hopefully has some useable equipment and a conducive setuu • Can’t easily modify for Media Stream’s individual needs • Contract with Very Chip to manufacture entire Marvel Box • gain manufacturing expertise • can focus on end result and don’t need to worry about the manufacturing process (outsourcing benefits) • lower plant and equipment costs • increased risk with IP infringements • increased risk regarding quality control • dependant on Very Chip and the Taiwanese government and economy • lose information control—must rely on what Very chip is telling you • Everyone has problems in Taiwan— their legal system isn’t set up. • China has rudimentary laws in place—a little safer • Germany is too expensive to manufacture Contract with Blizzard Electronics (Ohio) to manufacture the entire Marvel Box • US laws would govern • Same as above • Same as above, but IP risks are lower because you are dealing within the US • Contract with Blizzard or Very Chip to produce everything but the “guts” of the marvel box—core of the patented technology. The manufacture of the marvel box also involves trade secrets. Assemble in CA. • disperse some manufacturing costs and gain manufacturing expertise • can retain control of the magic control box—improved IP concerns • Retain QC and assembly process so that you have more information regarding the product. • Vulnerable to additional outside factors—the other company’s continued success, stable economy • Giving up trade secrets by making them known to the other company • Increased shipping costs • Multiple jurisdictions and international laws would affect your business • There are rules in place to determine whether you can sell as “made in the US” • Too risky to take technological product offshore. • You’ll still have to get international licenses Distribution Hire VP Sales and sales force to sell to distributors and/or retailers • control your destiny • improved information will be available to you since it’s your employees that are selling the product • More fixed selling costs since everyone is on your payroll • don’t have expertise in selling or hiring a selling department • expensive to start a sales department from scratch— infrastructure and personnel needs • Hire VP-Sales to supervise distributors and rely on their sales force • still have VP sales so you have individual looking out for company’s selling interests • gain expertise from distributors • loss some control of selling process • dependent on distributors • higher supervisory costs without much control over the selling process (dependent on distributors rules) • Strategic alliance with Blizzard—where Blizzard would use its sales forces to sell the Box to its customers on a sales commission basis. • Gain expertise from Blizzard • Increased access to potential existing customers through Blizzard • Don’t retain control or a point person in regards to your selling decisions • Completely dependent on blizzard • Probably higher costs for alliance because you won’t be able to offer Blizzard much value • Variable costs because of commission set-up • Labor rates cheaper in Ohio Sage investment valuation presentation Valuation is the center of all business transactions Applications: new business, early stage, mergers, acquisitions, divestitures, going private, fairness opinions, public equity, tax, defensive tactics • Fairness opinion—where stockholders want an outside expert to give an opinion about the fairness of a deal (protect minority shareholders) o Boards will use to protect themselves from liability Enterprise value= value of all the business assets • Equity is only the value of what the shareholders own Market capitalization—usually just equity shares outstanding…important to look at different valuations depending on company growth Leveraged buyouts—using debt to buy a company (use cash flow of business to pay off the debts) Company value: higher valuations • Size of future cash flow • Timing of cash flow—would rather have money in your hands now, than later on. • Risk of future cash flow • Purchasing power of future cash flow Venture capitalists usually demand higher returns because it’s a new, high risk firm. To determine discounted (cash flow) rate-• Look at risk free rate (government bond) • Increase/decrease by differing factors—like industry or company debt. Earlier stage companies—higher risk companies Bio-tech is very volatile—not very predictable. Start up business valuation is more like looking into a crystal ball Where profitability it high and growth is high—the multiple will be higher Sage deals with Juicy and Lucky fashion brands • Want equity to retain its value—value keeps growing. Up rounds—where the value of the business keeps going up in each round (selling the company multiple times when this happens—snapple) Initial investors can raise money without losing that much control if their company lives up to its projections—strong cash flows, etc. EBITDA= cash flow Look at the ranges and see how the companies compare with each other. Judgment is very important in valuationcompany, management, etc. Real value comes from being able to counsel your client. Agency transaction—where there is an investment bank involved (they’ll market it and try to sell your company)…they take a fee for their services • They also have investment fundswhere they can do principal deals (where they are the owners): Merchant Bank See handout! Monday, 11/1/04 Paper Questions o Similar to dark mediadon’t assume things (it would be at your detriment) o “I am making these recommendations based on the facts I know…if things change please let me know” o pages: 10-40 o Blank check preferred—serial preferred stock that can be issued as directors choose. Shareholders have given directors the power to issue up to x number of shares with any preferences as they choose. o Pro-formas comparing what a company would like under certain scenarios o Clarity of writing is important o Can work with others o Make it clear why you don’t know…make assumptions clear o Check the box—got to choose how you wanted the company to be treated for international tax purposes. o Revolving credit facility—after a company gets going it will create an accounts receivable (when the purchasers pay for their purchases). You are out a chunk of money until you get paid (gap between when you spend and when you get paid). Also, when you are making things in advance—storing them—you won’t be getting paid for them. Inventory is worth money (because of everything you’ve spent). A bank comes along and says it will lend them an amount (80%) of the receivables now—basically to cover the gap. Good receivables—when you have a customer that always pays in 45 days…the bank will give you credit for it. Not receivables out of date. Good inventory—stuff currently being sold (stuff being sold now…not parts or outdated goods) Banks are limited—they have their own ratios for how much they can give o Don’t have to follow brief format—facts-issue-short answer-discussion…just do something that works o COGS—cost of goods sold o SH equity—shareholder equity (aka net worth) o Total assets v. total liabilities o Professor Scarberry has a book with a chapter on how to read a financial statement o Net sales—net or returns and allowances. Goods go out, sometimes they come back for defects, order wrong, etc. Total sales—goods returned and allowances o COGS—cost of goods sold. Some labor costs and amortization costs are included. o Gross profit—difference between net sales and cogs People look at this number 50% or better for manufacturing company is ok—not great o SG&A—selling, general and administrative (secretary, sales force, etc) o R&D—research and development…important for investors to know o Operating income/EBITDA: important number (applied to industry multiplier) Sales minus costs o CAPEX—capital expenditures…machinery, plant, equipment o Depreciation—non-cash item (need to know for tax purposes) o Look at the type of company Catalogue company—high costs per unit or services with low or no manufacturing costs…COGS is 0…business may be valued on a multiple of sales. If you are a bank your principle is cash…they might sell 2-3 times their cash (multiple used) DCF—discounted cash flow will also be used (multiple of ebitda) Public company—PE ratioprice earnings ratio (net after tax income): market tells you what it is worth. • Income after tax per share…multiple depends on what type of industry. Above 15-20% is too speculative: gets into trading realm for what’s it worth For manufacturing company like our paper o 2 million liabilities is high. We’ll be looking at pre-ipo stuff from here on out… o Documents are very important Session 11 o What’s going on with very chip? Initial shipment was late, QC wasn’t up to par • You need to have the staying power to survive this type of mistake… Means that it puts them behind in sales… These problems probably aren’t unusual They are betting the farm on Christmas sales—that’s when most co’s make their money What are you going to do? Sue them—yah breach of contract, but you are still without products. • Where are you going to sue them? There aren’t really any court there… • The last thing they want to do is get involved in is a law suit…they want the goodsthey are new and they need to get some sales. o Torrance wasn’t very good either… At some point you need to stop coming up with improvements and get the product together. Hard to do because you want to put out the best product o Trainwreckdidn’t get product out. Orders cancelled. Customers not happy. o The sales and distribution partnership with Blizzard is working well… Their plant in Cleveland might be a perfect fit for media stream… • Pros of acquiring blizzard: it’s your plant, you have control, everything is under one roof, their expertise is valuable, lower cost of living • Cons: 10 year old plant (but has been updated), still not in ca. • What about how the purchase is structured? o 4 million cash up front: financing this has to be a good business deal • manufacturing profit—is this something that we can take now? Does it give us better control over our inventory, etc? • we need to do a discounted cash flow analysis one we figure out their income. o 2 million note: buyer wants this because he is leveraging rate of return on equity is an important number • Leverage up—higher rate of return on equity (riskier though because you need to pay this money every month…) • You’ll pay 5% now and roll 2% forward which is due when the note is due (just cumulates…balloon at the end)—cumulative 7% interest rate • What about purchase price? 6 million o What is the multiple of ebitda? Is it rx? • He could borrow the money (mezzanine lender), but the terms aren’t going to be great… o Much easier for seller to finance—nicer terms if he wants to sell • Debt o Secured v. unsecured SecuredDebt secured by some asset (mortgage on real estate, financing statements on everything) • If default—the debt holder stands first in line to get payment from secured assets o Senior lender v. junior lender May have several different classes Subordinated under more senior debt • Interest rates will get higher as you go down • Newcopurpose was to acquire sellers assets o Assets given for money from newco. o Newco buys assets and specified liabilities (it only wants to take certain liabilities…not unforeseen ones) It would be very clear what liabilities it was taking—just enough to continue business o Where does newco get money? From investors. o Here there are 3 separate pieces to work out… Actual acquisition Equity financing • Common and preferred stockholders. Everyone got a unit. Debt financing • Get the remaining 21 million through leveraging. o Senior debt would collect first o Subordinated Mezzanine debt— higher risk because senior debt gets first. Higher interest right and warrants at a cheap nominal price (equity upside) Might also have a right to put the warrants to newco at the difference between the strike price and the value of the underlying stock o Intercreditor contract—will set out how the senior and mezzanine debt will react on various circumstances. Negotiating this can be very difficult. Item 14—asset purchase agreement o Between buyer and sellers and stockholders o Definitions-extremely useful…where lots of negotiation takes place o Assumed liabilities—section 2.3…which selected liabilities the company is assuming o 2.1—purchased assets assets—we are buying these assets minus the excluded assets o Purchase price: 820,000small deal o Allocation of purchase price To the extent that buyer pays more than what the company is worth—this is good will and can’t be carried onto the books. • On top of good will we will probably have a convent not to compete—don’t want him to go next door and destroy the good will we paid a lot of money for. o In ca—this is the only time that the covenant not to compete is valid: must be reasonable in scope and duration (normally about 3 years)narrowly construed o In other states its more easily enforced—freedom of contract rule: anything you can agree to the court will enforce o Prima facie not enforceable—in employment contracts (in ca.) o Abuse of process—tort (from fraud) if companies put in certain unenforceable clauses o Tax requirements on how much of this you can use for covenant not to compete Assets are carried at the books on cost less depreciation (not current economic value) The more we can allocate to the assets the more depreciation we can take—non-cash expense Amortization: usually the useful life of the asset (what you buy). o Closing date—when the deal is consummated What happens after closing…who delivers what. o Warrantieswhat each party promises. Opinion of counsel from seller—says that lawyer thinks everything is truthful and honest. “fairly present”—we’ll indemnify if this isn’t true. o Schedules are attached at the end Monday, 11/8/04 VC’s are going to buy 1/3 of the company Look at item 27 on the CD Session 12 o Media stream is doing well…they are up to 21 million in 2004 o They are considering taking the public company Why would they want to do this? • Easier to raise money—can offer more stock for money • People can cash out • Market exposure—traded every day, brokerage firms will start to cover them and the financial press will be there. o Increases public awareness • Gets lots of money right now • Greater liquidity • Subject to SEC regulations and filings o Disclosure required Sarbanes-Oxley disclosure: MD&A o More public information Proxy statements o Easier to get stamp of approval for loans because they are regularly audited and reviewed by the SEC o Also, it will be more likely that you’ll catch insider trading Why is this bad? • It’s costly o For our company—300,000-400,000 will probably be the cost of compliance Not exactly chump change o For bigger companies, it’s barely measurable • Greater liabilities because of SEC Acts o Investors want to know what the company will do with the money that they raise o Should investors be skeptical of earnings jumping from 30 million to 44 million? You want to see how they get their estimates about marvel box series II • Is it around, can you demonstrate it? • How’d you get your estimates “Hockey stick”: where earnings go from flat to shooting up • might be entirely justifiable, but maybe not o Blizzard acquisition has been successful based on the numbers o What is the filing range of the common stock? Price per share that the market will bear. • Depends on different information and different assumptions • Pre-filing and post-filing quiet period o If you don’t follow it, you’re offering is going to be delayed o They might start an enforcement action against the company—another disclosure in your registration statement Chart on bottom of 12-1 shows the possible range of prices for the shares • The numbers in the net income column are dependant on what the market will let the company use as the predicted income • It will take at least 90 days to get to the market o A lot can change in 90 days The window can close overnight • World events like 9/11 affects the market o Fully diluted—any share that can be, is converted to common shares (options, conversions, etc) Don’t overlook the impact of fully dilutedimportant • 6759.5 is the average between 2005 and 2006 o you don’t know what the market will choose • P/E: price/earnings in this sector—20-50 o So you need to try different numbers • What’s the conclusion of this table: what’s the price per share, based on the assumptions we are making? 7.20-14.40 o Only immediate importance is that issuer is required to put on cover page the estimated public offering price. The market wants to know The SEC calculates its filing fee based on number of shares and expected price o What’s the significance of how the company characterizes itself? It is reflected in the P/E ratio. • Companies will want to be in a market segment that gives them a higher ratio • If you are making what media stream is, you want to be on the high end of manufacturing—not towards the lower end (maytag) What’s important about P/E? • It’s a measure of desirability: how much the market will pay for your company • If you start paying over 20, you are getting in the range of such speculation that it becomes very speculative and not realistic Public company is P/Emarket price/net income minus taxes • Different for private company because you don’t have general market price…illiquidity overhang. o 30-45% more for public company because liquidity is important o 2 presentations were made to the board: Mike and Chip: 2 different Investment Banks • Mike says 12 is good price o “Great regional firm”—flippant comment by bigger firm • Chip says 14 is good price o Is it true that Chip can get more for the company? It’s a national firm so it has more resources o They have more experience, so they have more knowledge and can probably get more money. • They will form a syndicate—so it’s not them buying all the shares. o There is some difference in ability to put together a better syndicate based on reputation of the firms o Why does lawyer want one of the big 4 auditing firms to do the financials? More credibility IPO’s are very dangerous for big auditing firms—costs are way up • They used to actively recruit them, but it’s too costly with all the SEC regulations They are being very selective—media stream might have to settle for lower tier o Roll up to C Corporation LLC—whatever your gains/losses are, they are yours personally Can’t have an LLC treated as an LLC with more than 100 shareholders • You’ll be taxed as a C corporation LLC’s aren’t practically allowed in a public company There will be a statutory procedure from changing a company from an LLC to a C corp. • You’d have to organize a new corporation and merge them • There are lots of tax gimmicks involved. You lose the LLC tax characterization (transparent) • With C corp—the corporation will be taxed Really can’t have a public LLC o Why Delaware? The law is more predictable You can merge an entity in one state (organized in one state), to the extent that your home state and new state law permit it. • Delaware laws permit roll up’s to Delaware from CA o Look at both CA and Del.’s legislation Most companies will re-incorporate in Delaware when they go public. • 2115—exempts Delaware public companies Avery’s list of things to do: o Review option plan—reserve 15% of the shares after IPO for stock options o Get high visibility director Want D&O insurance • How much would you like to have? o For companies this size—you want 25-30 million, which will probably cost you a lot. You’d obviously want more, but you won’t be able to afford Indemnification agreements with the companies—why do you want this? It explains that the company will pay your legal expenses. Chances are these cases get settled…so you want the company to pay your legal fees. • Should it turn out that the court decides that you breached your duty…then you’ll have to pay it back. • Want an agreement because if control changes you want to make sure that the company has your back…you want a contractual right to this • It’s about who pays the legal expenses and when Indemnification: state corporation laws will provide that the company pay/indemnify it’s officers/directors from various liabilities (del. Section 145) • You can’t be indemnified for your own misconduct o Possibly negligence…but not gross negligence o Won’t cover your breaches of duty • Companies indemnification is only as good as it’s net worth. o Therefore, you’ll want insurance, which is expensive 10 million in insurance will probably cost you 50 million o Also, other suggestions: some available in CA, some not (based on corporation code) o Don’t to opt out of Delaware GCL section 203—203 says that an insider attempts to do a deal with a company you can’t do that deal for 3 years. Other ways to get around this…whole board must approve Anti-take over section in Delaware law • Something similar in CA o Poison pill= one of various protection measures in case there is a tender offer Lots of variations Stockholder rights plans—requires companies to issue rights to the nontakkin over shareholders to give them the right to buy into the company and overcome the plurality of the take-over company. Going IPO o Time & Responsibility Schedule: it will list all the participants and all their contact information and also what they are responsible for. It will list what will happen every day. Helps keep people on track. It will be constantly updated. o Registration Statement (generally, form s-1)—there are several types of statements depending on type of company and what securities they are offering. Prospectus: included in registration statement—look at form S-1 and regulation C • Distributed to prospective shareholders • Discloses items in a narrative form • There will be numerous drafts of the registration statement—must back every word up. You’ll have to have a note to back up your statements. o Try to reduce to factual statements Red hearing: preliminary statement • It has a legend in red stating that it’s preliminary and hasn’t been approved/subject to amendment • You used to distribute the red hearings right away, because that’s how you form the syndicate. o Now they’ll usually wait until the SEC comes back with its initial comments Costly if there are material changes o SEC will give comments on the filing within 30 days • The syndicate department of the underwriter will form the syndicate (send out invitations to other brokerage firms around the country) Amendments • It will usually be amended numerous times o The sec will comment, and the company will respond, etc. o Accounting comments and narrative comments They can disagree, but it needs to be explained and figured out. • Can have multiple amendments o Better law firms won’t have multiple amendments • Last amendment will be price amendment o After you get through the amendment stage, the SEC will ask you when you want to file…then you’ll file the night before with the agreed upon price. o Syndicate will usually want to come in a little bit below projected price (so that there will be gradual upwards pressure) Revisions/Pricing o Agreement among underwriters Syndicate agrees to purchase x number of shares at y price (minus the spread—about 7.5%) • They are buying wholesale Their commitment to buy is affected by their net capital (calculation under 34 act about how much an underwriter can undertake at 1 time). Their ability to do deals depends on their net capital. Will set forth who is the managing underwriter • From 7.5% there will be a managing fee There will also be an underwriting fee o Underwriting agreements This is an exhibit to the agreement among underwriters It’s an agreement between the underwriters and the company— representations and warranties The underwriters can sell some, or lay some off to selling group o Selling group agreement They don’t commit their capital—they are just going to sell and they are just going to take the selling commission o Effectiveness: registration statement declared effective The underwriters are on the hook, but they have already pre-sold so they are off the hook. o Closing Company will get offering price minus the spread. • From this, they’ll have to pay costs Firm commitment v. best efforts o Firm commitment: agree to be shares at x price minus spread Doesn’t become binding until closing (when it becomes effective) • By then they will have placed the securities…they really don’t become bound until just before the offering (about 60-120 seconds) • The people they are selling to can back out at any time until they accept. • The underwriter will over sell the offering because some people won’t follow through Green shoe over allotment—extra shares reserved for over allotment by underwriters Under spread you have: o Management fee: usually 1 point o Underwriting fee: fee for committing your net capital o Selling commission *PRINTED OUT* 33 Act gives lee-way for underwriters to do their job… Monday, 11/15/04 Get notes!!! Who is regulating IPO process? o SEC o NASDAQ o Stock exchange NYSE AMEX NASDAQ—new company…probably here o State blue sky laws—most of these say if you are registered with SEC it’s ok with us. o Have to comply with all of these In registration—have to comply with SEC regulations o As soon as the board has decided to go forward with the IPO they are deemed to be in registration and the significance is that anything could be an unlawful prospectus. It could cost you another few months while you are waiting around. Regulation C—what they can do before or after they have filed. • Careful rules Why go public? How to select the best underwriter? o One who knows your market—experience o Reputation—they’ll make the sells: there are lots of underwriters… Big firms: bulge bracket—big allotment of stock • Their reputation rubs off on the company—good housekeeping seal of approval How is the price of the stock determined? o Most IPO’s go off in the range of 10-20. There is going to be a stock split to get the valuation down to 10-20. Float: stock that is out there, being traded. How do we know how much stock to sell? You have an idea about how much money you want to raise o One of the disclosures is how you are going to raise the money. o Need to have an active market, but don’t want to give up control o Usually IPOs sell 15-30% of their stock What if you only wanted to sell 10% of the company? Underwriters will say that they don’t have enough float…what is the alternative? o The underwriters might go to principal stockholders and ask them to sell their shares. They will ask some of the principals to put some of the stock out there. The proceeds go to the selling shareholders, but there will be enough of a float out there. o Company wouldn’t need more money if they are generating a good cash flow. Getting stock to company employees, friends and family….generally the SEC have gone every which way. The company does an IPO and they want to give their employees the opportunity to buy at the offering price, plus some of their friends. o Generally you can do this up to about 10% of the shares. The legal issue is if there is a public distribution, if a large enough amount of the stock is predetermined. • Generally 10% or less will work Registration statement is prepared by all hands, but company counsel will take a big role in it. They need to verify the statements made in it. Camel= horse drawn by committee. The difference between a registration statement and a prospectus? o The prospectus is part of the registration statement. o The registration statement is a whole bunch of papers, and inside of it is a whole bunch of papers. o Exhibits are part of the registration statement—articles of incorporation, stockholders agreements, other agreements between the company and others, acquisition agreements, IP rights When the registration statement is filed—it goes to a branch chief o It has SIC codes about what type of company this is. o The SEC is divided into branches, which specialize in different industries. They will review it to make sure: it makes sense, it’s understandable, that it can be backed up (support provided) Chief accountants will look at the financials You will get 2 types of review: accountants and general overview Response from the SEC in writing, and there will be some telephone calls and there will be an agreement about what the fix is. When is a stock price determined? It is set the night before between the managing underwriters and the company. o The underwriters want it lower because they want to give their clients some profits. they are concerned about the market—they want the market to have some action and so they look at their competitors and all the others that have gone public. They’ll be getting feedback from members of their syndicate. They want to see their offering have a nice steady rise. They can sell it at a fair price and their stock has a potential to grow. • Current market trends—you can only go so far with scientific analysis. You can be objective up to a point and at the end of the day it’s as much art as it is a science. Looking at SB-2: small business form 2 o Cross reference= lets the SEC know where you’ve addressed every item o Red herring= print is in red—lets people know that this is a preliminary prospectus Draft of the prospectus—price is going to be different than the filing price, but you’ll file an amendment Managing underwriters will get about 20% of the spread (7%) Prospectus summary—what you’ll find in the rest of the summary. Risk factors—most are boilerplates Use of proceeds—they need to make some assumptions about what price they are going to go out at • Form S-R: how they actually used the proceeds Dividend policy MD&A—extremely important: supposed to explain why the business has changed. • If there are going to be comments, they are going to be here! Business—this is the brand, this is how we do it • Every word will be tied down as an accurate statement Certain transactions= insider deals (affiliates of the company) Underwriter section: won’t list final amounts until the final prospectus— the final underwriting group F pages—index to financial statements Amendments come from SEC comments Final cover page—no red herring and all the spaces are filled in SEC comments—saying what they would like to see changed. Letter asking the SEC to accelerate the effective period (also make the 34 Act forms effective) The SEC letters are all after the fact—there is a lot of trust between the SEC and the people practicing before them. Underwriters power of attorney—gives managing underwriter power to act on behalf of syndicate Agreement among underwriters—who gets to take what Underwriter commission—given for their work. They will also get a fee if they commit their money. • There is also a fee for just selling the stocks. Underwriting agreement—says how the companies will do the underwriting • Defined terms • Statement about who is going to do what to whom • Warranties • Closing conditions • They are usually all the same and very old fashioned Until a buyer receives the prospectus, he can rescind the deal—but usually the underwriters have pre-sold the shares. • The underwriters know that there will be a certain number of people that will drop out and there is no way to enforce it. Therefore, they will oversale and there will be a greenshoe option (in case of overallotment) o This is also short selling: selling stock you don’t have. o This causes a second closing: where they close the initial offering and then close the overallotment closing. “Greenshoe”=what happens if there are overallotments. The greenshoe no action letter— the SEC addressed the question about what % of the initial offering can be overalloted15%. The purpose is to cover shorts. Can’t bind the buyer until they make commitments. Monday, 11/22/04 Example financial statement o Start out by looking at the accountants letter. If it’s only good paragraphs then its good news. o going concern exception: the last paragraph where the auditor is saying that the company is in default. If the company is not a going concern then it’s in trouble. Why are you worried if it’s not a going concern? • Not making any money • A lot of debt (more debt than equity) o Capital structure that has been so layered that it’s very difficult to figure out how we are going to get out of it. No cash flow o Here, the accountants didn’t walk…they just warned. o 2 ways a company goes bankrupt: once you are bankrupt you are done for (scarlet letter) liabilities greater than assets no cash flow—can’t pay debts as they become due o Fair assessment is all that is required, unless there is a going concern paragraph o Cash items Certificate, overnight deposits, CD’s—anything that can be easily converted o Uncollectible receivable—different time periods depending on industry o Inventory will be way down if it’s not a going concern o Current portion of long term debt (more than 12 months)—the interest due this year o Look at the footnotes o This company has way more debt than preferred stock…they aren’t getting any money. o This is not a big enough gross profit (30%) In a service company you shoot for 50% profit • So what can they do? Raise the price or lower the costs o This is a very competitive business…there is always someone who will do it cheaper. o Their SG&A is about 1/3 of their profits… How do you analyze a company? Compare the numbers with other companies in the industry o Accounting properties will vary business to business o How long do you write off goodwill? It used to be 15 years Goodwill-what you paid for the business and the hard assets on the books. Now, you don’t have to write it off unless the asset has become impaired (shut it down) o Related transactions—companies that have control over each other and participate in transactions (this will require stricter scrutiny) o Voidable—the other company has the bur