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Startup Law 101
DECIHPERING SAFE, CONVERTIBLE
NOTES & TERM SHEETS
• Tips for Startups
• Financing Road Map
• Term Sheet
• Convertible Debt
• Equity Financing
• Economic Terms
• Control Terms
• Other Terms
Key Business Issues
• Valuation and Price of Capital
• How Much Money to Raise
• Time Frame
Key Legal Issues
• Economic Rights and Control
TIPS FOR STARTUPS
HOW WILL YOU FINANCE?
• Non binding agreement between founders and investors.
• Why is it important if non binding?
BREAKDOWN OF A TERM SHEET
• SAFE vs. CONVERTIBLE NOTE vs. EQUITY (PREFERED EQUITY)
• ECONOMIC TERMS – regulate return the investors will ultimately get at
• CONTROL – provisions allowing to affirmatively exercise control over the
• OTHER – usually not that relevant, may be used as a smokescreen
TERM SHEET - BASICS
Simple Agreement For Future Equity
• Definition: money converts to future equity in next financing
• Not a loan and no interest
• Spray & Pray Investors
• Conversion mechanics
• Discount Price
• Valuation Cap
• Ticket to a baseball game
• Definition: a regular loan which will convert to equity at such
time as another round of financing is raised
• Used for bridge financing
• No need to negotiate the valuation of the company (the main
• Less paperwork
• No decision making power for investors
• Draws a line of what the company will be worth at the time of the
first series financing.
• Potential investors may refuse to fund the company unless the
debt investors remove or change the cap.
• Is a liability on the company’s balance sheet - may raise legal
issues of insolvency.
• Automatic conversion into equity of the same type and under the
same conditions as negotiated with subsequent investors but at
a better price.
• Price typically range between 10 and 30 %
• Investor-favorable term that puts a ceiling on the conversion price of the
• Protection against overvaluation of the company by the new investors
and resulting loss of influence.
• Effectively used caps can create alignment between entrepreneurs and
seed investors as long as they are thoughtfully negotiated
• Minimum upside the investor wants to have for the investment
• Should not be high as it is not the essence of the convertible debt
• Usually between 6 to 12 %
• Describe the time and the way in which the debt will convert.
• The debt does not convert and stays outstanding if the company does not
reach its financing goal, unless the creditors agree to extend it.
• Outstanding debt as gives the creditor control and possibility to initiate
• Mechanism applicable in the sale of the company may be arranged for in many
ways, the most popular being the payment of the interest and the debt or its
Common Stock (“Seed” Preferred)
• Usually no rights or preferences
• No downside protection (i.e., liquidation preference) for investors
• Its valuation must be determined
• Sets price for option grants
• VCs are not interested in it, usually issued during friends and family
• Provides extensive economic and governance rights, preferences
and privileges to the shareholder
• Issuance is expensive and time consuming
• The only type of stock accepted by large VC’s
• Price per share is a measure of what is being paid for the equity.
• The concepts of pre-money and post money valuation.
Investor says “I’ll invest 2 million at a valuation of $10 million”.
Post Money Pre-money
Pays $2,000,000 Pays $2,000,000
Buys 20% of the company Buys only 16.6% of the
• Conclusion: The pre-money understanding of valuation is more favorable
towards the founders.
• Liquidation preference = the way proceeds are shared in a liquidity
• What is a liquidity event? Sale of the company or the majority of its
assets, not only bankruptcy or winding down of the company.
• How does it work? The money is returned to a particular, preferred
series of the company’s stock ahead of other series of stock.
• Actual preference- multiple (x 1, x 2) of the original investment is
being returned to the investor before the common stock receives
• Participation – Investors are not only getting multiple of their
investment back but also participate, on as converted basis, in the
further distribution of profits with the other holders of the common
• Capped participation – the stock will share in the liquidation
proceedings on an as converted basis until a certain multiple is
Let’s assume that the company is being sold for $20 million. There
are 3 founders, each one of them is holding 20% of the common
stock and an Investor who invested $4 million. If Investor’s stock
has 2x preference and his/her stock is at the same time
participating, it effectively means that he/she will get his/her $8
million first and then will participate equally with the other founders
totaling $11 million.
Each founder will receive merely $3 million profit from this
apparently beneficial transaction.
• Usually one director will be chosen by the founders and one by
• Odd number of seats necessary in order to avoid a stalemate
• Board of Directors seat given directly to the CEO - initially a
Board of Directors
A right of an investor to block certain actions of the
• changing of the terms of stock owned by the VC
• issuing more stock
• Issuing stock senior or equal to the VC’s preferred
• selling the company
• changing the certificate or bylaws, i.e. size of board of directors
• Declaring or paying dividend
• Borrow money
• Drag along agreement gives a subset of the investors the ability
to “drag along”, i.e. simply force all of the other investors and the
founders to sell the company at the same time, to the same
• Desired provision - following the majority of the common stock,
not the preferred. what may force preferred investors to convert
some of their holdings to common stock to generate a majority
what in turn results in a benefit to the common stockholders as it
lowers the overall liquidation preference.
• Private Equity Background or Downside Protection
• Do not provide venture returns at the beginning.
Watch out for:
• Automatic dividends – can drag you to the insolvency zone.
• Cumulative dividends – pose accounting problems
Right of First Refusal (ROFR)
• Investor’s right to purchase certain amount of shares in a future
financing before any other interested entity.
• Very common and Venture Capital investors will insist on it
• Helps to control the shareholder base of the company what benefits all
• Watch out for the super pro rata right
• Voting rights establish the voting dynamics within the corporation,
usually between the common stock and various series of preferred
ROFR & VotingRights