Valuation, Cap Tables, Terms Sheets and Other Legal and Financial Considerations

March 20, 2021 Valuation, Cap Tables, Terms Sheets and Other Legal and Financial Considerations

Kristin Fox | Vantage Point Advisors

Patrick Anding | DLA Piper

TheSDAngels.com SDAngelConf SDAC Vantage Point Advisors

Vantage Point Advisors is a leading provider of valuation services for tax reporting and compliance, financial reporting, transaction advisory, fairness and solvency opinions, litigation support, and other business advisory services, with offices in San Diego, Los Angeles, Portland, Seattle, New York and Dallas-Fort Worth.

Kristin Fox Vantage Point Advisors Director of Business Development

11455 El Camino Real, Suite 450 San Diego, CA 92130 [email protected] Direct 773.251.5731

TheSDAngels.com SDAngelConf SDAC DLA Piper

DLA Piper is a global law firm with lawyers located in more than 40 countries throughout the Americas, Europe, the Middle East, Africa and Asia Pacific, positioning us to help clients with their legal needs around the world.

Patrick Anding DLA Piper Partner

4365 Executive Drive #1100 San Diego, CA 92121 [email protected] Direct 415.603.8150

TheSDAngels.com SDAngelConf SDAC AGENDA What we hope to accomplish today:

• Review the principal types of seed financing • Debt, Equity, Alternative • Key Terms • Benefits / Risks • Explain the basics of valuation and considerations that should be top of mind for early stage founders during negotiations • Provide an understanding as to why valuation is important in protecting founders’ ownership

TheSDAngels.com SDAngelConf SDAC Poling Question Are you an entrepreneur or an investor? • Entrepreneur • Investor If an investor, how many investments do you make per year? • 1-2 • 3-5 • 5+ If a founder, what category do you fall into from a fund-raising stage perspective: • Pre-Seed • Seed • Series A TheSDAngels.com SDAngelConf SDAC Principal Types of Seed Financing

• Cash contributions by founders • Convertible debt / bridge financing • SAFEs (Simple Agreement for Future Equity) • Preferred stock equity financing (Series Seed)

TheSDAngels.com SDAngelConf SDAC Founder Cash Contributions

• Initial fund raising from 3rd parties can take 6-12 months.

• Companies have expenses prior to 3rd party investment:

• Incorporation costs • Travel expenses • Software development / prototyping / wireframes • Accounting expenses / tax filing • License fees (software, patents, trademarks) • Legal fees • Domain names / websites • Office space • Consultants / employees / service providers

• Founders often provide their companies with initial working capital for startup expenses and early development expenses.

TheSDAngels.com SDAngelConf SDAC Founder Cash Contributions

Four ways to structure a cash contribution: • Contribution to capital • Upside  increased cost basis in their common stock; cheap & easy. • Downside  founders don’t get their money back. • Purchase common stock • Upside  get more shares of common (but they have so many already!). • Downside  sets value of common stock; tax implications for other founders; increases the exercise price used for option grants (409A). • Invest in SAFEs, convertible debt or preferred equity. • Upside  get additional company securities with investor terms. • Downside  legal fees; complexity of documentation; investors may not like the terms if founders set terms; may need to wait for 3rd investors before contributing cash. • Founder loan (non-convertible promissory note) [My Preference] • Upside  No 409A issues; simple & cheap, founders can sometimes get repaid by company (or convert in next round on investor terms), most flexible. • Downside  Liability on balance sheet, interest accrual.

TheSDAngels.com SDAngelConf SDAC Founder Cash Contributions

• Founder Loan  Short Form Promissory Note • Non-convertible note. • Simple interest (don’t forget AFR). • Maturity earlier of 3 years or time of first financing. • Can be set up to accommodate multiple loans.

TheSDAngels.com SDAngelConf SDAC Seed Money / How Much?

• “How much should I Raise?” • This is business not legal, but startups need our help with this. This is an opportunity to win clients on the basis of business experience and guidance.

• Answer should be driven by: • Near-term capital needs based on development roadmap & business • Long-term fund raising plan based on valuation inflection points • Raise to and through next valuation milestones • Typical funding raising cycle from first pitch to close can be 6-12 months

• What does the founder need to show the next round of investors (data, product market fit, validation, patents, prototype)? • What do you want in the next pitch deck? Build towards that!

TheSDAngels.com SDAngelConf SDAC Convertible Notes / SAFEs

• Convertible debt • aka  convertible promissory notes, bridge notes, bridge financing, converts, convertibles. • Simple Agreement for Future Equity • aka  SAFEs, Safes, Safe Notes (though not really “note”). • Both solve the early stage valuation problem • Early stage companies hard (maybe, impossible) to value (no revenue, no assets, etc.). How do you negotiate with investors? • If priced, would be so low investors would own the company. • Companies want to raise money to execute plan to reach value inflection points, then value company in priced round. • Like prepaying for stock in the equity round.

TheSDAngels.com SDAngelConf SDAC What Is A Convertible Note?

A debt instrument with, among other features:

• Automatic conversion . . . • . . . of principal and interest . . . • . . . into capital stock . . . • . . . typically at a discount . . . • . . . in a financing in which a minimum threshold is raised (“Qualified Financing”) • Ability to default; creditor status.

TheSDAngels.com SDAngelConf SDAC Purpose of Note/SAFE Offerings

• Unlike traditional debt, the expectation of the Note investor and the issuer is not that the investor will receive a return equal to principal plus interest, but instead . . .

• Expectation is that the investor will become an equity holder when Qualified Financing achieved.

• SAFEs have a similar purpose as Notes, but eliminate concept of ability to foreclose on assets, maturity date and accrued interest.

TheSDAngels.com SDAngelConf SDAC Perceived Benefits for the Issuer

• Faster and cheaper to close then Preferred Stock (fewer documents and terms to negotiate, no charter amendment). • Able to avoid pricing the round. • Q: how does that impact FMV of common? • SAFEs, as compared to Notes, have additional benefit for issuers of eliminating debt features. • Enables ability to customize pricing and other deal terms for particular investors.

TheSDAngels.com SDAngelConf SDAC Perceived Benefits for the Investors

• Faster and cheaper! Important to remember that the investors money is paying for the both issuer and investor transaction expenses. So more cash for the company. • Less negotiating / friction with founders. • Some investors (particular angels) appreciate the debt concept and priority in liquidation. • For more most startups, this doesn’t matter as most have little/no liquidation value. • SAFES mirror the same priorities by contract, but some investors are still suspicious.

TheSDAngels.com SDAngelConf SDAC Later Stage Convertible Debt / SAFEs

• Standard for early stage, pre Series Seed/A. • But also used in later stage–Post-Series A (often Post Series B or C). • Bridge the gap between equity financings or before a sale. • Typically, later stage non-equity financing are debt and not SAFEs, but that has been evolving.

TheSDAngels.com SDAngelConf SDAC Transaction Documents

• Term Sheet • Summarize the key business terms of the financing. • Not as common in SAFE financings. • Note Purchase Agreement • Not used in SAFE financing, but used in most debt financing by custom, though not all. • Sets the $ amount of notes that can be sold and establishes the timeframe for sale of notes (multiple / rolling closes). • Company and investor representations. • Sometimes additional commercial terms or investors rights. • Form Convertible Notes / SAFE • The security and/or evidence of indebtedness. • Contains principal, interest rate, terms of the repayment & conversion, events of default and other core terms.

TheSDAngels.com SDAngelConf SDAC Transaction Documents

• Warrants • Rare for seed capital investments. • More common in later stage investments. • Security Agreement • Rare for startup seed investments No assets to provided security. • Subordination Agreement • Rare in early stage investments, unless there is already outstanding debt, such as bank line. • Board and Stock Consents • Always needs board consent. • Sometimes need stockholders consents (waiver protective provision or negative covenants; interested party disclosure, disinterested 3rd patty consent). • Other 3rd party consents (other lenders)?

TheSDAngels.com SDAngelConf SDAC Key Terms

• Size of offering • Period of additional closings. Multiple/rolling closes. • Maturity Date. • For Notes (but not SAFEs): payable upon demand after maturity (typically, 1-3 years). Only pre-payable with holder consent • Interest (but not SAFEs). • 4-8% • Automatic conversion trigger. • Size of equity raise that triggers a conversion (i.e. what qualifies as a “qualified financing”). YC SAFES no $$$ threshold, just sale of preferred stock in priced round. • Typically, set to target for first equity round. $1M-$3M • Should be more than the bridge round.

TheSDAngels.com SDAngelConf SDAC Key Terms

• Conversion price • Discount off priced round (approx. 10-25%), • Price based on valuation cap. • Lesser or discount of valuation cap. (Market) • Optional conversion on maturity. • Into common stock or preferred at agreement upon price. Never allow FMW conversion price! • Event of default (but not SAFEs). • Can include CoC to ensure no overhang on exit. • Amendment/voting thresholds. • Holders of majority of principal; sometimes lead has block. Important for debt as extending the maturity date is common.

TheSDAngels.com SDAngelConf SDAC Key Terms

• Definition “Fully-Diluted Capitalization” for calculating conversion price. • Does it include full option pool, only issued options, other convertible notes or Safes, warrants issued with other debt. • Newest yCombinator used “Post-Money” calculation instead of pre-money calculation. • Treatment in change of control. • For Notes: if acquired prior to conversion, repayment with premium (typically, principal + interest + premium of 50% to 200%). • For SAFEs: if acquired or IPO prior to conversion, investor can elect either repayment of investment without premium or convert at the “Liquidity Price” (treated as if converted at valuation cap).

TheSDAngels.com SDAngelConf SDAC Key Terms

• Converts into Preferred Stock. • Liquidation preference based on new investor per share purchase. • Conversion price is discounted, so the note/SAFEs are paying less than the liquidation preference. • Example  • Series Seed share price of $1.00 • 20% discount means notes/SAFEs paying $0.80 • If converting $800,000 of Notes/SAFEs then $1M preference. • Difference in conversion price to liquidation preference can be very meaningful when using valuation caps. • SAFEs solve for this by creating “SAFE Preferred” where conversion price and liquidation preference are the same.

TheSDAngels.com SDAngelConf SDAC Additional Investor Asks in SAFE/Note Financings • Additional rights. Less common in Note and SAFE financing with institutional investors; but some ask. • Participation rights. • Most favored nations rights. • Security interest in assets; blanket subordination by future lenders or creditors. • Major investor approval of amendments. • Negative Covenants. • Cover legal expenses for review of legal documents upon conversion. • Board observer (or board seat). • Information rights.

TheSDAngels.com SDAngelConf SDAC Investor Considerations

Pros: • Simpler mechanism than Preferred Stock to deploy small amounts of capital • Valuation cap and discount provide built-in anti-dilution and price protection until next priced round. • If there have been prior priced rounds, convertible note provides structural liquidation preference until converted.

TheSDAngels.com SDAngelConf SDAC Investor Considerations

Cons: • Rights, protections and diligence often lighter than priced round. • Typically no board seat and little or no mechanisms for management oversight and control. • Since not a stockholder, does board owe investor fiduciary duty?

TheSDAngels.com SDAngelConf SDAC What’s Market (According to Data)

• Interest • 87% of deals less than 8% • Maturity • 78% of deals greater than 12 months • Discount • 60% of deals have a 20% discount • 20% of deals have a discount above 20% • 20% of deals have a discount below 20% • Valuation Cap • 69% of deals have valuation cap • Mean in 2019 for valuation cap was $9M • Mean Q1 of 2020 for valuation cap was $4M • Warrants • Less than 2%

Source: Wilson Sonsini Q1 2020 Entrepreneurs Report for Pre-Seed convertible debt rounds

TheSDAngels.com SDAngelConf SDAC What’s Market (My take)

• Interest • 4-8% simple interest, typically 6% • Maturity • 2 years • Discount • 20% • Valuation Cap • $4M to $10M • Depending on sector and target Seed/Series A valuation • Conversion Trigger • $2M • Change of Control • Principal + interest + premium equal to 100% of principal

If you offer terms in this range, you’ll be in the market.

TheSDAngels.com SDAngelConf SDAC Poling Question

Are you considering utilizing convertible debt or a SAFE to raise a seed round of financing?

If so, what discount is market? • 5% • 10% • 20% • 30%

TheSDAngels.com SDAngelConf SDAC Venture Debt: truly non-dilutive?

Venture debt providers coin their financing options as “non-dilutive capital”. But is it really? What to be aware of…

• Venture term loans typically have warrant coverage. This means you are being offered a typical interest bearing loan but also giving the lender essentially “options” to own an equity stake in the future, above a fixed strike price.

• Convertible notes often seem attractive but discount factors at conversion can overly dilute founder’s ownership. Example to follow.

• High yield debt with no equity component can still trigger dilution. How?

• Above market interest rates mean a higher burn rate and less cash flow retained. This equates to a shorter cash runway and the need to fundraise that next round earlier (triggering earlier than necessary dilution).

TheSDAngels.com SDAngelConf SDAC Raising convertible debt – why the discount matters

Most “first-in” debt financiers want a discount on their future conversion to equity and that discount matters… •Assume $1,000,000 convertible promissory note at 8% interest

•Next qualified financing (“NQF”) / conversion is 2 years from issuance date

•Interest accrued would be $160,000

•Principal and interest would be $1,160,000 at NQF •10,000,000 shares of common stock are outstanding in addition to the convertible note. •The next qualified financing issue price is expected to be $1.00.

TheSDAngels.com SDAngelConf SDAC Raising convertible debt – why the discount matters

•Ownership given up with no discount = 10.4% • Converts into 1,160,000 shares

•$1,160,000 / ($1.00 * (1 – 0%)) = 1,160,000 •Ownership given up with conversion at 20% discount = 12.7% • Converts into 1,450,000 shares

•$1,160,000 / ($1.00 * ( 1 – 20%)) = 1,450,000 •Ownership given up with conversion at 50% discount = 18.8% • Converts into 2,320,000 shares

•$1,160,000 / ($1.00 * ( 1 – 50%)) = 2,320,000

TheSDAngels.com SDAngelConf SDAC Series Seed Equity Financings

• Preferred vs 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 powers than common stock. • Common stock is typically “priced” at a lower price than preferred stock (i.e., for option granting purposes). • Preferred stock issued through the creation of multiple “series”. • Common stock typically a single series/class, though occasionally companies my implement multiple classes of common stock to provided for different voting rights or governance controls. • Preferred stock is typically convertible into common stock.

TheSDAngels.com SDAngelConf SDAC Preferred Stock Authority in Delaware General Corporate Law

§ 151 Classes and series of stock; redemption; rights

(a) Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any or all of which classes may be of stock with par value or stock without par value and which classes or series may have such voting powers, full or limited, or no voting powers, and such designations, preferences and relative, participating, optional or other special rights, and qualifications, limitations or restrictions thereof, as shall be stated and expressed in the certificate of incorporation or of any amendment thereto, or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors pursuant to authority expressly vested in it by the provisions of its certificate of incorporation…

TheSDAngels.com SDAngelConf SDAC Overview of Preferred Financing Stock Terms Economic Terms Control / Governance Other Deal Terms • Valuation • Protective provisions • Legal option Multiple closing / single closing / • Investment amount Board composition • • tranches & milestones • Use of proceeds • Management rights • Reincorporation (DE, convert • Liquidation • Observer rights from LLC) preference Exclusivity / no-shop period • Information rights • • Anti-dilution • Due diligence • Post-closing covenants protection • Founder/employee vesting (D&O insurance, mandatory • Conversion features • Employment agreements, non- board meetings) • Dividends competes, non-solicits • Redemption rights • Legal expenses • Registration rights • Confidentiality • Preemptive rights • Regulatory matters • ROFR/Co-sale • Commercial agreements • Pay-to-play • IP matters

TheSDAngels.com SDAngelConf SDAC

35 Series Seed Financing Terms

Series Seed Preferred Stock

• “Series Seed” equity rounds begin to in Silicon Valley in late 2000s • Technology advances allowed for companies to launch with less money than typically needed in “Series A” financing ($1.5M vs $4M). • Typical Series A terms too complicated for a small financing and some investors really do want equity (rather than convertibles). • Series “Seed” was intended to reduce transaction costs for equity rounds by limiting the terms/rights and documentation. • Also, allowed for higher valuations at Series A and beyond, which founders and VC funds liked optically.

TheSDAngels.com SDAngelConf SDAC Seed Series Equity Financing Terms • Following the trend, attorneys from Fenwick & West released form Series Seed Documents that striped away many standard Series A terms. The documents removed : • Preferential dividends • Price-based antidilution protection • Redemption rights • Closing conditions or closing certificates • Legal opinion • Many reps & warranties • Registration rights • Management covenants • Co-sale rights

See: https://www.seriesseed.com/

TheSDAngels.com SDAngelConf SDAC Seed Series Equity Financing Terms

• So what remained were 30 pages, rather than 100 pages of documents.

Economic Terms Control / Governance

• Valuation • Protective provisions • Investment amount • Board composition • Liquidation preference • Observer rights • Preemptive/participation • Information rights rights • NEW: Most-favored nation • ROFR over founder’s stock status with rights the investors sales in the next round of financing get

TheSDAngels.com SDAngelConf SDAC Series Seed Equity Financing Terms

• Adoption of “Series Seed” help contribute to increasing valuations for Series A and beyond. • Founders liked this because a higher valuation Series A had the optics of being a more successful, in-demand, or “hot” startup. • Companies eventually even began having “Series Pre-Seed” financings. • Today, a tech company may have a SAFE/debt financing, a Pre-Seed, Series Seed, and Series Seed-1 before raising a Series A. • As valuations increased through out the 2010’s, Series Seed financing began looking a lot more like a Series A. • Series Seed financing today have many or most of the standard Series A terms (antidilution, preferential dividends, registration rights, management rights, etc.). • Today, many investors use “Series Seed” and “Series A” to refer to the same set of rights, preferences, and powers.

TheSDAngels.com SDAngelConf SDAC Poling Question Do you know the range of multiples companies in your industry are trading at?

Do you have a financial forecast for your startup? • Yes • No

• If you answered yes, is your forecast: • High Level • Detailed

TheSDAngels.com SDAngelConf SDAC Equity Valuation

• Valuation: how much the company is “worth”

• No matter how a Company will be financed, valuation will play a major role in the terms

• Negotiated terms between the company and the investors using many different data points

• Simplified - All business valuations hinge upon 3 main factors: 1) Growth 2) Cash flow generation (margin & earnings) 3) Risk • Investors pay for future expected cash flows (earnings).

• Underlying assets (systems, products/services, or technologies, etc.) produce that expected cash flow. The rate of return captures the risk of achieving those cash flows.

• Most SDAC affiliated companies currently are: • High risk; • Low to no margin/earnings; • But with hyper growth potential.

TheSDAngels.com SDAngelConf SDAC Basics of Valuation

All companies, even early stage start-ups, can be valued using one of 3 main valuation approaches: Income Approach

Capitalization of Earnings Discounted Cash Flow

Market Approach Cost Approach

Guideline Public Company Enterprise Value Replacement Cost Transaction Analysis Analysis

Balance Sheet Adjustments

Equity Valuation

TheSDAngels.com SDAngelConf SDAC Basics of Valuation

• Income Approach – Discounted Cash Flow Method

• Where the company’s future performance discounted at an applicable rate of return indicates its worth today. • Should include future efforts of built-out management team and the benefits of the capital raise. • Discount rate selection is big. Using a public company cost of capital (single digits or low teens) will over inflate your valuation and make you look unsophisticated to some investors. • Using a typical venture-backed rate of return (20%-40%) is appropriate and will make you look like you know what you’re doing!

TheSDAngels.com SDAngelConf SDAC Basics of Valuation

• Market Approach – Guideline Public Company Method or Guideline Transaction Method • Pricing pre-money value off of multiples of future, projected metrics. • Examples: Pre-money valuation based off 2x 3-year forward revenue forecast or 8x 3-year forward EBITDA forecast.

• Cost Approach – Replacement Cost Method

• Method is applicable for tech companies where developed IP is the main asset of the company.

• Aggregation of the amount spent to date (including sweat equity) multiplied by an expected yield.

TheSDAngels.com SDAngelConf SDAC Equity Valuation

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

• Pre-Money is the valuation of the company before VC’s invest • The Number of Shares Outstanding On a Fully Diluted Basis Multiplied by the Share Price = The Proposed Pre-Money Valuation

• Post-Money is the valuation after investment • Pre-money + VC Investment= Post-money

• How much of the company are the current stockholders willing to give up.

TheSDAngels.com SDAngelConf SDAC Valuation VS. % Equity Ownership

• Valuation vs. percentage of equity ownership • For early stage company, valuation is very subjective and based on forward looking opportunity. During negotiations, oftentimes valuation will end up being a proxy for ownership percentage.

• Post-money ownership percentage for investors is: • Investment amount divided by post-money valuation • Post-money valuation = pre-money + investment amount

TheSDAngels.com SDAngelConf SDAC Valuation VS. % Equity Ownership

Example: “We’re willing to put $3M in at a $6M pre-money valuation” “We need to have 33.33% of the company if we are going to invest $3M” Post-money = $6M (pre) + $3M (new cash) = $9M Investors Ownership = $3M / $9 = 33.33% Founders ownership = 100% - 33.33% = 66.66%

TheSDAngels.com SDAngelConf SDAC Valuation: why it’s important to startups

A Simple Example – Most startups use the basic formula of how much ownership they are willing to initially give up and how much they need to fundraise. As follows:

•Seeking to raise $1 million in Series A

•Current shares outstanding are 100

•I’m only willing to give up 20% ownership

•Post-Money = $1 million ÷ 20% = $5 million

Now 25 Series A shares out of 125 total shares

•Pre-Money = $5 million post-money less $1 million invested = $4 million

TheSDAngels.com SDAngelConf SDAC Valuation: why it’s important to startups

What if a full valuation was performed and the Co. determined its pre-money value was actually $7 million??

•Post-Money = $7M Pre-$ + $1M raised = $8M

• $1M/$8M = 12.5% ownership given up

The owners have managed to keep 7.5% more ownership than at the $4M Pre-$. We’ve thwarted off unnecessary dilution!

Valuation equally important for debt financing where lenders focus on solvency metrics.

•Loan to enterprise value - $1M/$4M = 25%

•Loan to enterprise value - $1M/$7M = 14%

TheSDAngels.com SDAngelConf SDAC Summing it Up

But remember…ultimately, your Co. pre-$ valuation is what the market is willing to bear.

• A prominent VC once said that funding a company’s first round comes down to largely 2 things:

1) Do I TRUST this founder?

2) Did this pitch BORE or CONFUSE me?

TheSDAngels.com SDAngelConf SDAC FEATURES TO BE AWARE OF (INVESTOR FAVORABLE)

Financing Feature Debt – warrant coverage Debt – deep discount conversion %’s on convertible notes Debt – above market interest rates Equity - participation Equity – cumulative dividends Equity - >1:1 conversion Equity - >1x LP

51 Poling Question Founders: Are you raising capital in the next 6 – 12 months?

If so, what amount are you looking to raise? • $100K - $250K • $250K - $2M • $2M+

TheSDAngels.com SDAngelConf SDAC First Republic Bank

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Open a New $250K Business Checking Account • 409A Valuation – Vantage Point Advisors, Inc.

• $2020 Bonus Cash

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TheSDAngels.com SDAngelConf SDAC THANK YOU

TheSDAngels.com SDAngelConf SDAC