1 Law & Economics of Contracting & Organizations - Day 3 Erik P.M.Vermeulen
2 Case - Questions? MedTechCo Venture Capital Firm Term Sheet
3 Financing the Start-Up Options The hard way The other hard way The really hard way Debt Equity Bootstrapping VENTURE CAPITAL
4 Bootstrapping The Good News No loss of ownership No monthly payments No term sheet /legal documents The American Way The Bad News Unsophisticated Difficult to make large capital commitments Hard to recruit top-notch talent Risk of losing strategic focus by chasing tactical opportunities
5 Debt The Good News Other people s money No loss of ownership (initially) Screening mechanism for adverse selection problem The Bad News Debt service: Lenders want a little bit back every month Lack of liquid assets - focus on human capital Lenders care about repayment, not directly about the success of the start-up
6 Overview Financing $1x $ Amount Mechanism Type ,000 Visa card Debt 30,000 Second mortgage Debt ,000 Angel investor Debt/Equity 300,000 Angels and seed funds Equity ,000,000 Seed-stage venture capital Equity 3,000,000 Early-stage venture capital Equity ,000,000 Later-stage venture capital Equity 30,000,000 Public markets (IPO) Equity ,000,000 Corporate bonds Debt Traditional Venture Capital sweet spot
7 Venture Capital: Job-Creating Engine VC-backed companies outperform other companies Wages grow faster than national average Spend twice as much on R&D
8 The Role of the Government in Engineering a VC-market Example: The German WFG Founded by 29 German banks Government guaranteed losses 12 persons board Bad project selection No Incentives No Monitoring
9 360º View of VC Negotiations Entrepreneurs Demand-side VC versus Entrepreneur Supply-side Other VCs competition VC collaboration Other VCs VC as Entrepreneur Investors
10 VC versus Entrepreneurs get outside capital maximize financial gains from equity stake build successful firm build reputation get outside expertise and contracts negotiations Entrepreneurs Private Information Private Information VC maximize financial returns maintain option to abandon build or maintain reputation
11 Examples of Information Problems How can an entrepreneur raise capital for a new venture without losing control of critical intellectual property? How can an investor attract good projects and gain access to the information that is critical to assessing the merits of a project? How can an investor determine whether the projections in the business plan reflect what the entrepreneur truly expects? How can an entrepreneur convey a message of capability and commitment to the success of a venture?
12 Equity (Venture Capital) The Good News No monthly payments Large dollar volume available Long time horizon The Bad News Loss of ownership and often control Founder now reports to Board of Directors Focus on Strategy Role of the Lawyer: Align the Interest!
13 The Answer: The Term Sheet Entrepreneurs Adverse Selection Moral Hazard Signaling/Screening provisions Operational Governance/Control provisions Downside Investment Protection provisions Entrepreneur Favorable Middle of the Road VC Exogenous Risk Exit provisions Investor Favorable
14 Players in the VC-Cycle Institutional Investor & others Venture Capital Firm Equity Entrepreneur Liquidity Event (Sale or IPO) Capital Gains Carried Interest
15 VC versus Entrepreneur Negotiations Entrepreneurs Adverse Selection Moral Hazard Signaling/Screening provisions Operational Governance/Control provisions Downside Investment Protection provisions Entrepreneur Favorable Middle of the Road VC Exogenous Risk Exit provisions Investor Favorable
16 The Parties Entrepreneurs Delaware Corporation Why? VC US Limited Liability Partnership
17 The Organizational Structure of Corporations Stockholders elect Elect? Directors elect Officers CEO CMO
18 Term Sheet MEMORANDUM OF TERMS FOR PRIVATE PLACEMENT OF SERIES B PREFERRED STOCK OF MEDTECH INCORPORATED APRIL 14, 2003 A Section-by-Section What Written is a Term View in Stone? of Sheet? the Term Sheet
19 Negotiation Tips KISS Negotiate, but do not kill the deal Have a negotiation strategy Empathize with your prospective investors Avoid a lock-up provision
20 Sources of Negotiation Power Entrepreneur Deep expertise in hot specialty Solid team Can keep VC from investing in later rounds VC wants to lay groundwork for productive relationship VC s reputational concerns BATNAs VC Providing capital Adding credibility to entrepreneur Actions send signal to other potential VCs Adding value through expertise and contracts Entrepreneur s reputational concerns Imbalance between supply and demand Syndication BATNAs
21 The Financials Pre-Money Valuation: $6.5 million Amount of Financing: $5.0 million from the Investor, representing approximately 44% of the ownership of the Company (after giving effect to the creation of a 15% option pool; see the historical and pro forma capitalization tables attached hereto at Exhibit A). Security: Shares of Series B Preferred Stock ( Series B Preferred ) at $3.60 per share (the Purchase Price ). Pre-Money Valuation = Company value before the investment What is the Post-Money Valuation?
22 Exhibit A - Table 1
23 Exhibit A - Table 2
24 Exhibit A - Table 3
25 What are Stock Options? Rights to purchase shares at a specified price during a specified period of time Are the most popular long-term incentive compensation approachh
26 Option Events Grant date - time begins on an option at this date. Strike price is usually FMV & set at this date Vesting date - when option recipient can first exercise option & realize a profit Exercise date - when option recipient purchases the shares and takes control of the options
27 Capitalization Tables
28 DEMO Who Bears the Dilution Caused by the Stock Option Pool?
29 Convertible Preference Pre-Money Valuation: $6.5 million Shares Amount of Financing: $5.0 million from the Investor, representing approximately 44% of the ownership of the Company (after giving effect to the creation of a 15% option pool; see the historical and pro forma capitalization tables attached hereto at Exhibit A). Security: Shares of Series B Preferred Stock ( Series B Preferred ) at $3.60 per share (the Purchase Price ). Convertible A different class of security from common shares Converts to common under certain circumstances Preference Carries certain priviliges/rights/ preferences unique to that class of security
30 Staged Capital Infusions
31 SCI in more detail... Financing stages Financing round Pre-seed Seed Early-stage VC Later-stage VC -1 0 First Second Third Fourth Liquidity event Duration years years years Typical funding $ thousand $ thousand $250 thousand - 2 million $1-3 million $3-5 million $5-50 million Number of Jobs Current Survival rate to next stage 33% 50% 60% 67% 70% 71% Improve Survival rate 43% 65% 78% 67% 70% 71%
32 The Dual Roles of SCI Signaling and Screening Attract confident entrepreneurs Entrepreneurs: More Favourable - Founders Wealth Control Mechanism Entrepreneur has to come back to VC Monitoring Exit = Abondon Projects
33 The Consequences of the Investment What do our clients want to know? 1. What are the consequences of the investment (now and in the future)? 2. What terms can (and should) be negotiated and what terms are dealbreakers for the venture capitalists and your clients? 3. The next steps...
34 Put yourself in the investors shoes! Pre-Money Valuation: $ 6.5M $ amount to be invested: $ 5M No. of shares to be issued?
35 No. of shares to be issued? 1,000, ,000 Options 472,914 1,000,000 1,390,000
36 Capitalization Option pool not included (but assuming that the pool will contain 472,914 shares) Option pool included Common Stock 36,06% Common Stock 31,62% Series A Preferred 10,83% Series A Preferred 9,48% Series B Preferred 36,06% Series B Preferred 43,95% Stock Option Pool 17,05% Stock Option Pool 14,95%
37 Rights/Preferences Type of Preference Operational Governance/Control provisions Downside Investment Protection provisions Exit provisions Preference Convertibility Participation: Voting Participation: Board of Directors composition Consent to major actions (protective provisions) Preemptive rights Reports / Information Key-man insurance Vesting Dividend preference Liquidation preference Anti-dilution provision Redemption rights Registration rights Right of First Refusal Co-Sale rights Drag-along rights
38 The Negotiation What terms can (and should) be negotiated and what terms are dealbreakers for the venture capitalists and your clients? Importance of the term What s the standard? Investor favourable/ Middle of the road/ Founder favourable
39 Conversion Rights Importance of the term? What s the standard? Investor favourable or Middle of the road or Founder favourable?
40 Participation Importance of the term? What s the standard? Investor favourable or Middle of the road or Founder favourable?
41 Protective Provisions The problems: VC buys into biotech company, turns into property investment company Founders (post investment) push salary to $2M Company attracts significant levels of debt Company pays significant dividend to shareholders, even though negative cash flow Changes the company s articles of association The answer: SPECIAL APPROVALS
42 Pre-emptive Rights The Problem: Company going great guns, but company decides to sell new shares, but not to original VC-deprived from accessing upside The Answer: Preemptive Rights
43 Downside Investment Protection Liquidation Preference Definition? A disaster situation Any other sale of the company What type of preference? Nonparticipating Preferred Participating Preferred Multiple Preferences
44 Liquidation Preference Example Series A Preferred VCs - 30% of the Company for $3 million ($1 per share) What is the capital structure? What is the pre-money and post-money valuation?
45 Complete the Table... Proceeds 3M 9M 15M Common shareholders 1X nonparticipating Series A Preferred Common shareholders 1X participating Series A Preferred Common shareholders 3X nonparticipating Series A Preferred Common shareholders 3X participating Series A Preferred
46 Possible Comments on the MedTechCo Term Sheet We should argue against the 3x liquidation preference If the investor does not come down from 3x, we could suggest milestones-financing to reduce the multiple to 1-1.5x
47 Possible Comments on the MedTechCo Term Sheet We could also demand a cap (e.g., 5x) on the Series B s participation rights on liquidation
48 Possible Comments on the MedTechCo Term Sheet We could object to the inclusion of an IPO in the definition of the Liquidation Event
49 Antidilution Protection The Problem: Early stage VC takes big risk and invests With time (and $), all find the going tougher than anticipated Company raises more cash, but at lower $/ share (downround financing) - thus first VC lost by going early
50 Antidilution Protection The Answer: Anti-Dilution Provisions Mechanism to adjust conversion ration - so that more shares are issued to lower the initial $/share paid Full Ratchet - ALL VC s shares priced at new lower price Weighted Average - Partial reduction in share price
51 Share Multiplier (Conversion Ratio) Old conversion price Share Multiplier = New conversion price
52 New Conversion Price Full Ratchet = price at which new shares are issued Weighted Average = (old conversion price) (A+B/A+C)
53 A+B/A+C A = total number of shares outstanding before later-round financing narrow-based broad-based B = number of shares later round financing would have purchased at higher first-round price C= number of new shares actually purchased at the lower later-round price
54 Example Management and other shareholders own 500,000 shares of common stock There are an additional 750,000 shares of common stock covered by outstanding stock options and warrants VC 1 purchases 1 million shares of Series A preferred stock for $1.00 per share VC 2 purchases 500,000 shares of Series B preferred stock for $0.50 per share (total investment = $250,000)
55 Complete the Table... antidilution method full ratchet narrow-based weighted average broad-based weighted average new conversion price for Series A Share multiplier
56 Possible Comments on the MedTechCo Term Sheet We should ask for a weighted-average (broad-based) antidilution provision The full-ratchet protection is unnecessarily punitive (particularly in the event of a market downturn) Full-ratchet makes it extremely difficult to attract additional investors
57 Dividend Rights What are your comments?
58 Dividend Rights What are your comments?
59 Dividend Rights What are your comments?
60 Dividend Rights What are your comments?
61 Conclusion Why should the entrepreneur accept an Investor Favourable or Middle-of-the-Road Term Sheet? How are your clients protected?
62 EXIT Strategies
63 The Next Steps... Type of Preference Preference Next Step... Operational Governance/Control provisions Optional conversion Mandatory conversion Voting rights Protective provisions Downside Investment Protection provisions Dividend preference Liquidation preference Anti-dilution provision Articles of Association Exit provisions Redemption rights
64 The Third Exit: Redemption If you must live with redemption rights, try at least to push the redemption date as far into the future as possible Hardly used: What would you recommend?
65 The Second Exit: Sale Type of Preference Preference Next Step... Exit provisions Rights of First Refusal Right of Co-Sale Drag-Along Rights Stock Restriction Agreement Rights of First Refusal and Co-Sale Agreement
66 Right of First of Refusal and Co-Sale Agreement What s the problem and how to solve it? Third Party
67 Possible Solutions Right of First Refusal Right of Co-Sale Preferred Investors can purchase the shares on the same terms Preferred Stock may sell (proportional share of) their shares as part of the sale by Founder
68 Example The shares of Common Stock held by (the Founders ) shall be subject to restrictions on transfer and made subject to a right of first refusal and co-sale agreement (with the exceptions set forth below) with the Investors such that the Founders may not sell, transfer, or exchange their stock unless the Company first, and each of the Investors, second, has an opportunity to purchase such shares, which purchase with respect to the Investors shall be on a pro-rata basis [I F : (provided that any shares not subscribed for by an Investor may be reallocated among the other Investors)] and if such rights are not fully exercised, then each Investor has an opportunity to participate in the sale by a Founder to a third party on a prorata basis.
69 Drag-Along Rights What s the problem and how to solve it? Third Party
70 Possible Solutions Drag-Along Rights Preferred Stock right to cause Founders to vote for sale of Company if (for instance) 2/3 Preferred vote in favour
71 The First Exit... All rights under the Right of First Refusal/Co-Sale Agreement shall terminate upon the closing of the Company s Qualified Public Offering... WHY? These rights of first refusal and co-sale shall not apply to and shall terminate upon a [IF: Qualified IPO] [C F : IPO] [C F : acquisition, merger, or consolidation of the Company.]
72 The Initial Public Offering Preferred Shares should be converted into common stock The shares should be registered with the U.S. Securities and Exchange Commission INVESTOR RIGHTS AGREEMENT
73 Registration Rights The Term Sheet specifies the rights of the investor with regard to registering for public offerings in order to provide liquidity Demand Rights - Investor can request that the Company file a registration statement (form S-1) beyond a minimum offering price Registrations on form S-3 - A majority may require the Company to file up to a pre-specified amount of registration statement annually Piggy-back registrations - Investors are entitled to piggyback registration rights on registrations of the Company Registration expenses paid by the Company
74 So What About the Founders... IPO Lock-up provisions... Why should the Founders accept the Term Sheet? How are the Founders protected?
75 One More Thing... The Stock Purchase Agreement Representations and Warranties Conditions to Closing
76 So can you tell your clients the whole story?