Life Sciences Entrepreneur Bootcamp

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Entrepreneurs Bootcamp

October 7, 2015

Life Sciences

East Meets West Coast:

Structure Your Company So

Everyone Wins!

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Schedule

9:00 a.m.

9:30 a.m.

9:35 a.m.

10:00 a.m.

10:45 a.m.

11:00 a.m.

11:45 a.m.

12:30 p.m.

1:30 p.m.

2:15 p.m.

3:00 p.m.

3:45 p.m.

Registration & Networking

Welcome Remarks

Overview/Life Sciences Trends

Forming/Organizing the Start-up Entity

Break

Business Plans & Fundraising

Tales From The Trenches I

Networking Lunch

Valuation & Term Sheets

Liquidity & Exits

Tales From The Trenches II

Q&A/Adjourn/Networking

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OVERVIEW

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• Premier provider of value-added legal services to growth business

enterprises worldwide, as well as the public and private capital markets that

finance them

• Represent multi-billion dollar global enterprises as well as venture-backed

start-up companies

• Our track record:

– Represent more companies that receive venture financing than any other

law firm

– Advise more U.S. companies on their initial public offerings than any other

law firm

– Represent more technology companies in mergers and acquisitions than

any other U.S. law firm

– Advise more than 300 public and 3,000 private enterprises on issues of

corporate law, securities, and corporate governance

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Our Business Model

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On the Forefront of the Life Sciences Industry

Note: some clients may have merged or been acquired

Represent more than 500 life sciences clients, including:

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15

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Mintz Levin

DLA Piper

Latham &…

Fenwick & West

WilmerHale

Gunderson…

Goodwin…

Cooley

WSGR

*Source: Dow Jones VentureSource market share based on firms with 7 or more financings in 2014

• Founded in 1961 with over 650

attorneys located across the globe

• Actively represent more than 3,000

private companies

• Deep relationships in the venture

capital community

• Incorporate thousands of successful

businesses

• Provide value-added resources:

• Entrepreneurs College

• Entrepreneur’s Report

• Life Sciences Report

• Online Term Sheet Generator

• Bootcamps

• Office Hours

WSGR represents more life sciences companies that

receive venture financing than any other U.S. law firm*

Entrepreneur & Private Company Practice

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Select Life Sciences Venture Capital Clients

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VC Overview: The Good news

Commitments to Venture Capital

Funds (All Industries) (Based on multiple closings)

Source: Dow Jones VentureSource

VC Fundraising 1H’ 2015 vs 2007

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Deal Flow

and Equity

into Venture-

Backed

Healthcare

Companies


VC Overview: The Good News (cont.)

Healthcare Investment Steady in Q2 2015

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VC Overview: The Bad News

The Number of Healthcare Deals steady in Q2 2015

Number of healthcare*

mega deals done by

year

(Amount raised +$100M)

*Source: Pitchbook **Source: Dow Jones VentureSource

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VC Overview: The Bad News (cont.)

Since 2008 we’ve seen a consolidation of VC dollars in

precious few large, branded funds

The number of VC’s doing 3-5 deals

has been trending down

Source: Thompson One, Dow Jones Venture Source

The Concentration of VC $

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Early Stage Financings

• Early stage companies are increasingly using

nontraditional methods of financing

– Non-equity crowdfunding sites

– Series seed financing

– Convertible equity

– Government grants and tax incentives

• JOBS Act authorized the SEC to promulgate rules

for equity crowdfunding, but the SEC has yet to

approve regulations

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Angels & Incubators Filling In The Gaps

• Seed stage activity has experienced a paradigm shift as well.

Reduced costs to start a technology company have led to the

rise of new players such as “super angels” and incubators that

have filled gaps left by departing VCs

Seed investing moderated some but

remains at historically high levels

Participation by Angels &

Incubators is also at an all-

time high

Source: Thompson One, EY Venture Insights

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The Median Amount Raised in Pre-Series A

Bridge Loans Doubled from 2013 to 2014

Median Amount Raised – Bridge Loans

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VC Overview: Healthcare Investment Allocation

Healthcare Services Investment Shrinks in 2Q’ 2015


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Seed Stage Valuation Trends

• In 2011, the median seed stage pre-money valuation ($4.0M)

was the highest it had been post bubble. Since 2011, seed

stage valuations have declined—the median seed stage pre-

money valuation of $2.5M in 2013 represented a 30% decline

over 2012

• There is reason to remain optimistic. In 2014, as fundraising

levels have started to rise, financing rounds have increased in

size, and competition for deals has grown, we are beginning to

see an uptick

Source: Thompson One

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Early Stage Pre-Money Valuations Up in 2014

Median Pre-Money Valuation

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Valuation Trends for 2014

No. of High Pre-Money Valuations by Year $200M and above (U.S. deals only)

Pre-Money Valuations The number of high pre-money valuations

($200 million or more) jumped from 31 in 2013

to 48 in 2014. The number was 17 in 2010.

Valuations 48 WSGR deals had

valuations of $200M or

more in 2014.

Amounts Raised Median amounts raised in 2014

were the highest WSGR has

recorded since 2010.

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What this means to Start-ups

• Recognize the venture model has undergone a paradigm shift:

– Diversity of sources of funds

– Disaggregated and disparate angels and super angels

– Emergence of incubators and accelerators

– VC funds adopting seed stage strategies

– More venture capital concentrated into few funds

• Valuation is as much “art” as it is “science” and is a function of deal-

specific and industry-specific factors as well as a function of the

venture economic model

• More than ever, fundraising is a “full contact” sport and will require

perseverance and a dedicated and sustained “team” effort

– Build a team of advisors that not only bring expertise and

credibility, but also bring a broad network of potential funding

contacts

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FORMING & ORGANIZING THE

START-UP ENTITY

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Essentials of Start-up Law

• Forming and Organizing the Start-up

• Founders Stock

• Equity Incentives

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Choosing the Form of Business Entity

• Current status

– Partnership

– Sole proprietorship

• Why Limited Liability?

• Two common organizations

– Limited liability company

– Corporation

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Limited Liability Company

• Limited liability corporation (LLC)

– LLC members can operate as managers; all owners

have limited liability (i.e., only the amount of their

investment)

– No entity-level tax – taxes pass through to LLC

members

– Ownership interests of the “members” are defined

and established in the LLC operating agreement

Why doesn’t an LLC work for a VC-backed start-up?

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Corporation

• Attributes of a C corporation

– Corporate governance

Stockholders elect board of directors

Board appoints officers, oversees strategic direction

Officers manage day to day affairs of the company

– No pass through of tax benefits

C corporation is taxed as a separate legal entity (unlike the LLC and

the S Corporation).

– VCs can invest in it; employees can understand stock

incentives

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Corporation: Advantages

• Perpetual life

• Separation of Ownership from Management

• Fringe Benefits (Incentive Stock Options)

• Familiarity

• Limited Liability

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Corporation: Disadvantages

• Separate Tax Payer – the “Double Tax”

– Subchapter “S” Corporations

– Offshore Corporations

Cost

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Shareholders

Optionees

Investors Employees Others

Board of

Directors

CEO

Other Employees

VP VP VP VP VP

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Creating & Organizing the Corporation

• Jurisdiction of Incorporation

• Directors

• Charter and Bylaws

• Stock Issuance

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Where to Incorporate

• Delaware or Maryland?

– Cost

– Filing services

– Beneficial corporate law

– IPO objectives and

reincorporation

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Corporation

• S corporation has board members/shareholders,

etc.; but—

– Tax benefits and losses passed through to the individual shareholders

(i.e., a single level of taxation)

– Early stage start-ups will sometimes take advantage of “S Corporation”

status: losses get passed through to the owners

• Requirements for S corporation status: – no more than 100 shareholders

– all individuals (no corporation) (family trusts are OK in general)

– no “foreign” shareholders

– only one class of stock (i.e., no preferred stock)

• Simple conversion to C corporation

Why doesn’t an S corporation structure work for a VC-

backed start-up?

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Limited Liability Can be Lost

• The Corporate Veil Can Be Pierced

– Failure to Observe Corporate Formalities

– Commingling of Assets and Affairs

– Under Capitalization

– Deception

• Guarantees

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Start-up Documents: 4 Buckets

• Incorporation documents

• Founder documents

• Employee documents

• Basic third party agreements

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Incorporation Documents

• Certificate of Incorporation

• By-laws

• Organizational minutes and resolutions

– Establish Board

– Appoint Officers

– Issue stock

– Other Administrative matters

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Faculty Founders

• When a company is formed, often the faculty

member does not leave his or her post

• Often, the faculty member serves as a consultant

and is on the Scientific Advisory Board

– Normally a limit on time (e.g., 20%)

• Company may put in place a Sponsored Research

Agreement with faculty member’s lab

• Faculty members need to check with the relevant

administrative departments to understand relevant

policies. Tech Transfer Office can help navigate.

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Founder Documents: Founders’ Stock

• Typically purchased pursuant to a Restricted Stock

Purchase Agreement

• Founders’ stock: the first step in capitalizing the

Start-up

– Nearly always common stock

– Typically issued in exchange for IP, business plan or

nominal cash

– Usually issued at low value

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Founder Documents: Vesting – Why put in place?

• Solo founder

• Multiple founders

• Financings

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Founder Documents: Vesting – What is it? Why Put

it in Place? • Concept that recipient does not “own” all shares when issued

• Vesting also can, and typically does, apply to Options

– Mechanics depend on type of grant (Restricted Stock versus

Options)

• What are typical vesting provisions?

– Founders

– Employees

• Why put it place?

– One vs. Multiple Founders

– Financings

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Founder Documents: Acceleration Terms of

Founders’ Stock • Termination of employment

– “Cause” and “Good reason”

• Change of control

• Single trigger vs. double trigger

• Also can apply to options

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Founder Documents: Tax Considerations

• General Rule – Founders are taxed on FMV of

shares as they vest (i.e., as shares become “no

longer subject to forfeiture”)

• Exception

– File 83(b)!

– Choose to tax at grant

– File within 30 days

– No second chance!!

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Employee Documents

• Offer letter

• Invention Assignment Agreement

• Options

– What is an Option?

– Option Plans

– Issuing Options

– Process for Granting Options

– ISOs & NSOs

– 409A

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Employee Documents:

Options – What is an option?

• Right to buy Stock at a set price

• Typically granted to employees, board members,

advisors and consultants

• Issued through an “option plan”

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Employee Documents:

Stock Plans • Equity incentive structures for directors, employees and

consultants are usually implemented through the adoption and

administration of a “stock plan” or “stock option plan” (these

are synonymous)

– A stock plan is a formal written document approved by the

board of directors and the shareholders. The stock plan

establishes a “reserve” of stock (i.e., authorized but

unissued shares that are set aside, or earmarked,

specifically for issuance under the stock plan)

– VC investors include the reserve in negotiating valuation.

They want to ensure that the reserve is established at an

adequate level to avoid post-financing dilution to their

negotiated equity stake in the company

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Employee Documents: Options – Issuing

Options

• Every option grant/restricted stock grant has to be

approved by the board, and the board has to establish

the stock price (i.e., FMV)

– Result: Changes in stock price are determined at board

meetings, when the board approves option grants/stock grants

• How boards must price common stock in connection with

option grants/stock grants

– Objective is to price the common stock at or above fair market

value

– Section 409A of the Internal Revenue Code in many cases

requires pricing based on an independent valuation

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Employee Documents: Options – Process for

Granting Options • Review Charters, Bylaws, Plan and Constituent

Documents

• Review Securities Laws (Note: MD requires filing)

• Corporate Approval

• Issuing the agreement and maintaining good records

• Clean-up is costly so better to get it right the first time!

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Employee Documents: Options –

Nonstatutory Stock Options (NSOs)

• An NSO is any option that does not qualify as

an ISO

• No tax at grant

• At exercise, ordinary income = “spread”

• Subject to tax withholding (regardless of liquidity of

underlying shares); form W-2

• Sale – capital gain/loss – basis = purchase price + ordinary income recognized on exercise

– long-term capital gain/loss if held for > 1 year

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Employee Documents: Options – Incentive

Stock Options (ISOs)

• An ISO is eligible for favorable tax treatment

• Key Concepts:

– No tax at grant

– No tax at exercise (purchase)

Unless alternative minimum tax (AMT) applies

– Sale or other disposition triggers income

– Tax consequences differ depending on whether

disposition is “qualifying” or “disqualifying”

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Employee Documents: Options – ISOs

• Applicable Holding Periods

– 2 years from ISO grant AND

– 1 year from ISO exercise (purchase)

• Meeting BOTH of these holding periods results in a

QUALIFYING disposition

• Failure to meet EITHER of these holding periods

results in a DISQUALIFYING disposition

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Characteristics of ISOs

• ISOs must be granted pursuant to a written plan that:

– sets forth number of shares,

– states class of employees, and

– is approved by majority of S/Hs w/in 12 months of

Board Adoption.

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Characteristics of ISOs (cont.)

• Exercise price must be 100% of FMV on date of grant

(110% FMV for 10% S/Hs)

• Can only be granted to EMPLOYEES of company (or

parent or subsidiary)

• Maximum term of 10 years (5 yrs for 10% S/Hs)

• Must be exercised within 3 months of termination (12

months if disability)

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Employee Documents:

Options – Section 409A

• Discount stock options are treated as a deferral of

compensation under Section 409A

• Stock options covering other than “service recipient

stock” provide for a deferral of compensation

– Only includes common stock (i.e., does not include

preferred stock)

– Options in subsidiary stock potentially problematic

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Employee Documents:

Options – Section 409A (cont.)

• Tax at time of vesting, not date of exercise

• Potential interest penalty

• Employers have reporting and withholding

requirements

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Third Party Documents

• Form NDA

• Consulting Agreement

• Licenses

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Licensing: Steps for Success

Get Prepared

Get an Option /

Negotiate a Term Sheet

Create a Schedule

Use the University’s

Form

Make it Win-Win

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Get Prepared (I)

• Understand what you want to license

– Patent rights/Know-how/software/other

• Evaluate the business opportunity

– The product

– Market size

– Existing players

– The technology fit

– Pricing/margins

– Investment requirements

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Option/Letter of Intent (LOI)

• Objective: Obtain an exclusive right to negotiate a

license to the technology of interest for a defined

period

– Strategic decision: include key terms?

• Quid Pro Quo (usually there is one)

– Fee (usually nominal, if at all)

– Ongoing patent costs

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Negotiate A Term Sheet

• Allows you to resolve the business issues first

• Avoids getting mired in the weeds

• Who prepares the first draft?

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Key Points

Economic Terms

• Upfront

• Royalty

• Milestones

• Sublicensing

Revenue

• Patent Costs

• Equity

Non-Negotiable

• Indemnification

• Product Liability

• Retained Rights

• Right to Publish

• Use of Name

• Warranty

Non-Economic Terms

• Scope of IP (subject

matter, field of use)

• Exclusivity

• Retention of rights

and option to new IP

• Diligence

• Sublicensing

Restrictions

• Patent Prosecution

& Enforcement

• Assignment

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Create a Schedule

• A schedule creates a useful time pressure and sets

expectations

• Be realistic

• If you want the other side to meet its schedule,

make sure to live by yours

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Use the University’s Form

• Avoids need for extensive revision (saves time)

– Addresses University’s needs/concern

– Often specific language has been mandated

• You will get an opportunity

• Things that are generally required:

– Indemnification

– Insurance

– Diligence

• Things you won’t get:

– Ownership of university inventions

– Ability to block publication

– Extensive representations & warranties

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Make It Win-Win

(It’s only the beginning)

• Communication is key

• The negotiation/agreement is only the beginning of

the relationship

• Keep perspective – it’s about creating a successful

company not getting a perfect agreement

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Recent Example of a University License

• The Assets

• Patents claiming

compositions of small

molecules with early

indication of activity in CV

indications

• Data from cell and animal

studies

• The Terms

• $25K/year for 3 years and $10K/year thereafter

(creditable against royalties payable in same year)

• 2% equity (antidilution for 1st $4MM)

• 2% of <$500MM annual net sales

• 3% >$500MM – 1B annual net sales

• 4% >$1B annual net sales

• 50/50 stacking and combination reductions

• Milestones:

– $50K on initiation of Phase 1



– $250K on marketing approval

• Sublicensing revenue sharing

– 35% on sublicenses before first anniversary;

– 10% after first anniversary but before third

anniversary of agreement;

– 5% after third anniversary OR initiation of

clinical trial

• Reimburse for patent expenses

• Diligence with ability to purchase extensions

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BREAK

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BUSINESS PLANS &

FUNDRAISING

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The Business Plan

• Purposes

– Convey to others (i.e., investors) what you (will) do

with their money

– Force yourself to figure out how you will do it

– Demonstrate to others (i.e., investors) that you really

understand the space and have thought about all the

challenges

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The Business Plan

• Resources

– Other business plans

– IPO prospectuses

– Advisors

– Amazon

– But you have to write it yourself

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The Business Plan

• Executive summary

– Elevator pitch

• PowerPoint business presentation

– Deeper consideration

• Extended long-form plan (optional)

– Detailed road map for business

• Financial and projections

– Include disclaimer!

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Executive Summary

• 1-2 pages

• Easy to read and navigate

• Highlights:

– Team

– What do you do?

– What is the addressable market?

– What makes you different?

– How far along are you and what’s next?

• This just starts the dialogue – it’s not a Ph.D. thesis

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PowerPoint Business Presentation

• No more words than necessary

• Don’t waste time on the obvious

• 10-15 slides

• Same substantive points as Exec Summary, but

now with 1-2 slides per point rather than 1-2

sentences

– Third party market data

– Revenue model

– Differentiators

– The team and key advisors (one slide)

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Financials and Projections

• Income statement, Balance sheet, Cash flow statement

• How does funding accelerate growth?

• How long does the funding take you and how much more do

you need then?

• Don’t: “The market is $50B, but we are conservative,

assumed we’ll get merely 6% and cut that by 60%.”

• Everyone knows the projections won’t come true – it’s the

process and thinking that counts, and yes, it’s a test.

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Back-Up Materials

• Market background

• IP background

• Risk assessment

• Competitive landscape

• References

• Potential industry/other experts

• Other diligence materials

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Exercise for Working on Your Business Plan

• Identify your 4-5 top risks and uncertainties

– What can be done to reduce key risks pre-financing?

– What can be done to reduce key risks cost-

effectively post-financing?

• Identify your use of proceeds and how a cash

infusion may accelerate growth, timing, etc.

• Identify other elements beyond cash that you want

investors to bring to the table (i.e., partners,

additional management, strategic perspective, etc.).

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Capitalization: Practical Tips

• #1 Get the founders’ stock arrangements right!

– Make sure the founders are ok with their allocation

– Establish vesting schedule although the VCs may

reverse it later

– “Buy/sell” arrangements are generally not necessary

• #2: Anticipate up to 50% dilution for first/second

rounds

– Set aside approximately 20% for future employees in

the early stage

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Capitalization: Practical Tips

• #3: Establish an overall financing strategy

– Create an incentive matrix for all positions in the

organization

– Determine when you need to raise financing and

how much Establish milestones that demonstrate viability/progress

Expect 4-6 months process from beginning to receipt of

funds

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Two Basic Approaches for Financing

• Equity

– Common stock

– Series A Preferred Stock

– “Seed” preferred stock

• Debt

– Bank loans

– Convertible promissory notes

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Considerations in Structuring Financings for

Start-Ups • Three over-arching themes

– Protection of founders

– Incentivize investors

– Cost and speed

• Specific issues

– Amount being raised

– Identity of investors

– Terms (economic, governance, etc.)

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Equity – Common Stock

• What is common stock?

• Straightforward way to raise equity

– Usually no rights or preferences

– No downside protection (i.e., liquidation preference) for

investors

• Valuation must be determined

– Most significant negotiating point

– Sets price for option grants

• No VC’s and usually only non-professional angel

investors will do it (best suited for friends and family

round)

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Equity – Series A Preferred Stock

• What is preferred stock?

• Typically the most complicated way to raise equity

– Must establish separate rights, preferences and privileges

of preferred stock

– Extensive economic AND governance provisions

– Must establish valuation

• Results in 5 separate 20+ page agreements

• Usually takes 3-4 weeks minimum to complete and is

usually most expensive approach

• Best utilized for larger VC deals where larger proceeds

support higher cost

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Equity – Series A Preferred Stock (cont.)

Terms of Series A Preferred Stock

• Economic terms:

– Liquidation Preference

– Dividends

– Anti-dilution protection

– Redemption

– Founder vesting

• Governance terms:

– Board composition

– Protective provisions

– Liquidity constraints

ROFR

Tag along

Drag along

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Equity – Series A Preferred Stock (cont.)

Terms of Series A Preferred Stock (cont.)

• Others:

– Registration rights – Preemptive rights – Information rights

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Equity – Series “Seed” Preferred Stock

• “Light” version of Series A Preferred

• Terms typically more founder friendly

• “Punt” on various terms until Series A Preferred

• Need to set valuation

• Quicker and less expensive than full Series A

Preferred, but still can be time consuming and

relatively expensive

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Debt – Bank Debt

• Often requires personal guarantees

• Financial covenants

• Secured by cash flows and accounts receivable

• NOT typically an option for Start-ups!

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Debt – Convertible Bridge Note

• Easy to do, very straightforward

– No need to set valuation today

– Limited or no governance rights

– Minimal terms to negotiate

Maturity

Interest rate

Discount to next round

– Can be made more complicated

Optional conversion at maturity

Caps on conversion valuation

Change of control acceleration

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Debt – Convertible Bridge Note (cont.)

• Works best if subsequent financing is expected

(avoids “bridge to nowhere”)

• Short and sweet documentation

• Acceptable to a wide range of investors

• Now the predominant way to structure early stage

investments

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TALES FROM THE TRENCHES

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NETWORKING LUNCH

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VALUATION & TERM SHEETS

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Financing: Principles of Valuation

• Valuation: how much the company is “worth”

– Pre-money valuation

– Post-money valuation

• Valuation is the #1 issue in the negotiation between

the founder and the investor

• Valuation influenced by market conditions and

competition for the deal, amongst other factors

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Valuation

• Valuation is expressed in terms of pre-money and post-

money

• Pre-Money is the valuation of the company before VC’s

invest

– Technically the Number of Shares Outstanding On a Fully

Diluted Basis Multiplied by the Proposed Price = The

Proposed Pre-Money Valuation

• Post-Money is the valuation after investment

– Pre-money + VC Investment= Post-money OR

– The Number of Shares Outstanding After the Close On a

Fully Diluted Basis Multiplied by the Price Per Share Paid

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Valuation (cont.)

• Valuation – Percentage of equity interest

– “We’re willing to put $2M in at a $3M pre-money valuation”

– “We need to have 40% of the company if we are going to

invest $2M”

– When VC’s say they want a 40% stake in the Company for

$2M then the pre-money is $3M and post-money is $5M

• Factors that influence pre-money valuation:

– Leverage and the fundraising environment

– IP and milestones met (e.g., studies/trials/data)

– Size of market opportunity

– Experience of team

– Terms of transaction

• As much “art” as “science”

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Valuation (cont.)

• Post-financing capitalization is viewed on a “fully-

diluted” basis

– Narrow-based formula – issued options

– Broad-based formula – includes option reserves

• Valuations are market driven and depend in large

part on the level of competition for the deal

• Valuations are sector specific

92

The Employee Option Pool

• The reserve amount is typically based on

anticipated headcount growth

• This time horizon is usually associated with the time

the financing dollars last

• The reserve amount is usually assessed and

replenished with each financing

93

Start-up Company Valuation Model

Example – Incorporation

• Founders A and B each purchase 1,750,000 shares of

common stock at a purchase price of $0.001 per share

Person # Shares % of Shares Value

A 1,750,000 50% $1,750

B 1,750,000 50% $1,750

Total 3,500,000 100% $3,500

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Example – Establishment of Option Plan

• In order to attract employees, the company establishes

an option plan and reserves 500,000 shares for issuance

under the plan


A 1,750,000 43.75% $1,750

B 1,750,000 43.75% $1,750

Option plan 500,000 12.5% $500

Total 4,000,000 100% $4,000

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Example – Initial Financing Round

• The company completes a $1,000,000 seed capital financing

round of Series Seed Preferred Stock at a purchase price of $1.00

per share, representing a $4,000,000 pre-money valuation.


A 1,750,000 35% $1,750,000

B 1,750,000 35% $1,750,000

Option plan 500,000 10% $500,000

Series Seed 1,000,000 20% $1,000,000

Total 5,000,000 100% $5,000,000

96


Example – Series A Financing Round

• The company completes a $5,000,000 Series A financing at a

$15,000,000 pre-money valuation, at a purchase price of

$2.67 per share. The option pool is set at 15% post financing.


A 1,750,000 23.33% $4,666,667

B 1,750,000 23.33% $4,666,667

Option plan 1,125,000 15% $3,000,000

Series Seed 1,000,000 13.33% $2,666,667

Series A 1,875,000 25% $5,000,000

Total 7,500,000 100% $20,000,000

97

Preferred Stock – Term Sheet

• Preferred stock

• Valuation/option pool

• Liquidation preference

• Dividends

• Conversion features

• Antidilution protection (stock

splits, price-based)

• Voting rights

• Board composition

• Redemption

• Registration rights

• ROFR/Co-sale

• Preemptive rights

• Pay to play

• Founder/employee vesting

• Non-competes

• Exclusivity

• Expenses

• Confidentiality

98

Two Class Stock Structure

• Preferred and common stock

• Common stock is generally used for compensatory purposes (i.e., as

a form of payment to employees, board members, consultants,

advisors and other service providers) and issued to founders at

incorporation

• Preferred stock is generally used for investment purposes and has

many more rights, preferences and privileges than common stock

• Common stock is typically “priced” at a lower price than preferred

stock (i.e., for option granting purposes)

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Liquidation Preference

• Investors get a “Liquidation Preference” in the event of a liquidity

event of the company

• “Liquidity events” include M&A transactions

• A typical liquidation preference would provide the investors their

money back before any other stockholders receive any proceeds

• A “participating” liquidation preference entitles investors to their

money back, plus the right to participate in the remaining amounts

• Caps are often negotiated

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Liquidation Preference

Example of Fully and Non Participating Preferreds

(assumes $30m sale price and $6m invested)

Shares % o/s

Liquidation

preference

Payment of

remainder

Total

proceeds

Total

proceeds

with no

participation

Seed 1,000,000 13.33% $1,000,000 $3,200,000 $4,200,000 $4,000,000

A 1,875,000 25.00% $5,000,000 $6,000,000 $11,000,000 $7,500,000

Common

(founders) 3,500,000 46.66% N/A $11,200,000 $11,200,000 $14,000,000

Option

pool 1,125,000 15.00% N/A $3,600,000 $3,600,000 $4,500,000

Total 7,500,000 100.00% $6,000,000 $24,000,000 $24,000,000 $30,000,000

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Dividends

• Accruing/non-accruing

• Compounding/non-compounding

• Payable on specified dates/payable “if, as and

when” declared

• Participating/non-participating

102

Conversion

• Preferred stock convertible into common stock at

option of holder, initially on one for one basis

– Automatically convert upon an IPO

Typically size of deal and share price must exceed

certain levels

– Automatically convert upon the vote of the particular

series

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Antidilution Protection

• Conversion rate adjusts on certain events – Proportionate in the event of stock splits

– Price based antidilution upon a “down round” financing Weighted average protection: Conversion price is adjusted

based on a formula that considers the number of new

shares being issued compared to the shares outstanding

and the price at which the new shares are issued

Full ratchet protection: Conversion price is adjusted so that

the price per share is reset to the price per share in the new

financing, regardless of the number of shares issued and the

price at which they are issued.

– Provide for appropriate carveouts to antidilution protection

(i.e., for option issuances, strategic warrants, etc.)

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Antidilution Protection

• Conversion rate adjusts on certain events – Proportionate in the event of stock splits

– Price based antidilution upon a “down round” financing Weighted average protection: Conversion price is adjusted

based on a formula that considers the number of new

shares being issued compared to the shares outstanding

and the price at which the new shares are issued

Full ratchet protection: Conversion price is adjusted so that

the price per share is reset to the price per share in the new

financing, regardless of the number of shares issued and the

price at which they are issued.

– Provide for appropriate carveouts to antidilution protection

(i.e., for option issuances, strategic warrants, etc.)

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Board Composition/Voting Rights

• Companies are controlled by the board of directors

– Control over the board means control over the company

– Typical board composition post Series A investment is two

founders, two Series A investor representatives and one

industry expert/independent

• Even if board approves, “protective provisions” require

preferred holders to approve certain events, including:

– Change of control transactions

– Amendments to charter/bylaws

– Hiring/firing senior management

– Issuing senior securities

– Increasing size of the option pool

– Incurring debt

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Other Terms

• Redemption

• Registration rights

• ROFR/Co-Sale

• Preemptive rights

Last but not least, legal expenses!

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WSGR Term Sheet Generator tool

• This tool will generate a venture financing term sheet based

on your responses to an online questionnaire. It also has an

informational component, with basic tutorials and annotations

on financing terms. This term sheet generator is a modified

version of a tool that we use internally, which comprises one

part of a suite of document automation tools that we use to

generate start-up and venture-financing-related documents.

• Because it has been designed as a generic tool that takes into

account a number of options, this version of the term sheet

generator is fairly expansive and includes significantly more

detail than would likely be found in a customized application.

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Instructions for logging into the WSGR Term

Sheet Generator

1. Go to: www.wsgr.com

2. Click on “Practices” then select “Entrepreneurial Services”

from the list

3. Click on “WSGR Term Sheet Generator” (In the far left

hand column under “Related Information”)

4. Click on “Launch” button

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LIQUIDITY & EXITS

110

Corporate Governance

• The Role of the Board of Directors

• Composition of your Board of Directors

• Good corporate governance, and why it matters for

the private company

• Working effectively with your Board of Directors

111

The Role of the Board of Directors

• Generally, the role of the Board of Directors is to

evaluate and approve the company’s business strategy;

oversee and compensate senior executives; and ensure

accountability of the corporation

• Under Delaware law, – the role of Board is to “direct or manage the business and

affairs of the corporation”

– the Board has broad powers to exercise its authority,

including to amend bylaws, approve stock and option

issuances, hire and fire the CEO and other executive

officers, approve acquisitions, and approve (with the

stockholders) the sale of the Company

112

The Composition of the Board of Directors

• State law and the company’s Charter documents specify the

number of directors

• Keep it small – The Board of Directors is not the same as a Board of Advisors

– Boards of Directors have a lot of power, and require significant

commitment of time and effort

– Difficult to remove Board members (removal for cause; classified

Boards)

• Who? – CEO, other Common Stock representatives

– Venture capital and other investor representatives

– Independent Board members, with breadth and depth of

experiences - technical, sales, marketing, finance, and industry

knowledge

• The balance of power – on the Board and with the stockholders

113

The Board’s Fiduciary Duties &

Obligations Under Law • Duty of Care

• Duty of Loyalty

• Court standards – The Business Judgment Rule

– Entire Fairness Standard

• Special situations – Interested director transactions; conflicts of interest

– Sale of the company

114

Good Corporate Governance & Why it

Matters to the Private Company • What is Corporate Governance?

– The rules, processes, customs, policies, laws, and

institutions affecting the way a company is directed,

administered and controlled, and interacts with its

stakeholders

– Sources State corporate law and state courts

Federal law (e.g., Congress) and agencies (e.g. SEC)

Stock exchanges (NYSE and Nasdaq listing standards)

Other

– Shareholder organizations (e.g., RiskMetrics/ISS)

– Plaintiffs’ bar

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Good Corporate Governance & Why it

Matters to the Private Company (cont.)

• Why it matters to the private company – Well-thought out process and structure help establish trust

and credibility among constituents

– Better satisfies the Board’s key oversight responsibilities

– Better prepares the company for an initial public offering or

other liquidity event NYSE and Nasdaq listing standards require independent,

qualified Board committees and other corporate governance

measures

Sarbanes-Oxley controls; risk management

– Attracts qualified Board members (director candidates

expect good corporate governance)

– Demonstrates to prospective D&O insurance carriers that

the company is an appropriate underwriting risk

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Working Effectively with your Board

• Structure and process (have an agenda, schedule regular Board

meetings with advance notice, and ensure timely delivery of

Board materials)

• No surprises at a Board meeting

• Recognizing and addressing conflicts of interest (disclosure and

process)

• Dealing effectively with differences in opinion

• Being sensitive to liability concerns

• Record keeping best practices (Board packages; minutes)

• Consider elective corporate governance practices – Committee structure (Audit, Compensation, other)

– Adding independent directors

– Executive Board sessions (without management)

117

Paths to Liquidity

• The traditional paths – IPO – M&A

• Alternative paths – Achieve profitability and pay dividends

May be accelerated with the right corporate partnerships Not a typical path for VC investors

– Secondary market for private company shares Generally not a strong market for companies that don’t show

good prospects of obtaining liquidity in another way Several VC financing terms designed to make this difficult to

tap (rights of first refusal/co-sale rights)

• Liquidity events are not always “exits”

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Benefits of an IPO

• Liquidity for investors/employees – Post-lockup and subject to insider trading compliance

• Opportunity for investors to personalize when they sell

• Access to capital

• Acquisition currency

• Prestige and perceived stability – As long as the stock price holds up

• Employee compensation alternatives

119

Drawbacks of an IPO

• Loss of confidentiality

• Potential loss of control – Stockholder activism

• Increased compliance burdens

• Increased legal exposure

• Tyranny of quarterly results

• Execution challenges (market choppiness)

• Cost of capital – Management time and offering expense

• Risk of stock price decline

120

What It Takes to Go Public

• IPO prospects are at the mercy of the market – “Windows” open and close quickly

– What is hot and the criteria for a successful offering move with

the market’s tides

– Top companies can sometimes defy the market’s laws of gravity

• Factors that generally excite potential underwriters are: – Revenue scale (typically at least $50M annually, often much

higher)

– Compelling growth prospects (“20% is the new 30%”)

– Profitability (1 or 2 quarters with momentum desirable)

– Sustainability and visibility

– Unique/disruptive solution and/or ties to “hot” investment themes

– Scalability to achieve growth potential

– Solid management team

– Financial controls, reporting and Board/governance infrastructure

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Benefits of a Sale

• Liquidity for investors/employees – Typically obtained more quickly than with an IPO

• Lowers standalone execution risk – More market power/presence/capital

– Turbulent quarterly results can be made less significant when combined

with a larger enterprise

• Not all companies have the growth and scalability to go

public

• Maintain confidentiality (vis a vis public) to a greater degree

• Lower required investment in administration

• Synergies may favorably impact valuation

• Liquidation preference for investors

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Risks and Costs

• Disruption of business

• Confidentiality issues

• Substantial costs and negotiation time

• Loss of control

• Potential to be “left at the altar”

• Unless for cash, acquiror’s stock performance risks

• Liquidation preferences and carve-outs

• Escrows, indemnities and earn-outs

• Failure to integrate and execute successfully

123

Timing Factors

• Competitive threats

• Market consolidation means you could be left without dance partner

• Solid performance (ideally)

• Potential to step up a level in combined company

• Non-receptive IPO market

124

Selected M&A Issues

• The Board Process and Role

• Shopping the Company

• Carve-out Plans

• Change of Control Acceleration

• Re-incentivizing Continuing Key Management and

Employees

• Non-competes and Change in Control Agreements

• Earnouts

• Indemnification and Escrow Provisions

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Earn-outs

• Used to bridge “valuation gap”

• Structural considerations – Objective vs. subjective earn-out milestones

– R&D milestones

– Commercial introduction milestones

– Revenue metrics (other financial metrics more

difficult)

– All or none vs. proportional or quasi-proportional

– “Last man standing” issues

– Duration and staging of earn-outs

– “Freedom to operate” conflicts

126

Escrow Purpose, Size and Duration

• Security for indemnity of stockholders for breaches of representations, warranties and covenants

• Typical size is 10-20% of purchase price – Special escrows for known specific liabilities or

contingencies

• Typically duration is one year to two years – Are there commercial or product development events

that suggest longer or shorter escrow/indemnity periods?

– Are there identifiable contingent liabilities where special escrow/indemnity terms should be applied?

– Indemnity for certain matters, including fraud, typically of longer duration

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Escrow as a Cap on Liability Exposure

• Typically escrow is exclusive remedy other than fraud

• Other considerations: – Is escrow too small to be the only remedy in light of

risk profile of target company? – Indemnity beyond escrow for additional percentage

or all of deal price? – Should asset deal structure be considered in light of

liability risks of target?

• Other potential exceptions to exclusivity: – Tax – Capitalization – Environmental – Intellectual Property

128

Sale Strategy Issues

• Valuation is generally determined by 3 things: – Ability to pay (buyer’s balance sheet, tolerance for dilution, etc…)

– Willingness to pay (strategic importance, limited alternatives, fit)

– Need to pay (competition, including IPO)

• Be careful about over-optimizing: – It takes luck to perfectly time the market

– Negotiators who overplay their leverage can miss good deals

• Technology companies tend to be bought not sold

• Know your investors - different constituencies may have

different outcome priorities – Liquidation preferences

– Value expectations and basis

– Views of market trends

– Management’s desire to keep or divest control

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Sale Tactical Issues

• Shopping the company – Market checks, broad and narrow auctions

– Keeping confidentiality, managing leaks

– Role of a banker

• Designing the Board process – Board duties and role

• Indemnification and escrow provisions – Caps and baskets

– Time periods

– Myriad process points to negotiate

• Earn-outs – Milestones

– “Freedom to operate” conflicts

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Planning for Liquidity

• Discuss liquidity strategy regularly with key investors – Seek alignment (or at least understanding) on priorities and timing

expectations

• Assess preferred stock terms in light of implications for liquidity alternatives

– Carve out plans and recaps

• Develop the infrastructure required to achieve liquidity objectives – Managing toward a sale can be different than managing toward an IPO – Consider the doors opened and closed by partnerships and exclusivities – Consider capabilities and risks in light of how the company would be

marketed

• Pay attention to the market – Watch for consolidation trends – they can accelerate quickly

Market consolidation can leave some players without a dance partner

– Build relationships around the industry; never eat lunch alone

• Keep your nose clean – Auditor relationships – Legal best practices – Risk management

131

TALES FROM THE TRENCHES

Life Sciences Entrepreneur Bootcamp

Business

Transcript of Life Sciences Entrepreneur Bootcamp