Three Basic Rules: Dilution, Dilution, Dilution

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stage investments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.


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Ten Tips to Magnetize Your Business Plan

It is a rare entrepreneur who can raise money beyond the seed round without a well prepared, thoroughly research business plan. It maps out the road to success. The business plan must convince investors that you know the best route to get there and that if there are twists and turns in the road, as there inevitably will be, you can navigate them. Typically, venture capitalists (VCs) and angels focus primarily on the management team, the idea, market opportunity, and the financials, but other factors play into the final decision of an investor to fund a business. Here are ten tips that will magnetize your business plan making it more attractive to investors.

1. Hook them Immediately

Investors are deluged with business plans, rejecting most within a few minutes of beginning to read them. How do you stand out from the rest? Open with a couple of sentences that grab the attention and imagination of investors and entice them to want to read more. These first few sentences must tell the reader what you do, why you are unique, the size of the market, and the share of market you expect to capture and when.

2. Project Solid Management Expertise

The strength of your start-up’s management team is absolutely critical to your success and your ability to raise venture and angel financing. A start-up doesn’t need to have a complete team to raise funding, but it should, at the least, have key players on board who have the experience and the vision to make the company a success. VCs and angels invest in people, not just ideas on paper, and they want to make sure that your team can deliver. Investors look for an effective management team that:

  • Has successfully started and run other companies
  • Works cooperatively
  • Consists of members selected to provide a range of industry knowledge and functional skills
  • Has integrity, passion, flexibility and reliability

Corporate and advisory board members can help enhance the expertise, experience, and network of the managers of a start-up. Marquis names impress investors. Choosing well-represented professional resources such as accountants and lawyers will not only expand your network but also increase your credibility with investors.

3. Develop Captivating and Believable Financials

Investors will want to know how you arrived at your projections. These assumptions should be clearly spelled out. If you have an existing business, you have a pretty good sense of how much things will cost, how much staff you’ll need, and the sales, you’re likely to make. But when you’re just starting out, these projections are difficult to make. Instead, develop your financials from the bottom up.

  • Examine different distribution channels and the opportunities and costs in each
  • Source manufacturers and suppliers
  • Project staffing needs with salaries and start dates

Investors will expect numbers to be more or less aggressive depending on the stage, level of risk of the company and whether they are a VC or an angel. Angels tend to have less aggressive goals than VCs.

Know your numbers and be ready to explain how each item in your projections has been calculated, because any serious investor is likely to grill you on the detail. You’ll also be expected to know your brake event point, burn rate, when you are going to run out of money and what the investor’s exit strategy is (buyout, IPO, merger/acquisition).

4. Target a Significant Market With Opportunity

VCs in particular are looking for big opportunities – they want to know that your business will serve a large market (at least $1 billion) and possibly become a market leader. They want to understand what the market situation is that needs to be addressed and how you plan to exploit it. Is the consumer frustrated, perhaps the industry is plagued by poor quality control? Is it an untapped market niche? Are you consolidating a fragmented market? Have you developed a technological or medical breakthrough?

5. Include a Well-Researched Market Analysis

Part of targeting a significant market opportunity is knowing everything about the market, not just is size and opportunity. Provide a full analysis of the market, its characteristics, growth potential and all relevant trends. Include a competitive analysis, which describes the strengths and weaknesses of the competitors within your market and your competitive advantage.

6. Create Competitive Barriers

You must have a sustainable competitive advantage. Do you have patents, copyrights, a proprietary process or technology, exclusive licenses or agreements? Are you the first to market? How long can you protect that lead if a big company enters the market? Do you have the best people or the best strategic partners?

7. Forge Strategic Alliances

Securing strategic alliances with key players in the industry, distributors, vendors, etc., shows venture capitalists and angels that others trust you, want to work with you and establishes proof of concept, which is particularly important for a start-up. This definitely increases an investor’s confidence in you.

8. Set Realistic and Achievable Milestones

Investors don’t give a large sum of money in one chunk. You’ll need to address how much will be needed, when each contribution will be made and what the goals are to be accomplished in that period. If you don’t achieve your goals you may not get the next contribution so make your milestones realistic.

9. Show Management’s Commitment

For start-ups, a personal investment on the part of the entrepreneur demonstrates his or her seriousness and willingness to take on part of the risk and shows investors the entrepreneur’s commitment to the project.

10. Attend to the Details

VCs and angels don’t have a lot of time or patience. The business plan should be:

  • Concise – about 30 pages
  • Consistent – numbers in particular need to be consistent throughout the text of the plan, the
  • Financials and the assumptions
  • Well documented – footnote where appropriate
  • Accurate – don’t make things up
  • Easy to read
  • Well laid out
  • Written in an acceptable business plan style
  • Handsome – use of color on the cover and graphics can be beneficial

Be sure the cover page has the name of your company, logo, its address, phone and fax numbers and company URL, plus the name and title of the contact with email address. Include a table of contents that provides a logical arrangement of the sections of your business plan, with page numbers. Believe it or not entrepreneurs sometimes overlook these small details.

Final Points

Getting funding is no easy task. Hard work, persistence and following these tips will improve your chances of success.

Why Founders and Employees of Emerging Businesses Need to Understand 83(b) Elections

Written By: Daniel H. Peters and Stefan P. Smith of Locke Lord LLP

Entrepreneurs founding startup companies are often unaware of a potentially significant tax liability that can rear its ugly head with respect to stock issued to founders and employees. Emerging business founders often acquire their stock through a restricted stock purchase arrangement providing for time-based vesting. However, this common structure may set the stage for an unwelcome and unexpected tax bill down the road. An 83(b) election can, in the right circumstances, provide a relatively simple and effective way to avoid the tax.

An emerging business will commonly issue equity to its founders and early employees in the form of restricted stock subject to a vesting schedule that incentivizes those individuals to remain with the company during its critical early years. Unless and until it vests, restricted stock is normally subject to forfeiture to the company if the founder or employee leaves the business. For example, under an ordinary four-year graded vesting schedule, one-quarter of the stock would vest and therefore cease to be subject to the risk of forfeiture after the first year, and the remaining restricted stock would vest pro rata on a monthly, quarterly, or annual basis over the next three years.

The potential tax problem arises because the IRS does not consider restricted stock to be actually received by the founder or employee until it is no longer subject to a substantial risk of forfeiture. The stock’s holder is therefore deemed for tax purposes to acquire the stock in installments over time as it vests, rather than all at once when originally issued. As restricted stock vests according to the agreed vesting schedule, the founder or employee would be subject to taxation based on the value of the stock at the time of vesting, and this taxation will be based on the recipient’s ordinary income tax rate and the value of the stock on the vesting date. If the emerging business is successful and performs well, resulting in the company’s value increasing year-over-year, the holder of the restricted stock may become subject to an increasing tax liability as his or her equity vests. And there is no corresponding tax relief in the event that the value of the business subsequently declines. In addition, the holding period for determining the future capital gain or loss treatment upon the disposition of the stock will not start to run until the shares vest.

For an example of how the tax would apply in the real world, assume that a startup company founder were to acquire 100,000 shares of restricted stock valued at $0.01 per share at the time of issuance, subject to a four-year graded vesting schedule. One year later, the company has substantially increased in value so that the founder’s restricted stock is then worth $5.00 per share.

Under the vesting schedule, one quarter of the founder’s stock would vest, and those 25,000 newly-vested shares would have a total fair market value of $125,000. The founder would have to include that $125,000 of value as ordinary taxable income for the year in which the shares vest. One can easily imagine a similar scenario leading to an unexpected and painful tax burden.

An 83(b) election can provide a solution. 83(b) refers to a section of the Internal Revenue Code that allows a person acquiring restricted stock to choose to be taxed upfront based on the value of that stock at the time of issuance, notwithstanding that the shares are unvested. The holder of the stock making such an election is taxed on the difference between the fair market value of the equity at the time of issuance and the price, if any, the holder paid for the equity. In the case of a founding employees, the purchase price and value of the restricted stock is typically a very low or nominal amount because the startup has little value at the time of original issuance. If the purchase price for the stock equals the stock’s fair market value, then no taxable income would result from the transaction. In addition, since the value of the shares will have been included in the holder’s ordinary income, the holding period for capital gain or loss purposes will begin to run as of the date of issuance.

A person acquiring restricted stock can make an 83(b) election by filing a relatively simple form with the IRS within thirty days after issuance of the equity. However, anyone considering making an 83(b) election with regard to the acquisition of equity should consult his or her tax advisor before doing so. The election is irrevocable once made, and may not make sense for every situation. In most cases, however, the ability to make an 83(b) election can offer an emerging business founder a welcome relief from a possible future tax headache.


Daniel H. Peters, Partner, dpeters@lockelord.com

Daniel H. Peters is a Partner in the Los Angeles office of Locke Lord LLP where he counsels clients engaging in domestic and cross-border corporate and financial transactions in a variety of industries. Mr. Peters concentrates his practice on mergers and acquisitions, joint ventures, strategic alliances, investments and similar transactions. He regularly represents clients in the purchase and sale of both public and private companies, and has substantial experience advising both strategic investors and issuers in venture capital and similar investment transactions. He also counsels both public and private companies in various legal aspects of their business operations and activities, including corporate governance and compliance matters. He advises emerging companies in various stages of growth, providing legal and strategic guidance in all phases from formation through exit. In addition to corporate transactional matters, Mr. Peters also has experience representing both financial institutions and borrowers in commercial lending, equipment finance and public finance transactions.

Full Bio

Stefan P. Smith, Partner, spsmith@lockelord.com

Stefan P. Smith, a Partner in the Dallas office of Locke Lord LLP, has extensive experience in employee benefits and executive compensation law. He works with both public and private entities to establish and ensure the continued compliance of tax-qualified defined contribution and defined benefit retirement plans, including 401(k)/profit sharing plans, traditional defined benefit plans, money purchase plans, employee stock ownership plans, and cash balance plans. In addition, Mr. Smith assists with employee benefit matters arising during mergers and acquisitions and works with all forms of health and welfare plans and executive and equity-based compensation, including incentive and non-qualified stock options, restricted stock awards, stock appreciation rights, employee stock purchase plans, phantom equity, performance unit and bonus plans, SERPs and other excess benefit plans, and non-qualified deferred compensation plans.

Full Bio

Locke Lord LLP

Locke Lord is a full-service, international law firm with offices in Atlanta, Austin, Chicago, Dallas, Hong Kong, Houston, London, Los Angeles, New Orleans, New York, Sacramento, San Francisco and Washington, D.C. Its team of approximately 650 lawyers has earned a solid reputation in complex litigation, regulatory and transactional work. Locke Lord serves its clients’ interests first, and these clients range from Fortune 500 and middle market public and private companies to start-ups and emerging businesses. Among Locke Lord’s many strong practice areas are appellate, aviation, bankruptcy/restructuring/insolvency, business litigation and dispute resolution, class action litigation, consumer finance, corporate, employee benefits, energy, environmental, financial services, health care, insurance and reinsurance, intellectual property, international, labor and employment, mergers and acquisitions, private equity, public law, real estate, regulatory, REIT, tax, technology, and white collar criminal defense and internal investigations.

So You Want To Raise Capital

Mary Jones, a biochemist, has stumbled across an interesting piece of science and has been given the opportunity to license the same by the university for which she works, for a nominal up-front fee, an ongoing royalty, plus a gratis equity position in the company. The principal condition of the license is that the science be exploited commercially. The science, if proven to perform as early indications suggest, will greatly reduce the need for insulin injections by patients suffering from juvenile and adult-onset diabetes. Since diabetes is growing at an alarming rate, particularly among adults, Jones is excited and prepared to quit her job. She is intimidated, however, by the fact the development of the drug through FDA animal and clinical trials may, she understands from individuals who have “been there,” cost upwards of $30 to $40 million. Indeed, simply to fund testing to get a new drug ready for the FDA will require several hundred thousands of dollars of additional work in the lab.

Jones goes to the Internet and downloads some of the existing literature on early-stage finance; she puts together a business plan seeking to raise the entire amount necessary to get her product on the market. At this point, the case study is interrupted by a supervening fact: Jones is almost certain to fail. With exceptions with which I am not personally familiar (other than a few extraordinary Internet-related examples), it is impossible to raise a multimillion-dollar amount of capital for a start-up in one lump sum. If one sets out to do so, time and money are wasted. The successful examples, accordingly, divide the fund-raising process into small bites. The first amount of capital raised (a “tranche” in VC jargon) is $500,000. There is no magic in that number but it has repeated itself often enough that it has become part of the canon. Five hundred thousand dollars takes the startup to the point where indications of success have become strong. There is, perhaps, even a so-called beta test, meaning a working prototype of the product or technology and, in the biotech arena, successful phase-one trials. The next tranche is, therefore, $3 million. (Again, there is no magic to the number, but it repeats itself so often it has become part of the culture.) The $3 million also may come from high net worth individuals, often those acquainted with the founder (and here the jargon is that the founder is going through his or her “Rolodex offering”), but also may include a venture fund, turning the financing into the “first venture round.” Getting ahead of the story, the $3 million does not arrive in one lump sum, ordinarily, but in increments. Recognizing that $3 million is only a fraction of the $30 to $40 million needed, the founder and her advisers, perhaps including a boutique placement agent at this stage, are coincidentally searching for strategic investment, for example, a minority tranche from an ethical drug company in exchange for stock, marketing, and distribution rights to the technology if it clicks. Again, the case study indicates the rules of thumb in the trade. The strategic investor invests at a 25 percent more favorable valuation than the financial partners, a number validated by reliable survey materials. But the bad news is that it takes about twice as long for a strategic investor to make up its mind as a financial partner.

The company is then up and operating, slogging its way through the FDA gauntlet of phase-one, phase-two, and phase-three trials, and burning money at a rate of several hundred thousand dollars a month. As the science arrives at the early stages of FDA scrutiny and trials, the VCs and the founder start talking about a mega-financing by tapping the public equity markets—an initial public offering (IPO).

Again, referencing current fashion, serious investment bankers (and not those firms of questionable pedigrees sometimes known as the “Boca Raton” bankers) express an interest conditional on the company having at least one, and preferably more, applications of its science in phase-three trials. The minimum size of the offering is $30 million for somewhere around one-third of the company, meaning a total post-IPO company valuation of $100 million. A financing takes about six months from start to finish and is fraught with risk, including the possibility of a “fail” on the eve of the effective date if the market turns against biotech stocks, as it does episodically for reasons which can be totally unrelated to Jones and her firm. Assuming a successful public offering, $30 million still may not be enough to get to cash-flow break-even, since the company is taking on other scientific projects, which burn money at a rapid rate, in order to justify the expectations of the market that it is a real company and not just a line of one or two products. The IPO is then followed by another primary offering some six months later, assuming the stock holds up well and the market continues to stay in love with the company’s prospects. This time the valuation is advanced to, say, $150 million and the company again puts $30 million in its pocket. The period between the first and the second financing is stressful for Jones because she is not only managing her firm but also, once the company has become public, continually spending time cozying up to stockholders, analysts, and other members of the investment community so that the popularity of her company, as measured by the trading price of her stock, remains strong. Jones has been told that the “road show” (that presentation she made to the investment community and investment bankers immediately prior to the IPO) “never ends.” The irony is that at a company valuation anywhere under $300 to $500 million, the company risks a visit to the so-called growing orphanage, meaning that cohort comprising 70 percent of the 12,000 companies currently public which are not followed by the investment analysts, and, therefore, are not liquid in any true economic sense, with a stock price reflecting an efficient market. Jones is advised, accordingly, to pursue a so-called rollup or platform strategy, meaning using her public company as the platform to absorb other public and private companies which have not been able to make it on their own but which house interesting science and have brought their intellectual property to the brink of commercial exploitation. By rolling up those companies into her platform, she is able to increase her market capitalization to one-half billion dollars and finally take a one-week vacation in the Bahamas.

After all the dilution she still owns about 7 percent of her company personally, which translates, on paper at least, into $35 million. She cannot get out at that price because she is contractually obligated to “lock up” (i.e., not sell) for various periods of time so as not to create undue selling pressure. And, she has been living for four or five years on a salary which is somewhat less than half of what she could have earned had she not entered into this enterprise in the first place. However, she beat the odds. She will ultimately have some liquidity, together with the priceless satisfaction of having grown a major public firm and served mankind in the process. She will no longer, incidentally, be chief executive officer. That post was filled shortly after the first venture round, with Jones continuing as chair and chief scientific officer. The first individual hired having not worked out, there have been two CEOs since: the last one a grizzled veteran of the pharmaceutical industry and a long-time favorite of Wall Street. The office of chief financial officer has also changed hands a few times, the law and accounting firms are new, and a major-bracket investment bank long ago replaced the placement agent. Alleged dissident shareholders have sued Jones twice, in fact stimulated by underemployed plaintiffs’ counsel for allegedly keeping good news (or bad news, depending on how the stock price performed) under wraps for too long. Was it worth it? The answer, of course, depends on the individual. This game is not for everybody.

Term Sheets: Important Negotiating Issues

Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

It is customary to begin the negotiation of a venture investment with the circulation of a document known as a term sheet, a summary of the terms the proposer (the issuer, the investor, or an intermediary) is prepared to accept. The term sheet is analogous to a letter of intent, a nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. The advantage of the abbreviated term sheet format is, first, that it expedites the process. Experienced counsel immediately know generally what is meant when the term sheet specifies “one demand registration at the issuer‘s expense, unlimited piggybacks at the issuer‘s expense, weighted average antidilution,” it saves time not to have to spell out the long-form edition of those references.

Important Negotiating Issues

Entrepreneurs who are in the process of effecting a venture capital financing for their start-up or emerging companies will negotiate with one or more venture capital firms on a number of fundamental and important issues. These issues are generally initially set forth in a “Term Sheet” which will serve as the basic framework for the investment. It is important that the company anticipate these issues and that the Term Sheet reflect the parties’ understanding with respect to them.

The following are some of the more important issues that arise:

  • The Valuation of the Company. While valuation is often viewed as the most important issue by the company, it needs to be considered in light of other issues, including vesting of founder shares, follow-on investment capabilities by the venture investors, and terms of the security issued to the investors. Significant financial and legal due diligence will occur and entrepreneurs should ensure that their companies’ financial projections are reasonable and that important assumptions are explained. Venture investors will consider stock options and stock needed to be issued to future employees in determining a value per share. This is often referred to as determining valuation on a “fully diluted” basis.
  • The Amount and Timing of the Investment. Venture investors in early stage companies often wish to stage their investment, with an obligation to make installment contributions only if certain pre-designated milestones are met.
  • The Form of the Investment by the Venture Investors. Venture investors often prefer to invest in convertible preferred stock, giving them a preference over common shareholders in dividends and upon liquidation of the company, but with the upside potential of being able to convert into the common stock of the company. There are strong tax considerations in favor of employee-shareholders for use of convertible preferred stock, allowing the employees to obtain options in the company at a much reduced price to that paid by the venture investors (a pricing of employee stock options at 1/10th of the price for preferred stock is common among Silicon Valley companies). Often times, venture investors will seek to establish interim opportunities to realize a return on this investment such as by incorporating a current dividend yield or redemption feature in the security. [Redemption rights allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.]
  • The Number of Directors the Venture Investors Can Elect. The venture investors will often want the right to appoint a designated number of directors to the company’s Board. This will be important to the venture investors for at least two reasons: (1) they will be better able to monitor their investment and have a say in running of the business and (2) this will be helpful for characterization of venture capital fund investors as “venture capital operating companies” for purposes of the ERISA plan asset regulations. Companies often resist giving venture investors control of, or a blocking position on, a company’s Board. A frequent compromise is to allow outside directors, acceptable to the company and venture investors, to hold the balance of power. Occasionally, Board visitation rights in lieu of a Board seat is granted.
  • Vesting of the Founders’ Stock. Venture investors will often insist that all or a portion of the stock owned or to be owned by the founders and key employees vest (i.e., become “earned”) only in stages after continued employment with the company. The amount deemed already vested and the period over which the remaining shares will vest is often one of the most sensitive and difficult negotiating issues. Vesting of founder stock is less of an issue in later stage companies. Another issue with the founders can arise if the VC insist that the founders lock-up the issuer‘s representatives and warranties. Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. [Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders.
  • Additional Management Members. The investors will occasionally insist that additional or substitute management employees be hired following their investment. A crucial issue in this regard will be the extent to which the stock or options issued to the additional management will dilute the holdings of the founders and the investors.
  • The Protection of Conversion Rights of the Investors from Future Company Stock Issuances. The venture investors will insist on at least a weighted average anti-dilution protection, such that if the company were to issue stock in the future based on a valuation of the company less than the valuation represented by their investment, the venture investors’ conversion price would be lowered. The company will want to avoid the more severe “ratchet” anti-dilution clause and to specifically exempt from the anti-dilution protection shares or options that are issued to officers and key employees. It is also sometimes desirable from the company’s perspective to modify the anti-dilution protection by providing that only those investors who invest in a subsequent dilutive round of financing can take advantage of an adjustment downward of their conversion price, a so-called “pay to play” provision. If the formula states that if the number of shares in the formula is “broadest” based, this helps the common shareholder. [If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.]
  • Pre-emptive Rights of the Investors to Purchase any Future Stock Issuances on a Priority Basis. The company will want this pre-emptive right to terminate on a public offering and will want the right to exclude employee stock issuances and issuances in connection with acquisitions, employee stock issues, and securities issuances to lenders and equipment lessors.
  • Employment Agreements With Key Founders. Management should anticipate that venture investors will typically not want employment agreements. If they are negotiated, the key issues often are: (1) compensation and benefits; (2) duties of the employee and under what circumstances those duties can be changed; (3) the circumstances under which the employee can be fired; (4) severance payments on termination; (5) the rights of the company to repurchase stock of the terminated employee and at what price; (6) term of employment; and (7) restrictions on post-employment activities and competition.
  • The Proprietary Rights of the Company. If the company has a key product, the investors will want some comfort as to the ownership by the company of the proprietary rights to the product and the company’s ability to protect those rights. Furthermore, the investors will want some comfort that any employees who have left other companies are not bringing confidential or proprietary information of their former employer to the new company. If the product of the company was invented by a particular individual, appropriate assignments to the company will often be required. Investors may require that all employees sign a standard form Confidentiality and Inventions Assignment Agreement.
  • Founders Non-Competes. The investors want to make sure the founders and key employees sign non-competes.
  • Exit Strategy for the Investors. The venture investors will be interested in how they will be able to realize on the value of their investment. In this regard, they will insist on registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions. The company will need to consider and negotiate these rights to assure that they will not adversely affect any future rounds of financing.
  • Lock-Up Rights. Increasingly, venture investors are insisting on a lock-up period at the term sheet stage where the investors have a period of time (usually 30-60 days) where they have the exclusive right, but not the obligation, to make the investment. The lock-up period allows the investors to complete due diligence without fear that other investors will pre-empt their opportunity to invest in the company. The company will be naturally reluctant to agree to such an exclusivity period, as it will hamper its ability to get needed financing if the parties cannot reach agreement on a definitive deal.

Form of Term Sheet

Term sheets are intended to set forth the basic terms of a venture investor’s prospective investment in the company. There are varying philosophies on the use and extent of Term Sheets. One approach is to have an abbreviated short form Term Sheet where only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and not be hampered by argument over side points. Another approach to Term Sheets is the long form all-encompassing approach, where virtually all issues that need to be negotiated are raised so that the drafting and negotiating of the definitive documents can be quick and easy. The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage and, if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal. The disadvantage of the long form approach from the venture investors’ perspective is that it may tend to scare away unsophisticated companies.

Lagniappe Terms:

The Charter: (Certificate of Incorporation) is a public document, filed with the Secretary of State of the state in which the company is incorporated, that establishes all of the rights, preferences, privileges and restrictions of the Preferred Stock.

Accrued and unpaid dividends are payable on conversion as well as upon a liquidation event in some cases. Most typically, however, dividends are not paid if the preferred is converted.

PIK” (payment-in-kind) dividends: another alternative to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

“Opt Out”: For corporations incorporated in California, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock. The purpose of this provision is to “opt out” of DGL 242(b)(2).

Preferred Stock: Note that as a matter of background law, Section 242(b)(2) of the Delaware General Corporation Law provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.

The per share test: ensures that the investor achieves a significant return on investment before the Company can go public. Also consider allowing a non-QPO to become a QPO if an adjustment is made to the Conversion Price for the benefit of the investor, so that the investor does not have the power to block a public offering.

Blank Check Preferred: If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.

Redemption rights: allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.

Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders. Note that Founders/management sometimes also seek limited registration rights.

Registration: The Company will want the percentage to be high enough so that a significant portion of the investor base is behind the demand. Companies will typically resist allowing a single investor to cause a registration. Experienced investors will want to ensure that less experienced investors do not have the right to cause a demand registration. In some cases, different series of Preferred Stock may request the right for that series to initiate a certain number of demand registrations. Companies will typically resist this due to the cost and diversion of management resources when multiple constituencies have this right.

Break Up Fee: It is unusual to provide for such “break-up” fees in connection with a venture capital financing, but might be something to consider where there is a substantial possibility the Company may be sold prior to consummation of the financing (e.g., a later stage deal).

For more information on Venture Capital, please visit VC Experts

Three Basic Rules: Dilution, Dilution, Dilution

Written by Joseph W. BartlettVC Experts Founder

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stage investments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.

[1] Williams, “Community Development Venture Capital: Best Practices & Case Studies,” (Jan.2004)