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INITIAL FINANCING CONCEPTS

Initial Financing Concepts

Michael Weiner April 18, 2019

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Form

• Convertible Debt (Friends / Angels) • SAFE (Friends / Angels) • Seed Series Preferred Stock (Angel / Smaller Funds) • Preferred Stock (VC)

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Convertible Debt

• A loan that is intended by its terms to convert into the next real equity round

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Convertible Debt Benefits

• Avoids Setting a Valuation • Few Governance Rights

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Convertible Debt Negatives

• Priority Over Equity • Interest • Caps, discounts and amount of debt, can impact size

of equity round • May need to pay the money back

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Conversion Cap

Concept: • Conversion price will not exceed the price set by

dividing a valuation by the outstanding shares. Example: • Selling stock at $1.00 per share, or $10,000,000 pre-

money valuation • 10,000,000 shares outstanding • If conversion cap set at $4,000,000, then conversion

price is $4,000,000 / 10,000,000 = $.40 per share. • $100,000 loan treated as $244,877 investment.

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Conversion Discount

• Conversion price will be 80% of price paid by investors

Example:

• Selling stock at $1,000 per share, of $10,000,000 pre-money valuation

• Conversion price is $.80 per share

• $100,000 loan treated as $125,000 investment

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SAFE

• “Simple agreement for future equity” • Similar to convertible debt in concept • Not considered debt • Conversion discount and conversion cap points of

negotiation • Usually no interest • No maturity date so no ability to force payment

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SAFE Negatives

• No investor protection • Feels like free money

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SAFE Positives

• Easy to negotiate • No maturity date means no ability to force payment


Seed Series

• Preferred stock • Limited rights • Sets a company valuation

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Seed Series Benefits

• Typically Low Governance • Company favorable equity • Investors are diluted by future financings

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Seed Series Negatives

• Sets company valuation • Investors may ask for full rights with small

investment • Real Founder dilution

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Negotiating Points

• Pre-money valuation • Liquidation preference – simple • Voting rights

– Protective provision – minimal – no vetoes – Board seats – no/maybe

• Anti-dilution protection

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Additional VC Terms

• Drag Along • Tag Along • Registration Rights • Disclosure – reps + warranties • Protective provisions + covenants – for real • Board seats

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Only Two Issues Matter

• Economics – Pre-Money Valuation – Amount raised – Liquidation preference

• Control – Protective provisions – Board seats – Drag Along

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Pre-Money Valuation

• Concept: The value of the company prior to the proposed financing – Divide pre-money valuation by current outstanding numbers

of shares plus reserved options to provide purchase price per share of Preferred Stock

– Useful fiction for financing: Preferred Stock and Common Stock are worth the same

– There is no magic to setting a pre-money valuation – Often driven by amount needed to be raised

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Pre-Money Valuation

Pre-Money Example # 1Shares

Founders 4,000,000Employee Pool 1,000,000

Total 5,000,000Pre-Money Valuation $5,000,000 = $1.00 per shareOutstanding Shares 5,000,000

Post-Money CapitalizationFounders 4,000,000 50%Employee Pool 1,000,000 12.5%Investors 3,000,000 37.5%

8,000,000 100%

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Pre-Money Valuation

Pre-Money Example # 2Shares

Founders 4,000,000Employee Pool 1,000,000

Total 5,000,000Pre-Money Valuation $5,000,000 = $1.00 per shareOutstanding Shares 5,000,000

Post-Money CapitalizationFounders 4,000,000 40%Employee Pool 1,000,000 10%Investors 5,000,000 50%

9,166,666 100%

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Liquidation Preference

• Concept: Preferred stockholders get their money back first on liquidation of the company – Liquidation event includes changes of control – Simple preference

• Investors get money back or increased multiple off the top, common stock gets residual

• Investors will convert to common stick if will get more money in liquidation

– Participating Preferred • Investors get money back first, then share with common stock

on an as-converted basis • Sometimes capped • If uncapped, preferred stock will only convert on IPO

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Protective Provisions

• Concept: Gives investors veto rights over major decisions – Stockholder right, can vote differently than at the board level – No fiduciary duty owed by investor to company or other

stockholders – Often without 51%, protective provisions give investors

effective control

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Drag Along

• Concept: Gives Investors right to drag along minority stockholders on sale of the company – Minority stockholders lose appraisal rights – Appraisal rights: FMV Cash

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Board Seats

• Aim for odd number of seats • Who elects independent board members

– Majority stockholders – Agreement of the classes of stock – Agreement of the Board

• How independent are they? • CEO as common stock representative

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Diligence

• Clean cap table • Financials / Payable up to date • IP / Licenses in order • Understood regulatory pathway

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Common Mistakes

• Set pre-money valuation too high • Lower amount raised to protect pre-money valuation • Too much concern over control – 51% • Too many shares reserved for future employees • Independent board members not very independent

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Thank you!

For more information, please contact:

Michael Weiner [email protected]

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