Preparing for Early Stage Financing - Pedley, Millin & Gordinier - June 11, 2013

PREPARING FOR
EARLY STAGE FINANCING
June 11, 2013
Copyright © 2013 Pedley, Millin & Gordinier, PLLC. All rights reserved.
Anthony Millin, Esq.
Partner
Pedley, Millin & Gordinier, PPLC

Anthony Millin - Bio
Anthony Millin has a corporate and securities practice, focusing on start-up and
emerging growth companies. Anthony is also a successful serial entrepreneur who has
co-founded multiple companies in the United States and China, several of which have
been institutionally funded. This experience in raising capital, and building and
running companies, provides Anthony with valuable insights into the legal and
business needs of his clients. It enables Anthony to understand a business, its goals
and its challenges from the perspective of the entrepreneur.
Anthony’s legal practice includes general corporate counseling, preparation of investment materials and
presentations, equity and debt financings, joint ventures, corporate governance, and mergers and
acquisitions. He also has worked closely with angel investors and a range of institutional investors.
Anthony serves businesses across multiple industries, including internet/technology, biotech, clean
energy, education and health care. He also brings his China-based experience to assist early-stage and
middle-market companies interested in conducting business in China.
Anthony also serves as Founder and Chairman of Bramley Ventures, Vice Chairman of the Board of
Bethesda Green, Member of the Board of Directors of the Montgomery County Chamber Community
Foundation, Co-Founder and Member of the Board of Directors of Lauren’s Light, and Member of the
Advisory Board of the Maryland Clean Energy Center.
2

Agenda
• Investor Packages
– Creating a compelling investor package and preparing for investor
presentations
• Stages of Company
– Evaluating the sources of financing and legal structures for each stage of a
company’s lifecycle
• Term Sheet
– Negotiating a term sheet – a deep dive into the key legal provisions and their
impact
• Definitive Documentation
– Understanding the different set of documents that comprise the “Definitive
Documentation”
• Due Diligence
– Preparing for the due diligence process
• Regulatory Compliance
– Complying with federal and state regulatory requirements
3

Investor Packages
4

Investor Package
• “Teaser”
• Non-Disclosure Agreement (NDA)
• Executive Summary
• Investor Presentation (PowerPoint)
• Financial Model
• Business Plan (Internal Document)/ Implementation Plan
5

Investor Packages
6
SECTIONS TO COVER IN INVESTOR MATERIAL
• Vision
• Business Summary/Executive Summary
• Market Need/Opportunity / Problem You Are Solving
• Your Solution – Your Products and/or Services
• Market
• The Competition and Your Competitive Advantage
• Marketing/Sales/Distribution Strategy
• Business Model – How Do You Generate Profit
• Current Milestones Achieved/ ”TRACTION”
• Management Team
• Financial Summary
• The Ask (Funds Seeking) and Uses

Teaser
• 1-2 pages
• Goal of a “Teaser” is to get to a meeting
• Tool for you and your advisors to easily share
with prospects
• Quick to read, compelling
• Prior to an NDA - Share only information
comfortable sharing more broadly
7

Non-Disclosure Agreement
• Most VCs and many angel groups will not sign
• How should you proceed ?
– Judgment call specific to each potential investor
– Risk Level and Risk Aversion
– Should label all your documents “Confidential”
8

Executive Summary
• 5-10 Pages
• Expands on each section of the “Teaser”
• Includes detailed bios of the management
team and a more detailed financial summary
• Distribute to potential investors after initial
meeting
9

Financial Model
• It is important to build a financial model
• Forces you to understand your underlying business
model
• Investors understand that actual results will usually vary
from your projections
• The key is your understanding of the assumptions that
drive the Revenue, COGS and SG&A in your business
• Summary Income Statement and Cash Flow projections
for 3-5 years
• Very detailed Cash Flow projections for next 12 months
10

Financial Model
• Performs Sensitivity Analysis
– What if your assumptions are off by 10%, 25%, 50%
– What if the first sale takes 6 months longer than
projected
– What if the pricing needs to be cut by 30%
– Understand the impact on Cash Flow
• Try to raise sufficient capital to ensure that you do
not run out of cash under the more conservative
set of assumptions
11

Financial Model
• What items from the financial model should you
include in the investor package
– Teaser
• Revenue and EBITDA line for 3-5 years
– Executive Summary and Investor Presentation
• Summary chart of Income Statement and Cash Flow
Statement for 3-5 years
– The more detailed financial model will be shared with
potential inventors with whom you are engaged in
serious discussion and/or due diligence
12

Investor Presentation
• Prepare for the Presentation
– Research who you will be meeting (Investor Bios, Investor focus areas,
portfolio companies relevant to your market)
– Know how much time you will have to present your company
– Customize presentation to address your audience and allotted time
– Practice, Practice, Practice !!
• Invite questions and make the presentation interactive
– Increases the likelihood that you will address the specific questions and
concerns of the audience
• Be Passionate - If you are not, your audience will not be
• If you do not know an answer to a questions, it is OK to acknowledge that
and follow-up later with the answer
13

Stages of a Company
14

Stages of Company
• Seed Stage
• Early Stage
• Growth/Expansion Stage
15

Stages of Company - Seed
STAGE SEED
Investor • Self
• Friends & Family
• Angels
Objectives Include • Complete organization structure
• R&D related to building or testing product/service offering
• Validation - assessment of potential/early customer interest
• Develop a marketing and sales plan
Structure • Common Stock/Membership Units
• Convertible Note
• Series AA Preferred Stock/Membership Units
16

Stages of Company - Early
STAGE EARLY
Investor • Angel
• Institutional Angel
• Venture Capital
Objectives Include • Launch initial product and/or service
• Continued product development
• First commercial sales
• Build Management Team, Board, Advisors
Structure • Series A Preferred Stock/Membership Units
17

Stages of Company - Growth
STAGE GROWTH / EXPANSION STAGE
Investor • Venture Capital
• Other Institutional Investors (PE/Hedge Fund/IB Group)
Objectives • Scale Marketing, Sales and Distribution
• Scale Operations
• Expand Product Lines
• Expand Geographically
Structure • Series B Preferred Stock
• Series C Preferred Stock
18

Term Sheet
19

Term Sheet
• Term sheets can take several different forms, depending on the
preferences of the Parties involved
– A brief list of terms
– A letter agreement
– A short agreement
• Reasons for Using Term Sheets
– Highlights key terms of the transaction
– Enables earlier discovery of points of contention or deal breakers
– While it requires additional time and cost upfront, ultimately reduces
the amount of time and expense incurred by facilitating the drafting
and negotiation of the definitive transaction documents
– Makes it harder for parties to change their business positions later
• Term sheets are generally non-binding, but may include a
few binding provisions
20

Three Key Negotiation Areas
• VALUE OF THE COMPANY
– Drives the percent of the Company you are selling in the financing
• INVESTOR RIGHTS & PREFERENCES
– Drives the investors’ preferences with respect to distributions of profit or
distributions upon a liquidity event
– Drives the investors ‘ rights to participate in new issuances of securities and
transfers of issued securities
• INVESTOR PROTECTIONS (CONTROL)
– Drives the level of control that the investor (usually holding only a minority
interest) exerts on major actions of the Company
21

Value of The Company
• Key Valuation Concepts
–Pre-Money vs. Post Money Valuation
–Fully-Diluted Basis
22

Pre-Money/Post-Money
• The Pre-Money Valuation is the valuation of
the Company not including the new cash to be
raised
• The Post-Money Valuation is the valuation of
the Company including the new cash to be
raised
23

Pre-Money/Post-Money
Example - Entrepreneur is raising $500,000 and the investor
and entrepreneur agree on a valuation of $2 million
• Is the $2 million pre-money or post-money?
– If it is pre-money, the business is worth $2.5 million upon
closing and the investor will receive 20% ($500,000/$2.5 million)
of the company upon closing
– If it is post-money the business is worth $2.0 million upon
closing ($1.5 million pre-closing) and the investor will receive
25% ($500,000/$2.0 million) of the company upon closing
24

Fully-Diluted Basis
• To calculate the share price or membership unit price
– Divide the value of the company by the number of shares/units issued and
outstanding
• How do you account for stock options, warrants, or convertible notes that
could become issued and outstanding units upon exercise or conversion ?
– Investors almost always want to avoid having their shares diluted in the future
when these instruments are exercised or converted, often at a price lower
than the price paid by the investor
• The investor will want the share/membership unit price calculated on a
“FULLY DILUTED BASIS”
– Includes the number of shares/units subject to options, warrants, convertible notes in
the denominator
25

Fully Diluted-Basis - Example
• Shares issued and outstanding - 1.8 million
• Stock Option Plan: 200,000 (Includes options not yet granted, and granted but not
yet vested or exercised)
• Investment Amount: $ 500,000
• Pre-money valuation: $ 2 million
Based on Shares Currently Outstanding
Divide the pre-money valuation by the sum of
the shares issued and outstanding
2,000,000/1,800,000 = $1.11 per share
Number of shares issued in financing =
$500,000/ $1.11 = 450,000
Investor will acquire an 18 % ownership interest
(450,000/2,450,000 = 18%)
Fully-Diluted Basis
Divide the pre-money valuation by the sum of
the shares issued and outstanding plus the
options in the stock option plan
2,000,000/2,000,000 = $1.00 per share
Number of shares issued in financing = $500,000/
$1.00 = 500,000
Investor will acquire a 20 % ownership interest
(500,000/2,500,000 = 20%)
26

Rights and Preferences
• Liquidation Preference
• Participating vs. Non-Participating
• Dividend Rights/Preferred Return
• Anti-Dilution
• Preemptive Rights
• Right of First Refusal & Co-Sale Rights
• Drag Along Rights
• Redemption Rights
• Registration Rights
• Information Rights
27

The Liquidation Preference
• A mechanism by which the investor seeks to recoup its original investment
or a multiple thereof, plus any declared and unpaid dividends, before
there are any distributions to the common stockholders/unit holders
• Usually is defined to occur upon a liquidation, dissolution or winding up of
the company, a merger, or a sale of the company or its assets
• Example - $1 million dollar investment:
1X Liquidation Preference =
$1 million to investor before
common shareholders/units
holders get 1st dollar
2X Liquidation Preference =
$2.0 million to investor before
common shareholders/units
holders get 1st dollar
28

Participating vs. Non-Participating
Non-Participating Preferred
Limits the investor to its
Liquidation Preference
(In practice, an investor will
exercise its right to convert its
preferred stock/units into
common stock/units and give up
its Liquidation Preference if it
would get a larger return as a
common stockholder/unit
holder)
Participating Preferred
with A Cap
Investor receives its Liquidation
Preference plus further
distributions on a pro-rata basis
with the common stockholders/
unit holders up to the Cap
(In practice, an investor will
exercise its right to convert its
preferred stock/units into
common stock/units and give up
its Liquidation Preference if it
would get a larger return as a
common stockholder/unit
holder)
Participating Preferred
With No Cap
Investor receives its Liquidation
Preference plus further
distributions on a pro-rata basis
with the common stockholders/
unit holders
29

Cumulative vs. Non-Cumulative
No Preferred Return 8% Non-Cumulative
Preferred Return
8% Cumulative Preferred
Return
The preferred stockholders/
unit holders and common
stockholders/unit holders
participate in dividend
distributions on a pro rata basis
1st – Company must pay 8%
dividend to the preferred
stockholders/unit holders for
the current year before making
a distribution on any junior
securities
2nd – Preferred stockholders/
stockholders/unit holders then
share in dividend distributions
on a pro rata basis
1st – Company must pay 8%
dividend to the preferred
stockholders/unit holders for
the current year, and for all
prior years for which a
Preferred Return was accrued
but not paid
2nd – Preferred stockholders/
stockholders/unit holders then
share in dividend distributions
on a pro rata basis
30

Anti-Dilution Protection
• Protection to investor in the event the
Company issues new shares/units at a price
lower than the price paid by the investor
• Adjusts the investor’s conversion ratio for the
conversion of Preferred Stock to Common
Stock (from a 1:1 ratio) to increase the
number of shares of Common Stock the
investor receives on conversion
31

Anti-Dilution Protection
• Three Forms of Anti-Dilution Protection *
– Full Ratchet - Least favorable to Entrepreneur
• Only accounts for the share/unit price of the new issuance. A single new share/ unit
issued at a lower price will result in the original investor receiving such lower price on
their full prior investment
– Narrow Based Weighted Average - More Favorable to Entrepreneur
• Accounts for the share/unit price of the new issuance plus the size of the new
issuance relative to the number of shares / units issued and outstanding
– Broad Based Weighted Average - Most Favorable to Entrepreneur
• Accounts for the share/unit price of the new issuance plus the size of the new
issuance relative to the number of shares/units issued and outstanding on a fully
diluted basis
* Subject to customary exceptions
32

Preemptive Rights
• The investor’s pro rata right, based on
percentage equity ownership, to participate in
subsequent issuances (usually only financings)
• If the investor owns 20% of Company before
the subsequent financing, the investor has the
right to take 20% of the subsequent financing
33

Right Of First Refusal
Co-Sale Right
• In the event a shareholder/unit holder receives a
bona fide offer to buy its stock / units, the remaining
shareholders/unit holders have a pro rata right to
either acquire those shares/units on the same terms,
or to sell their shares/units, on an as-converted basis
pro rata, as part of such sale of such shares/units
34

Drag Along Rights
• The right of a pre-requisite number (i.e., a
majority) of the selling shareholders/unit
holders who all agree to sell their shares/
units, to drag along the remaining
shareholders in the sale of the Company
35

Redemption Rights
• Right to have the company redeem investor’s
shares/units
• Usually at the greater of the purchase price or the
FMV as determined by a formula, the Board, or
an independent appraisal of the Company
• Could be at the investors’ option or mandatory
• Payment terms are critical to Company, since
Company does not know its cash situation at the
time of redemption
36

Registration Rights
• Grants the investor the right to either:
– Force the Company, after a period of time, to
register the investor’s shares and offer them
publicly, or
– Register and sell the investor’s shares as part of a
registration and public offering, including a
registered offering initiated by the Company or
another stockholder
37

Information Rights
• Right to financial information such as income
statements, cash flow statements, and balance
sheets
• Right to other information such as budgets and
budget reconciliations, a dashboard of key
metrics, and Board observation rights
• Could be on an annual, quarterly or monthly
basis. Need to weigh benefits to investor vs.
burden on management to produce
• Could be unaudited or audited
38

Protective Provisions
• Board Representation/Voting Agreements
• Provides investors, who are minority shareholders
(i.e., control less than 50%), significant control over
designated actions of the Company
• Requires the approval of a majority, or
supermajority, of preferred shareholders/unit
holders voting as a separate class
• May also require the approval of a majority of the
Directors designated by the preferred shareholders/
unit holders
39

Protective Provisions
• Investors and entrepreneurs will negotiate over which
protective provisions to include. Examples are:
– Amending the Certificate of Incorporation and Bylaws / Operating
Agreement
– A repurchase or redemption of equity
– A material change in the nature of the Company’s business
– A change in the size of the Board
– The issuance of new equity or securities convertible into equity (pari-
pasu, superior or junior to existing securities)
– The sale of all or substantially all of assets of the Company or merger
into another company resulting in a change of control
– The liquidation, dissolution, and winding up of the Company
– Incurring debt above a designated amount
40

Definitive Documentation
41

Form of Securities
• Corporation
– Common Stock
– Preferred Stock (Rights & Preferences/Protections)
• Limited Liability Company
– Common Units
– Preferred Units (Rights & Preferences/Protections)
• Corporation and Limited Liability Company
– Convertible Note (Secured or Unsecured)
42

Form of Securities
• Common Stock/Units
–Founders, Friends and Family
– Friends and Family, Angel
• Preferred Stock
–Angel, Institutional Angel, Venture Capital
43

Common Stock
• A security that represents an equity ownership interest
• First form of stock issued upon creating a new
corporation
• Conveys some basic rights – vote, right to dividends and
proceeds of sale
• Usually comes with restrictions – e.g., restrictions on
transfer
• Right to the assets of the company upon liquidation,
after distributions to the holders of debt and preferred
equity
44

Convertible Note
• Debt instrument, with interest that usually accrues
• Bypasses the need for upfront agreement on valuation
• Can be secured or unsecured; subordinated
• Convertible into a company’s stock /units:
– Automatically, at the time the company closes on its next qualified round of
equity financing
– If no such round occurs, at pre-agreed upon terms
– Anytime prior to maturity, upon a vote of a majority of the convertible note
holders
• If no conversion, repayable along with accrued interest, upon its maturity
• Provides investor with a discount to the next round (may also include warrants)
• Relatively simple legal structure, lower transaction cost
• Priority status over common and preferred shareholders/unit holders
45

Convertible Note With A “CAP”
• A Convertible Note is often the first non-friends and family
investment
• Comes into the Company during a period of very high risk (market
risk, execution risk, technology/product risk and financing risk)
• To compensate for all of the risk, many investors now negotiate a
“CAP” on the conversion price (Negotiating maximum conversion
value upfront)
• Protects investor in event of rapid value growth prior to conversion
• Investor will usually have the option to convert at the lower of:
• A negotiated discount (i.e., 20%) to the next equity round
• The agreed-upon valuation cap
46

“CAP” - EXAMPLE
• A Company with 1 million shares of common stock/units
outstanding
• Issued a $500,000 convertible note, with a conversion
discount of 20% and a conversion cap of $6 million
• The start-up was able to raise $15 million at a pre-money
valuation of $45 million in its next round of financing
$ 6 million
Cap
20%
Discount
No Cap or
Discount
Valuation $6 million $36 million $45 million
Per Share Price $6.00 $36.00 $45.00
Shares Upon Conversion 83,333 13,889 11,111
% Of Company (Post) 5.9% 1.0% 0.8%
47

Preferred Stock
• Security that represents an equity ownership
interest
• Rights and preferences (priorities):
– Over the common stock related to the assets
and profits of a company
– Rights in the event of issuance of new equity
or existing shareholders sale of equity
• Protective provisions that limit actions that
can be taken by the Company without
preferred stockholder approval
48

Common Stock/Units
• Common Stock
– Stock Purchase Agreement or Subscription
Agreement
– Stockholders Agreement
• Common Membership Units
– Membership Unit Purchase Agreement or
Subscription Agreement
– Amended and Restated Operating Agreement
49

Convertible Note
• Convertible Promissory Note Purchase
Agreement
• Convertible Promissory Note(s)
• Pledge & Security Agreement (If Secured)
50

Preferred Stock/Units
• Series Seed/Series AA (Limited Rights and Protections)
– Stock Purchase Agreement
– Investor Rights Agreement
– Amended and Restated Certificate of Incorporation
• Series A Membership Units
– Membership Unit Purchase Agreement or Subscription Agreement
– Amended and Restated Operating Agreement
• Series A Preferred, Series B Preferred, Series C Preferred
– Stock Purchase Agreement
– Investor Rights Agreement
– Right of First Refusal and Co-Sale Agreement
– Voting Agreement
– Amended and Restated Certificate of Incorporation
51

Due Diligence
52

Due Diligence
• A comprehensive review of a company's business
• Components of Due Diligence
– Legal Due Diligence
– Business Due Diligence
– Financial Due Diligence
• Time to complete due diligence - Two weeks to two
months depending on the size of the investment, the
group making the investment, the stage of the
company, and the level of preparation by the
Company
53

Due Diligence on Investor
• Early investor becomes an important partner in the
success of the Company
• Company should conduct due diligence on the
investor
– Understand investor’s expertise, track record, value
beyond money being provided
– Speak to other CEO’s funded by investor to learn how the
investor was to work with (in both good times and bad
times)
54

Preparation Of Documents
• Documents will include:
– Organizational Documents
• COI, Bylaws, Operating Agreement, Stockholder Agreement, Good Standing
Certificate, Qualifications)
– Ownership
• Capitalization Table (Ownership)
• Share Certificates
– Corporate Document
• Minutes from Board and shareholder meetings
– Financial (Up to 3 years if available)
• Tax Returns, Financial statements (Income Statement/ Cash flow
Statement/Balance Sheet)
– Customers/Suppliers /Strategic Partnerships
• Names; Copies of agreements
• Contact information for reference checks
55

Preparation Of Documents
• Documents will include (continued):
– Intellectual Property
• List of all Intellectual Property (Patents/Trademarks/ Copyrights)
– Insurance policies
– People
• Organization chart
• Bios of key managers
– Agreements
• Copies of all prior financing agreements (debt & equity)
• Copies of all other material agreements
– Marketing collateral and marketing and sales strategies
– Detailed product or service descriptions and information
– Business plans
56

Preparation Of People
• Make sure all key members of the team who will
interact with investors are prepared for the process
• If Investors plan to contact a few key customers
and/or partners
– Let the customers and/or partners know that they may be
contacted by investors
– If there have been issues with a customer, explain the
situation to the investor ahead of time
57

Regulatory Compliance
58

Regulatory Compliance
• Ability to raise money from individual investors
regulated by the Securities Act of 1933 (the “Securities
Act”) and certain state securities laws (“Blue Sky
Laws”)
• Security Filings will be required with the Securities and
Exchange Commission, and unless the financing falls
under a self-executing state exemption, with state
security agencies
59 59

Contact Information
60
Anthony Millin, Esq.
Partner
Pedley, Millin & Gordinier, PLLC
4520 East West Highway, Suite 700
Bethesda, Maryland 20814
Tel: (240) 235-1101
Cell: (301) 908-0005
Fax: (240) 235-1097
Email: almillin@pedleymillin.com
Web: www.pedleymillin.com

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