Capital Saving and Raising at the Brink

The Capital Saving and Raising at the Brink event held Monday, August 22, 2011 as part of the Forward Technology Festival was a success!  Entrepreneurs, investors, government representatives, and others interacted and shared ideas in a collaborative forum. 

Capital Saving

In the Capital Saving segment led by Troy Vosseller, attendees were divided into six teams, and each team collaborated to identify the ways in which they have saved capital in their businesses.  Teams simultaneously entered their ideas in different tabs of a GoogleDocs workbook.  Team captains pitched their team’s top two ideas, and attendees voted electronically on the top two ideas.  The winning ideas were: Continue reading →

Bridge Financing Documents

One of the sets of documents that we automated at AlphaTech is the bridge financing documents for an emerging company.  Attached is a sample of the documents: Convertible Note and Subscription Agreement

Instead of just using form documents as most law firms do, robust automation allows us to deliver common document sets for emerging companies in a more efficient manner.  So what else does “robust automation” yield?  It improves document accuracy, provides a valuable knowledgebase from which to draw, and enables us to deliver common document sets to our clients quickly.  It also frees up time of our lawyers to enable them to spend less time on basic contract drafting and more time on activities that afford our clients higher value. Continue reading →

Paper Stock Certificates: A Thing of the Past?

As public companies are increasingly opting out of providing paper certificates to shareholders in favor of providing electronic registration (a movement known as “dematerialization”), most private companies and their shareholders have yet to follow suit.  Issuing uncertificated shares is allowed under most states’ laws, and, as many on the public company side can attest, numerous cost and time efficiencies can be gained by going paperless with shares.  As we accept electronic statements to represent our public company holdings and exhibits to Operating Agreements to note our LLC ownership interests, do we really still need as evidence of our private company ownership a hokey, bordered piece of paper with an eagle on it?

Disadvantages of Issuing Paper Stock Certificates

Consider the inefficiency and chances for errors in the typical cumbersome process to issue paper stock certificates:  Continue reading →

Angel Financing Transaction Form Documents

As a follow up on the angel investor and venture capital term sheet post, I want to elaborate on some efforts to streamline angel investor transactions and reduce related transactional legal costs. In the last year or so, there has been considerable effort to create standardized open source angel financing documents. The first of these recent efforts was from Y Combinator. With the assistance of the law firm of Wilson Sonsini, Y Combinator published the Series AA Equity Financing Documents. Another organization focused on seed stage companies, TechStars, subsequently released its Model Seed Funding Documents, which were prepared by the Cooley Godward law firm. And, most recently, attorney Ted Wang from Fenwick & West led an effort to put together the Series Seed documents. There are others as well, especially form term sheets, such as this one from gust. In coming months, a Midwest group of attorneys and law firms plan to publish a set of documents that will add to the mix, with a Midwest flavor of default terms.

This post provides a brief summary of each publisher of the open source form documents as well as a brief overview of the standardized terms for each set.

The Reasons for Using Standardized Forms in Angel Financings

As mentioned in an earlier post in connection with the National Venture Capital Association‘s (NVCA) efforts in adopting form venture capital investment documents, industry standardization would be helpful to achieve these and other goals:

  • Reduce transaction costs
  • Reduce time to closing
  • Reflect industry norms
  • Promote consistency among transactions
  • Establish certain industry standards
  • Provide basic explanations as to the reason for particular provisions or the context in which certain provisions should be included

While achieving these goals would be laudable, creating a standard set of angel financing documents that are used by various groups presents challenges. I will cover these issues in a later post. But first, here is a summary of the current open source documents:

Y Combinator Series AA Equity Financing Documents

Toward the end of 2008, Y Combinator was the first of the groups to release an open source set of angel financing documents. Y Combinator provides small investments (typically less than $20,000) to computer, Internet, and software startups. Along with the investment, they provide initial consulting and networking opportunities for startups, including a three-month training program in the San Francisco Bay Area. According to Y Combinator, they take a 2-10% equity stake in participating companies. To date, they have worked with over 140 companies.

The Y Combinator documents were originally created for Y Combinator’s portfolio companies to use for their angel financing rounds. Among other provisions, the documents contain a 1x nonparticipating liquidation preference, no springing future rights from subsequent issuances, participation rights, a basic set of representations and covenants from the issuer, and a board seat.

TechStars Model Seed Funding Documents

In early 2009, TechStars released its set of model seed funding documents. TechStars provides up to $18,000 in seed funding to emerging companies, primarily in Internet and software industries. In addition, they provide educational programs and mentoring for three months in Boston, Boulder, and Seattle, with the chance to pitch angel investors and venture capitalists at the end of the program. In exchange for the funding and services, TechStars takes a 6% stake in companies.

TechStars provides its model documents to founders and lead investors as a starting point in seed and angel financing rounds in the $250,000 to $2 million range. The TechStars documents contain, among other provisions, a 1x nonparticipating liquidation preference, broad-based weighted average anti-dilution protection, springing future rights from subsequent issuances, participation rights, a basic set of representations and covenants from the issuer, and a limited right to a board seat that remains in place until the holders drop below 5% ownership of the company on a fully diluted basis.

Ted Wang’s Series Seed Financing Documents

The Series Seed Financing Documents were released last month (March 2010). An important characteristic of these documents is that they are, for the most part, slimmed down versions of the NVCA forms. As a result, investors who use the NVCA documents will generally be familiar with the terms of these documents. According to Ted Wang, the documents are intended for typical angel financing rounds in the $500,000 to $1.5 million range.

Although the documents are intended to be neutral, they generally contain the most investor-friendly terms of the three sets. Among them are assignment of the company’s right of first refusal to investors, drag-along rights, reimbursement of investor legal fees (up to $10k), and protective provisions typical for a company-friendly venture capital financing. Still, some investors have commented that the terms in the Series Seed documents are not aggressive enough.

The Series Seed documents are also intended to be used “as-is” without further negotiation (just fill in the blanks). The philosophy behind this approach is that the value of standardization outweighs the costs of customization: a controversial concept for many companies and investors. Ted Wang has invited comments and is planning to publish a revised set of documents after one quarter, including regular updates thereafter.

Comparison of Angel Investment Form Documents

All three sets of model documents anticipate that the security issued is preferred stock. Generally speaking, the Y Combinator and TechStars documents are more company-friendly than the Series Seed documents, although the TechStars documents contain anti-dilution protection and the other two do not.

While it may sound like only a self-serving comment, the open source forms should not be a substitute for involving an attorney experienced in angel and venture capital financing transactions. Selecting and negotiating terms (and alternatives), addressing the inevitable deal-specific terms not encompassed within the forms, providing a check as to what current “market” is, and securities law compliance are some of the reasons to involve an experienced attorney in the process. That said, industry or at least regional adoption of a standard set of angel investment documents (with common variations) should significantly reduce transaction legal costs, especially if both sides are represented by experienced counsel familiar with the forms.

If and when the Midwest-based angel financing documents are published, I will provide another update.

Term Sheets for Angel and Venture Capital Investments

When raising funds from angel investors or venture capital firms (VCs), the offering terms are often summarized in a term sheet prior to consummating the deal.  Term sheets negotiated with angel investors are typically less complex than those proposed by VCs, but there can be considerable overlap between the two.

Negotiating with Angel Investors

When dealing with angel investors, it is typical for the company to produce the initial draft of the term sheet.  There are variations by region and it is not uncommon to see an angel investor or angel group prepare the initial draft of the term sheet, especially if the company has not already prepared one.  If an angel investor or angel group has taken on the role of lead investor, it is common to see the term sheet negotiated. In such cases when a term sheet has been negotiated, it is important that the company communicate that fact with subsequent prospective investors to avoid further negotiations and different terms.

Elements of an Angel Investment Term Sheet

In an equity financing with angel investors, the terms of the deal are often rather straightforward.  Typically, the security being offered is either common stock or a stripped down preferred stock. The angel investor term sheet will typically contain at least the following:

  • A description of the security being sold
  • The price for the security
  • The company pre-money valuation
  • The minimum (if any) and maximum amount to be raised
  • Basic information about the issuer (e.g., whether it is a corporation or limited liability company, the state of incorporation/organization)
  • The current capitalization table
  • Any applicable security transfer restrictions

The term sheet may also contain other provisions that address issues such as board representation, veto rights over certain types of transactions or conduct, co-sale or tag-along rights, drag-along rights, dividends, put rights, piggyback registration rights, and anti-dilution provisions.

Once the term sheet is “finalized” for the equity financing with angel investors, it often becomes an important element of the issuing company’s private placement memorandum, if one is used.

Negotiating with VCs

When dealing with VCs, in almost every case, it is the VC who prepares the initial draft of the term sheet. Unless the deal is very small, VCs commonly invest in small groups or syndicates (e.g., two or three firms), with one VC acting as the lead. The lead VC will typically present the term sheet, and the company will have a relatively short time period to accept it or negotiate its terms (in an attempt to prevent the company from “shopping” the deal).

Elements of a Venture Capital Term Sheet

Venture Capital term sheets are usually complex. Below is a list of issues that are often included or addressed in a VC term sheet. This list is in addition to the items listed above for an angel investment term sheet.

  • Conditions to closing the investment
  • Closing date
  • Identity of investors.
  • Dividends (the percentage and whether cumulatve or not)
  • Liquidation preference (e.g., amount (multiple) and whether the security is participating preferred stock or not)
  • Board representation (e.g., single board member or control of the board)
  • Protective provisions (veto rights over certain types of transactions or conduct)
  • Conversion rights
  • Anti-dilution provisions (weighted average or full ratchet)
  • Pay-to-play provisions (assuming more than one VC is participating)
  • Redemption/put rights (requiring the company to buy back the investors’ shares on a given date)
  • VC’s attorneys’ fees (shifting costs over to the company)
  • Demand registration, S-3 registration, and piggyback registration rights
  • Management and information rights
  • Participation or preemptive rights
  • Employee stock or equity incentive requirements and limitations
  • Tag-along (co-sale) and drag-along rights
  • Confidentiality and no shop requirements

There can be a variety of other provisions and requirements included, such as a tranche or milestone funding process.

Upon acceptance of the term sheet, the VC’s attorney steps into the process (if he or she had not already done so at the initial due diligence stage). The VC’s attorney typically produces the initial drafts of the investment documents.

Term Sheet Forms

There are many good resources on the Internet with sample venture capital term sheets. Likely the best known is the one published by the National Venture Capital Association (NVCA). The NVCA form term sheet contains many good explanations of the various provisions in a VC term sheet. However, as you might have guessed with the authors of the form (VCs and their lawyers), the NVCA term sheet is generally drafted in favor of the VCs.

A version of the NVCA term sheet form that contains more company-friendly terms and more detailed discussions of the various negotiating points was prepared by those of us on the American Bar Association (ABA) Private Equity and Venture Capital  Committee. The ABA Comments to the NVCA term sheet form is intended to do the following:

  • Generate more options and alternative provisions, including many that are more company-friendly
  • Provide more detailed explanations concerning key provisions and negotiating points
  • Elaborate on current case law and the implications of various provisions
  • Identify which of the alternative provisions are more frequently used

Using resources such as the NVCA term sheet and the ABA Comments can help prepare companies to negotiate effectively (and more efficiently) with angels and VCs.

Best Practices for the Friends and Family Financing Round

When companies start up, often the first place they look for seed financing is from friends and family. As frequently as they occur, there is very little available on the details of what consists of a “good” friends and family financing. In this post, we will go through some of the considerations for your next friends and family round of financing.

Friends and family financings are frequently the first financing from outsiders of the company. Increasingly though with tough financial times, companies are relying more heavily and for longer periods of time on friends and family support to get them through the early times. So, let us get into some of the details.

Type of Securities to Issue

Almost invariably, when the company is a corporation, the company issues common stock in the friends and family round. For limited liability companies (LLCs), the security issued in the friends and family round is whatever the common stock comparable security is for the LLC—sometimes it is referred to as Class A Units or sometimes it is just a percentage interest or just “units” (if the LLC has only one class of securities). As LLC capital structures are most often a matter of contract per the company’s operating or LLC agreement and the laws vary from state-to-state, there is no single standard name for the type of security.

As later posts will echo, one important point to keep in my mind in terms of deciding on the type of security to issue is the importance of keeping the capital structure simple. In this case, with a friends and family round, it is typically best to issue common stock (or the LLC comparable). While one sees convertible notes, a “stripped down preferred,” or a certain level of warrant coverage, I recommend keeping the capitalization structure as simple as possible, for as long as possible.

Pricing

High Risk and High Price?

Pricing is often a difficult topic for a friends and family round. In my experience, it is often the round least likely where one is to see negotiation on price. It is not uncommon, however, for the friends and family round to be overpriced. How do I know that? Few would argue that of all the rounds of outside investment that companies go through, the friends and family round is likely where there is the most risk (technical and commercial) and there is likely the fewest tangible and intangible assets. I’ve seen some statistics indicate that over 90% of tech startups end unsuccessfully. Yet, it is (1) very common to see seven (or in some cases, eight) figure pre-money valuations for not much more than a skeleton of a management team, a business plan, and a patent application, license right, prototype, or vaporware, and (2) not uncommon to see either a flat round or better terms offered in the first VC or angel deal following the friends and family financing. It is not that entrepreneurs are trying to take advantage of their friends and family. But rather, it is likely because they are overly optimistic concerning their prospects; they are entrepreneurs after all, and a good sense of optimism is essential to success.

Impact of Price on Subsequent Rounds

When pricing a friends and family round, it is also important to consider the impact of the price in the context of the long term capitalization strategy. I talk about the long term strategy in my earlier post, Capitalization Strategy: Begin with the End in Mind. As mentioned in the previous paragraph, a common problem that some entrepreneurs face is having too high of a price in the friends and family round (or subsequent angel round for that matter). How can too high of a price be a problem for a company? After all, a higher price means less stock is issued and therefore less dilution. The reason it can be a problem goes back to your long term plan. Often, a high price in an early round yields problems in later rounds in terms of existing investor expectations. If you understand the likely pricing expectations of later round investors, those expectations should be incorporated in earlier round pricing. Promising companies can sometimes get too aggressive on pricing in early rounds and often stall, not because of their technology or lack of success in their commercialization efforts, but rather because they cannot find financing sources that meet their existing investor expectations. So, after a considerable delay in not getting a timely financing, companies are forced to consider either (a) “down round” pricing to get the amount of financing they need from subsequent round investors or (b) accepting less investment (most likely from existing investors) and prolonging the current share pricing as they hobble along and exist on less than ideal amounts of financing. Also, by accepting down round pricing, it can not only affect morale of existing investors but also employees as well in terms of the perception of the direction and speed of the company’s momentum.

Effect of Price on Stock Options

On a related note to employees, one other thing to keep in mind is the impact of your friends and family round pricing on your stock option pricing (or other equity-based incentive), especially if you issue common stock in the friends and family round. The price at which you sell your securities will likely affect significantly your stock option exercise price or the amount that has to be taken into income by employees and contractors if stock or other equity-based securities are issued to them. This is especially true as the ability to issue discounted stock options is no longer the option (pardon the pun) it once was in light of tax code section 409A. This is one area where offering convertible notes (or preferred stock) to friends and family yields a benefit over common stock.

Accredited Investor Status

As a general rule, it is best to limit your friends and family offering to accredited investors only. Many companies want to enable their friends and family who are not well off to “get into the action” early. Ignoring the issue of whether friends and family who are not accredited can bear the risk associated with an investment in a start-up, by including friends and family who are not accredited in an offering can drive up your legal costs to do the transaction and increase the risks of legal problems associated with the entire offering. If you are considering including investors who are not accredited in your offering, have a discussion with your attorney first before announcing the offering. Doing so will help to ensure that you make an informed decision without the pressures of the implications of backing down from an earlier announcement to your friends and family.

Amount of Funding

The amount of financing should be driven by, you guessed it, your long term capitalization plan. Conventional wisdom is that you should raise sufficient money to comfortably get you to the next significant milestone that increases your valuation. However, there are some companies that believe that they should get as much money as they can, as soon as they can. The problem with this latter approach is that, assuming your subsequent round financing is an up-round, you will suffer more dilution by getting the money earlier than what you would otherwise experience by waiting and then selling the securities later at a higher price. Also, some people believe that companies can become less efficient, less “hungry,” and lose their sense of urgency with significant amounts in the bank. On the flip side, a benefit of raising more in an early round is that less time is spent on subsequent fundraising. In addition, as those who adopted this approach a year ago will say, they are not now seeking financing in what is a very difficult time to raise money.

Importance of the Friends and Family Round

While typically not the biggest round of financing to say the least, the friends and family financing is essential for most high growth companies. It is important to do the financing right and not fall into one of the easy traps that create problems later in the company’s life cycle. If there’s interest, I can elaborate on some other traps and pitfalls in a later post.

Capitalization Strategy: Begin with the End in Mind

“Begin with the End in Mind”: what a simple, yet profound concept. It is one of the habits of Stephen Covey’s 7 Habits of Highly Effective People. It is so simple, but too often overlooked.

When entrepreneurs start companies they often have vivid visions of success. Through the business planning process, entrepreneurs often develop and work through the various issues that need to be addressed in order to obtain the commercial success for which they are looking. But, what is the desired end state or exit? Or, is death the only exit? Seriously though, is the exit, sale of the company within 5 or 10 years? Is it working with and growing the company until retirement, with younger management or the next family generation buying out the company? Is it an intellectual property holding company collecting royalties from various licensees? Is it the sale of stock after a public offering? Too often, entrepreneurs dedicate only two or three sentences in the business plan to the intended exit, using almost boilerplate language. Of course, only time will tell how things will end up, but having a vision for a desired outcome will help drive decisions and planning, making your desired outcome more likely to come to fruition.

Backwards Planning Process

With the desired end in mind, the business planning process and capitalization strategy development can truly begin. It is what is referred to as the backwards planning process. Many people do this instinctively as part of their normal planning. Identify what assuredly has to happen in order to get you in position to meet your desired end state. Think of these “have to happen” items as interim objectives. It may be a certain level of sales or EBITDA, successful completion of a lead drug phase II clinical trial, a successful public offering, etc. Then, identify what conditions, tasks, and shorter-term objectives it will take to meet those interim objectives. Continue to repeat that process until you are back in time to the present day.

Capitalization Strategy

When looking at your capitalization strategy, it is a very similar process. In fact, it should go hand in hand with business planning. You also need to consider though the needs, expectations, and desires of your sources of capital—meaning your prospective investors, bankers, government agencies, customers, etc. Figure out what it will likely take in order for you to get the sources and amount of capital you need to reach your desired end state. When looking at equity capital, think through valuation issues, dilution, capitalization structure, liquidation preferences, etc. Again though, start with the end in mind and work back through time, through each anticipated round of investment, each grant and grant phase, etc. It will help you develop a coherent strategy and identify what needs to be done to get you where you want to be.

Understanding Investor Needs

I’ll go through more on investor needs, expectations, and desires in later posts, but for present purposes I will touch on two very basic ones to illustrate some of the considerations to include in developing your capitalization strategy: the amounts of money that different types of investors invest as well as when in a company’s life cycle those investors invest.

Here are a couple of charts to consider. The first one shows the ranges of investment amount by investor type. The chart contains generalizations. Of course, sometimes investments are outside of these ranges for unique deals or situations or current market conditions. For instance, this year we are in relatively tight markets so both the number of deals and the amount of investments by group are generally down.

Investor Amount by Investor Type

Investor Amount by Investor Type

This next chart shows the stage of company development that investors generally invest at. As with the amount of investment, one see deals outside of these ranges based on unique opportunities or situations or the general market conditions. Also, there are variations by industry. For example, in therapeutics, the categories on the y-axis would be different: they would likely include positive preclinical animal data, filing a new drug application, commencing the clinical trial, completing phase I of the trial, etc.

 

Investor Interest by Company Stage of Development

Investor Interest by Company Stage of Development

The point to take from all this is that developing a coherent capitalization strategy is a deliberate process. It should take into account the entire time between today and the day you meet you desired end state, not just where your next grant or equity financing is going to come from. Have a long term strategy will actually help guide you through many decisions and assessments of opportunities that you will likely encounter.