Venture Capital & Start Ups Outline by Cinhsieh

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									                                           VC & Start up Outline
                                                THE VC INDUSTRY

      a. Silicon Valley has market share over #2 region (New England) by a ration of 4 to 1
                i. SV has an attractive infrastructure: universities, clustered tech companies, lawyers, money
      b. Currently, no IPO market. M&A/IPO exits are only 20:1. But back in 1999-2000, it was 1:1.
                i. 2007 was the 4th largest year ever in VC investments in the US - $31billion
               ii. 2008 & 09 were down, but there is cautious optimism for 2010
             iii. In general, U.S. IPO market is NOT a viable exist to most VC backed companies
              iv. IPO Market open only to companies with substantial and predictable revenues and economic fundamentals
      c. Two ways to get liquidity. It‘s now taking much longer from the date of first funding
                i. IPO: 2.8 yrs in ‘99, 7.8 years in ‗09
               ii. M&A: 2.1 years in ‘01 to 4.8 yrs in ‗09
             iii. So, more capital is req’d to carry the co to an exit event
      d. The company is the nexus of contracts b/w all the parties.
                i. Entrepreneurs/founders bring ideas
               ii. Employees have K agmt with Company
             iii. VCs give money to the Entrepreneurs, have K with the company

      a. Their reputation can go even farther than the size of the fund.
      b. Provide risk capital for start ups
      c. Assist in strategic direction & guidance on operational/management issues
                i. Entrepreneurs usually have the ideas, but not the business know-how or personalities to run a company.
                   VCs put in $$ AND have operational experience.
               ii. Also help with business strategy & help decide the legal structure of the company
              iii. When they are on the board, they may not participate in daily business management but will have very
                   close relationships with the founders
      d. Act as agents for fund LPs – the LPs are the ultimate capital source
                i. LP‘s: insurance co.s, universities, endowment funds, pensions funds, large institutional investors
               ii. The VCs have a fiduciary duty to the LPs in managing their money or fund.
      a. Estimated that a CEO of a successful startup can make $6.5 mil in 5 years. A VC can make that amt or more, but
         takes on far less risk. VCs can diversify bets and come out net winner
      b. VCs are expected by their investors to produce a ROI (return on investment) of at least 20-25% per year
      c. In reality very few successful high-tech deals are done w/o classic venture capital.
      d. VCs often command a lot of control in the company
                i. Seat on the board of directors: influence slaraies, options of shares granted to employees, structures of deals
                   w/ suppliers and customers, timing/pricing of the next addition of capital
               ii. Approving budgets and annual operating plans
              iii. Exercise of special covenants in the terms of the K for the preferred stock that was sold to the VC.
      e. But control can be positive, as the VCs bring with them a lot of experience and connections
      f. Process of raising VC
      a. When VCs put $$ into a co. there are a # of outcomes one of which is $0 in return (more common). Then there are a
         few successes which make up for the failures
                i. Enough of these home runs make the high risk tolerable
      b. In last 10 years, VC returns are much less, some have even been negative. In 90‘s it was 40-50% returns
      a. Private  Goal is purely financial
                i. Sequoia, Kleiner Perkins
               ii. Investment mangers (GPs)
              iii. Significant # of institutional and individual investors (LPs)
              iv. Clear financial agenda (more returns!)
      b. Corporate or Government  Goal is NOT purely financial, usually involves a strategic purpose

                  Intel Capital, In-Q-Tel, Seagate
                  ―strategic‖ investors
                  Investment managers are corporate employees
                  A single investor – the company
                  Financial agenda combined with a commercial agenda
                       1. gives the investing company the option of buying the start up later, instead of having to create that
                            technology out of scratch
      a. Structure
               i. Most VC firms are formed as limited partnerships
              ii. GPs are the fund professionals
                       1. Most have significant operational experience before joining VC firm
                                 a. but realize that success is usually aided by good luck/timing
                       2. Many VCs have MBAs or engineering degrees
                       3. Even some lawyers in there
                       4. GP (general partner) has unlimited liability
                                 a. Although the GP is typically a corporation
             iii. LPs (limited partners) by definition have limited liability. They are liable only for the amount of their
                  investment in the fund. Put up the $$, typically consists of pension funds, financial institutions, university
                  endowments, investment management funds, and the like. SMALL percentage of individual investors.
      b. Historic structure

                i. There may be many different funds under the same ―umbrella.‖
                         1. Can have VC Firm I, VC Firm II, VC Firm III – and each may even have different GPs and LPs
                              but are under the same general umbrella
                         2. May have different funds for different reasons, i.e. one for new investments and one for old
                              ―follow-on‖ investments (old companies that need more funding)
        c. Process:
                i. GP will ―raise‖ a fund. Doesn‘t mean that the LP will actually give them the $, it means they have a K
                    (often over 10 years) where the GPs can ―call on‖ this $$ for new investments.  ―capital calls‖
               ii. Every time they do a new investment, they budget how much $$ to give the co. and for how many years
                    that $$ is needed.
        d. Compensation
                i. General Partner (GP)
                         1. Management fee: 2-3%
                                   a. Normally 2%. 2% of the total funds committed (NOT necessarily deployed), even if
                                       not all the funds used  Made annually
                                   b. GP receives this regardless of the return
                                   c. So 2-3% every year, over 10 years
                                   d. EX. if you raise a $2bil fund, 2% of $2bil = $20mil a year for 10 years = $200 mil ($800
                                       mil left to invest)
                         2. Carry interest: 20-30%  Share of any of the profits made
                                   a. Typically 20% of the net profit (= after the management fee over the lifetime of the
                                       fund is given the GPs AND the remaining original investment is given back to the LPs)
                                   b. Naturally, the remaining 80% (100%-20%) of the net profit is the LP allocation
                                   c. EX. if we make $500mil on the $800mil we invested, the GPs gent their share, then the
                                       balance goes to the LPs.

              ii. Limited Partner (LP)
                        1. Return of original capital minus the management fees over the lifetime of the fund
                        2. Then (100% - carry) allocation of the net profit
             iii. But if fund > return, then NO net profit, then
                        1. GP only gets the management fee
                        2. LP only gets (fund – management fee) back
      a. High tolerance for risk and uncertainty, unlike banks and financial institutions
      b. Intense focus on investment performance
      c. Ability to bring capital AND business acumen to business
      d. Ability to bring substantial business contacts in the local community to the benefit of the start up
      e. Reputation of the VC fund itself can validate the business of the start-up
      a. Fundraising is essential to the continuity of the VC firm
               i. Serial activity: as a fund is depleted, the fund partners have to raise money for successor fund (if they can)
      b. Top tier funs are surviving; many of the lesser funds drop out as they simply run out of capital
      c. A fund is typically expected to have a 10 year life span
               i. First 5 years is devoted to finding and supporting investments
              ii. Next 5 years is focused on almost entirely on supporting investments (ie. no new investments) – ―follow on
      d. Each fund is traditionally allocated 40% to new investments, 40% to follow on, 20% to management fees (2% for 10
      e. Fund size is important and have gotten larger over time in response to a changing economy – 10 years ago there
         were NO billion $$ funds and a $100mil fund would‘ve been considered large
      a. Only about 1-2% of the start ups that VCs hear from get funded
      b. Process
               i. 2,000 leads. Some are more qualified, i.e. recommendations from firms or others
              ii. 300 mtgs
             iii. 150 are actively pursued. They are ―engaged‖ w/ this lead & spend time w/ founders to learn about the
                   business idea & founders to decide if they want to finance
             iv. 20-50 are actually financed. Decisions are made differently in each firm, some require a unanimous vote,
                   some just require a majority.
      c. Getting a VC term sheet is very difficult now.
      a. Payback ratio: how many times of their $$ they want back
               i. Simple ratio showing amount of money coming back measured against amount invested
                        1. eg. $1 invested, $5 coming back = 5:1 payback ratio
      b. Return on investment (ROI) – also takes into account the amt of time it takes to get the $$ (money has time value)
               i. Measurement showing amount of money returned as a percentage of amount invested.
              ii. Return amount is (total yield coming back) – (original invested principal)
      c. Committed capital
               i. The amount a LP Ks to commit to a certain fund over the fund‘s investment life
              ii. Captured in a subscription agreement that each LP signs
      d. Deployed or invested capital
               i. Amount of capital that is actually paid to the VC fund and which is then invested in the fund‘s portfolio
                   companies  $$ that has actually been ‗called‖ on
              ii. Usually, capital called by the fund at 20% increments of 5 years, representing the typical investment life of
                   the fund.
      a. Objective: most VC firms expect every portfolio company to generate at least a 40% ROI
               i. Aka a ―payback ratio‖ of 5:1 or better
      b. Basically, you need to make the difference from 1.4x what you had last year. So over 10 years, you want to have
         coming back = (original invested principal)*(1.4)10 = (original invested principal)*(28.93). So ―return‖ = (coming
         back amount) – (original invested principal).
      c. ROI = (return)/(original invested principal)
      d. EX. Invest $5.00
               i. End of yr 1: $5.00 x 1.4 = $7.00

                   ii. Yr 2: $7.00 x 1.4 = $9.80
                  iii. Yr 3: $9.80 x 1.4 = $13.72
                  iv. Yr 4: $13.72 x 1.4 = $19.21
                   v. Yr 5: $19.21 x 1.4 = $26.89
          e. Chance of success of any company takes into account a number of different events, and the success does not
              necessarily depend on the probability of that ONE even happening. So even if the probability of the following
              events is 80% EACH event, company has sufficient capital, management is capable/focused, product development
              goes as planned, production and component sourcing goes as planned, competitors behave as expected…etc….the
              combined probability of success may just be 17%.
                    i. Why so low? The chance that ALL the conditions will be present at the same time over extended period of
                       times is VERY low.
    L. Worksheet

                                                    AGENCY THEORY

      a. Principal hires agent
      b. Legal responsibility of the agent is to look out of the best interest of the principal
               i. But in reality, there will always be conflict between the interests of the principal and agent
      c. Here, Principals: shareholders. Agent: board of directors.
               i. Board of directors owes a fiduciary duty to the SH.
              ii. BOD then appoints management (e.g. officers like CEO), who then runs the company.
      d. Conflict of interests
               i. BOD and management group
                       1. eg. John Thain spends $1m to renovate his office
      e. Agency theory
               i. Absolutely impossible to perfectly alight the interests of principal and agent
              ii. ―Shirking‖: actions by managers that diverge from the interests of the SH
             iii. Only can think about how to minimize loss (eg. Cost) to the principal
             iv. Costs
                       1. monitoring costs
                                a. principal making sure that agent is doing what he‘s supposed to be doing
                                b. eg. Audit costs, Sarbanes-Oxley,
                       2. bonding costs
                                a. what company does affirmatively to align the interests of the BOD and those of the
                                b. eg. Stock options or any kind of equity incentive (very common in Silicon Valley)
                                c. eg. Cash bonuses payable on performance milestones
      f. Other issues of Financial Ks/Agency
               i. Adverse selection
                       1. idea that anytime that anybody takes a position, you should have a natural cynicism that that position is
                            adverse to you
              ii. Moral hazard
                       1. That you may be doing things that will incentivize behavior that will not be in your interest
                       2. eg. TARP bailouts and spending
             iii. Asymmetric information
                       1. Parties on different sides of a deal have disproportionate information on the transaction
                       2. eg. Shot gun weddings between companies
                       3. eg. Used cars
                                a. seller of car has superior knowledge of the product
                                b. buyer knows less and also has a cynicism towards the product
                                c. thus, you will get an average price. Thusly, half the market will overpay and the other half
                                      will underpay.
                       4. eg. Origin of the IP
                       5. Mitigated with due diligence
             iv. Ks with
                       1. employees
                       2. suppliers

             v. Stock option
                      1. K right to buy a fixed number of shares at a fixed price for a fixed period of time
                      2. eg. Employee option to buy 1000 shares of INTL at $12/share for a period equal to the lesser of (1) as
                          long as you remain employee or (2) 10 years
     a. GS‘s business
              i. Investment banking/financial advisor for stock issuances. Aka Underwriting
                      1. example
                               a. 4/1 file S-1 with SEC
                               b. 5/1 SEC comments
                               c. 6/15 SEC review is over
                               d. Roadshow
                                         i. GS goes to large investors about buying shares of the company‘s IPO
                               e. Pricing
                                         i. GS goes to company with the offers that they‘ve gotten for the IPO company‘s stock.
                                        ii. Then GS prices the each share.
                                       iii. GS and the IPO company then enter into an ―underwriting agreement‖ (just another
                                            financial K). At the point that GS signs this K, that is point where they start taking
                                            on risk.
                                       iv. Moderate risk
                                        v. GS then buys the stocks as closing.
             ii. Advisory for M&As
                      1. GS comes in to help negotiate favorable terms of the trxn
                      2. GS has engagement letter, but are not usually at risk.
                      3. GS can be exposed to risk if it signs a fairness opinion.
                      4. Low risk
            iii. Trading
                      1. proprietary trade
                               a. using GS‘s own capital to take on market risk
                               b. MOST risky business
                      2. asset management
     b. In general partnership, because partners are trading with their own capital, it actually enjoys less risk.

ERA                           PRINCIPAL                MANAGEMENT                     COMPETITIVE          LEGAL           COMPENSATION
                              BUSINESS/RISK            STRUCTURE                      LANDSCAPE            STRUCTURE       STRUCTURE
Early GS (pre 1930)           Underwriter of CP –      Management                                          Partnership =   Base Salary + % of profits.
                              medium risk              Committee consisting                                personalized    Lock-step compensation w/
                                                       of partners – agency                                liability       seniority determining amt.
                                                       issues not this large at                                            Capital is coming from
                                                       this pt                                                             partners.
Weinburg (1930-1968)          Relationship based i-    Same                                                Same            Same as before
VERY successful               banking; medium risk
preeminent co.
Levy (1969-1976)              No longer club-like.     Levy doesn‘t like              Hostile Takeove                      Same as before. They‘ve
BIG changes in bus. at this   Many diff branches w/    management comm.,              became big. B4                       been making a LOT in this
pt on – gets in trouble for   diff management..        loosens control.               no one would                         period.
first time.                   Increasing Risk.                                        work on these.
Weinburg/Whitehead            M&A increases, trading
(1976-1990)                   area is in trouble.
                              Increasing Risk
Friedman/Rubin (1990-         Increasing Risk                                         Start to hire                        GS can only give out cash,
1994) 1 from trading, other                                                           laterals for first                   competitors can give out
from asset management.                                                                time (attrition                      stock (public), incentivze w/
DIFF views on risk and                                                                high). When bus                      stock. GS not on merit – no
management.                                                                           is bad in ‘94,                       incentive
                                                                                      partners start to
Corzine/Paulson(1994)         Increasing Risk

       a. When VC funds a startup, do VCs want the company to take high or low risk? HIGH. VC is riskiest form of

                    i. VC trends
                            1. More interest in taking equity
         b.   Differences between East and West coast VCs.
                    i. West coast is more risky.
         c.   Different levels of risk are also determined by the type of industry
         d.   Preferred stock
                    i. Has liquidation preference
                   ii. What VCs get
         e.   Common stock
                    i. Has NO liquidation preference
                   ii. What founders and SHs get
                  iii. Such structure incentivizes the company to get over the liquidation hurdle and try to make as much money as
                       possible. Later, liquidation restriction is gone.


      a. Liability of SH/entrepreneurs/management for creditor obligations of the business
      b. Tax efficiency
               i. Extent to which business structure will minimize aggregate taxes paid in connection with the business
              ii. Double taxation like in C Corporation
             iii. Pass through vs. Non pass through entities
                       1. Passing tax liability to someone else who hs more capital may have many advantages
                       2. In general VC firms don‘t invest in pass through entities
      c. Financiability
               i. Extent to which the business structure will accommodate financing requirements of business
              ii. Will VCs want to contribute?
      d. Employee incentives
               i. Whether business structure is sufficiently flexible to accommodate some form of equity incentive/participation
              ii. This is an important area for start ups that can‘t afford large salaries but hope this will encourage
                   motivated/skilled employees will sign up
      a. Summary
               i. Sole proprietorships – very rare
              ii. Partnership
                       1. general v. limited partnership
             iii. Limited Liability Company
             iv. Corporation
                       1. ―C‖ corporation v. ―S‖ corporation
              v. Most start ups consider either LLC, C corp, or S corp
      b. Sole Proprietorships
               i. NO legal entity If you want to start a business with NO filing or formalities, they are sole proprietorships
                       1. VCs DON‘T invest in sole proprietorships – there is NO protection
              ii. ―mom and pop‖ shop
             iii. One level of taxation. For liability and tax purposes: the business and the entrepreneur are the same
                       1. assets of entrepreneur available to satisfy claims of creditors of the business. Liability & taxation is full
                            for the entrepreneur
                       2. Earnings are taxes at the individual rates of each person investing
                                 a. earnings taxed at indiv rates to the entrepreneur regardless of whether actually distributed
             iv. no ability to obtain 3rd party equity financing
              v. limited ability for equity participation by employees
             vi. actually, don‘t hate on this tooo much because if you‘re just a programmer working by yourself, many times
                   you can remain as a sole proprietorship until your business needs to interact with other people
      c. Partnerships
               i. General partnership and limited partnership
                       1. Limited partnership has LPs and GPs
              ii. General partners have joint and several liability (eg. Creditor can sue from either or both of the partners)
             iii. One level taxation (pass through entity  IRS does NOT look to the legal entity and straight to the personal)

                  1. Problem: you must pay taxes in all the states in which your business operates
         iv. LP may be financing vehicle but limited by number of participants, transferability
          v. There are a LOT of successful companies that are partnerships – like law firms & private equity firms. But
              almost NO partnerships are VC funded. Not something a VC will gain enough on…why?
                  1. Complexity to investors
                  2. Pass through tax entity
                  3. Employee initiatives
d.   Limited Liability Companies (LLCs)
           i. Most states allow LLCs – they are a creation of statutes
          ii. Created solely for tax purposes
                  1. LLCs have pass through taxation – i.e. income/deduction/credits/losses are passed through to indiv
                        members, resulting in only ONE level of taxation
                  2. B/C OF THIS,VCs do NOT want to invest in these b/c it would be subject to taxation much like a
                        partner in a GP would. This is bad for a VC b/c:
                             a. Tax-exempt investors in a venture fund may incur unrelated business taxable income
                                       i. VCs don‘t want losses flowing through to limited partners
                             b. Foreign investors in a venture fund may be subject to U.S. taxation
        iii. Can grant options (but there are lots of complexity here)
                  1. Not like Corp option grants that are standard. LLCs require a option plan that is specific to the
                        company, so its more costly for legal fees
         iv. Combines corporate and limited partnership attributes: limited liability of the owners, but pass-through of
              federal tax consequences
          v. LPs can have management roles
         vi. In essence, an LLC is a limited partnership without the requirement of a general partner
e.   Corporations
           i. Corporation is a separate legal entity formed under the corporate laws of jurisdiction
                  1. CA Corp code
                  2. DE general corp code
          ii. A legal ―person‖ with ability to won property, enter Ks, corp is subject to taxation
                  1. Formed by the action of the incorporator by the filing of the ―articles of incorporation‖
        iii. SH have limited liability in the corp. They are only liable to the amount of money that they put in
         iv. Formed by the action of an ―incorporator‖ by filing ―articles of incorporation‖ with Secretary of State (in DE, a
              ―Certificate of Incorporation‖)
          v. Limited liability for shareholders
         vi. Taxation at corporate level and as dividends when earnings are distributed to SH – double taxation
        vii. Corporate attributes
                  1. Flexible capital structure. Abilities to:
                             a. Add any number of classes/series of stock
                                       i. Many types to pick from…pref v. common; different series; ―nonvoting series of C
                                           stock,‖ etc.
                             b. Issue any number of shares
                             c. Sequence seniority of equity securities
                             d. Value stock at any price – may even have diff prices for same stock
                             e. Transfer equity interests easily – can sell or buy corp shares very easily – not easy to buy
                                  membership interests in other forms
                             f. Issue debt
                  2. Well defined parameters for equity inventive arrangements (in contrast to a LLC)
                             a. Stock option structures are easy in corporations, but not in LLCs where they must be tailored
                                  specifically to that LLC. Stock option agmts for corps are well known and standard.
       viii. Optional benefits for corporations
                  1. exculpate directors from personal liability for monetary damages with exculpatory language in the
                        Articles of Incorporation
                  2. mandatory indemnification language in the bylaws
                  3. indemnification agreements with directors
                  4. director and officer liability insurance
                  5. incorporation in favorable jurisdiction
         ix. C Corp  total taxation rate ~50% (includes corp and personal income taxes)
                  1. but otherwise, very flexible and can allow for IPOs in the future.

              x. S Corp
                         1. EXCEPTION to general tax rule for corp
                                 a. only SINGLE (personal income) taxation
                                 b. Tax benefits and losses passed through individual s/h‘s – NO corporate level of tax
                         2. Only ONE class of stock
                         3. Must be domestic, owned wholly by US citizens, derive no more than 80% of its revenues from non-
                            US sources
                         4. Requirements
                                 a. no more than 100 SH
                                 b. all individuals (family trusts are OK)
                                 c. only one class of stock (ie. no preferred ok)
                         5. If you fail to meet these requirements you are automatically disqualified from S Corp status.
                                 a. ONCE YOU are funded by a VC, you are automatically NO LONGER A S corp (because VC
                                      firms are usually partnerships, which cannot hold shares in an S corp).
                         6. Compared with LLC
                                 a. both offer pass-through of tax attributes (no double taxation)
                                 b. both offer limited liability to all owners
                         7. Lacks from C corp
                                 a. No flexibility in financing
                                 b. No flexibility in giving employees equity
      a. DE is the preferred state of incorporation
      b. Factors to consider
               i. Filing services. Filing is harder/more annoying in CA. DE wants to attract companies so they make filing must
                   faster and easier.
              ii. Ability of counsel to offer legal opinions
                         1. CA: Very slow process. Sec of State may take positions that are different from where all the major
                            law firms stand.
             iii. Pro-management corporate law (CA tends to be more pro-management)
             iv. Cost of reincorp
                         1. Really slow to go from CA to DE
                         2. now, it‘s frowned upon to move from CA to DE because you‘ll be moving from a more SH friendly
                            state to a more BOD friendly state
              v. Ability to attract outside directors
      c. Why DE is Awesome as a place of incorporation
               i. DE offers a level of certainty that no other state can provide  a predictable, fair and well-developed body of
                   corporate law.
                         1. Special court system: Court of Chauncery (they do nothing by corporation law!). Cases are decided by
                            judges NOT juries.
                         2. DE has the body of case law that other states can‘t offer
                         3. Appeals from the Court of Chauncery can take place at the DE Supreme Court in a matter of days.
              ii. Procedural more efficient
                         1. Allows electronic proxy and attendance at SH meetings through the internet. Filings can also be made
                         2. DE also has a very tech savvy Secretary of State office (helpful for incorporation process).
             iii. High level of protection for directors
                         1. DE law is more in favor of directors (BJR, director indemnification, §120(b)(7) can limit the damages
                            for breach of due care)
                                 a. Good for IPOs. 2/3 of all public companies are incorporated in DE.
      a. B/c ―first in time‖ applies – important that Founder choose a name as soon as possible
      b. Where you want to incorp?
               i. Check with Sec of State to see if the name is available
      c. Where you want to do business?
      d. As a trademark?
               i. Check with online services & if have the resources, hire a outside search company to do a in-dept search
              ii. If not already trademarked, file for trademark.
      e. As a domain name?

      a. Broadly, the responsibility of a director is to promote the best interests of his or her corporation and its stockholders in
         directing the corporations business and affairs. They are generally given broad discretion
      b. Size: should be small enough to be accountable and to act as a deliberative body, but large enough to carry out all
         necessary responsibilities
      c. Inside (2-3). Runs the day-to-day business of the corporation
      d. Independent/outside. Experienced industry member, executives of other corporations
                i. comprise independent committees (e.g. to determine executive compensation)
      a. Want to make ownership clear so that at point of IPO, investors can be sure that the company owns it‘s IP
      b. Need to conduct due diligence to make sure that your technology does not infringe upon anyone else‘s IP
      c. Tax  IRS §351: If an investor‘s contribution is technology in exchange for equity, the transaction is tax free if
                i. Corporation must be granted exclusive rights to use, exploit and sell or transfer the IP right in a designated area.
               ii. It is part of the company‘s initial plan of organization (―transferor in control immediately after exchange)
              iii. The technology contributor/investor at that time own not less than 80% of the total equity interest in the
              iv. Then the stock will have a carryover cost basis equal to the cost basis in the technology.
      a. BJR: Directors may make bad decisions in hindsight. But the BJR says that if they didn‘t violate their duty of loyaly,
         they‘re not liable.
      b. Governed by STATE law: each state has own formulation
                i. Most states have a standard based on the interests of the s/h‘s (CA & DE)
                         1. Codified in CA (CA GCL §309)
                         2. Common law in DE
               ii. Other states have a ―stakeholder‖ std
      c. CA GCL §309: codified BJR
                i. Each director is a fiduciary, entrusted to conduct the business of the corp on the SH std
               ii. Includes ALL stockholders
              iii. Basic elements:
                         1. ―good faith‖
                         2. ―such care‖: includes reasonable inquiry, as an ordinarily prudent person in a like position would use
                              under similar circumstances
      d. CA GCL §310: codification of the duty of loyalty
                i. Requires the director to avoid self-dealing and any other conflict of interests
      e. In CA, the courts frame a director‘s duty as consisting of:
                i. Duty of Loyalty: requires a director to avoid any personal or financial conflict of interest w/ the company (avoid
                   competition, avoid exploiting any business opp of the co. to received personal gain)
               ii. Duty of Care: requires director to act w/ the level of diligence and due inquiry tat a reasonably prudent person in
                   the same position would exercise (includes responsibility to use reasonable means to obtain info for a given
                   action brought for his approval and taking the time in making the decision)
              iii. Duty of Candor: (sometimes) requires a director to act w/ candor and transparency in undertaking a fiduciary
      f. If BJR is followed, the court‘s will not second guess a director‘s decision (if it‘s dumb but honest): presumption in favor
         of the board
      g. However, if directors fail to follow the requirements of the BJR, then court will apply a higher std of scrutiny and may
         intervene. Court may even reverse the board‘s decision and can sometimes result in personal liability of the directors.
                i. This is of great concern to directors.
      a. Basically, even if you‘re incorp outside of the CA and you do business outside of CA, you still might be subject CA laws
         if you have a certain nexus with CA state
      b. Implicated if
                i. 50%+ of SHs of record have addresses located in CA; AND the average of the assets is more than 50% (located
                   in CA?!)
               ii. If §2115 applies, then other CA statutes (§301, 309, 317, chapter 1200 and chapter 13) will apply to the
                   corporation even if it‘s NOT incorporated in CA
      c. VantagePoint Venture 1996 v. Examen: DE refused to apply §2115 to a DE corporation  internal affairs doctrine
         (basically, should apply the laws of the state in which the a corporation is formed for maximum clarity in operation).
         Decision is affirmed by DE Supreme Ct. SCOTUS has NOT resolved the issue. CA is not bound to the DE decision.

I.   Allan Thysgesen
         a. Venture Capital
                  i. Minority investments, early state, high grow potential
         b. How does VC differ from other PE assets?
                  i. Obvious
                         1. smaller check and fund sizes
                         2. non-control investments
                         3. more focused on technology (as a proxy for growth)
                 ii. Less Obvious
                         1. limited historical data, emphasis on growth as driver of returns => more ―gut‖
                         2. more dispersion of returns between companies, funds – getting into the ―Right‖ deal/fund most
                         3. more hands on with companies, broader range of strategic options at the formative stage
                         4. not clear that is scales well, deal sizes capped (other than expansion stage), less leverage from larger
                         5. VCs spend the most time with their struggling companies, even though they all want to do the opposite
         c. Success and failure scenarios for a VC
                  i. Venture portfolios usually consist of 20-40 companies per fund
                 ii. Fund returns are driver by several factors
                         1. large wins (san 10x+ invested capital in early details)
                         2. ration of ―singles‖ to ―strikeouts‖
                iii. Drivers that fund can influence
                         1. sector selection
                         2. deal sourcing (do we see the best entrepreneurs/ideas)?
                         3. ability to win competitive deals
                         4. adding value post investment
                         5. exit timing
                iv. market conditions at entry and exit (MOST important!)
         d. Raising VC
                  i. Model capital needs of company at all stages
                         1. evaluate sources of capital, opportunity/risk tradeoff with each: boot strap, angels,
                              customers/suppliers/partners, banks, VCs
                 ii. Many companies are poor candidates for VC investment
                         1. –VCs need hypergrowth, rapid capital appreciation
                         2. VCs will control the company until it is cash flow neutral or is so successful that outsiders keep them
                              in check
                iii. Key issues to consider when approaching VCs
                         1. fund focus/fit – check past investments
                         2. Best introduction to the best partner
                         3. creating a auction, maintaining options until deal is closed
                iv. working with VCs
                         1. not friends nor enemies – business partners
                         2. leverage aligned incentives – and be mindful when they aren‘t
                         3. boards dynamic is critical and requires intensive diligence
         e. How do VCs allocate money?

                                  FOUNDERS STOCK ISSUANCES/STOCK OPTIONS

         a. Tax Consequences of selling IP for founders‘ stock
               i. You want to be able to sell the IP for the smallest tax consequences possible. Whenever you sell an asset that is
                    a taxable event. Here, there‘s IP that the founders created and there may be some tax costs here. The IP has
                    value at the time it is transferred, so we want to make sure that when we transfer IP from founder to corp we
                    don‘t WANT to trigger tax event for founder b/c they probably don‘t have the $$ to pay it, and also b/c we don‘t
                    know the value of the IP at the time (usually)
         b. Why transfer the IP? Its important that if the co. is to be financeable, that the company HAS TO OWN the IP. It can‘t
            just rely on a license to the engineers. Ownership of key IP is critical to creating value and attracting capital

            i. Basic problem is that VC‘s won‘t fund based on a license. The license is a contractual right subject to
               contractual remedies
           ii. Has to be owned by company, VERY few exceptions to this rule
          iii. Form Invention Assignment Agreement: EVERYONE has to sign this, even after the founders set up the co.
          iv. Employee Proprietary Information Agmts: Employees should sign one as a condition of employment. Assigns
               all IP created by employee during employment at the co.
     c. Identifying and transferring the IP into the corp
            i. When is the IP impt to the success of the business? Common sense
     d. Internal Revenue Code §351
            i. Basic concept of 351, if I own a asset but transfer it to a corp but the ownership is still mine, that is not taxable.
               So the founder can transfer the IP for stock of same value, and 351 says that they don‘t have to pay tax on that
           ii. Tax-free exchange and carryover cost basis if 80% or more control immediately upon transfer. Those
               transferring have to own 80% of the common stock afterwards so that they ―control‖ the co.
                  1. Founders will typically get 80% of the common stock in exchange for something (eg. IP, cash)
                  2. EX, we have Company A, and we have 4 founders, 3 engineers and 1 CFO. Each of the engineers have
                       some property (the IP) and so we have to figure out allocation of stock among the 4 founders.
                           a. So we can do E1 = 20, E2 = 10, E3 = 50, CFO = 20.
                           b. CFO is getting stock solely for his services as the CFO for the company
                           c. For the 3 engineers the transfers are okay, they meet the 3 elements of 351 so it‘s a tax-free
                           d. But for the CFO its NOT a 351 transfer because it‘s a transfer for services NOT property
          iii. Tax-free exchange permitted of any asset upon incorporated
          iv. Underlying policy is that no tax liability should accrue where has not be a neither a capital gain or loss
           v. Three elements of a good 351 exchange
                  1. (1) Transfers of property (includes cash! Excludes indebtedness, services)
                           a. prior services are okay. Future services are NOT!
                  2. (2) Transfer solely in exchange for stock
                           a. If founder is exchanging IP, then the corporation must be granted exclusive rights to use, exploit
                                and sell or transfer the IP right in a designated area.
                  3. (3) Transferor in control immediately after the exchange
                           a. The indiv or group of indivs that are transferring the property have to ―control‖ the company
     e. CA Labor Code §2870
            i. Creates a presumption in favor of the employee; BUT
           ii. Carveouts to the concept that an invention belongs to the employee
                  1. use of employer‘s facilities
                  2. invention relates to employer‘s business
                           a. Basically, presumes that inventions created during employment belongs to employer
                  3. invention results from work performed for employer

B. FOUNDER’S STOCK: the first step in capitalizing the start-up
          i. Usually common stock
         ii. Typically issued in exchanged for technology, hard assets, past services or nominal cash
                1. Remember §351 tax-free exchange!
        iii. Objective is to issue founder‘s stock for lowest possible value, EX. 1/10 of a cent
                1.   We‘re talking about millions of shares of stock – can be very expensive even if shares are so low in price
    b. Two class capital structure:
          i. Investors pay more for preferred stock
                1. investment
                2. high price
                3. senior rights
         ii. Common stock is for compensatory purposes
                1. compensatory
                2. low price
                3. residual rights
    c. Preferred stock: rights and preferences
          i. Liquidation preference
         ii. Conversion features

           iii. Antidilution protection
           iv. Class or series voting rights (CGCL 903)
            v. Protective covenants
           vi. Board representation
     d.   See question 4 of problem set #3 (valid forms of consideration)

    a. Stock options are beneficial because someone can buy a stock later, when it‘s more, for the same time at the time that
       the options were issued
           i. But initially and at the time of formation, it is probably better to issue stock directly instead of options
    b. How boards have traditionally priced common stock in connection with option grants/stock grants
           i. Objective is to price the common stock at FMV (eg. established through commercial negotiations between
               disinterested third parties) so that the strike price is the same as FMV
          ii. FMV = 80-90% discount off the preferred stock price sold in the most recent financing
         iii. FMV = dead reckoning by the board (ie. no methodology used as basis)
         iv. Recent change in the tax laws is going to change this: §409A of the IRS
    c. Every option granted/restricted stock grant has to be approved by the board and the board has to establish the stock
       price (ie. FMV at the time of the board meeting)
           i. Result: changes in stock price coincide with board meetings, when the board approves option grants/stock grants
               for compensatory purposes.
    d. Stock prices – 2 class stock structure, preferred stock more valuable.
           i. Common stock is usually priced lower than preferred stock price
          ii. But as the company matures, the common stock price approaches the price of the preferred stock
         iii. Investors like this structure, they want employees that work as hard as they can to help build the company. The
               point is to attract and retain talent, not to raise funds from options that are exercised.
         iv. Liquidation preferences
                 1. Preferred stock typically gets money back before the common stock gets anything.
                 2. When company gets sold, before the common stock gets anything the company needs to be sold for
                      enough to cover them, because they are last in line.
    e. In technology companies, it is commonplace to provide equity at all levels of the organization. Venture-backed
       companies are unique in their dependence on stock as a key component of compensation
    f. Should reserve about 15-25% of shares under the stock option plan in the OPTION POOL, see below
    g. Equity incentives for early stage employees: stock grants
           i. Low price = up front cash payment
          ii. Subject to typical vesting arrangement
         iii. File §83(b) election
         iv. Begin capital gains holding period (one year)
                 1. 15% capital gain tax at the federal level
          v. It votes (Even if it is subject to a vesting arrangement)
    h. Section 83(b) of Internal Revenue Code regarding stock grants
           i. 83(b): Someone who is buying restricted stock and elect to pay the tax up front
                 1.   One of those few things that CAN‘T be fixed if you make a mistake with it. You need to get it right the
                      first time around.
          ii. If you file this then you wouldn‘t have to pay tax on the income AS the stock vests
                 1. That is the price at which you paid for the stock (option price) MINUS the price at which the stocks are
                      valued by the time they vest.
                 2. Basically, §83(b) allows the taxation (on essentially 0) to take place at grant (and includes a 1 year
                      holding period). Whereas §83(a) taxation occurs at vesting.
                            a. If founder pays full FMV at time of purchase, NO tax will be due b/c the value of the stock on
                                 that date will NOT excess the purchase price
                            b. Then after this, the vesting stock will not be subject to tax
                 3. Before it vests you have a huge risk of forfeiture if you don‘t file 83(b) you have a tax event that is equal
                      to the purchase price of the stock and the FMV that you paid for it.
                 4.   You may owe potentially significant taxes on illiquid investment
         iii. Must be made within 30 days within the purchase date of the stock as required by §83(a)
         iv. Permits a founder or employee receiving stock subject to a vesting provision to include in their income for the
               current year the spread (as of the time of the issuance) between the price they paid for the shares and shares’
               FMV at issuance.

                   1.Because the price a founder pays for the shares will generally equal their FMV, the applicable spread—
                     and resulting taxable income – will typically be nil.  basically, the taxable income = (price founders pay
                     for the shares, which is usually FMV at issuance) – (FMV at issuance)
                2. basically, §83(b) election will bypass §83(a) and
    i. Equity incentives for later stage employees: STOCK OPTIONS
           i. Stock option is the right to buy a fixed number of shares at a fixed price for a fixed period of time
          ii. Modest to high exercise prices: but payment later
        iii. Subject to vesting (based on ―exercisability‖ of the option)
         iv. Capital gains holding period begins only on exercise
          v. It does NOT vote until exercised
    j. Stock option plan, offered to directors, employees and consultants. Legal doc that governs the grant of awards. Then
       once everytime options were granted an option agreement would be signed by the employee
                1. A formal plan that is approved by the board and SH
                2. Plan establishes a ―reserve‖ of stock that are set aside, or earmarked, specifically for issuance under the
                     stock plan
                3. IMPORTANT: VC investors include the reserve in negotiating valuation. They want to ensure that the
                     reserve is established at and adequate level to avoid post-financing dilution to their negotiated equity
                     stake in the company.
                4. Term of options mechanisms for determining exercise price
                5. There needs to be a plan for tax purposes & for state of CA corp law purposes
          ii. Differences from Common Stock:
                1. Stockholder has voting rights (depends on which kind of stock they have)
                          a. Election of directors, whether the co. can be sold, etc
                2. Option held by a employee does NOT have voting rights, option is just a K right to buy a fixed # of shares
                     of common stock at a fixed price (the ―exercise price‖) for a fixed period of time. Option NEVER gives
                     you voting rights, just gives you rt to buy stock. This K is only good for a stated period of time.
                     Generally, its for 10 years as long as you work for the company. If you STOP working for the company,
                     the option terminates as to the options that have NOT vested within 30-40 days of the termination
                     (depending on whatever the option says).
                          a. Vesting (1) 25% after year 1 (ex. if you have 48 options, 12/48) this is called the 1 year cliff (2)
                               Probably over the next 3 years on a monthly basis (ex. the rest 36/48)
                          b. So if you quit at 355 days, you DON‘T GET THE STOCK!
                          c. Prior to this yu have no voting rights, you just have the K right
                          d. Whether or not these options have value depends on the current market price compared to the
                               option price.
                          e. So it‘s really just an economic right tied to the appreciation or depreciation of the stock in the
    a. Practice conventions in the use of stock or stock options for compensatory purposes
           i. A substantial, predominance of companies use a time-based, four-year vesting schedule. Typically, for new
              employees, 25% cliff vesting at one year, monthly vesting thereafter; for continuing employees, monthly vesting
              from the date of grant
          ii. Cliff-Vesting: stock is completely unvested at issuance, then ¼ of the stock vests after 1 year, and the rest vests
              over the next 3 years.
    b. Vesting: what is it and how does it work
           i. Veting is that you don‘t get the rt to hold onto the stock until certain things happen – normally they are time
              based, a 4 yr vesting schedule for ex., with the rest vesting beyond that
          ii. Subject to continuing employment
        iii. Upon employee termination, company right to repurchase employee stock at original purchase price
         iv. Types
                1. time based
                2. performance based (Eg. When certain milestones are reached)
          v. What is the rationale for the ―no fault‖ premise that is found in most vesting arrangements (ie. repurchase rights
              activate upon termination for any reason)
                1. eg. In case employee dies and company need to regain the shares
    c. Vesting is one of the main points of the conflict between founds and investors
                1. VCs WANT vesting schedule – they want to ensure that the management team they are investing in won‘t
                     just leave after formation.

                   2.   Founders will want the stock immediately.

    a. APB 25 (old) and FAS 123R (new)
    b. APB 25 (old)
           i. NO expense to be recorded on the income statement for stock option grants as long as (i) the option exercise
              price was not less than FMV on the grant date, and (ii) the only vesting condition was time-based.
          ii. this was a good deal for any company that depended on the use of equity incentives as a key component of the
              compensation package to new and continuing employees
    c. Financing Accounting Std 123R (new)
           i. Effective date for private companies was January 1, 2006.
          ii. Under FAS 123R, the ―fair value‖ of stock options is determined on the date of grant, and that amount is then
              amortized as a compensation expense over the vesting period of the option
                1. Private companies can use ―intrinsic value‖ of the option (ie. the spread between the exercise price and
                     the value of the underlying stock) instead of ―fair value‖; but ―intrinsic value‖ has to be assessed each
                     quarter (referred to as ―mark-to-market‖ accounting)
         iii. ―Fair value‖ can be determined using an option-pricing model like Black-Scholes or the binomial method
         iv. Anticipated impact of FAS 123R on equity comp practices
                1. No longer a penalty on the use of performance-based awards; time-based and performance-based options
                     both get expensed at the date of grant
                2. Value of restricted stock is determined on the grant date and amortized over the expected vesting period.
                          a. Under current accounting rules, no determination of value of restricted stock is made until the
                               stock is vested; at that time, the value is determined and amortized over the remaining life

    a. Two kinds
          i. Incentive stock option (ISOs):
               1. tax-preferred under the Internal Revenue Code
               2. when these are exercised, there is no tax event at time of exercise
               3. ISO‘s (in contrast with ―non-statutory‖ or ―non-qualified‖ options = NSO) in general do NOT result in a
                    tax event upon exercise, subject to exceptions based on the federal ―alternative minimum tax‖  ISO
                    results in NO taxation upon exercise. ISO can only granted to employees. NSOs are for non-
                         a. In order to avoid, ISO also needs to follow holding periods:
                                 i. 1 year after date of exercise of ISO and
                                ii. More than 2 years after the date of grant of the ISO
               4. ISOs can be granted only to employees; where options are granted to consultants, advisors or directors, ie.
                    non-employees, the options have to be NSOs
               5. To avoid having ISO ―disqualified‖ to NSO status (ie. BAD thing), you have to hold the stock you
                    acquired by exercising your ISO beyond the later of the following two dates:
                         a. One year after the date you exercised the ISO, or
                         b. Two years after the date your employer granted the ISO to you
         ii. Section 409A makes NSOs possibly subject to heavy taxation
               1. Basically, must make sure that stock options are not priced below FMV for NSOs
               2. Passed in 2004 in wake of corporate fraud cases. Intent of §409A is to penalize any incentive structure
                    constituting ―deferred compensation‖ (NSO that are priced at least than FMV)
               3. Summary
                         a. NSOs that vest after 1/1/2005 and that are priced at less than FMV on the date of grant will be
                              considered ―deferred compensation‖
                         b. Consequence of ―deferred compensation‖
                                 i. As option vests, that vested portion gets included in the optionee‘s taxable income (even
                                    though the option is not exercised) and
                                ii. A 20% excise tax is added to the taxed portion of the option
               4. Before: How did boards price options prior to 409A?
                         a. 90% discount off of the preferred stock price in the
               5. Now: Establish FMV in option pricing
                         a. Factors to be considered, as applicable:
                                 i. the value of tangible and intangible assets

                                       ii. the present value of anticipated future cash-flows
                                      iii. the readily determinable market value of similar
                                b.   Presumptions of reasonableness
                                        i. Independent appraisal
                                       ii. Binding formula
                                      iii. Good-faith written report

        a. The negotiations over stock allocation can start from Day 1
               i. EX. if you decide both of 2 founders has 50/50, then BOTH have to agree on everything for anything to move
                  forward. If one has 60/40 then the one with 60% has more power
              ii. Over time their power will be diluted, as employees exercise their options than more people are added to the
                  pool. But still, founders will have majority control for a while, because options likely will not vest for a while
        b. ―Option pool‖  Reserve of Shares of common stock for future grant as option. Shares that‘ve been set aside for
           purposes of future grants to new employees
               i. Established so that they will last 12-18 months
              ii. This becomes VERY impt for purposes of valuation
             iii. Option Pools need to be taken into acct for Stock divisions
        c. Guidelines:
               i. Use at 5 million authorized share structure to begin
                    1. allow for founders, early stage employees and a future reserve
                    2. plan for the Preferred Stock for investors to come in on top of the 5m share structure
              ii. Get the founders‘ stock arrangements right!
                    1. They need to make sure there‘s enough in that option pool for all the incoming employees, if not they will
                         force the founders stock to be diluted
                    2. How big the pool is depends on what your hiring requirements are. If the founder can be the CEO for the
                         next 5 years, then you will need a CFO, a CTO, a VP of Marketing, etc….you KNOW there are certain
                         positions that NEED to be filled, and those ppl may have expectations as to how much stock they get
                         (CEO may expect 5-10% of the co.)
             iii. Establish an overall game plan for equity incentives and make sure it is competitive
             iv. Optimize incentive arrangements in the employee‘s favor: stock v. stock options
              v. Know how to price common stock to early stage employees: it is generally ok to price more aggressively (i.e.
                  low at the early sages of a company)
        d. Majority of companies established their stock pools in 15-20% on a fully diluted basis
               i. So VC generally will start with big #, ex. option pool should be 25%, and founders come back with bottom up
                  calculation of what spots NEED to be filled and come back with smaller percentage
        e. EXAMPLE
                                            Common Shares                  Preferred Shares           %
           Founders                         100                                                       50%        40%
           Series A                                                        100                        50%        40%
           Option Pool                      50                                                                   20%

                  i. If you give the option pool 50 common shares, the founder has 100 shares, the series A has 100 shares, total this
                     is 250 shares
                 ii. On a fully diluted basis, 50 of 250 = 20% of the shares.
                iii. This is an option pool of 20% on a fully diluted basis.
                iv. NOTE: from a VOTING control perspective, the voting control is STILL 50/50, b/c options are NOT voting rts
                        1. But this DOES go to the economics – if there is liquidity event, then the options DOES have some value.


       a. Proper valuation of the entrepreneurial business is the seminal event in the corporate maturation process however and it
          becomes an absolute requisite when the entrepreneur wants to raise private or public capital. Once the company is
          properly valued, then the entrepreneur can determine how much of the company can be sold for the capital injection
          provided by the investor or venture capitalist.

      a. Venture funds need to obtain an average return on investment of more than 20% -- so the VC expects/targets at least a
         40% ROI for every single investment
                i. Ie. a venture investment has to return approximately 4 to 5 times money within 5 years the ―payback ratio‖
      b. One of principle negotiation points when trying to do the series A financing is the valuation. Not the overall value, but
         what % of the company will I get.
      c. Different Approaches:
                i. Income Approach: Estimate future cash flow that could be taken out of business wo impairing future operations.
                   Most common methods in this approach: Net Present Value, Equity Cash Flow and Capital Cash Flow
               ii. Market Approach: Estimates the value of a going concern business by comparing to similar firms whose stock
                   is publicly traded. In many cases Market Approach is used as a secondary valuation method to verify the
                   estimates derived from the Income Approach
              iii. Asset Approach: valuation based on the firm as a financial option
      a. “Pre-money valuation”: The price paid per share in the financing round multiplied by the number of shares outstanding
         before the financing event
                i. Formula: Post-money valuation – new investment
      b. “Post-money valuation”: The price paid per share in the financing round times the number of shares outstanding after
         the financing event
                i. Formula: investment / % ownership acquired
      c. “Fully diluted capital” (according to GAAP): total outstanding shares excluding the reserve for future option grants
      d. Example:
                i. VC may say a few different things:
                        1. I‘ll put in $2mil based on a 3 pre-money
                        2. I‘m thinking 2/3 based on 3 pre, that will get you to 5-post
                        3. I want 2/5 of the company post-money, and for that I‘ll put up the 2
                        4. It‘s worth $3mil pre-money, and I want to own 40% after we close
               ii. Meaning: the VC is willing to invest $2mil in the co., and is proposing that the co. is valued at $3mil pre-
                   money, which will = $5mil post-money (pre-money + investment).
                        1. He wants 40% of the company post-money, which is the same as 2/5 ($2mil/$5mil)
              iii. So, if the co. has 6 mil shares already outstanding, they know they will have to issue 4mil shares for the VC to
                   own 40% of the co. That means $2mil investment/4mil shares = $.50/share.
                        1. To figure this out:
                                  a. OSP/ (1 – VC%) = Shares Outstanding Post-Money
                                            i. Outstanding Shares Pre-money divided by 1 minus the % that the VC will own
                                           ii. EX. 6mil/(1-.40) = 6mil/.60 = 10mil shares outstanding post money
      a. After the initial contacts with the VC
      b. After presentation of business plan
      c. Takes about 3-5 months (or more)
      a. Take the best offer (ie. the highest pre-money valuation)
      b. Take only the minimum cash you need
      c. Maximize the founder‘s equity stake in the company
      d. Make sure the founder keeps control
      a. Accept a reasonable valuation from the ―Best‖ VC
      b. If additional financing is available, take the money
      c. Bringing in the right investors and capable management is more important than preserving capital
      d. See voluntary reading
G. CONTROL IS OVERRATED most founders give it up to ensure the growth of the company
      a. Use stock to raise capital
      b. Use stock for employee incentives
      c. Use stock to secure strategic relationships
      d. Use stock in acquisitions
      a. Models
      b. Comparable company method

                 i. Often used to arrive at a ‗ballpark‘ valuation of a firm.
                ii. First firms that display similar ‗value characteristics‘ are selected. These value characteristics include risk,
                    growth rate, capital structure, and the size and timing of cash flows.
                         1. Often, these value characteristics are driven by other underlying attributes of the company which can
                              be incorporated in a multiple (like a PE ratio)
                         2. This valuation method is most useful when all the chosen comparable firms are publicly traded and
                              their capital structure, revenue, profit margins, net profit figures are known. The most common
                              measures used while valuation using this method are:
                                   a. P-E Ratio (share price divided by the earnings per share)
                                   b. Market value of the firm divided by total revenue
                                   c. Market-to-book ration (Market value of the firm divided by the shareholder‘s equity)
                                   d. Market Value divided by EBITDA (earnings before interest, taxes, depreciation and
               iii. An average of these ratios for the chosen comparable firms is calculated and based on that the value of the firm
                    is calculated for each measure. This gives a range of values for the firm based on these measures.
      c. VC method
                 i. This method is commonly applied in the private equity industry. Most private equity investments are
                    characterized by negative cash flows and earnings in the early stages and highly uncertain but potentially
                    substantial future rewards.
                ii. Determine terminal value (ie. how big will the pie be in the future): Values a company using a multiple, at a
                    time in the future when it is projected to have achieved positive cash flows and earnings. This terminal value is
                    then discounted back to the present value at a typically very high discount rate 40% to 75%.
                         1. Discounted cash flow
                         2. Comparable company datapoints
               iii. Discount cash flows at the right IRR (internal rate of return) (ie. guess at what rate the pie will grow between
                    now and the terminal date)
               iv. Calculate ownership percentage
                v. Future looking
      a. How big the market
      b. How many customers
      c. How many employees
      d. How long will the product development take
      e. How much financing will be required
      f. How long before getting to a liquidity event
      a. Breakthrough technology
      b. First mover advantage
      c. World class management team
      d. Untapped, unlimited market
      e. No competition
      f. Insurmountable barriers to entry
      a. Competent, proven management team
      b. Products that save money/disruptive technology
      c. Customers
      d. Big and growing market
      e. Competitive differentiation
      f. Ability to become profitable within 18-24 months
      a. Founder gets 2,000,000 of common stock, and VC would say if there is 4,000,000 pre money valuation and $5,000,000
         of their OWN investment
                 i. Pre-money valuation – the aggregate value before they put any money in.
                ii. This means they put in $9,000,000 ―post money valuation‖
      b. This means that afterwards, the VC will own 5/9 of the company (5,000,000 of their investment out of 9,000,000 total),
         i.e. .555 (55.5%) of the control.
      c. To figure out how many preferred SHARES the VC gets: THAT means the founders own .444 of the company
                 i. SO to figure out the division of shares: 2,000,000 = .444(x)

                 ii. X = 4,504,505 TOTAL shares
                iii. 4,504,505 – 2,000,000 = 2,504,505 of PREFERRED shares
                iv. 2,000,000 common shares + 2,504,505 preferred shares = 4,504,505 total shares
        d. BUT THEN – we have to count in the DILUTION
                          Common Stock         Preferred Stock Total
         Founder          2,000,000                            2,000,000         29.5%
         Series A                              3,762,712       3,762,712         55.5%
         Option Pool      1,016,949                            1,016,949         15%
         TOTALS           1,016,949            3,762,712       6,779,661

                                                      BUSINESS PLANS

      a. Drafted by the founders
      b. Usually includes descriptions of: (1) industry (2) market (3) means to produce/deliver product/service (4) competition (5)
         superiority of product/service over other similar things (6) marketing plan (7) IP (8) management team.
      c. 10-15 years ago 50-100p b plans covering in great detail where the co. was going, today MUCH shorter, VCs reviews
         hundreds of plans
      d. Purpose:
               i. Used as basis for educating and ―selling‖ the VC community on the start-up
              ii. Forces founders to think through business (problem set 3), get foot in door with VCs and angel investors
             iii. Gives everyone a way to see if the co. is meeting benchmarks
                       1. BUT Things move so quickly today though that it may not be realistic to benchmark against a plan 6
                           months in
      a. Putting key pts together just to see if there‘s interest, and if there is then they can dive into more details. What are its
         technical plans and plans for hiring, etc. 1-2 page executive summary, 10-15 page slide deck to go through. Usually
         when you meet you don‘t get far into it, VCs are familiar with these industries and they start to ask a lot of questions
      b. What do they want to see when they look at an executive summary?
               i. Compare the co. to existing businesses and explain why their company would be better
                       1. Here‘s what‘s out there currently, BUT here‘s where we differ and why we can be successful
                       2. What is stopping others from doing the same thing
              ii. Market size and projections
                       1. May be good to have other experts look at these projections AND the b plan as a hole to see where
                           there are holes and where there would be issues
             iii. Why are the founders the right one‘s to do it? Particular skills sets? Track records? Etc
             iv. How much $$ do they need to get to the next milestone and why do they need it
                       1. Usually VCs invest for 12-18 months, what will they do with the money.
              v. Idea is to take the money now and to try and reach some milestone‘s and then that allows them to and raise
                  more money later at a higher valuation

     a. Usually early stage companies, VCs will refuse to sign a NDA. Why? They don‘t want a situation where they get sued
         for investing in one company in the same industry as that co. they have the NDA with and then get sued for ―stealing‖
         their secrets
     b. There is a way to tell the VCs just enough to get them interest, and if then keep showing more if they become more
         serious and get to the diligence level
     c. It‘s better to manage the confidential info this way, to slowly release information
     d. When the E says they have NO competition, this is probably not true

      a. ―I can‘t show you my business plan unless you sign a confidentiality agreement‖
               i. VCs very rarely sign a NDA because they hear multiple pitches on technology in the same space
      b. ―We don‘t have any competition‖
      c. ―Our projections are conservative‖
               i. VCs will already discount the numbers anyway.

        d.   ―We expect to get our first major OEM agreement next week.‖
        e.   ―We‘re going to go after our first customers in three different vertical markets.‖
                  i. This could sound too ambitious. Want to make sure that you can conquer one market before attacking 3.
        f.   ―We don‘t‘ think that we need to relocate the company out of Ukiah, CA‖
                  i. No labor pool! VCs would prefer a cluster of technologies, like in Silicon Valley.
                 ii. Also, VCs are probably not in Ukiah and they would rather be closely located to their companies.
        g.   ―We‘re also talking to Kleiner, Mayfield, NEA.‖
                  i. Don‘t bluff because the VCs will find out.
        h.   Other Common Mistakes
                  i. Making market TOO broad – they can‘t go out and tackle 3 diff markets initially, they have to usually start in 1
                     market and then spread
                 ii. Don‘t want to do the same exact pitch for multiple VC firms – you should know WHY you want to work with
                     this specific person/firm. Really be careful and research and know who you are going to meet with.

      a. In every instance where entrepreneur is soliciting VC for money, he is ―offering‖ to sell securities by federal law
      b. §2 of the Securities Act: Definition of ―sale,‖ ―offer to sell,‖ and ―security.‖
      c. §10b-5 of 1934 Securities Act
               i. You violate this section if you:
                       1. made an untrue statement
                       2. omit to make a material statement
      d. §25401, CA Corporate Code: ―It is unlawful for any person to offer or sell a security in this state, or buy or offer to buy
         a security…by means of any written or oral communication which includes an untrue statement of a material fact or
         omits to state a material fact necessary in order to make the statements made, in the light of circumstances under which
         they were made, not misleading.‖
      e. When are you selling a security? Basically, everything you deal with in Silicon Valley is a security for both federal and
         state purposes, the definition of ―security‖ is very broad
               i. What is a security - §25019 ―any note, stock, certificate of interest or participation in any profit-sharing agmt‖
              ii. What is an offer to sell - §25017 ―every attempt or offer to dispose of, or solicitation of any offer to buy, a
                   security for value‖
      f. What happens if you offer to sell a security thru the distribution of a business plan and the plan contains false
         information? If audience were VC, the VC can come back to sue you and claim damages. But this is rare.


A. NEED TO EITHER 1) register or 2) be exempt OR else face legal consequences (eg. Misrepresentation)

      a. Venture Capital. Risk: low
      b. Angel investors. Risk: medium
                      1. from disclosure perspectives and process of selling securities
                ii. High net worth
               iii. Experienced management
      c. Friends and family. Risk: high
                 i. These are the types of investors that fed and state securities laws are trying to protect
                ii. Individuals
               iii. Maybe unsophisticated

      a. Securities laws are meant to protect people who cannot protect themselves in purchasing securities
      b. Depression era legislation meant to react to securities issues at the time
      c. To ensure trust in the US securities markets by requiring transparency.

     a. Securities Act of 1933
                i. Address any offers or sales of securities. So if any co. pub or private, is selling stock or bonds that are
                   securities, they must comply with the 33 Act. The 33Act covers that financing transactions. So an IPO
                   would fall within 33 Act, a venture backed start up also counts

                            1.   Our focus is on 33 Act for this class
                            2.   When the SEC reviews a company, it has the authority to prosocute securities fraud, but in general
                                 what they do is forcing co.s to make adequate and accurate disclosures to the market. So they can‘t
                                 say that a co. can‘t go public, only that they must disclose the terms of the transactions and issues
                                 related to the co
                     ii. Encounter all the time in VC context; basically, anytime a company issues a security, it has to comply with
                         requirements of the this Act
                    iii. Intended to protect ―mom and pop‖ type investors
                    iv. §5: Unlawful to sell/offer to sell a security unless it‘s registered or an exemption for registration is available.
                           1. Can‘t offer to sell or sell a security unless it‘s
                                      a. registered OR
                                      b. you have an exemption
                           2. Almost everything sold in VC arena IS a security by §5
                           3. SEC‘s primary role is to monitor disclosure, NOT to say whether a deal is good or bad (eg. SEC is
                                 NOT supposed to make a substantive review of the deal. Unlike at state level  CA judges whether
                                 the trxn is ―fair‖)
                           4. Remedy of violation of section 5 is recission, which is available to ALL investors (even if it‘s just
                                 ONE investor who did not meet the requirements)  very bad!
                     v. Why avoid registration? Expensive & Time consuming
                           1. Registration 4-6 month process b/c of review process with SEC, costs several millions of dollars to go
                                 through this process
                           2. So a small VC backed company they will never want to register their securities with the SEC, so they
                                 will need to find an exemptions
                           3. Registration essentially makes your company a public company. So private companies just do NOT
                                 want to do this. And this won‘t help their business.
         b.   Securities Act of 1934
                      i. Applies to PUBLIC companies
                     ii. Legislation that requires co.s to provide current info to the market
                           1. EXs. Form 10-K & 10-Q
                           2. Disclosure docs that must be filed with SEC that must proide financial info, risk information, describe
                                 business, describe in qualitative way what is happening with the company
                    iii. Besides 10b-5, ‘34 Act rarely comes up in VC context.

       a. Section 3: “exempt securities”
                  i. Rarely relied upon in practice
                 ii. Eg. Govt bonds…etc
                iii. §3(a)(10): if you are issuing shares in merger transaction and that trans is approved as to its fairness by court
                     or body, then you have a exempt security
                       1. Passed on for ―fairness‖ by a court or state regulatory body
                       2. Can be a foreign court – in Canada and UK can go to courts and ask them to rule based on the fairness
                            standard. The co. can then use this ruling for 3a10 purposes even though it‘s a foreign court.
                       3. Does 2 good things
                                 a. gives investors securities that are not restricted (eg. Don‘t need to hold stock before selling it)
                                 b. saves company money
                       4. Bad thing
                                 a. invites regulatory bodies to inspect the transaction and possibly make suggestions
                iv. §3(a)(11) – Intrastate exemption
       b. Section 4: “exempt transactions”
                  i. Relied on ALL the time
                 ii. §4(1): Exemption for resales by those NOT a underwriter, issuer, or dealer on Open Market
                       1. When: Triggered when someone (other than an issuer, underwriter or dealer) tries to resell his
                            securities on the open stock market. NOT when issuer transacts.
                       2. Applies to both public and private companies
                       3. Trxn other than by issuer, underwriter or dealer.
                                 a. What is an underwriter? Basically, the purchaser must have an investment intent.
                       4. Underwriter concept is the crux

                 a.  Investment Intent: If you buy a bunch of stocks and then plans on selling it to other people,
                     the you may be considered as an underwriter (eg. Investment bankers) – you didn‘t intend to
                     buy to invest, you bought with purpose to distribute or resell.
      5.     How to avoid underwriter liability? Rule 144: safe harbor under §4(1)
                 a. Governs the time period that you have to hold the stock before you can sell it. This is a safe
                     harbor UNDER 4(1). So once you pass that time period, you‘d know you could sell the stock
                     and be okay as far as the 4(1) exemption
                 b. Rebuts the presumption of underwriter status.
                 c. Applies to both private and public companies
                 d. Requirements
                            i. Non-affiliates (and has been non-affiliate during prior 3 months)
                                    1. Restricted Securities of Reporting Issuers
                                              a. 6 month holding period –no resales
                                              b. 6 month-1 year –unlimited public resales if:
                                                        i. current public info requirement
                                              c. Post 1 Year –unlimited public resales
                                    2. Restricted Securities of Non-Reporting Issuers
                                              a. 1 Year Holding Period –no resales
                                              b. Post 1 Year –unlimited public resales
                           ii. Affiliates  Control person/affiliate: Officers, directors, 10% s/h’s, or a joint group/
                               family control (Lambert)
                                    1. Restricted Securities of Reporting Issuers
                                              a. 6 month holding period –no resales
                                              b. Post 6 month –may resell in accordance w/ all Rule 144
                                                  requirements including:
                                                        i. Current public info
                                                       ii. Volume Limitations
                                                      iii. Manner of Sale
                                    2. Restricted Securities of Non-reporting Issuers
                                              a. 1 year holding period –no resales
                                              b. Post 1 year –may resell in accordance w/ all Rule 144
                                                  requirements including:
                                                        i. Current public info
                                                       ii. Volume Limitations
                                                      iii. Manner of Sale
iii. §4(2)   General private placement exemption
       1.    Transaction by issuer NOT involving a “public offering”. So in order to comply with §4(2), an
             issuer CANNOT have a “public offering.”
                 a. These transactions usually involve small numbers of investors (usually sophisticated).
      2.     What does ―public offering‖ mean? Not a lot of case law and is not consistent.
                 a. But the purchaser CANNOT be an underwriter, for whom a public offering would be
                     inevitable. So if an underwriter purchases the securities, then the sale falls out of the §4(2)
                 b. General characteristics to looks for:
                            i. # of offerees – how many people did the co. go out and make the offer to?
                           ii. Sophistication of investors & acces to information
                          iii. Methods of Solicitation: how did they sell them? Advertise to the public?
                 c. Seminal case by SCOTUS was Ralston-Purina, which was decided in 1953
      3.     Need investment intent
      4.     Relevant factors to look at (even before Ralston):
                 a. number of offerees
                 b. level of sophistication of the investors
                 c. manner in which offering was conducted
                            i. SEC would frown upon soliciting/advertising to the broad public (eg. Handing
                               out leaflets, making TV/radio announcements)
                 d. Opportunity to ask questions of management
                 e. Investment intent
                            i. Presumption of underwriter status is resale occurs prior to 1 year

        f. No advertising or solicitation
5.   Regulation D (Adopted in 1980s) – Created to clear up confusion about 4(2)
        a. Includes Rule 501-508
        b. Rule 501: Defines ―accredited investor‖
                  i. Idea: if you‘re selling to a “accredited investor,” then you will most likely be
                     exempt under §4(2)
                          1. Gives co.s broad leverage to sell securities to these accredited investors,
                               who are deemd sophisticated enough. TO be an accredited investor you
                               must: (1) have a net worth of at least $1mil, OR (2) net income of at least
                               $200K for last 2 years + reasonable expectation that you would make that in
                               current year. If married you + spouse must make $300k
                 ii. Accredited Investors Include
                          1. Includes any officer or director of the company
                          2. Any individual with a net worth of over $1mil OR has at least $200,000/yr
                               over the last 2 years and the current years individually OR $300K as a
                          3. Corporations, institutions, employee benefit plans
        c. Rule 502:
                  i. Informational requirements
                          1. None if there are only accredited investors
                          2. If there are non-accredited investors, then information content depends on
                               the aggregate offering price
                 ii. NO advertising or solicitation
                          1. Prohibits advertising or soliciting
                iii. Integration
                          1. 6 months before or after the Reg D transaction. So if you do a 504
                               transaction then wait 6 months 1day, you can do a 506 transaction without
                               any integration.
                          2. EX: Co. has 2 rounds of financing: (1) ―A‖ Preferred – 20 accredited
                               investors, 34 non-accredited investors (2) 5 months later ―B‖ preferred: 18
                               accredited investors, 2 non-accredited investors
                          3. Hypo: Sept 2007, you sell $5m of Series A pref stock to NEA & US VP
                                    a. February 2008: friends and family want to buy some stock so sell
                                         stock to 5 non-accredited investors
                                    b. Do we still have §5 exemption?
                                    c. Need to look at whether there is 6 months apart between 2 trxns. If
                                         trxns are within 6 months AND meet traditional 5 factor test*, then
                                         the 2 trxns must be treated as 1 trxn.
                                    d. Must integrate 9/07 and 2/08 trxns
                                    e. April 2008: sell to 20 non-accredited investors
                                    f. Because 4/08 and 2/08 are less than 6 months apart, must
                                         integrate all 3 trxns
                                    g. June 2008: sell to 11 more non-accredited investors.
                                    h. Must integrate the 6/08 trxn with the rest. Now you have 36 non-
                                         accredited investors!
                iv. *Traditional 5-factor test: (1) Single plan of financing (2) same class of securities;
                     (3) sales at same time (4) same type of consideration (5) same general purpose
        d. Rule 504: Offerings to the Public of Up to $1mil w/i a 12-month period
                  i. NO limit on # of purchasers (even unsophisticated ones)
                          1. So frequently relied on for sales of securities to friends/family/angels in
                               initial rounds of financing
                 ii. May use general solicitation
                iii. But NOT available for reporting companies
                iv. Careful of integration!! 502(a) 6 month safe harbor
        e. Rule 505: Offerings up to $5mil in a 12 month period
                  i. Unlimited # of accredited investors, 35 unaccredited investors
                          1. Specific info must be disclosed to the investors, unless ALL the investors
                               are accredited

                                        ii. NO general solicitations
                                   Rule 506: Safe harbor under §4(2) – NO dollar limit.
                                         i. Sell to as many accredited investors as possible and sell up to 35 non-accredited
                                            investors (info disclosure requirements for these investors)
                                                 1. Those 35 must be ―sophisticated‖ and you must meet certain information
                                                      delivery requirements (pretty comprehensive information)
                                                 2. Must have a reasonable belief that accredited investors are actually
                                        ii. To comply with 506, the # offerees don‘t matter. Doesn‘t matter who you offer to,
                                            as long as those who BUY fall within 506
                                       iii. VC transactions usually count in 506 – they are usually accredited investors.
                                       iv. Generally under this provision don‘t have to worry about the few fam + friends that
                                            partake, as long as they are given enough info to disclose.
                                        v. No limit on the amount of the offering price
                                       vi. No advertisements
     a. If you don‘t qualify under an exemption, then registration is required under Section 5 of the ‘33 Act.
     b. And violation of section 5 may give rise to many remedies, including recovery the price paid, rescission of the trxn and
        damages (12(a)(1))

      a. Two regulatory regimes in US
                 i. Federal (‘33, ‘34 with SEC as the regulatory body and promulgator of rules)
                ii. State law (―Blue Sky laws‖)
      b. Traditionally, have to comply with both federal and state levels. State laws are not always consistent.
                 i. If you are sell from one state and the potential purchaser is in another state, then you must comply with the
                    laws of both states.
      c. NSMIA (National Securities Market Improvement Act) preempted state laws. Said that if you met Regulation D, then
         you are exempted from state laws. Although, states can still charge you fees.
                 i. CA: in order to benefit from NSMIA, you must turn in Form D within 15 days of the closing of the trxn and
                    you pay a fee
                ii. In certain situations, if you comply with fed laws, the fed law would preempt state laws. In particular, if you
                    satisfy certain provisions of Rule 506 Safe Harbor, NSMIA preempts state law and you don‘t have to comply
                    with state laws (you may still have to register with state though)
      d. CA corp securities law of 1968 (applies when the issuer is making and offer/sale to purchasers in CA)
                 i. §25102(f) exemption
                       1. pretty much like Regulation D under the federal law
                       2. any number of accredited investors
                       3. non-accredited investors are less than 35
                       4. no advertising or solicitation
                ii. §25102(o) requirements for which the exemption will apply?
               iii. ―Fairness standard‖ Whereas fed securities laws are solely on disclosure, that‘s not always true at state level.
                    At state level, and esp in CA, there is a ‗fairness standard.‖ So CA dept of corporations has authority to say
                    we don‘t like the terms of this transactions, if you want to proceed in CA you have to change the terms.
                    There are normally exemptions, but then if you fall utside those exemptions in fed laws then CA law will
                    apply and there is a fairness std

                                                        TERM SHEET

     a. What is a Term Sheet?
             i. A term sheet is a doc prepared by venture capitalists that sets forth the key terms of a proposed investment.
            ii. A term sheet is a conditional offer. The VC will perform further due diligence and negotiate key contracts, such
                as employment agreements, the option plan, registration rights, shareholder agreements, and so on, before you
                see the complete the deal. The process can easily take several months.
     b. Background
             i. The company has been incorporated

                  ii. Assets have been transferred
                 iii. Founders stock has been issued
                 iv. Early employees have received common stock
                  v. Venture fund wants to invest
         c.   Purpose of terms sheets for entrepreneurs:
                   i. Build a successful business
                  ii. Raise enough money to fund the venture
                 iii. Maintain as much value and control of the company as possible
                 iv. Get expertise and contacts to grow the company
                  v. Share some of the risks with investors
                 vi. Financial rewards if the venture turns out to be a good one
         d.   Purpose of term sheets for VCs:
                   i. Maximize financial returns to justify the risk and effort involved
                  ii. Ensure the firm is using the capital in best possible way
                 iii. Participate in later rounds of funding if the venture is a success
                 iv. Eventually achieving liquidity
                  v. Building their own reputation
         e.   Key business issues behind the term sheet
                   i. What are company objectives
                  ii. Who are existing investors? Are they putting more money in?
                 iii. What does the term sheet say about the new investor?
                 iv. How much time and cost will it take to get the financing completed?
                  v. Does the valuation make sense
                 vi. Industry market norms create a natural limit on the boundaries of achievable valuation
         f.   Cost of Financing
                   i. For company - $50k
                  ii. For investors - $40k

      a. Lawyers get involved at term sheet stage
      b. Preferred stock purchase agreement
               i. Articles of incorporation: to establish the rights and preferences of the preferred stock
              ii. Voting agreements: to establish who sits on the board of directors
             iii. SH agreements: to establish information rights, registration rights, rights of the first refusal on stock sale
      c. Board and SH approval
      d. Close

     a. (1) Preferred Stock: When a company is created, the founders will get common shares, which represent ownership in the
        venture. These are also referred to as founder's shares. VCs don't want these shares; instead, they want preferred stock.
        These securities have a variety of protections (the list that follows)—such as liquidation preferences and voting rights—
        that provide VCs with downside protection and control. However, there is virtually no way to get rid of the preferred
        stock. Although, you can certainly negotiate some of the underlying protections
              i. Two tier pricing structure: (1) VCs pay for preferred stock (2) Founders get common stock
             ii. Rights of the preferred is superior to those of the common stockholders
            iii. NOTE: Keep subsequent financings in mind. Earlier investors (eg. Series A) are senior or one round ―up‖ from
                  later investors (eg. Series B). Thus, Series A investors would not want Series B investors to have more
                  favorable terms than them. (Eg. liquidation preference, antidilution adjustments)
     b. (2) Liquidation Preferences. VCs have a broad definition of "liquidation," which includes an acquisition, bankruptcy,
        and the sale of much of a company's assets. For the most part, a VC wants to get as much capital back on such events. As
        the name implies, a liquidation preference means that a VC gets the first money out of a deal. [SEE BELOW]
     c. (3) Dividends. This is an annual return on the preferred stock, which can range from 5% to 15% (payable in either stock
        or cash, at declaration of the board). Founders should try to negotiate for the lower amount.
              i. Cumulative Dividends: dividends that are not paid will be added up. If this happens over 5 or 6 years, the
                  impact can be substantial, so founders should negotiate clause that makes dividends noncumulative
                       1. VCs may also get a liq pref that is the original purchase price + any accrued unpaid dividiends – if this
                            is the case there may be a mandatory annual dividend that would accumulate.
             ii. Virtually never distributed because all cash is desired to be kept and reinvested into the company

        d. (4) Drag-Along Rights. Minority s/h‘s must agree to a sale or liquidation of co. For the most part, this is triggered when
           the proceeds are less than the liquidation preference, which means that the founders will get nothing.
        e. (5) Anti-dilution. This provision is meant to protect investors in the event of a down round. To understand how the anti-
           dilution concept works [SEE BELOW]
                 i. Type 1: Protection along lines of stock splits
                ii. Type 2: Price based
               iii. Pre-emptive Rights. Rights for investors to participate in future rounds of financing
                          1. There are price based anti-dilution carveouts
               iv. Rights of First Refusal. Allows any existing s/h to buy their pro rata share in any subsequent issuance so their
                     holding isn‘t diluted. Usually terminates on IPO. Usually will have time prd they have the ―right‖ to refuse
                          1. This rarely happens
        f. (6) Legal fees. fees can easily range from $25,000 to $50,000, which can be a big chunk for a small financing. Keep in
           mind that the legal work may include more than just term sheet issues but also corporate cleanup (such as correcting
           poorly drafted contracts, board minutes, and so on). The bad news: though you can negotiate a cap on the fees, the VC
           will require the company pay for all the fees
        g. (7) No shop. Founders agree not to negotiate w/ any other invesotrs for a period of time after the term sheet.
           Essentially, the VC wants to lock in the company and not have to deal with renegotiations—or even losing the deal. A
           VC will probably not relent on the "no shop." However, you can limit the term, such as to 30 to 45 day
        h. (8) Redemption Provisions. Permits the preferred stockholders to require the company to repurchase their shares at a
           prescribed time and price
                 i. Triggered at sale of the company, let‘s the SH suddenly become a creditor
                ii. Some preferred stock include either mandatory or an optional right to cause the preferred stock to be redeemed.
               iii. Redemption rights are a last resort for an investor because they cannot be exercised unless there is sufficient net
                     worth to do so, after allowance for all debts and all liquidation preferences of any remaining preferred stock.
                          1. Investors may insist on mandatory redemption as means of rescuing capital if no other exit path is avail
                          2. A protection in case the co. doesn‘t do well & there is no other way to achieve liquidity (sale/merger)
               iv. Usually don‘t activate until 5 to 7 years after the investment
                v. When there are redemption provisions, preferred stock might be characterized as debt on the balance sheet
        i. (9) Conversion Rights. Rt for the VC to either decide to convert to common stock, or for conversion to happen
           automatically, usually in relation to liquidity event. [SEE BELOW]
        j. (10) Directors. Who gets to elect directors and what the composition will be?
                 i. They may decide, for ex, that there will only be 2 founders, 2 VCs, and 2-3 seats for industry leaders
        k. (11) Protective Covenants/Provisions. Certain matters for which co. must get approval from the pref stock. These
           provisions set who will have to consent to things for certain events to go through
                 i. Veto rights determined by ―protective covenants‖ or ―negative covenants‖ – these are in articles/certificate of
                     incorp – list of things the company cannot do unless its approved by preferred stock holders.
                          1. There are also statutory consents
                ii. Voting rights in the Articles of Incorporation
                          1. To be interpreted in conjunction with rights to board representation
                          2. Structured typically to ensure that major investors have veto right based on equity ownership interest
               iii. Common examples: Can‘t amend stock certificates to create a MORE senior class of stock. Can‘t sell company
                     (sales transaction or merger); Can‘t sell without the Series A/B consents; can‘t redeem stock w/o approval
        l. (12) Registration Rights. Rt to force co. to register the holder‘s stock with the SEC so it can be sold on the open market.
                 i. Rule 144 – rules on reselling restricted stock
                          1. If s/h has held stock for > year, then they can sell a certain amt (volume limits) in any 3 month period.
                          2. If seller is NOT an affiliate, then it can resell any shares he has owned for > 2years w/ NO restriction
                          3. Rule 144 is usually not available to VCs b/c they are usually affiliates. It is ALSO not available if the
                               co. has NOT gone public.
        m. (13) Information Rights. Holders of large blocks of stock may be granted rts to certain info.
                 i. Right of inspection
                ii. Annual and quarterly financial statements and annual budget
               iii. Monthly financial statements
               iv. Observer rights to attend Board meetings

      a. Makes sure you have enough authorized stock to sell
      b. There is typically common and preferred stock. Make sure there is enough stock for ratio of preferred stock, exercise of
         options, in establishing authorized shares of common stock

        c.   Board approval is required for issuance of shares, whether it‘s common or preferred
        d.   All SH of the same series MUST have the same rights (eg. liquidation preference, conversion rights …etc)
        e.   SH approval is required to amend the Articles of incorp to authorize the capital and to est the stock rights (§902(a),

                    Stage            Status                                                        Pre-Money

                    Seed             3 people and slideware; 5 people and pilots                   $3-5 million

                                     Proven CEO; product referenceability; seasoneed core team
                    First                                                                          $5-10 million
                                     and revenue

                    Second           Almost complete team, scaling revenue                         $10-20 million
                                                                                                   2x or more trailling
                    Expansion        Complete team, proven revenue model, close to profitability

      a. I & II: valuation and capitalization: negotiation of price is reflected here. Biggest sticking point between the
         entrepreneurs and the investors.
      b. III:
                i. Dividends. Though most investors have no interest in ordinary income or distributions from the company, the
                   dividend clauses for preferred stock are simply designed to guarantee that the preferred stock is not disfavored
                   by comparison with the common stock
                        1. Not very much will be spent negotiating this
               ii. Liquidation preference – SEE BELOW
                        1. VERY important: has the biggest impact on how the proceeds of an acquisition will be distributed
                            between the founders and the investors
                        2. Types: (1) Non-participating preferred stock. LP capped at his investment. As long as the LP holds
                            preferred stock, he can never get any more than his investment. LP may convert. If convert to
                            common stock (assuming that the preferred price is lower than the common price, everyone gets the
                            same money (2) Participating preferred stock. always gets its liquidation preference back and whatever
                            is left over, it shares with the common stock (3) Compromise: participating preferred with a capAfter
                            2x-3x original investment, the investors will stop participating
              iii. Conversion: Occurs usually when (1) IPO that meets certain threshold (2) If some threshold percentage of SH
                   agree to convert
              iv. Anti-dilution adjustment. Price based anti-dilution is if in a subsequent round of financing, the stock is sold at
                   a lower prices, then the ratio is adjusted. Types (1) full-ratchet (2) weighted average

                                                Term Sheet: Preferred Stock Rights

     a. Don‘t need to only worry about financing and liquidation prefs, also need to worry about control.
     b. Five principal control issues: (1) ownership (2) protective voting provisions (3) board composition (4) ―drag-along‖
        rights (5) founders‘ stock vesting provisions
              i. Ownership: how much of the pie do founders & VC‘s get and is their dilution?
             ii. Protective Voting Provisions: give holders of pref shares the rt to approve specified acts undertaken by the co.
                  and represent blocking rts for investors
            iii. Board Composition: how man seats each group will get
            iv. Drag Along Rights: at most extreme, they are rts given to major investors to force a vote by the holders of
                  common stock and minority investors in favor of a M&A transaction that the major investors approve. Takes
                  away ability for founders to block a merger.
             v. Founder Vesting: VCs will require the founders to get stock on a vesting schedule
     c. Company Control: corporate statutes giving voting power to SH
              i. Power to elect directors
                      1. usually VC will have at least 1 seat
             ii. A separate class or series vote may be required on a significant corporate transaction = veto right
                      1. Mergers and sales

                                   a.   Biggest diff between CA and DE
                                   b.   DE: unless charters say otherwise, 50% of the outstanding capital can virtually approve of any
                                              i. So if the founders retained 50% of the stock, under DE law, they can pretty dictate
                                                  how the company will be run
                                   c. CA: in order to approve these kinds of trxns, you need SHs from each class, voting separately.
                                        In general, CA makes more of a substantive review of the Articles whereas DE takes more of
                                        a facial assessment.
                           2.  any senior security
                           3.  amendments of articles of incorporation
                iii. Statutes
                           1. California
                                     a. 152, 181, 204, 204.5, 309, 310, 317, 400, 708, 902, 903, 1001, 1200, 1201, 2115
                                     b. 2115: even if you‘re not incorporated in CA but you have sufficient nexus to CA, then your
                                          corporation will still be subject to CA corporate law
                           2. Delaware: Most important thing: even though you‘re in DE, there is a possibility that CA still applies
                                and impose these voting requirements
                                     a. 141, 142, 144, 151, 152, 153, 242, 251, 312
        d.   Company Control: the voting power of the SH – as a matter of legal contract
                  i. See term sheet: A class or series (ie. a veto right) can also be accomplished through contractual rights
                           1. West Coast funds tend to stay at a high level: mergers and sales, amendment to articles, authorizations
                                and issuances of senior securities; redemption of stock
                           2. East Coast funds tend to want control over a broader spectrum of matters: incurrence of debt; failure to
                                pay taxes; approval of operating budget; changes in business objectives; change in the CEO; approval
                                of D&O insurances; etc
                 ii. It‘s critical how the statutory or contractual vote threshold for a class or series is drafted – how much
                     investment justifies a veto right on trxns?
                iii. EX. Co. has 500,000 shares of series A preferred outstanding.
                           1. Mayfield owns 300,000 shares; Sequoia Capital owns 200,000 shares
                           2. Preferred shares can be automatically converted into common on a 50% vote of all the preferred.
                           3. Therefore, Mayfield can ALWAYS have the power to auto convert b/c they have over 50%!
        e.   Company Control: voting power of the common stock held by founders
                  i. CA law: imposes a class vote requirement on specific actions (differs from DE law)
                           1. CA law (not DE) common s/h‘s have right to vote as common s/h‘s in a CA co. to vote as a separate
                                class in the event of a proposed merger of the corp – gives leverage to common s/h‘s
                                     a. In DE merger must be approved by majority of ALL classes of stock, voting together.
                           2. Stock or stock options (ie. does it vote?)
                           3. Is it subject to vesting?
                           4. Is it subject to a voting agreement in favor of a pre-selected group of directors to sit on the board
                 ii. Example: founder of a company has 90% of the outstanding common stock. It is fully vested. That interest is
                     15% of the entire outstanding voting stock (ie., both common and preferred)
                           1. Founder is fired and thinks evil thoughts about incumbent management.
                           2. Company wants to raise money in a Series A financing. Problem?
                                     a. Founder will try to use his 15% control in bringing down the company(?)
        f.   Company control: Composition of the board
                  i. Boards are usually not more than about 4-7 directors (usually odd number so can have majority quorum)
                           1. Usually a balance of VCs, founders and ―outside‖ directors
                 ii. VCs who invest in a series of preferred stock are usually given in a guaranteed right to elect a specific number
                     of directors
                iii. Board observer rights as an alternative to a formal board seat
                iv. Chemistry and commitment at the board level

      a. In General
              i. Liquidation preferences are designed to protect the investor‘s economic interests. Liquidation preference
                 protects the investors‘ originally invested capital against dilution. Hence liquidation preference provides that on
                 liquidation or change-in-control transactions the preferred investors get money back before anyone else.

          ii. Preferred Stock gets HIGHER preference than common stock: gets higher preference over common stock in the
              event of a liquidation. Purpose of preferred stock is to:
                   1. Prevent founders from being able to pull out money before they create any real value
                   2. Redemption of preferred stock does not attract capital gain tax as it is just a return of capital
                   3. Limits returns to the founder for modest outcomes – incentives to reach high payoffs
                   4. The extent to which VC wants to encourage the entrepreneur to go for the big payoffs can be
                        controlled by specific choice of security.
b.   What is a Liquidation Right? Most important for investor: how to get your money back!
           i. When you have assets, there are multiple claims on the assets – Creditors & shareholders
                   1. The law creates a hierarchy of the claimants
                             a. Secured Creditors: they have a lien on the assets of the company
                             b. Unsecured Creditors: only after all these secured creditors are paid, do these creditors get paid
                             c. Shareholders: Only get paid after ALL the creditors, i.e. they have a ―residual claim.‖
                                       i. Among shareholders, there are 2 types
                                               1. Outside investors  preferred stock
                                               2. Inside investors (founders/employees)  common stock
                                      ii. Liquidation preferences tries to determine as b/w these 2 groups, how the claims will
                                          be prioritized if the company is liquidated
          ii. Liquidation may mean many things: Bankruptcy, or a sale
                   1. ―Deemed Liquidation‖: this means a merger or acquisition to VCs - relevant to VC deals
                             a. What a deemed liquidation term in a agreement means Based on the consideration paid to
                                 shareholder, this is how it will be divied up b/w the preferred and common s/h‘s
         iii. Downside protection for investors: in case the company is liquidated for less than there is to go around, the
              liquidation preference protects the s/h‘s. If there is MORe risk, than the s/h can ask for MORE, so like double
              the per share price they originally paid…usually the liquid preference per share will be the SAME as the
              original per share price
         iv. Contained in Articles of incorporation
          v. Only outstanding shares count. NOT reserve or stock options.
c.   EXAMPLE1: See Analysis in sections below.
            Class               Shares           Liq. Preference Share           Aggregate Liq.
     Series B              1,500,000           $2.00                          $3,000,000
     Series A              1,000,000           $1.00                          $1,000,000
     Common Stock          3,000,000           --                             --

d.   EX. Simple ex. that the preference amt is equal to the amt initially paid for stock.
            i. So, if Series A sold at $.50/share, the liq. Pref. is $.50/share
           ii. So, if VCs invested $2mil for 40% of the co., then the first $2mil will go to the VCs, and the rest will be
               distributed to the common shareholders.
          iii. IF, however, the co. will be sold for $9mil, the VC‘s will convert to common stock and abandon the liq. pref.
                    1. 40% of $9mil is $3.6mil, which is greater than $2mil.
e.   Different Liquidation Rights
            i. (1) senior liquidation rights
                    1. If B is senior to A, than B will always get paid first.
           ii. (2) ―Pari Passu‖ liquidation rights
                    1. They get paid out depending on their aggregate holdings
                    2. This is negotiated between the preferred s/h‘s, so in our EX between B and A.
                    3. EX1, if the co. was sold for $1mil, then Series B would get $750,000 and A would go to $250,000
f.   KINDS (preferred can ALWAYS convert to common –in IPO preferred automatically converts to common, not always
     in a merger though)
            i. Participating preferred:
                    1.   Participating preferred stock is entitled both to receive its liquidation preference and then to
                         ―participate‖ as common s/h‘s on an ‗as if converted‘ basis in the disbursement of remaining proceeds
                              a. Share in the remaining proceeds pro rata with the common stock.
                    2.   FULLY Participating preferred stock: right to get both its preference and a common equivalent share
                         with no upper limit.
                    3. Investor never has a need to convert to common

                           a. VERY favorable to the investor
                  4.  EX1 (from above) sell company for $100,000,000
                           a. Preferred s/h‘s get their original payment back first
                                      i. Series B would get $3,000,000
                                     ii. Series A would get $1,000,000
                           b. THEN they would divide up the remaining 96,000,000 by percentage
                                      i. Series B gets 27.27% (they own 1,500,000 of 5,500,000 total) of $96 mil =
                                         $26,200,000  $19.50 per share
                                     ii. Series A gets 18.18% of 96mil = 17,450,000
                                    iii. Common gets 54.5% of $96mil = $52,400,000
                 5. EX company is sold for $10 million. Series A had invested $1 million and owns 33% of the stock. A
                      will get $1 million back, which leaves $9 million remaining. Then A will again get 33% of the
                      remaining $9 million while the common stockholders get the other 66%.
         ii. Non-participating preferred:
                 1. Preferred stock has ONLY the right to get its money back. The investor is permitted only the return of
                      the defined liquidation preference; any remaining proceeds are distributed to the common stockholders
                           a. As long as the s/h holds preferred stock, no matter how much the co. is sold for the s/h will
                                ONLY get the money they paid back
                 2. Investor will need to make a decision regarding conversion: whether greater recovery can be
                      obtained by leaving preferred stock unconverted and taking the liquidation preference, or converting
                      preferred into common and sharing in the proceeds with the other common SHs.
                 3. More favorable to the common SHs, so founders want this!!
                           a. Founders will ALWAYS want non-participating, VCs will always want participating.
                           b. Back in the day, stock was almost non-participating, very rare now.
                 4. So from EX1, if sold for $100,000,000
                           a. Series B would get $3,000,000 ($2.00 a share)
                           b. Series A gets $1,000,000 ($1.00 a share)
                           c. And the Common s/h‘s get $96,000,000 ($32.00 a share)
                           d. But the preferred holders won‘t stand for this, they will try to convert to common stock. So
                                Series B and A would convert – so then you divide that $100,000,000 by all the shares. S/h‘s
                                would do whichever benefits them more.
        iii. Hybrid participating structure (ie capped participation right):
                 1. Investor is permitted first the return of the defined liquidation preference right, and thereafter a shared
                      participation right (up to the cap) with any remaining distribution to the common stockholders, but
                      only up to a specific amount
                           a. Cap often set at 2x or 3x the original investment. Once the cap is reached, the remaining will
                                go only to the common stockholders
                           b. EX. VCs have 3x cap, they are entitled to receive their liq pref, then to share in pro rata
                                proceeds w/ common s/h‘s UP TO POINT they received 3x their original investment.
                 2. Investor will need to make a decision regarding conversion
                           a. If preferred holders would get MORE than capped amt if they converted to common, they
                                would forgo the liq pref and convert.
                 3. ―under water‖ the exercise price is above the prices they‘d get during the merger
g.   EX: Co. A accepts offer to be acquired for $30mil
          i. Capital structure
                 1. 6mil common;
                 2. 2mil outstanding stock options for common;
                 3. 4 mil preferred ($2/share; 1x liquidation pref ($2 liq pref); covertible at 1:1 on election)
         ii. No Participation Right – have to determine if will convert or not

If no Conversion                                               Is Series A converts
Series A                $8mil =      $2.00/share               Series A + Common = 4mil + 6mil = 10 mil shares
Common Stock            $22m =       $2.20/share               $30mil/10mil shares = $3.00/share

                   1. Series A will convert!! So they can get $3/share instead of $2/share
         iii. Full Participation Right – NO need to decide with full rights!

                          1.Series A gets the liq preg of $2/share first  4mil shares x $2/share = $8 mil
                          2.Then determine what‘s left: $30mil - $8mil = $22mil
                          3.Then ALL shares get to share in what‘s left, so $22mil/10mil shares = $2.20/share
                          4.In other words, from this sale
                                 a. Series A gets: $2.00/sh + $2.20/sh = $4.20/share
                                 b. Common gets: $2.20/sh
                 iv. Capped Participation Right – 2x cap  must decide whether or not to convert
                        1. If Series A doesn‘t convert:
                                 a. First A gets their liq pref, $2.00/sh x 4mil shares = $8mil
                                 b. Then both A and Common both share in some of the rest. To determine: A gets 2x its liq.
                                     pref (total), so that means they get $4.00/share TOTAL. $4.00/sh-$2.00/sh = $2.00/share
                                           i. SO, $2.00/share x 10mil total shares = $20mil
                                          ii. i.e. A ends up with $4.00/share
                                 c. $20m + $8m = $28m, $30m=$28m = $2mil left  common gets this, $2m/6mil shares = $.33
                                           i. So common ends up with $2.33/share
                        2. If Series A does convert:
                                 a. Series A + Common = 4mil + 6mil = 10mil shares
                                 b. $30mil/10mil shares = $3.00/shares
                        3. Series A will NOT convert because the get $4.00/share before conversion

     a. VC‘s convertible preferred stock typically carries both rights and obligations to convert into common stock.
              i. For optional conversion, the investor typically retains the option to convert the preferred stock to common stock
                 at will, except that it is conventional to bar conversion after an investor has demanded redemption of the stock.
                      1. Usually ratio at which pref stock is converted into common is determined by dividing the initial
                           purchase price by the ―conversion price‖ – which may change depending on the event.
                      2. Initially the ratio is 1:1 (1 share of preferred for 1 share of common)
             ii. For mandatory conversion, there is automatic conversion of preferred stock at specified point in time or at the
                 occurrence of a certain event
                      1. The co. wants these auto conversion rts, b/c they want to eliminate the special rights
                      2. Often a majority or supermajority of preferred s/h;s is req‘d to force the auto conversion – VCs will
                           want a supermajority requirement, the founders will want the majority requiremenet.
     b. Typical Mandatory Conversion points
              i. On IPO at above-price targets: The requisite per-share price is typically 3-5 times
             ii. On Majority conversion: compel conversion of any remaining shares when a majority of originally issued
                 shares of the series has converted
            iii. On merger above price targets: in the event of a merger or sale of the company at or above an agreed-on per-
                 share price.
     c. Significance of Conversion Rights:
              i. On conversion, all the rts associated w/ it (liq pref, antidilution, etc) are GONE.
             ii. Some rts like registration rts usually remain
            iii. Terminology: ―common equivalent shares‖

      a. What is an antidilution provision?
              i. They are included in term sheets to ensure that the economic effect of the conversion is preserved in case of
                  changes in common stocks, such as splits, combinations, recapitalization, and subsequent sales of stock at prices
                  below the price they paid.
             ii. Typically, investors would like to issue themselves more shares; that is, if someone else is getting a better price
                  than the investors paid, the investors would like to effectively reprice their investment to a new lower price
                  thereby protecting from economic dilution of the later lower priced investment.
      b. Right of First Refusal (aka “preemptive right”) – type of antidilution protection
              i. Permits investors to purchase more stock in future rounds of financing
             ii. Intent to ensure continued right to maintain the investor‘s equity interest in the company
            iii. Pro rata only
            iv. Addresses only financing trxn
      c. Transaction-based

           i. Typically for stock splits and stock dividends. Impacts the conversion ratio of the preferred stock in proportion
              to the split ratio.
          ii. Example: 3:1 forward split of the common stock
d.   Price-based
           i. Typically addresses the situation where a company is selling a new series of Preferred Stock at a price that is
              less than the price of the earlier series
          ii. Protection is effected through adjustment to the conversion rate of the preferred
         iii. Usually, the conversion rate of the preferred begins with a 1:1 ratio
         iv. Conversion rate: ―purchase price‖/ ―conversion price‖
e.   Purpose of antidilution protection
           i. Invoked only where the per share price of new stock is lower than the purchase price of outstanding stock
          ii. Benefits existing stockholders by increasing the conversion rate of their outstanding preferred
f.   Types
           i. Full Ratchet (high volatility)
                   1. If VC has full ratchet protection, then if anyt stock is sold at a lower price per share in a LATER
                        round, the ratio for converting preferred to common is adjusted so an investor would get the ―same
                        deal‖ that they would‘ve gotten if they had purchased in the later round.
                              a. If company comes back to sell stock at lower price (from $1 to 50 cents) at the next round,
                                  then the old stock gets reset to the new price. Now, older series stock has a ratio of 2:1 (two
                                  preferred stock converts to one common stock)
                   2. Formula: (old price)/(new price per share)
                              a. You have to recalculate the provisions until the #s are right
                   3. Most favorable to up round investors
                              a. It‘s rare for a early stage or Series A investor to ask for full ratchet anti-dilution – but it
                                  happens, especially with est. VC firms
                              b. You do see it when there was bad downround financing, and a early stage investor may come
                                  in and ask for protection
                   4. Considered very punitive. Only used when there is a lot of uncertainty about valuation.
                   5. EX. VC1 buys Series A preferred shares for Co. A at a pre-money valuation of $9mil.
                              a. They pay $3mil for 25% ownership of the co.  $12mil post-money valuation
                              b. There were 4.5 shares of common outstanding (held by founders), so VC1 get 1.5 mil shares
                                  of preferred stock (1.5 = 25% of (4.5+1.5)).
                              c. This is $2.00/share since they paid $3mil. The conversion rate to common is 1.1 rt now.
                              d. Then there is a second round of financing, Series B. The pre-money valuation is only $10mil
                                  (less than the post money valuation of the first round) – the co. hasn‘t done well.
                              e. VC2 buys at $1.67/share ($10mil valuation/6mil shares outstanding). They want to spend
                                  $2mil, so they get 1.2mil shares.
                              f. BEFORE full ratchet anti-dilution Protection:

                                                      Number of Shares         Percentage of Co.
                             First Round
                             Common                         4.5 mil                   75%
                             Series A                       1.5 mil                   25%
                             Second Round
                             Common                         4.5 mil                 62.50%
                             Series A                       1.5 mil                 20.83%
                             Series B                       1.2 mil                 16.67%

                            g.   AFTER full ratchet anti-dilution protection

                                                      Number of Shares         Percentage of Co.
                             Second Round
                             Common                         4.5 mil                   60%
                             Series A                       1.8 mil                   24%
                             Series B                       1.2 mil                   16%

                                      i. The conversion price is set to the lower sale price, so the conversion rate is
                                         $2.00/$1.67 = 1.1976

                                     ii. 1.1976 x 1.5mil = 1.8 mil shares of common stock
        ii. Weighted antidilution protectiom
                1. Weighted average anti-dilution provisions change the conversion price for the instrument in a way that
                     will have only minimal effects if only a few new shares are issued, and that will have progressively
                     larger effects as more and more shares are issued
                          a. Formula that gets built into the Articles.
                          b. Much more common now.
                2. Formula: NCP = OCP ((OB+(MI/OCP))/(OB+SI))
                          a. NCP = new conversion price
                          b. OCP = old conversion price
                          c. OB = # of shares outstanding before the new issuance
                          d. MI = money invested in the current round
                          e. SI = # of shares issued in the current round
                3. 2 Types: broad-based and narrow-based refer to the # of shares included in ‗old shares‘ in the fraction.
                          a. Narrow-based (medium volatility)
                                      i. Typically counts only issued common shares and issued preferred shares
                                              1. Includes preferred stock; excludes common stock and outstanding stock
                                     ii. Usually a larger adjustment
                          b. Broad-based (low volatility)
                                      i. typically counts old shares as all outstanding shares, and all shares issuable on
                                         exercise of granted options, warrants, and convertible debt
                                     ii. All components of capitalization included, but NOT future reserves
                                    iii. least favorable to up round investors
                                    iv. Usually a smaller adjustment
g.   EXAMPLE: ABC corp
         i. Capital Structure:
                1. 3mil common
                2. 1mil option reserve
                3. 2mil Series A preferred
                          a. $1.00/sh  invested $2mil total.
                          b. Got 33% of ABC on pre-money valuation of $4mil
                4. = 6mil shares TOTAL
        ii. ABC proposes second round of financing
                1. 2mil shares @ $.50/sh  $1mil total investment
                2. On a pre-money valuation of $3mil
       iii. No antidilution
                1. Add the 2mil shares to total
                          a. 3mil + 1mil +2mil +2mil = 8mil
                2. NOW, A only owns 2mil/8mil = 25% (used to own 33%)
       iv. Full-Ratchet Antidilution
                1. New conversion price = $.50/share
                2. New conversion ratio = original price/new price = $1.00/$.50 = 2
                3. SO A‘s 2mil of preferred becomes 4mil of common
                4. Capitalization after round B
                          a. 3mil common
                          b. 1mil option reserve
                          c. 4mil shares of ―A‖ preferred (common equivalent)
                          d. 2mil shares of ―B‖ preferred
                          e. = 10mil TOTAL
                5. NOW A has 40% ownership.
                          a. But PROBLEM – now the option pool is only 10% of the capitalization. This is a prob b/c it
                               is supposed to be 20-25% of all outstanding shares to protect. So often will ―refresh‖ the
                               option pool before a new round to protect this.
        v. Weighted Anti-dilution: Narrow Based (includes pref stock; excludes common & outstanding stock options)
                1. NCP = OCP ((OB+(MI/OCP))/(OB+SI))
                          a. NCP = new conversion price
                          b. OCP = old conversion price

                                    c. OB = # of shares outstanding before the new issuance (TOTAL)
                                    d. MI = money invested in the current round
                                    e. SI = # of shares issued in the current round
                           2. NCP = $1mil ( (2m + ($1m/1)) / (2m+2m)) = $1mi (3/4) = ¾ = .75  New Conversion Price
                           3. Conversion Ratio: $1.00/$.75 = 1.33
                           4. SO, the 2,000,000 of A preferred shares x 1.33 = 2,666,667 common equivalent
                           5. Capitalization NOW:
                                    a. 3mil common
                                    b. 1mil option reserve
                                    c. 2,666,667 Series A preferred
                                               i. 2,666,667/8,666,667 = 31%
                                    d. 2mil Series B preferred
                                    e. = 8,666,667 shares TOTAL
                           6. NOW, Series A has 31% ownership
                 vi. Weighted Anti-Dilution: Broad Based: (includes ALL stock in capitalization, but NOT future reserves)
                           1. NCP = OCP ((OB+(MI/OCP))/(OB+SI))
                           2. NCP = $1 [(6m + ($1m/$1))/(6m+2m)] = $1 (7/8) = $.875/share
                           3. Conversion ratio = $1.00/$.875 = 1.143
                           4. 2mil of Series A preferred shares x 1.43 = 2,285,714 (common equivalent)
                           5. Capitalization AFTER round:
                                    a. 3mil common
                                    b. 1mil option reserve
                                    c. 2,285,714 Series A Preferred
                                               i. 2,285,714/6,285,714 = 36.4%
                                    d. 2mil Series B Preferred
                                    e. = 6,285,714 TOTAL
                           6. NOW, Series A has 36.4% ownership
                vii. Full ratchet is the best for the VC, weighted is better for the founders.
        h.   Dilution and the stock option reserve
                   i. Based on the company‘s headcount requirements over a 12-18 month period—normally a 20% to 25%
                      component for the early stage startup
                  ii. This is a component of the capitalization that dilutes every existing shareholder equally. New investors will
                      often seek to ―refresh‖ the option pool prior to the found so as to mitigate the dilutive impact on

     a. Securities law restrictions
     b. Vesting requirements
     c. Right of first refusal/right of co-sale
     d. Lock-up arrangements

                                                  DOWNROUND FINANCING

     a. Role of the Board: the reality in the private company environment
             i. VC board members in private companies function more as an adjunct to the CEO
                     1. in the best situations, they are mentors and confidants; they open doors in the customer and vendor
                         communities; they provide executive search services; they offer operational advice
                     2. in worst scenarios, VC board members are highly focused on protecting their economic situation
                              a. BJR does NOT usually play a big role in director behavior in the private company
                                    context. Although, the BJR does come up in the context of down round financing.
                                    Usually, there are some VCs who want to invest to enable the company to continue; and
                                    there are VCs who don’t/can’t
                              b. In the worst situations, VC board members are highly focused on protecting their economic
                              c. When the company isn‘t performing, the VCs will want to hire new people to run the
                              d. Recall that the VCs are also fiduciaries to their LPs

     a. Company has been around for a while and still viable but the valuation is significantly down from previous rounds of
        financing. Prospects are not great so can‘t get new investors but old investors still believe in the company. The market
        health is a big factor.
     b. When entrepreneurs to a financing, most have to agree to an anti-dilution provision in the term sheet.
              i. This provision is meant to protect investors if the company's valuation is reduced in the next round of financing.
                  (Such a round is known as a "down round.")
             ii. Unfortunately, because of the recession and plunging markets, management at many companies will have to
                  decide whether or not to pursue a down round to raise additional capital at some point in the near future
     a. EX, The founders of ABC Corp. raised $1 million two years ago in a Series A round with VCs at a $5 million valuation,
        giving up 20% of the company's equity. The investors received 1 million shares, resulting in a price of $1 per share.
        Since then, ABC has encountered various problems, and its valuation has fallen to about $3 million. To keep things
        moving ahead, the company needs to raise another $3 million. Assuming there is no anti-dilution provision, the founders
        will suffer a reduction in their equity stake from 80% to 45.7%

     b. When: there are some (typically, insider) VCs who want to invest to enable to the company to continue; and there are
        some VCs who don‘t/can‘t
     c. Main components:
              i. additional funding at a highly reduced valuation
             ii. highly attractive investment terms for the investors with additional funding
            iii. punitive terms for those investors who elect not to participate (e.g. pay to play)
     d. Pay-to-play provision: if you participate in the down round financing, then you can convert your preferred shares from
        previous rounds of financing into common stock
              i. i.e. loss of anti-dilution protection, loss of liquidation preference, loss of other preferred stock rights
             ii. How to implement
                       1. charter
            iii. Benefit to implementing this earlier: when the time comes to enforce the provision, it‘s harder for the investors
                 who bought the shares with awareness of this provision to not comply with it
     e. Question:
              i. Does the BJR protect the board if they approve of the down round financing transaction?
     f. Mechanics
              i. Evaluate alternative sources of financing
             ii. Terms of the new investment
                       1. ―carrot‖ for the participating investors
                       2. ―stick‖ for the non-participating investors
            iii. Rights offering and disclosure to all stockholders
            iv. Execute on financing and close
             v. Reverse stock split to normalize capital structure
            vi. Option replenishment for continuing employees to restore competitive levels of compensation
     g. Protective mechanisms for the Board
              i. Does the BJR work?
                       1. disinterested directors?
                       2. disinterested stockholders/
             ii. Implement ―market check‖ for alternative sources of funding
            iii. Establish clear Board record of distressed circumstances, lack of alternatives
                       1. always want to show that you‘ve maintained detailed minutes of deliberations. Want, on record, that
                            the board was appropriately diligent.
            iv. Full disclosure of information—in advance—to the shareholders
                       1. information statement for proxy statement
                       2. earn approval from the disinterested shareholders
             v. Rights offering to the stockholders
                       1. this is CRITICAL
            vi. Amend charter to allow for change of rights of previous preferred SHs

                 vii. Will not lose BJR if have a committee comprised of independent/disinterested board members who approve of
                      the transaction
        h.   In DE: when VC shareholder gets sued for violating fiduciary duty:
                   i. First, P has to rebut the BJR by showing that VC breached duty of due case (eg. self-dealing)
                  ii. Next, D has to show ―entire fairness‖  fair price and fair dealing
                 iii. DE courts like to defer to terms on the business Ks
        i.   CA has similar ―inherent fairness‖ standard

      a. Types
                i. Duty of loyalty
                        1. requires a director to avoid any personal or financial conflict of interest with eh company
               ii. Duty of care
                        1. requires a director to act with the level of diligence and due inquiry that is reasonably prudent person
                             in the same position would exercise
              iii. Duty of candor
                        1. requires a director to act with candor and transparency in undertaking a fiduciary responsibility
      b. People who are putting money into the company are the people on the board. So their 1) jobs and 2) equity are on the
                i. Basically, everyone on the board always has an interest in the success of the trxn.
      c. In public company context, there is a lot less self interested behavior.
      d. In reality, VCs always act in their best interest despite their fiduciary duties
      e. Business judgment rule: applies to the Board only (not to executive, employee)
                i. As long as the duty of care (and loyalty?) is maintained, then the court will respect the business judgment
               ii. From the board‘s perspective, in showing fiduciary duty, always want to show that you‘ve maintained detailed
                   minutes of deliberations. Want, on record, that the board was appropriately diligent.
                        1. good to see that the board had been looking for different investors in multiple board meetings, not just
                             one! Basically, want to show that the board did the necessary due diligence
                        2. want to give full disclosure to all the SHs
                        3. rights offering
                                  a. really CRITICAL
                                  b. were the shares offered to everyone on the same terms?
              iii. will not lose BJR if
                        1. have independent/disinterested board members
                                  a. corp will usually comprise a smaller group of disinterested board members approve of the
      a. Usually the existing investors aren‘t dying to finance the company. They would prefer outside investors.
      b. How to get the current investors to invest (pay to play provision): if you don‘t, then your preferred stock will become
         converted to common stock. Basically, if you don‘t participate in this round of financing, then you lose the financial
         benefits of the preferred stock.

      a. Drag along right
               i. Basically provides that if there is a liquidity event (sale but NOT IPO), if there is some combination of votes,
                  then the other investors at the company will vote for the same trxn
              ii. 90% of the time: investors ask for this right from the founders who hold common stock or other holders of large
                  blocks of common stock. During sales, sometimes the common stock will get very little and investors do not
                  want founders to hold out from sales. From time to time, investors will ask drag alongs from other sales holders
                  as well (angels)
             iii. Drag along is designed to overcome the CA statutory hurdle which requires ALL SHs to agree to a sale of the
      b. Sale trxn also triggers the liquidation preferences

      a. Simplified capital structure
      b. Reduced liquidation overhang
      c. Renewed equity incentive arrangement

         d.   More working capital
         e.   New ownership
         f.   Marginalized non-contributors

        a. Nobody is happy about it
        b. Expensive!

                                                STOCKHOLDER CONSENT

       a. CA
                i. §1200: requires the Board of Directors to approve of sale
               ii. §1201(a): sale will need to be approved by each class of shares (eg. common is a class, preferred in a class)
              iii. §2115: Imposes consent requirements under §1201 of the CA Corporations Code on corps incorporated outside
                   CA if the corporation has a sufficient nexus to CA
                        1. eg. basically, even if a company is incorporated in DE, but has sufficient assets in CA, then that
                             company must also comply with the voting requirements of CA‘s code
       b. DE
                i. §251(b): Board of Directors must approve of the transaction
               ii. §251(c): requires majority vote by all outstanding stockholders (NO separate voting by class)
       c. Articles of Incorporation  be sure to check to see if the Articles have even more stringent voting requirements than is
          called by state law
       a. CA (§903)
                i. Common only (§(903(a))
               ii. Common and Preferred together (§903(c))
              iii. Preferred stock if (§903(a))
                        1. increasing/decreasing aggregate number of authorized shares
                        2. changes the rights, preferences, restrictions
                        3. create a new class of shares that has senior rights to prior classes or increases rights of prior class
                        4. divides shares of any class into series having different rights
                        5. (§903(b)): series of preferred stock will NOT vote separately unless series is adversely affected by
                             an amendment in a different manner than other shares of the same class

California Corporations Code §903

(a) A proposed amendment must be approved by the outstanding
shares (Section 152) of a class, whether or not such class is
entitled to vote thereon by the provisions of the articles, if the
amendment would:
  (1) Increase or decrease the aggregate number of authorized shares
of such class, other than an increase as provided in either
subdivision (b) of Section 405 or subdivision (c) of Section 902.
  (2) Effect an exchange, reclassification, or cancellation of all
or part of the shares of such class, including a reverse stock split
but excluding a stock split.
  (3) Effect an exchange, or create a right of exchange, of all or
part of the shares of another class into the shares of such class.
  (4) Change the rights, preferences, privileges or restrictions of
the shares of such class.
  (5) Create a new class of shares having rights, preferences or
privileges prior to the shares of such class, or increase the rights,
preferences or privileges or the number of authorized shares of any
class having rights, preferences or privileges prior to the shares of
such class.
  (6) In the case of preferred shares, divide the shares of any
class into series having different rights, preferences, privileges or
restrictions or authorize the board to do so.
  (7) Cancel or otherwise affect dividends on the shares of such
class which have accrued but have not been paid.
  (b) Different series of the same class shall not constitute
different classes for the purpose of voting by classes except when a
series is adversely affected by an amendment in a different manner
than other shares of the same class.
  (c) In addition to approval by a class as provided in subdivision
(a), a proposed amendment must also be approved by the outstanding
voting shares (Section 152).

California Corporations Code §204.5
(a) If the articles of a corporation include a provision
reading substantially as follows: "The liability of the directors of
the corporation for monetary damages shall be eliminated to the
fullest extent permissible under California law"; the corporation
shall be considered to have adopted a provision as authorized by
paragraph (10) of subdivision (a) of Section 204 and more specific
wording shall not be required.
  (b) This section shall not be construed as setting forth the
exclusive method of adopting an article provision as authorized by
paragraph (10) of subdivision (a) of Section 204.
  (c) This section shall not change the otherwise applicable
standards or duties to make full and fair disclosure to shareholders
when approval of such a provision is sought.

California Corporations Code §309

(a) A director shall perform the duties of a director,
including duties as a member of any committee of the board upon which
the director may serve, in good faith, in a manner such director
believes to be in the best interests of the corporation and its
shareholders and with such care, including reasonable inquiry, as an

ordinarily prudent person in a like position would use under similar
  (b) In performing the duties of a director, a director shall be
entitled to rely on information, opinions, reports or statements,
including financial statements and other financial data, in each case
prepared or presented by any of the following: (1) One or more
officers or employees of the corporation whom the director believes
to be reliable and competent in the matters presented. (2)
Counsel, independent accountants or other persons as to matters which
the director believes to be within such person's professional or
expert competence. (3) A committee of the board upon which the
director does not serve, as to matters within its designated
authority, which committee the director believes to merit confidence,

so long as, in any such case, the director acts in good faith, after
reasonable inquiry when the need therefor is indicated by the
circumstances and without knowledge that would cause such reliance to
be unwarranted.
  (c) A person who performs the duties of a director in accordance
with subdivisions (a) and (b) shall have no liability based upon any
alleged failure to discharge the person's obligations as a director.
In addition, the liability of a director for monetary damages may be
eliminated or limited in a corporation's articles to the extent
provided in paragraph (10) of subdivision (a) of Section 204.


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