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6-25-2020

Valuing Young Startups is Unavoidably Difficult: Using (and Misusing) Deferred-Equity Instruments for Seed Investing

John L. Orcutt University of New Hampshire Franklin Pierce School of Law, Concord, New Hampshire, [email protected]

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Recommended Citation John L. Orcutt, Valuing Young Startups is Unavoidably Difficult: Using (and Misusing) Deferred-Equity Instruments for Seed Investing, 55 Tulsa L.Rev. 469 (2020).

This Article is brought to you for free and open access by the University of New Hampshire – Franklin Pierce School of Law at University of New Hampshire Scholars' Repository. It has been accepted for inclusion in Law Faculty Scholarship by an authorized administrator of University of New Hampshire Scholars' Repository. For more information, please contact [email protected]. 42208-tul_55-3 Sheet No. 58 Side A 05/15/2020 10:30:18 (Wiley - NALYSIS A EFERRED D HROUGH T ncing Occurs...... 502 Occurs...... ncing AKING AKING M HALLENGE WITH * C ECISION D lified Equity Fina Equity lified ...... 474 ...... 469 469 ALUATION V MPROVING :I YCLES ) 5/14/2020) 9:49 AM C John L. Orcutt L. John ELETE TARTUP D ...... 477 ...... 499 ...... -S ALUATION OT OT V N UNDING O F (D OUNG Y ATENT ATENT TARTUPS S UBLISHER IFE AND NSTRUMENTS P L I OUNG OUNG S ’ FOR FOR Y 1. 1. 509 ...... Safes 512 ...... KISS The 2. 2. Change of Control ...... 503 ...... Control of Change 2. 503 ...... Maturity Reach Notes 3. 504 ...... Caps and Discounts 4. 507 ...... Rights Control 5. 1. Automatic Conversion if a Qua a if Conversion Automatic 1. 1. and Its Future Cash Payments ...... 479 ...... Payments Cash Future Its and Stock 1. 480 ...... Residual the and Flows, Cash Free Profits, 2. 481 ...... Flow Cash Discounted 1. 489 ...... Value Relative 2. 494 ...... Method Capital Venture 3. 496 ...... Method Chicago First 4. QUITY QUITY B. Alternatives to Convertible Notes...... 508 Notes...... Convertible to Alternatives B. 512 Flows...... Cash and Deferral Valuation C. A. Convertible Notes ...... 501 ...... Notes Convertible A. A. Financial Instruments ...... 477 ...... Instruments Financial A. 478 ...... Value? Is What B. 481 Methods...... Valuation Startup C. 498 ...... Discourage Challenges Valuation D. E J - FINAL TARTUP VERCOMING THE EQUITY INSTRUMENTS FORINVESTING SEED M K ALUING ALUING VALUING STARTUPSYOUNG IS UNAVOIDABLY DIFFICULT: (AND USING MISUSING) DEFERRED- C Y AS RCUTT RCUTT Professor of Law at the University of New Hampshire Franklin Pierce School of Law. Among other writings, writings, other Law. Among of School Pierce Franklin Hampshire New of at Law the of University Professor investmentbank for startups. I. Orcutt is a co-author of isP a of co-author Orcutt

* O III. O II. V Finance, 2012). Prior to joining UNH Law, Orcutt worked for Robertson Stephens from 1997–2001 (the former former (the 1997–2001 from Stephens Robertson for worked Orcutt Law, UNH joining to Prior 2012). Finance, investment bank subsidiary of the FleetBoston Financial Group and Chief Practice Banking and Investment of Services Telecom Bank as Coast the of West head firm’s serving of including America) in various roles, leadinga RobertsonGroup. Stephens was Acquisitions the MergersOfficer firm’s & of Administrative 42208-tul_55-3 Sheet No. 58 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 58 42208-tul_55-3 42208-tul_55-3 Sheet No. 58 Side B 05/15/2020 10:30:18 8 1 L.J. M K AND AND , vey of C Y ENTURE ENTURE Sur V ial Finance: Finance: ial ASTINGS ur ISTRESSED ote: A ote: NVESTMENT AND NVESTMENT ene I N r ,D , 66 H , ep r ESEARCH ON ON ESEARCH (Oct. 15, 2019), 2019), 15, (Oct. OUNG R ROWDFUNDINGAND Y , and the , e Capital ] (“Knowing asset is an what ?C SS ur NALYSIS FOR ]. ]. tion of Ent of tion Historically, they invested invested they Historically, A u 6 ALUING ALUING NVESTOPEDIA :V Part I. Part ANDBOOK OF a ALUATION r V VERYONE ALUATION , I [Vol. 55:469 55:469 [Vol. AFE, the KI The Evol The ECURITY inf 2 H S E V ns (collectively, “Specialized Startup Startup “Specialized (collectively, r :S in , Young startups’ valuation difficulties valuation startups’ Young The 5 ALUATION et 3 V IDE OF IDE OF rk Unico S al in Vent in Innovation al u IGHT FOR ALUATION ARK act IDE OF IDE OF AMODARAN ON V R . 42, 43–44 (2018) [hereinafter Coyle & Green (2018)]. (2018)]. Green Coyle & [hereinafter 43–44 (2018) . 42, r S EV Cont A LAW REVIEW A LAW ARK However, in the mid-2000s, Specialized Startup Startup Specialized mid-2000s, the in However, S D 7 ) 5/14/2020) 9:45 AM .L.R HE e of the the e of Angel Ma INN 4 TUL ELETE ,T ur D at . 773, 804 (2018). 804 (2018). . 773, AMODARAN ON 17, 21–22 (Hans Landström & Colin Mason eds., 2012). 17, eds., Mason Colin 21–22& Landström (Hans note 6, at 136; J. Brad Bernthal, Bernthal, J. Brad 136; at 6, note N NSTRUMENTS NSTRUMENTS OT OT a I EV ,D N r , 103 M , ...... 513 ...... p O u s L. R (D acts r AMODARAN NDUSTRY QUITY QUITY I D QUITY -E AMODARAN 11 (3d ed. 2018) [hereinafter D [hereinafter 2018) ed. 11 (3d -E 1 (2d ed. 2006) [hereinafter D [hereinafter 2006) ed. 1 (2d UBLISHER D The Changing Changing The P ...... 533 ...... SWATH , 2018 B.Y.U. , FOR FOR , A 1. 1. 520 ...... Safes 526 ...... Notes Convertible 2. INANCE LOBALIZING LOBALIZING SWATH F EFERRED and otherhigh-flying startupsget the press, but every startup must first launch USINESSES John F. CoyleJoseph & Green, M. EFERRED A 2 at 146–51, 154; John F. Coyle & Joseph M. Green, Green, F. M. Coyle & Joseph John 154; at 146–51, D B A. The Issuers ...... 516 ...... Issuers The A. 520 ...... Terms Instruments’ The B. 530 ...... Steps? Next C. D eed Financing Cont Financing eed :AG ee, e.g. ee, ee ee S J - FINAL There is no getting around it: valuing young startups is unavoidably difficult. unavoidably is startups young valuing it: around no getting is There Partly in response to the valuation challenge, specialized startup —such as as investors—such startup specialized challenge, valuation the to response in Partly S S S RE p ONCLUSION . . . Id. . u A t ew Typology ew 1 4 7 6 r N APITAL ORPORATE OMPLEX RCUTT RCUTT ta A 8. Coyle & Green (2014), (2014), Green & Coyle 8. 3. Jeffrey Sohl, https://www.investopedia.com/terms/u/unicorn.asp. Jeffrey 3. in young-startups by buying stock. buying by inyoung-startups Investors started using deferred-equity investment contracts (or deferred-equity deferred-equity (or contracts investment deferred-equity using started Investors 2005, around notes convertible with It stock. began to alternative an as instruments) V. C a value of 2. over $1 billion.” James Chen, “A is a term used in the industry to describe a privately held with C C C IV. 470 470 O venture capital firms, angels, and accelerators worth and what determines that value is a prerequisite for intelligent decision making—in choosing investments choosing making—in decision intelligent for a prerequisite is value that determines what and worth for a portfolio, in deciding on the appropriate an investor is pricethat investing of tosound a . . . pay. business postulate A running or receivewhen choices and dividend in afinancing, takeover, and in making investment, does not payanasset more for than it is worth.”). 5. in defined are accelerators and angels, firms, capital Venture 133, 133–34, 160–62 (2014) [hereinafter Coyle & Green (2014)]. (2014)]. & Green Coyle [hereinafter (2014) 160–62 133–34, 133, Investors”)—evolved how they contract for seed investments. seed for contract they how Investors”)—evolved

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The SEC EV OMM ://500.co/kiss/ ://500.co/kiss/ , Crowdfunding, 471 471 .C et seq et .L.R andthe Keep little attention attention little ee A S 10 XCH (Dec. 6, 2013), 2013), 6, (Dec. .&E , 102 V , EC AFE in 2013, in S 9 OMBINATOR (July 3, 2014), https 2014), 3, (July , U.S. S AFE AFE S LOG B o- and the United States Securities Securities States United the and , Y C S nding u 13 ot- otes N but the issue has since largely faded N owdf AVOIDABLY DIFFICULT r 14 TARTUPS N tible U .”). r ) S ’ , 500, S ’ I Each of these instruments allows investors to to investors allows instruments these of Each ity S AFEs in C AFEs SS 11 nding and the the and nding S ur u KI ‘ ec Conve r S s of ) 5/14/2020) 9:49 AM u owdf r nces nces tio C u u TARTUP imple ELETE S S D itle III itle JOBS the of Act established the foundation afor retail securities G OT OT N N ps Anno ps u O t Keep It It Keep r ‘ (D ( ta lletin: Be Ca S u B G YOU G KISS r 500 N UBLISHER afe, a Replacement fo a Replacement afe, P S Investo www.sec.gov/oiea/investor-alerts-and-bulletins/ib_safes [hereinafter SECInvestor Bulletin]. FOR FOR , VALUI (“YC partner (and lawyer) Carolyn Levy has created a new alternative to convertible notes, called a ee, e.g. ee, J - FINAL Despite itsindispensable role in startup investing, valuationreceives S Deferred-equity instruments were designed for a particular setting. They were They setting. particular a for designed were instruments Deferred-equity ncing the the ncing M K u . Id. . C Y 10 14 RCUTT RCUTT safe, that has the advantages of convertible debt without some of the disadvantages.”). disadvantages.”). the of some without debt convertible of advantages the has that safe, Once Regulation Crowdfunding (Regulation CF) came into effect on May 16, 2016, 16, May on effect into came CF) (Regulation Crowdfunding Regulation Once capitalized (e.g., AIDS or NASA), decided to writeAnno the word in lower case. , 12. Pub. 2012. 5, law on April into signed was (the “JOBS Act”) Act Startups Our Business Jumpstart The first safe was invented by Carolyn Levy, a Y Combinator partner,“safe” spelling. this article adopts Y Combinator’s lowercase and Exchange Commission (the “SEC”)in 2017, from legal academics and policymakers. This article explicitly considers valuation in its its in valuation considers explicitly article This policymakers. and academics legal from generate to investments make investors Financial instruments. deferred-equity of analysis value present the is investment financial any of value The fundamental flows. cash future into the background. Meanwhile, deferred-equity instruments have become a prominent a prominent become have instruments deferred-equity Meanwhile, background. the into issuers. CF for Regulation choice financing followed by the simple agreement for future equity (the “safe”) (the equity future for agreement simple the by followed 9, 2017), https:// 2017), 9, 11. Gregory Raiten, Gregory 11. and investors for documents founders legal of set useful, super yet unsexy, a totally announce to thrilled (“We’re the called affectionately 9. is anoften acronym in each letter While equity.” future for agreement “simple isfor an acronym Safe T 306 (2012). 126 Stat. 112-106, L. and 4A theof 4(a)(6) Securities in sections is codified that III “Title exemption”) (the exemption crowdfunding a of set the SEC promulgated exemption, III Title the To implement 77d-1. §§ 77d(a)(6), 15 1933. U.S.C. of Act §§ 227.100 C.F.R. 17 CF.” “Regulation or Crowdfunding” “Regulation as to referred rules 2020] 2020] O adopted the final rules on October 30, 2015, which mostly took effect on May 16, 2016. 2016. 16, on May took effect mostly which 30, 2015, October on rules the final adopted 2015). 30, (Oct. No. 33-9974 Release Act Securities 13. M. Green Joseph John F. Coyle, & It Simple Security (the “KISS”) in 2014. (the “KISS”) Security It Simple https://blog.ycombinator.com/announcing-the-safe-a-replacement-for-convertible-notes/ got we acronym, an is name the Although equity.’ future for agreement ‘Simple from comes (“‘Safe’ (2013)] [hereinafter Graham tiredtypingof‘SAFE’ all the time whentalking about and it, we’ve already switchedto lowercase.”). Sincethe 168 (2016) [hereinafter Green & Coyle (2016)]. (2016)]. Coyle Green & [hereinafter 168 (2016) designed for Specialized Startup Investors to use when investing in young startups with a with startups in young investing when use to Investors Startup Specialized for designed many like However, round. capital venture traditional a future, doing of chance reasonable purpose. original its beyond expanded usage instruments’ deferred-equity , thoughtfully invest in young startups without valuing them at the time of the seed of time the at them valuing without startups in young invest thoughtfully more is startup the when value determine to rounds funding future allow They investment. last the Over analysis. valuation to itself lends that history operating an has and mature for tools financing important become have instruments deferred-equity years, fifteen young startups. issuers started using deferred-equity instruments to raise capital from public investors investors public from capital raise to instruments deferred-equity using started issuers beneficial is which deferral, valuation Does bad? or good that Is portals. funding through offerings? CF in Regulation investors public benefit also Investors, Startup for Specialized Or, do these instruments create CF problems that Regulation make for them generally unsuitable instruments for deferred-equity of suitability The offerings? CF Regulation 2016 in scholars a few of attention the drew offerings 42208-tul_55-3 Sheet No. 59 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 59 42208-tul_55-3 42208-tul_55-3 Sheet No. 59 Side B 05/15/2020 10:30:18 : 18 M K C Y INANCE F NTREPRENEURIAL ,E —which consists of Silicon Silicon of consists —which LISS 20 T. B [Vol. 55:469 55:469 [Vol. ICHARD &R note 15, at 342. 15, note Equity investors have a residual claim to the the to claim residual a have investors Equity a ., https://fundersclub.com/learn/glossary/q/priced-round/ (last https://fundersclub.com/learn/glossary/q/priced-round/ ., r MITH MITH A LAW REVIEW A LAW 15 p TR S u ) 5/14/2020) 9:45 AM 342 (2011). 342 (2011). s .C , L. S note 1, at 29. 1, note TUL ELETE LISS DUC a r D p note 7, at 42. (“Over the past decade, there has been an explosion in seed :E u &B OT OT a s ICHARD ICHARD r TRUCTURE N , p LUB S O u C ,R s (D MITH MITH EAL EAL ,S Part II.B.1. MITH a r S &D ALUATION UNDERS MITH inf V UBLISHER S , F P While these tasks are always challenging, even for mature, publicly traded traded publicly mature, for even challenging, always are tasks these While nd Predicting those future payments fundamentally requires forecasting the the forecasting requires fundamentally payments future those Predicting u ally IHOLM IHOLM 17 FOR FOR r IDE OF 16 K S ALUATION When investors buy stock, they purchase an ownership percentage in the the in percentage ownership an purchase they stock, buy investors When discussion ,V 19 iced Ro iced ARK r ee gene ee ANET J - FINAL Finding seed funding solutions for young startups is critical. Young startups need need startups Young critical. is startups young for solutions funding seed Finding S Conventional stock deals are commonly referred to as “priced rounds” or “priced “priced or rounds” “priced as to referred are commonly deals stock Conventional S However, the spread of deferred-equity instruments to the Regulation CF market is is market CF Regulation the to instruments deferred-equity of spread the However, . . P . 18 19 16 RCUTT RCUTT TRATEGY company’s future profits or cash flows and assessing the risk associated with this future future this with associated risk the assessing and flows cash or profits future company’s performance. ’s assets (its excess cash after creditors have been paid, or what this article article this what or paid, been have creditors after cash excess (its assets corporation’s liquidation and dividends through collect generally they which “residual”), the as to refers distributions.The a value for ofa share generate of stock, to therefore, projects share that should distributions reflect liquidation the presentand dividends value future of the stockholder. companies, they are unavoidably difficult for young startups for two principle reasons. principle two for startups young for difficult unavoidably are they companies, capital to launch and grow. Without this capital, fewer startups are formed and more fail. fail. more and formed are startups fewer capital, this Without grow. and launch to capital avoid investors and issuers helping by solution a partial offer instruments Deferred-equity seed US years, ten last the roughly Over challenge. valuation young-startup typical the market startup traditional the for exploded has financing company. To price that percentage,the company and the investors no mustagreeand on a priced, be cannot company the agree, cannot parties the If valuation. company a purchase still investors instruments, deferred-equity With place. takes investment percentage the of company. However, the percentage amount the not to is determined deferred until a thus is from Pricing occurs. offering analysis stock a future when investment typically the date, later change instruments Deferred-equity offering. subsequent uncertainty their for accounting and flows profits/cash future startup’s young a forecasting high-quality a future, conduct will it whether predicting to difficult) unavoidably is (which Investors). Startup Specialized for task manageable a is (which offering stock S 15. J 15. ofthose projected future cashflows. 472 472 O visited Feb. 20, 2020). The FundersClub glossary uses the term “priced round.” However, the terms “priced terms the However, round.” “priced term the uses glossary FundersClub The 2020). 20, Feb. visited First, projecting future profits/cash flows for a new venture without any meaningful meaningful any without venture new a for flows profits/cash future projecting First, the Second, guesswork. than better little often is and difficult very is history operating uncertainty. extreme to subject usually are projections equity.” a differentmatter. Thisarticle examinedthe Regulation offerings CF onthree popular Valley-style startups that raise capital from Specialized Startup Investors—and deferred- Investors—and Startup Specialized from capital raise that startups Valley-style and works deferral valuation how examines article This helped. have instruments equity startup traditional the to contribution positive a make instruments these why explains inherently an in investments thoughtful make to investors expert allow They market. uncertain environment. 17. D 17. equity” and “priced-equity round” are used interchangeably. interchangeably. used are round” and “priced-equity equity” 20. Coyle & Green (2018), (2018), Green & Coyle 20. financing for early-stage technology startups.”). startups.”). technology early-stage for financing 42208-tul_55-3 Sheet No. 59 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 59 42208-tul_55-3 42208-tul_55-3 Sheet No. 60 Side A 05/15/2020 10:30:18 (June 9, (June , FINRA, , FINRA, RA EAT N B 473 473 t FI u ENTURE Abo , V s r —to get an informed an get informed —to 24 mbe Nu By the — ms AVOIDABLY DIFFICULT r N ; and ;and U 23 S I S impose a suitability duty on funding portals that that portals funding on duty suitability a impose nding Platfo nding u 25 ) 5/14/2020) 9:49 AM owdf r TARTUP ELETE S ;StartEngine D 22 G OT OT N N s Best s Best C O ’ (D Today G YOU G N —Republic , https://www.startengine.com/ (last visited Feb. 20, 2020). 2020). 20, Feb. visited (last , https://www.startengine.com/ UBLISHER P 21 , https://wefunder.com/ (last visited Feb. 20, 2020). 2020). 20, Feb. visited (last , https://wefunder.com/ , https://republic.co/ (last visited Feb. 20, 2020). 2020). 20, Feb. visited (last , https://republic.co/ FOR FOR NGINE VALUI E Most of the issuers appear unlikely ever to raise money from venture capital capital venture from money raise to ever unlikely appear issuers the of Most firms. The instruments’ terms are very issuer friendly. The instruments are far more more far are instruments The friendly. issuer very are terms instruments’ The favorable to issuers than one would expect for suchhigh-risk investments. The issuer-friendly terms raise concerns that Regulation CF investors lack the the lack investors CF Regulation that concerns raise terms issuer-friendly The their of terms and risks the internalize and understand to sophistication investments. EFUNDER EPUBLIC TART x x x J - FINAL This article proceeds as follows: Part I explains a typical startup’s life and funding and funding life startup’s a typical PartI explains follows: as proceeds article This While deferred-equity instruments have been a positive innovation for the traditional traditional the for innovation positive a been have instruments deferred-equity While M K C Y RCUTT RCUTT 23. S 23. funding portals funding 24. W 24. investors by making sure the broker-dealer events.” market daily of industry billions analyze[s] operates country—and the across fairlybrokers and 634,000 honestly.[FINRA oversees] morethan 21. Sherwood Neiss, Neiss, Sherwood 21. 25. Financial Industry Regulatory Authority. “FINRA is authorized by Congress to protect America’s 2020] 2020] O

host Regulation CF deferred-equity offerings. offerings. deferred-equity CF Regulation host the highlights overview The startups. for overview a valuation presents II Part cycle. III Part face. investors their and startups young that challenges valuation unavoidable the in instruments deferred-equity of use Investors’ Startup Specialized examines the overcome investors these help they how explains and market startup traditional the examines IV Part investments. seed thoughtful make can they so challenges valuation their explains and offerings CF in Regulation instruments deferred-equity of use funding on imposed be should duty a suitability how explains also IV Part shortcomings. a conclusion. offers V Part Finally, investors. public protect to portals 2018), https://venturebeat.com/2018/06/09/todays-best-crowdfunding-platforms-by-the-numbers/. https://venturebeat.com/2018/06/09/todays-best-crowdfunding-platforms-by-the-numbers/. 2018), R 22. picture of Regulation CF deferred-equity offerings. The examination consisted of all the of consisted examination The offerings. deferred-equity CF Regulation of picture The “Study”). (the 2019 during portals three those through funded deals CF Regulation twenty- and offerings safe were which seventy-one of deals, funded captured 205 Study two were convertible note offerings. deferred- the It examined of themost deferred-equity that issuers concludes andtheauthor terms this review, that on Based instruments. their of offer to appear not do that investments risky very are Study the in offerings equity investors enough upside potentialto offset risk. the More specifically, this author concludes: http://www.finra.org/about (last visited Feb. 20, 2020). 2020). 20, Feb. visited (last http://www.finra.org/about startup market (facilitating informed capital raising for young startups), they are not are they startups), young for raising capital informed (facilitating market startup these market, CF Regulation the In market. CF Regulation the in role a similar performing while investors public to investments high-risk very transfer to issuers allow instruments be to turn out may deals few a Although potential. upside investors’ the limiting generally successful,thisarrangement is unlikely to produce a sustainablearticle this source capital of for problem, the address To investors. public harm to likely is it but startups, young recommendsthat the SEC FINRA or 42208-tul_55-3 Sheet No. 60 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 60 42208-tul_55-3 42208-tul_55-3 Sheet No. 60 Side B 05/15/2020 10:30:18 RT RT A M K C Y HE ccess at :T ANADATHE AND INANCE C F TUDY OF S YCLES C NTREPRENEURIAL NTREPRENEURIAL E in [Vol. 55:469 55:469 [Vol. , OMPARATIVE OMPARATIVE UNDING F :AC note 15, at 15–17. Luisa Alemany and Job J. Andreoli Andreoli J. and Job Alemany Luisa at 15–17. 15, note ial Finance ial this article divides it into four stages. stages. four into it divides article this a r ur 27 p u IFE AND ene s , NCENTIVES r L I S A LAW REVIEW A LAW ep The startup has started production and has some has some and production started has startup The ’ r S LISS AX AX ) 5/14/2020) 9:45 AM T &B TUL The startup is relatively mature and has shown su shown has and mature relatively is startup The ELETE The startup’s concept shows promise. For example, the 2, 13–19 (Luisa Alemany & Job J. Andreoli J. Job & Alemany 2018). 13–19 (Luisa eds., 2, D TARTUP MITH MITH OT OT ction to Ent N u ,S O od APITAL AND r (D C ENTURES ENTURES The startup is just beginning and must determine whether the the whether determine must and beginning just is startup The MITH Int V I. A S UBLISHER ENTURE ENTURE P ROWING Unlike startups, livelihood businesses are low-growth ventures with no no with ventures low-growth are businesses livelihood startups, Unlike ,V G 26 FOR FOR 2 (2004). 2 (2004). business venture is worth pursuing. For example, the founders have an idea for for an idea have founders the example, For pursuing. worth is venture business anew product, buthave yet to develop a proven prototype. technology has been shown to work (e.g.,a prototype has been is built company and the and developed, been have tested), lines production and chains supply yet not have sales However, product. its introduce commercially to prepared begun. sales. For example, the technology is being sold and showing some commercial commercial some showing and sold being is technology the example, For sales. not has however, startups, characterizes that expansion sales rapid The viability. place. taken yet scaling up its business. This is the rapid-growth phase for the startup. startup. the for phase rapid-growth the is This business. its up scaling ANDLER TATES S S J - FINAL (1) Idea stage. (2) stage. Development (3) stage. Sales-introduction (4) stage. Rapid-growth Because startups are built for growth, they generally must sacrifice near-term near-term sacrifice must generally they growth, for built are startups Because Defining “startups” upfront is useful. Startups are recently formed companies that companies formed recently are Startups useful. is upfront “startups” Defining Like all businesses, startups must progress through a life cycle. While there is no no is there While cycle. life a through progress must startups all businesses, Like CIENCE OF CIENCE OF S ANIEL NITED RCUTT RCUTT

profitability and endure years of losses. Losses are often moderate during the idea stage stage idea the during moderate often are Losses losses. of years and endure profitability but accelerate during the development stage as the the in startup begin undertakes Sales the expenseenterprise. of commercial functioning a building and development product Sales slow. to start eventually should losses increase, sales As stage. sales-introduction sustainable successful, a become to is startup the If stage. rapid-growth the in rapidly grow along cycle life a startup’s shows 1 Figure profitable. becomes it when is this company, with a possible revenue and loss/profit performance throughthe four stages. development into six stages: (1) Opportunity; (2) Research and Development; (3) Start-up; (4) Early-growth; (5) (5) Early-growth; (4) Start-up; (3) Development; and Research 27. (2) Opportunity; For (1) example, stages: Janet six into Kiholm Smith,development Richard L. Smith, and Richard T. Bliss divide new venture Rapid-growth; and (6) Exit. S AND start small butare builtto grow rapidly in andhave congregating the potential companies to becomehigh-technology the The large, future. the of companies dominant as businesses—such small most from differ They startup. US the epitomize Valley Silicon local restaurants, owner-operated convenience stores,hair (“livelihood salons, founders and the local for constructionincome an provide to built are companies—that businesses”). businesses. small US of percent ninety than more for 26. account businesses livelihood estimates, some By D U 474 474 O divide new venture development into four stages: (1) Seed; (2) Startup; (3) Growth; and (4) Maturity. Luisa Maturity. and (4) Growth; (3) (2) Startup; Seed; (1) stages: into four development venture new divide J. Andreoli, Job & Alemany realistic hope of ever becoming large, dominant companies. companies. dominant large, becoming ever of hope realistic single formulation for the startup life cycle, 42208-tul_55-3 Sheet No. 60 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 60 42208-tul_55-3 42208-tul_55-3 Sheet No. 61 Side A 05/15/2020 10:30:18 , 9–12 IDE OF S p Assistance p Assistance ARK u t 475 475 r ta S Phenomenon r note 30, at 1. 30, note ato r a r p u s 29 istics Among istics r eed Accele S acte r ps: The The ps: An accelerator makes money by u t 30 r AVOIDABLY DIFFICULT 31 ta N S U S ating ating I s: Defining Cha r r S ato r . 3–5 (Oct. 2014), https://www.sba.gov/sites/default/files/rs425- 2014), . 3–5 (Oct. Accele ) 5/14/2020) 9:49 AM DVOC TARTUP A ELETE S are, as the description suggests, the founders’ friends and and friends founders’ the suggests, description the as are, D OF . G OT OT N N note 30, at 11; Dempwolf, Auer & D’Ippolito, & Auer Dempwolf, 11; at 30, note FF O a 28 r ., O (D p are highly selective programs that help speed up the business business the up speed help that programs selective highly are Innovation Accele Innovation u s DMIN G YOU G N .A are wealthy individuals whoinvest their own capital directly in startups. UBLISHER P US note 1, at 260. 1, note B a r FOR FOR p VALUI u s development process for young startups. Accelerators bring in cohorts of of cohorts in bring Accelerators startups. for young process development startupsan for intense, immersive experience. Most programshave a fixedterm of group a with work startups the time which during months) three (often mentors jumpstartto their businesses. family members who are willing to provide funding. provide to willing are who members family Beginning in 1996 with Band of Angels, many angels do their investing through through investing their do angels many Angels, of Band with 1996 in Beginning investing small amounts in its startups. its in amounts small investing MALL , , S J - FINAL (2) Accelerators Figure 1 1 Figure Cycle Life Startup (1) Friends and family (3) Angels Startups need funding to advance through their life cycles. Few founders have have founders Few cycles. life their through advance to funding need Startups M K ams r C Y og ALUATION RCUTT RCUTT r 30. Hochberg, V. Yael & Cohen G. Susan V Jennifer Dempwolf, Scott C. 2014), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2418000; 30, (Mar. Auer, Michelle D’Ippolito, 28. This diagram was motivateddiagram bya produced by AswathDamodaran in D 2020] 2020] O enough resources to self-finance their startups through profitability. Founders usually usually Founders profitability. through startups their self-finance to resources enough the more of Some sources. external funding to look then funding, the initial provide and angels; (3) accelerators; (2) family; and friends are: (1) investors external important firms. capital (4) venture Innovation-Accelerators-Research-Summary-FINAL.pdf. Hochberg, Innovation-Accelerators-Research-Summary-FINAL.pdf. & Cohen 31.

investors and family friends why explain helps also It capital. 29. they ones, favorable profit-driven and most purely than rather reasons, fastest the altruistic of for some invest and often provide family can friends Because and fools.” family, “friends, to as referred pejoratively often are P 42208-tul_55-3 Sheet No. 61 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 61 42208-tul_55-3 42208-tul_55-3 Sheet No. 61 Side B 05/15/2020 10:30:18 M K C Y [Vol. 55:469 55:469 [Vol. Friends and family family and Friends Angels Founders Founders Accelerators Accelerators firms capital venture Early-stage Angels firms capital venture Intermediate-stage firms capital venture Late-stage Angels A LAW REVIEW A LAW S x x x x x x x x x x Potential Investors Investors Potential ) 5/14/2020) 9:45 AM come in several forms, but most are professionally professionally are most but forms, in several come The groups’ formalities vary considerably. Some are are Some considerably. vary formalities groups’ The 33 TUL ELETE 32 D note 15, at 41. at 15, note OT OT a r N p O u s (D , 34 LISS &B UBLISHER P note 3, at 29. at 3, note a r MITH MITH FOR FOR p u ,S The Series A, Series B, and onwardrounds are whenthe startup sells s formal with full-time management and standardized investment practices, while while practices, investment standardized and management full-time with formal informal. quite are some managed funds. Outside investors—such as pension funds, insurance funds, pension as investors—such Outside funds. managed individuals— wealthy extremely and endowments, university companies, with charged are who professionals by managed is the that fund a to money harvesting commit and entrepreneurs, with working selection, “investment investments.” formal angel formal groups. 35 Sales-introduction Stage Stage Sales-introduction Rapid-growth Stage Table 1 1 Table Sequence Funding Startup Typical a of Stages Four Stage Life-Cycle Stage Idea Stage Development at 29–35. at MITH J - FINAL (4) firms capital Venture The different investor types tend to focus on different stages in a startup’s life cycle. cycle. life startup’s a in stages different on focus to tend types investor different The Seed financing—which is often used to fund research, product development, and the the and development, product research, fund to used often is financing—which Seed . Id.. 33 RCUTT RCUTT rollout of the company’s product or service—comes before the traditional venture capital capital venture traditional the before service—comes or product company’s the of rollout and rounds, B Series rounds, A Series labeled commonly are that rounds financing onwards. 32. Sohl, Sohl, 32. 476 476 O Friends and family are often the earliest external investors while venture capital firms are are firms capital venture while investors external earliest the often are family and Friends to tend sources funding different the which in stages the shows 1 Table latest. the often operate. typically firms capital venture that 35. fact the from come A,”labels “Series onward The and B,” “Series convertible to investors. When venture capital firms (or angels) are willing willing are angels) (or firms capital venture When investors. to stock preferred convertible willing are firms capital venture Sometimes time. over changes rounds A Series conduct to is constant generally is what However, later. sometimes cycle, life the in earlier invest to typically stage seed the result, a As traction. business and sales meaningful see to a desire sales-introduction its into runs and stage development or idea startup’s a during begins stage. 34. S 34. receive convertible preferred stock when they invest. Because each round of convertible preferred stock has its its has stock preferred convertible of round each Because invest. they when stock preferred convertible receive round the second A, Series labeled is round commonly The first label. a unique requires each terms, specific own and B, onward. Series 42208-tul_55-3 Sheet No. 61 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 61 42208-tul_55-3 42208-tul_55-3 Sheet No. 62 Side A 05/15/2020 10:30:18 & 36 ODIGLIANI ODIGLIANI M 477 477 RANCO RANCO ,F ABOZZI (4th ed. 2010). 2010). ed. (4th J. F RANK 37 F TARTUPS S NSTITUTIONS NSTITUTIONS see see AVOIDABLY DIFFICULT I N U OUNG OUNG S I Y S ARKETS AND M ) 5/14/2020) 9:49 AM $10 million of immediate cash to grow the company. company. the grow to cash immediate of million $10 ALUING ALUING The issuer sellsinvestors an ownership stake in the TARTUP ELETE S D Theissuer borrows money from investors in exchange for ecessary to provide guidance on how to use the instruments, instruments, the use to how on guidance provide to ecessary INANCIAL G OT OT F N II. V II. N O (D pay immediate cash to buy the issuers’ rights to future cash flows. cash future to rights issuers’ the buy to cash immediate pay G YOU G sell rights to future cash flows in order to receive immediate cash. cash. immediate receive to order in flows cash future to rights sell ments N UBLISHER ru P OUNDATIONS OF OF OUNDATIONS FOR FOR ,F VALUI Issuers Investors Debt instruments. on focuses article this , are startups many so Because company. the to rights receive Stockholders stock. or instruments, equity corporate and dividends through collect generally they which residual, corporation’s liquidation distributions. a repayment promise. The issuer promises to repay the amount borrowed (the (the borrowed amount the repay to promises issuer The promise. repayment a the lending for investors compensate to interest pay as well as principal) money. Theinvestors’ future cashrights are the principaland interest payments. Equity instruments. at 3. at ONES x x x x J. J J - FINAL Financial investmentsinvolve buying and sellingrights to future cash flows. Valuation is a prerequisite to thoughtful investing. Putting aside for a moment what what moment a for aside Putting investing. thoughtful to a prerequisite is Valuation For example, assumeTechCo, a startup, issues $10 millionof to a and buy, to investors allow that contracts investment are instruments Financial M K . Id. C Y 37 RCUTT RCUTT RANK 36. instruments, to financial introduction an accessible For startups unless they can value the opportunity. This Part looks at the challenges analysts analysts challenges the at looks Part This opportunity. the value can they unless startups lawyers, helps challenges these Understanding startups. young valuing when face An instruments. deferred-equity understand better regulators and lawmakers, academics, n is valuation of understanding whento use them,and whento avoid them. Inst Financial A. 2020] 2020] O F One way to organize the concept is to classify financial instruments as loan-based (debt (debt loan-based as instruments financial classify to is concept the organize to way One instruments). (equity ownership-based or instruments) “value” means, reasonable investors seek investments offering the best value. If an an If value. best the offering investments seek investors reasonable means, “value” the determine to wants it investment, an make to whether considering is investor choosing is investor an If cost. acquisition the with it compare and value investment’s cannot Investors one. valuable most the choose to wants it investments, different between which opportunities, investment their value can they unless determinations these make young in invest not should investors Thoughtful proposition: fundamental the to leads group investors. of TechCo receives instruments. financial of types many are There rights. flow cash future sell, to issuers However, it gives up a portion of its future cash flow rights to the investors.part The with investors$10 million cash, of butthey receive arata pro right to TechCo’s immediate the accumulated it believes because deal the does TechCo residual. its or flows, cash future because deal the do investors The selling. is it rights cash future the than more worth is cash cash immediate the than more worth is residual future TechCo’s to right their believe they up. giving are they

42208-tul_55-3 Sheet No. 62 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 62 42208-tul_55-3 42208-tul_55-3 Sheet No. 62 Side B 05/15/2020 10:30:18 M K C Y For a alified alified 40 They also also They 39 . art. § 1.XV, ONST equity instruments, instruments, equity .C AL ed- rr defe value for any asset or service (including a [Vol. 55:469 55:469 [Vol. ndamental ndamental u f or A LAW REVIEW A LAW insic r S ) 5/14/2020) 9:45 AM int and Internal Revenue Service tax purposes. tax Service Revenue Internal and TUL ELETE 38 are short-term loans that convert to equity if the startup startup the if equity to convert that loans short-term are D OT OT N O (D comes in two versions. There is a debt version that is comparable to to comparable is that version a debt is There versions. two in comes are a contractual right to receive a startup’s stock if it completes a a completes it if stock a startup’s receive to right contractual a are UBLISHER P e? e? u FOR FOR Convertible notes notes instruments, Convertible debt are They financing. equity future qualified a completes unlike However, interest. pay and principal the repay must startup the meaning cash. with repaid be to look not do investors note convertible debt, traditional equity future qualified the from shares with repaid be to hope they Instead, financing. qualified future equity financing. Unlike convertible notes, safes do not require require not do safes notes, convertible Unlike financing. equity future qualified repayment.Investors purchase the safes andreceive stock in the qu Safes Safes occurs. it if financing equity future The KISS Any a safe. to comparable is that version equity an and note a convertible debt the include to read be can notes the convertible to include section to this in read references be can safes to references any And KISS. the of version KISS. the of version equity x x x J - FINAL Not all instruments fit neatly into one category or the other. The features of of features The other. the or category one into neatly fit instruments all Not A valuation analysis seeks to determine something’s value. Most people intuitively intuitively people Most value. something’s determine to seeks analysis valuation A Frominvestor’s an perspective, convertiblenotes and safes are best described as Convertible notes fall into both the debt and equity categories. They are debt debt are They categories. equity and debt the both into fall notes Convertible RCUTT RCUTT (a) of ten 38. higher to the loans non-consumer rates on interest limits law usury California’s C example, For percent or origination. (b) five loan’s the percent to over prior themonth the rate of day charged for advances twenty-fifth the on to member Francisco San banks by the Federal Reserve Bank of convertible notes, safes, and the KISS are discussed in detail below in Parts III and IV. IV. and III in Parts below detail in discussed are KISS the and safes, notes, convertible versus loan-based the on fit instruments these how understand readers help to However, ownership-based spectrum and they are why classified as 478 478 O 39. Interest rates must not fall below Internal Revenue Service minimum interest rates, or they could trigger trigger could they or rates, interest minimum Service Revenue Internal below fall 39. not must § 1272(a). I.R.C. rates consequences. discount” issue Interest “original

appreciate what “value” means: it refers to the benefits that something produces. something that benefits the to refers it means: “value” what appreciate deferred-equity instruments. Investors buy them to obtain future ownership rather than than rather ownership future obtain to them buy Investors instruments. deferred-equity immediate ownership. The cash investors flows buy are largely deferred. equity cash simply are flows; namely, flows cash Those residual. startup’s the to right a Val Is What B. require principal repayment and earn interest. However, they derive most of their their of most derive they However, interest. earn and repayment principal require other the on Safes, convert. they which into securities equity the from value economic earn or repayment principal require not do They category. in either neatly not fit do hand, immediate an to holders entitle not do they Moreover, debt. not clearly are they so interest, ownership stakethe in company. However,as with convertiblenotes, they grant investors securities. equity to right a future here is a cursory summary. summary. cursory a is here 40. Thereare value, many“value” fairmarket definitions. value, going-concernFor example,acquisition value, intrinsic value,value, bookinvestment value, enterprisevalue value, areliquidation value, all faircommon value, valueand transaction definitions. Each definition measurescontext.Despite the varyingvalue definitions,the differently and is used in a different instruments for state lending law lending state for instruments 42208-tul_55-3 Sheet No. 62 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 62 42208-tul_55-3 42208-tul_55-3 Sheet No. 63 Side A 05/15/2020 10:30:18 , : 45 LUB ONES C While While , tokens. , tokens. &J 44 UNDERS native 479 479 , F , or , or ps ODIGLIANI ODIGLIANI u t r insic ,M r ta S int note 8, at 789–814. at 789–814. 8, note a r tage p ABOZZI S u F s ly- r 46 ee also S andrevenue-based loans. 43 AVOIDABLY DIFFICULT N . Some blockchains, such as the Bitcoin blockchain, U ity Investing in Ea in Investing ity S note 1, at 29. 29. at 1, note u ens I a k r S p u s If the corporation is liquidated, its stockholders stockholders its liquidated, is corporation the If ed to , , k 42 ) 5/14/2020) 9:49 AM ction to to Eq ction u TARTUP ELETE od S r D asset-bac ALUATION G OT OT V N N . 8, § 170. tit. . 8,§ 281(a)–(b). tit. O (D NN NN IDE OF IDE OF If the corporation has a positive residual, it may distribute a portion a portion distribute may it residual, a positive has corporation the If A A S G YOU G 47 ODE ODE including tokens, including N ARK UBLISHER .C .C 41 D P Assuming a typical form of commontypical of Assuming form stockholdersstock, a receive generally ity Investments: Intity EL EL u ee ., https://fundersclub.com/learn/guides/understanding-startup-investments/startup-equity- ., S note 135. note FOR FOR , D , D a VALUI TR r share equally in the corporation’s final residual after all its liabilities have been been have liabilities its all after residual final corporation’s the in equally share satisfied. Liquidation distribution. Dividends. dividends. through to residual stockholders of the p Eq u t r ee inf ee, e.g. ee, ta ee, e.g. ee, ee id. x x J - FINAL S The value a of share common of stock, therefore, shouldreflect the present value of S Over the last twenty years, several new financial instruments have emerged for for emerged have instruments financial new several years, twenty last the Over S Corporate stock comes intwo basic flavors: common and preferred. Common stock S S 1. Stock and Its Future Cash Payments Payments Cash Future Its and 1. Stock note 36, at 3. at 36, note M K .C . . . . . a r C Y 47 46 43 44 45 p DUC RCUTT RCUTT u

the corporation’s future dividends plus its liquidation distribution. distribution. liquidation its plus dividends future corporation’s the financial cash investor, future the benefitits isthe future of cash that flows value come fromthe financialpresent the is investment financial a of value the Thus, instrument. flows. s 41. J. Brad Bernthal catalogued the new financial instruments in Bernthal, 42. asto referred these tokens with to operate, tokens require Companies Some blockchains tokens. using blockchain technology may use tokens to raise capital. There are different types of E funding startups, funding financial investment) is the present value of the future benefits (such as cash flows or profits) that come from the from come that profits) or flows as cash (such benefits future the of value present the is investment) financial service. or asset 2020] 2020] O investments/ (last visited Feb. 20, 2020). 2020). 20, Feb. visited (last investments/ these new instruments expand startup funding options in some settings, the primary primary the settings, some in options funding startup expand instruments new these instruments. anddeferred-equity equity are startups for young sources capital external Therefore, this article focuses its valuation discussion on stock and the future cash flows flows cash future the and stock on discussion valuation its focuses article this Therefore, investors. for generates it corporation’s the to rights with stockholders provides It instrument. equity classic the is for accounting after assets net its is residual corporation’s A 2). Figure (see residual owed. liabilities residual. corporation’s the to relate which of both stock, their from rights economic two Other tokens are not essential to the blockchain architecture, and instead represent a claim on an underlying asset. asset. underlying an on a claim represent instead and architecture, blockchain the to essential not are tokens Other as to referred are tokens other These require intrinsic tokens to operate, while others do not. However, all blockchains usecan asset-backed tokens. Blockchain companies canraise capital by sellingasset-backed tokensto purchasers. 42208-tul_55-3 Sheet No. 63 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 63 42208-tul_55-3 42208-tul_55-3 Sheet No. 63 Side B 05/15/2020 10:30:18 M K C Y Thus, even Thus, even 49 [Vol. 55:469 55:469 [Vol. A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM TUL In each case,the profit measurement provides useful ELETE D note 15, at 353. 353. at 15, note 50 OT OT a r N p O u s (D , LISS all the dividends or the liquidation distribution, they are not left empty- left not are they distribution, liquidation the or dividends all the &B UBLISHER P MITH MITH FOR FOR ,S They receive a lump-sum payment when they selltheir shares that should 48 MITH ee id. J - FINAL What about investors who sell their shares before the corporation liquidates? While While liquidates? corporation the before shares their sell who investors about What Figure 2 2 Figure Corporation’sA Residual If the corporation has multiple classes of stock (e.g., common and preferred stock), preferred and common (e.g., stock of classes multiple has corporation the If Where does theresidual come from? Theresidual is the company’s excess cash— S 2. Profits, Free Cash Flows, and the Residual . 49 RCUTT RCUTT 48. S 48. they do not receive handed. 480 480 O the stockholders’ residual rights can be more complex. Priorities and mandatory payments payments mandatory and Priorities complex. more be can rights residual stockholders’ the The same. the remains concept fundamental the However, for. accounted be must through collect they which residual, corporation’s the to rights have stockholders distribution. a final and dividends when an investor intendsto resellher common stock before liquidation, theshould stock’sreflect value the present value all of the future dividends plus the liquidation shares. the distribution with associated after creditors have been paid and reinvestment needs have been met—thatcanreceive. shareholders This excess cash comes fromrunning a profitable business. different Profitsseveral in are a profits report Companies expenses. its minus revenues company’s ways (e.g., gross profits, operatingprofits, pre-tax profits, and net deducted. being income) are expenses based on which a measures 50. profit” “Operating costs. production its minus a revenues firm’s measures profit” “Gross approximate the value of the post-sale dividends and liquidation distribution. liquidation and dividends post-sale the of value the approximate information, but is an accounting number subject to various accounting rules. As a result, result, a As rules. accounting various to subject number accounting an is but information, firm’s revenues minus its production costs and operating costs. “Pre-tax profits” measures a firm’s revenues revenues a firm’s measures profits” “Pre-tax costs. operating and costs production its minus revenues firm’s minus its production costs, operating costs, interest is “Net income” taxes. the income firm’s expenses, not does it deduct but income expenses, or and any extraordinary amortization/depreciationincludes charges. It also the firm’s bottom-line profit. It accounts for all the firm’s revenues and expenses, including income taxes. income including and expenses, revenues the all firm’s for It accounts profit. bottom-line firm’s the 42208-tul_55-3 Sheet No. 63 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 63 42208-tul_55-3 42208-tul_55-3 Sheet No. 64 Side A 05/15/2020 10:30:18 This 53 481 481 ETERMINING THE ETERMINING D ] (“While discounted cash Readers canthink of free 52 ECHNIQUES FOR note 1, 317–20. 1, at note ALUATION T a V r p u s , OOLS AND 54 AVOIDABLY DIFFICULT :T but each approach begins with profit N NVESTMENT NVESTMENT 51 U ALUATION S V note 4, at 79–80. at 79–80. 4, note I S a r ALUATION p V u IDE OF s S , ) 5/14/2020) 9:49 AM ARK TARTUP D ELETE S D note 15, at 347–48. 347–48. at 15, note G NVESTMENT NVESTMENT ALUATION OT OT a r V N ,I N p O u see also also see s (D , LISS G YOU G at 349; 349; at N AMODARAN 11 (U. ed., 3d ed. 2012) [hereinafter I [hereinafter 2012) 3d ed. ed., 11 (U. &B UBLISHER D P ation Methods Methods ation AMODARAN ON including startup equity investments. A DCF analysis seeks to determine a a determine to seeks analysis DCF A investments. equity startup including u ally id. SSET SSET MITH MITH FOR FOR r ,D 55 A VALUI ,S Y SWATH SWATH N A p Val A at 80. 80. at u t MITH ee gene ee, e.g. ee, ee r J - FINAL S There aremany methods for valuing youngstartups, each with itsnuances. own The S Free cash flow is the more accurate source for the residual. Free cash flow is the the is flow cash Free residual. the for source accurate more the is flow cash Free S (1) (DCF). flow cash Discounted (2) value. Relative (3) method. capital venture The (4) and situations, method. all for Chicago method First The best the definitively is that approach single no is There A DCF analysis is arguably the most fundamental method for valuing financial financial valuing for method fundamental most the arguably is analysis DCF A 1. M K ta . . . . Id. S C Y 54 55 51 52 ALUE OF RCUTT RCUTT cash flow forecasts as more refined profit forecasts. If profits cannot be estimated estimated be cannot profits If forecasts. profit refined more as forecasts flow cash confidently,neither can free cash flows. C. underlying concept, however, is constant: An investment’s value is equal to the present present the to equal is value investment’s An constant: is however, concept, underlying the discount explicitly methods Some generate. to projects it flows cash future the of value value. that infer indirectly to try others while flows, cash future the of value present projections that are then adjusted to arrive at free cash flows. cash at free arrive to adjusted then are that projections extra cash produced a by company’soperations that stockholders will it could receiveso viaprimer, a valuation not is article This distribution. liquidation the or dividends should readers Instead, and profits. flow cash free between distinctions the on dwell not know that free cash flow forecasts are derived froma company’s profit projections. flows, cash free calculate to There ways a few are while profits are where the residual originates from, none of the profit measurements measurements profit the of none from, originates residual the where are profits while stockholders. to available cash excess the track explicitly flow valuation is only one of the three ways of approaching valuation and most valuations done in the real world real in the world done and valuations most valuation approaching of the of one three ways is only valuation flow relative To do are built. approaches valuation other all on which the foundation is it valuations, relative are apply To valuation. flow cash discounted of fundamentals the understand to need we correctly, valuation who Anyone . . . valuation. flow cash discounted a with begin to have often we assets, value to models pricing other the use and analyze to able be will analysis] cash flow a discounted of fundamentals [the understands approaches.”). V 2020] 2020] O 53. S 53. financial investment’s intrinsic value, as it directly measuresthe present value the of cash there are plusses and minuses to each method. However, it is important to note that each each that note to important is it However, method. each to minuses and plusses are there methods—require credible most as well article—as this in described methods four the of forecasts flow profit/cash reasonable If flows. cash or profits startup’s the forecasting cannot be generated, whichis oftenthe case for young startups, each of these result. methods valuation a useful generate to struggle article considers four of the more popular methods: popular more the of four considers article investments, 42208-tul_55-3 Sheet No. 64 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 64 42208-tul_55-3 42208-tul_55-3 Sheet No. 64 Side B 05/15/2020 10:30:18 M K ହ C Y note 1, at 2–3. ̈́͸ͲǡͲͲͲ note 1, at 29. at 1, note a ሺͳ ൅ǤͲͷሻ r a r p p u u s , ൅ s , ସ p u t ͳǤʹ͹͸͵ r ̈́ͳͳͲǡͲͲͲ ௡ ta S ALUATION ௡ ALUATION V ൅ a ̈́ͳͲǡͲͲͲ V r ሺͳ ൅ǤͲͷሻ ܥܨ However, the basic approachis [Vol. 55:469 55:469 [Vol. ሺͳ ൅ ݎሻ IDE OF IDE OF 58 ൅ IDE OF IDE OF S ଷ S ͳǤʹͳͷͷ ̈́ͳͲǡͲͲͲ ൅ǥ ARK ARK ARK ଷ ൅ ଷ ̈́ͳͲǡͲͲͲ ܥܨ nning a DCF fo a nning DCF ሺͳ ൅ǤͲͷሻ u 56 ሺͳ ൅ ݎሻ A LAW REVIEW A LAW ͳǤͳͷ͹͸ note 55,note 12. at ൅ S ̈́ͳͲǡͲͲͲ ൅ ) 5/14/2020) 9:45 AM a ଶ note 55, at 12; D note 4, at 10; D 10; 4, at note ଶ r p a a : r r u ൅ ଶ TUL s p p ELETE 57 , u u la D ts When R When ts s s ܥܨ u , , u OT OT m ሺͳ ൅ ݎሻ N r ̈́ͳͲǡͲͲͲ O ሺͳ ൅ǤͲͷሻ ൅ ͳǤͳͲʹͷ (D ̈́ͳͲǡͲͲͲ discount rate discount cash flow ALUATION last period cash flows are to be received received be to are flows cash period last the subscriptrefers the to period whenthe future cash are flows ൅ ଵ V ALUATION ALUATION = = = = generated generated ଵ V V ൅ ܥܨ mation Inp mation ͳ൅ݎ r UBLISHER P FOR FOR ͳǤͲͷ 1,2,3, etc. 1,2,3, ̈́ͳͲǡͲͲͲ NVESTMENT b. Info a. The Basic Fo Basic The a. : Mary has an opportunity to buy a financial instrument from TechCo for $75,000. $75,000. for TechCo from instrument a financial : buy to opportunity an has Mary ̈́ͳͲǡͲͲͲ ሺͳ ൅ǤͲͷሻ NVESTMENT NVESTMENT I n r CF CF ݑ݁ ൌ݈ܸܽ AMODARAN ON ee ൌ ̈́ͺʹǡͶ͹ͳ ൌ ̈́ͻǡͷʹͶ ൅ ̈́ͻǡͲ͹Ͳ ൅ ̈́ͺǡ͸͵ͺ ൅ ̈́ͺǡʹʹ͹ ൅ Ͷ͹ǡͲͳʹ J - FINAL S Determining a startup’s equity value with a DCF calculation requires three sets of sets three requires calculation a DCF with value equity a startup’s Determining There are many variations of the DCF model. DCF the of variations many are There The basic DCF formula is where . ൌ  ܸܲ ൌ  The instrument will pay Mary $10,000 for each of the next five years. At the end of five five of end the At years. five next the of each for $10,000 Mary pay will instrument The that Assume $50,000. for Mary from instrument financial the repurchase will TechCo years, instrument’s financial The apply. to Mary for rate discount reasonable a is percent five present value is$82,471, makingit a good buy. Example 57 RCUTT RCUTT consistent between all them: of project theinvestment’s cash flows periodby and apply a value. present its determine to rate discount 58. Damodaran explains: “There are literally thousands of discounted cash flow models in existence. existence. in models flow cash discounted of thousands literally are 58. “There explains: Damodaran 56. D 56. flows the investment expectsto produce. 482 482 O

information inputs. An analyst must (1) project the future cash flows that are expected to to expected are that flows cash future the project (1) must analyst An inputs. information a discount estimate (3) and value, terminal a (2) estimate stock, the owning from come rate. Investment ofbanks a couple or consulting only vary can models firms flow cash often discounted claimhowever, that Ultimately, their contemporaries. valuation their by used modelsthose are better or more sophisticated than dimensions.” I 42208-tul_55-3 Sheet No. 64 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 64 42208-tul_55-3 42208-tul_55-3 Sheet No. 65 Side A 05/15/2020 10:30:18 CIENCE OF S so it does it does so 61 483 483 (Nov. 27, 2016), 2016), 27, (Nov. RT AND As noted above, OOL F 63 :A note 15, at 388 (Smith et 388 (Smith at 15, note The analyst projects projects analyst The a r note 15, at 352–53. 352–53. at 15, note 64 p u a s r OTLEY , INANCE p F u s ,M , LISS 62 LISS &B nings? r &B MITH MITH ,S AVOIDABLY DIFFICULT MITH MITH N ,S NTREPRENEURIAL MITH U E S in MITH I , S S es ur These analysts useDCF the analysis to value stock ) 5/14/2020) 9:49 AM 59 see also also see TARTUP note 55,note S 304; at ELETE ew Vent ew S D a N r G p OT OT u N N s The DDM approach often is used DDM for determining The whether , O 60 (D ation of of ation u note 61, at 217; a G YOU G r Val p N ALUATION u ii. Value Terminal ii. i. FreeCash Flows UBLISHER s 214, 218 (Luisa Alemany & Job J. Andreoli eds., 2018). 2018). eds., Andreoli J. Job & Alemany (Luisa 218 214, V P Can Dividends Be Paid in Excess of Retained Ea FOR FOR , VALUI ENTURES Alemany, Alemany, at 323. 323. at V . ee, e.g. ee, ee NVESTMENT J - FINAL Id. S With the DDM approach eliminated, analysts commonly use the startup’s free cash cash free use startup’s the commonly analysts eliminated, approach DDM the With S For public companies that pay dividends, some analysts ignore the liquidation liquidation the ignore analysts some dividends, pay that companies public For Companies can potentially last , so valuing a startup with a DCF analysis analysis a DCF with a startup valuing so forever, last potentially can Companies M K . Id . . C Y 60 62 63 ROWING RCUTT RCUTT al. refer to terminal value as “continuing value”). value”). “continuing as value terminal to refer al. publicly traded are overpriced ora bargain. If the present value of the projecteddividends is lower thanthe stock price, the stock is overpriced. And if the present value of the projected dividendshigher isthanthe stock price, is a stock the bargain.The DDM dividends, pay already that companies mature for used be only can approach free cash flow is the extra cash produced by a company’s operations that stockholders stockholders that operations a company’s by produced cash extra the is flow cash free could receivevia dividends ortheliquidation distribution.The DCF measuresthe present then must analyst The residual. or cash flows, free projected startup’s the of value stock. of each share by represented residual the of portion the determine requires forecasting its free cash flows in perpetuity.than However, game projecting a guessing of free cash more flows becomes It impractical. often is years a few beyond analyst’s the beyond flows cash free produces company a When analysis. thoughtful value” “terminal a period”), “projection (the estimates thoughtful generate to ability flows. cash post-projection-period the capture to used is calculation not work for most startups and definitely does not work for young startups. Young startups startups Young startups. for young not work does and definitely startups most for not work they profitable, become they when even and dividends, pay to needed cash excess the lack growth. more fund to earnings their retain to choose usually 61. Luisa Alemany, Luisa 61. G (“Retained https://www.fool.com/knowledge-center/can-dividends-be-paid-in-excess-of-retained-earnin.aspx money lose companies Most formation. its since a company from earnings accumulated the represent earnings theirretainedtime,a they when up,and first for so start earningsbe negative. will That’s reason one why most start-ups don’t pay dividends, in addition to the fact that new companiesthey generally have to needgrow theirto hold ontobusiness.”). any cash 59. 59. 2020] 2020] O free cash for flows many as years as she feels confidentherin projections, then free concludes future the of value the approximates that value terminal a with calculation DCF the formula DCF The time. of end the until period projection the of end the from flows cash 64. I 64. as the present value of its projected future dividends, whichreferredis to as the dividend(DDM). model discount flows to approximate the stockholders’ future investment cash flows. cash investment future stockholders’ the approximate to flows distributionand focuson dividendsas the sole source ofinvestor cash flows. If thecompany continuesperpetuity, in “thecash only flow receiveyou when shares buy you in dividend.” a is firm traded a publicly 42208-tul_55-3 Sheet No. 65 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 65 42208-tul_55-3 42208-tul_55-3 Sheet No. 65 Side B 05/15/2020 10:30:18 M K $971 ILLIAM C Y W ALUING A ALUING ,V ௡ ሻ AKING THROUGH THROUGH AKING see alsosee M $744 today (or (or $744 today ICULITA 69 ͳ൅ݎ ሺ V. N ECISION It takesthe projected D ݒ݈ܽݑ݈݁ܽ݊݅݉ݎݐ݁ 67 LINA LINA ൅ ௡ &A The stable growth method method growth stable The : ሻ 183 (5th ed. 2008); 2008); 183 ed. (5th 66 ௡ 68 MPROVING RATT ܥܨ [Vol. 55:469 55:469 [Vol. :I ͳ൅ݎ ሺ P. P ݎെ݃ ݔሺͳ ൅ ݃ሻ OMPANIES ௙ C ܥܨ ൅ǥ ALUATION ELD ELD ଷ V HANNON HANNON H ଷ ܥܨ ATENT A LAW REVIEW A LAW LOSELY LOSELY ሺͳ ൅ ݎሻ ,P S note 1, at 266–67. at 266–67. 1, note C ) 5/14/2020) 9:45 AM This is the return rate a party foregoes when it defers defers it when foregoes a party rate return the is This a ൅ ee Rate Rate ee r 70 r p note 15, at 391. 15, note EMUS ଶ TUL u note 55,note 304. at 55,note 306. at ELETE a -F s r D a a , ଶ note 15, at 354; S 354; at 15, note note 69, at 183. 183. at 69, note k p r r C. R u p p a a OT OT s r r u u ܥܨ N , s s p p  ݒ݈ܽݑ݁ ൌ݈ܽ݊݅݉ݎ݁ܶ , , u u O PPRAISAL OF PPRAISAL OF AUL ሺͳ ൅ ݎሻ s s : A , , (D LISS discount rate discount (a) Ris &P 65 free cash flow from the final periodthe of projection period the constant growthrate in perpetuity ൅ ALUATION = = = LISS V &B ଵ ICULITA ALUATION ALUATION &B iii. Discount Rate Rate Discount iii. RCUTT UBLISHER ܥܨ V V ͳ൅ݎ P MITH MITH IDE OF IDE OF &N S ,S L. O NALYSIS AND ). Collectively, the lost-investment-opportunities rate plus the inflation rate rate inflation the plus rate lost-investment-opportunities the Collectively, ). MITH MITH FOR FOR A f 10 ,S ARK OHN RATT RATT MITH HE P D CF g r ,J 151–54 (2012). ; S :T MITH ee ee ݑ݁ ൌ݈ܸܽ NVESTMENT NVESTMENT J - FINAL S The time value of money recognizes the value of having money in hand. Money-in- hand. in money having of value the recognizes money of value time The Why do theprojected cash need flows to present be valued?reason: The thepromise S When a valued item is expected to generate cash flows in perpetuity, analysts often often analysts perpetuity, in flows cash generate to expected is item valued a When where . . Id.. URPHY 70 66 68 NALYSIS USINESS RCUTT RCUTT A 65. I 65. B J. M with a terminal value is value terminal a with 484 484 O cash flows from the final projection period and assumes they will grow at a constant rate rate a constant at grow will they assumes and period projection final the from flows cash is method growth stable the for formula The perpetuity. in 69. S 69. calculate terminal value with the stable growth method. growth stable the with value terminal calculate today (or $1,000/1.03). Assuming a constant three percent inflation rate for ten years, years, ten for rate inflation percent three a constant Assuming $1,000/1.03). (or today $1,000received at the the end of ten-year period isworth only $1,000/1.03 hand can be invested in profitable projects (e.g., it can be deposited in the bank and earn earn and bank the in deposited be can it (e.g., projects profitable in invested be can hand these sacrifices she receipt, defers party a When cannot. payments future while interest), payments. future of value the at away eats inflation Additionally, opportunities. investment Assuminga three percent inflationrate, receiving $1,000onein is year worth only assumes the valued item will settle into a constant growth rate. growth a constant into settle will item valued the assumes payments, but without considering any risk associated with those payments. payments. those with associated risk any considering without but payments, represent a party’s “risk-freerate.” ofreceiving money inthe future is worthless thanan immediate payment anidentical of sum. Discountingthe futurereceipts cash ismeant to approximate rate the return of an investorrequires to the buy future cash flows.The discountrate has two components: (1) thereturn rate for investingrisk-free in a asset; andriska (2) premium. 67. I 67. 42208-tul_55-3 Sheet No. 65 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 65 42208-tul_55-3 42208-tul_55-3 Sheet No. 66 Side A 05/15/2020 10:30:18 7 7 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $3,836,597 $19,074,074 $19,074,074 485 485 6 6 $994,446 $994,446 $4,800,000 $4,800,000 $4,800,000 $4,800,000 This additional return is the the is return additional This 5 5 71 = $19,074,074 $19,074,074 = $4,500,000 $4,500,000 $1,211,981 $4,500,000 $4,500,000 AVOIDABLY DIFFICULT 4 N 4 U S $4,000,000 $4,000,000 $1,400,511 Ǥଷ଴ିǤ଴ଷ $4,000,000 $4,000,000 I S Total present value at 30% discount rate $10,377,080 $10,377,080 rate 30% discount at value present Total m m ̈́ହǡ଴଴଴ǡ଴଴଴௫ሺଵାǤ଴ଷሻ u 3 ) 5/14/2020) 9:49 AM 3 emi $3,000,000 $3,000,000 $1,365,498 r TARTUP ELETE $3,000,000 $3,000,000 S P D k G OT OT N N 2 O 72 (D 2 (b) Ris $2,000,000 $2,000,000 $1,183,432 $2,000,000 $2,000,000 G YOU G N  ݒ݈ܽݑ݁ ൌ݈ܽ݊݅݉ݎ݁ܶ UBLISHER 1 P implified Example DCF 1 S $500,000 $500,000 $384,615 FOR FOR Future Year VALUI c. c. : An investor: is considering investing$2 million inTechCo for a one-third $500,000 $500,000 Future Year Future at 184. 184. at J - FINAL The following simplified example demonstrates how a DCF can work to determine determine to work can DCF a how demonstrates example simplified following The Parties could choose to commit all their funds to largely risk-free investments like like investments risk-free largely to funds their all commit to choose could Parties M K . Id. Finally, the investor calculated its risk-free rate + risk premium for investing in TechCo as as TechCo in investing for premium risk + rate risk-free its calculated investor for the value Finally, terminal a estimated investor the hand, in information this With percent. thirty $19,074,074. of TechCo thirty a using value terminal + projections flow cash free TechCo’s for DCF the is Here percent discount rate. The present value of TechCo’sprojected free cash flowsterminal + is value $10,377,080. Example ownership interestinthe company. Assuming the $2 million cash free cashinfusion, TechCo’s projected the investor investor The TechCo. for projections flow cash free developed flows for the next seven years, at which point it believes TechCo will reach a stable growthrate three of percent. C Y 71 RCUTT RCUTT Free cash flows Terminal value value Present 30% at discount rate

72. calculation. DCF The example is greatly simplified. Its only purpose is to show readers the basic steps and math behind a Free cash cash Free flows 2020] 2020] O risk premium. It addresses the risk, or uncertainty, surrounding the valued asset’s future future asset’s valued the surrounding uncertainty, or risk, the addresses It premium. risk performance. Projected payments are simply that;they are just projections.risk The premiumtries account to risk the for that the amountandtiming the of forecasted payments are wrong.The forecasted payments lessmay be than forecasted or takelonger to generate than expected. The greater the risk, thehigher the discount rate; and the higher the discount rate, thelower the present value the of projected free cash flows. a company’s equity value. equity a company’s United States Treasury bonds. To induce parties to pursue riskier projects, there must be a be must there projects, riskier pursue to parties induce To bonds. Treasury States United risk. greater the justifies that rate risk-free the above return 42208-tul_55-3 Sheet No. 66 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 66 42208-tul_55-3 42208-tul_55-3 Sheet No. 66 Side B 05/15/2020 10:30:18 M K C Y y r [Vol. 55:469 55:469 [Vol. ations ations u p Val ating Histo u r t Free cash flow estimates can generated be r 73 ta S l Ope u ng- A LAW REVIEW A LAW u S ) 5/14/2020) 9:45 AM note 69, at 69, note 136. Yo a r TUL r ELETE p D u s , OT OT o Meaningf N N O EMUS (D (a) &R i. Projecting Free Cash Flows Flows Cash Free Projecting i. UBLISHER P RCUTT RCUTT ,O FOR FOR d. DCF Challenges fo Challenges d. DCF The currentand future target market for the company’s products or services; The company’s for pursuing the market opportunities; market the pursuing for plan business company’s The The company’s management team and its ability to successfully run the the run successfully to ability its and team management company’s The company; The quality of the company’s products or services, including the company’s company’s the including services, or products company’s the of quality The time; over quality their improve to ability The strength of the company’s rights; property intellectual company’s the of strength The The company’s investmentplan and access to financing; The competitive landscape for the company’s market opportunities; and opportunities; market company’s the for landscape competitive The The company’s historicaltrack record. URPHY x x x x x x x x J - FINAL When measuring a young startup’s equity value with a DCF analysis, the the analysis, a DCF with value equity startup’s young a measuring When Projecting a startup’s free cash flows is inherently difficult. It typically includes includes typically It difficult. inherently is flows cash free startup’s a Projecting With this type of information, one can begin to build a profit model for the startup’s startup’s the for model profit a build to begin can one information, of type this With Building a profit model requires forecasting the company’s revenues and costs. A A costs. and revenues company’s the forecasting requires model profit a Building The present value of the projected free cash flows + terminal value justifies the investment, investment, the justifies value terminal + flows cash free projected the of value present The million. $2 than greater is $10,377,080 of percent 33.3 since RCUTT RCUTT 73. M 73. 486 486 O from the profit forecasts. Because Generating performance. revenue future their and about cost projections uncertainty extreme to for due young difficult startupsisparticularly by led are and markets, new pursue technologies, new introduce often startups young technology new the uncertain. Will particularly are futures their managers, unproven be technology the Will technology? the embrace customers Will effectively? function prevent to enough strong rights property intellectual the Are scalable? commercially information inputs are free cash flow projections, a discount rate, and a terminal value. If If value. terminal a and rate, discount a projections, flow cash free are inputs information analyst The exercise. trivial a is analysis DCF the inputs, information perfect has analyst an an generate and formula, DCF the into them plug inputs, information her perfect take can are inputs information these However, answer. perfect a to lead would that result accurate probabilities associated varying with futures Multiple uncertainty. substantial to subject usually is outcomes potential of distribution the startups, young With company. any await very broad. In fact, the distribution of outcomes result. can value be so broad DCF the of for young usefulness startups the jeopardizes that it analyzing, among other things: things: other among analyzing, futureperformance, whichthen can adjusted be to project free cash flows. For young startups—which lack meaningful operating histories guesswork. than better andlittle suffer from often is high failure projections rates— such generating common method is to forecast revenues, then estimate the costs for that level of revenue revenue of level that for costs the estimate then revenues, forecast to is method common estimates. profit the at arrive to production 42208-tul_55-3 Sheet No. 66 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 66 42208-tul_55-3 42208-tul_55-3 Sheet No. 67 Side A 05/15/2020 10:30:18 . CH .S note 1, . (Sept.. US a r B p u DVOC s , A 487 487 OF ARVARD . FF , H The more specific specific more The k ALUATION 77 ., O V and this technique is is technique this and DMIN 74 nce Bac u IDE OF .A 78 S US B ARK s Can Bo Can s D r MALL MALL nde u AVOIDABLY DIFFICULT see also also see Fo N r , U.S. S U S I siness S u e Rate ur and How Thei and How ) 5/14/2020) 9:49 AM mall B — S it requires more investigation and, as noted above, above, noted as and, investigation more requires it note 1, at 265. 265. 1, at note t TARTUP u ELETE a 75 S r D note 15, at 208–11. 208–11. at 15, note p u G OT OT a s r N , N p O u s including the startup’s incentive to exaggerate its future results. results. future its exaggerate to incentive startup’s the including (D , (b) High Fail estions Abo estions u 76 LISS (Mar. 7, 2011), https://hbswk.hbs.edu/item/why-companies-failand-how-their- 7, 2011), (Mar. G YOU G ALUATION N Why Companies Fail Companies Why ed Q V ii. Choosing a Discount Rate &B UBLISHER k P MITH MITH FOR FOR IDE OF VALUI NOWLEDGE S Thirty to forty percent of startups will end up liquidating their assets with with assets their liquidating up end will startups of percent forty to Thirty investors losing their all (or most) of investment. Seventy to eighty percent of startups will fail to generate investors’ projected projected investors’ generate to fail will startups of percent eighty to Seventy investment. on return Ninety to ninety-five percent of startups will fail to generate the profit profit the generate to fail will startups of percent ninety-five to Ninety investment. the of time the at provided projections ,S ently As K u at212–22, for example, details severaltechniques; eq ARK r MITH x x x J - FINAL Forecasts are easiestto generate whenthere is a performance trackrecord. It is easier Underlying any attempt to forecast a young startup’s profits/cash flows is the fact fact the is flows profits/cash startup’s a young forecast to attempt any Underlying Because every young startup seeking capital claimsit will be successful,investors The discount rate’s risk-free component is usually easy to estimate. Analysts use the the use Analysts estimate. to easy usually is component risk-free rate’s discount The F M K . Id. . C Y 75 ORKING ORKING RCUTT RCUTT simply not available for young startups. Young-startup forecasts must be generated from from generated be must forecasts Young-startup startups. young for available not simply impossible, not While scratch. 2019), https://advocacy.sba.gov/2019/09/24/frequently-asked-questions-about-small-business/. https://advocacy.sba.gov/2019/09/24/frequently-asked-questions-about-small-business/. 2019), Noble, Carmen 78. competitors, particularly larger ones, from taking away the opportunity? How sound is the the is sound How theopportunity? away taking from ones, larger particularly competitors, financial enough have startup the Will opportunity? the pursuing for strategy startup’s perform? team management startup’s the will How opportunity? the pursue to resources disruptive brand-new startup’s a project to is it than costs and sales iPhone future project to to is projections developing for techniques used commonly most the of One technology. record, track historical a from performance future extrapolate W statistics for startups are just as bleak. Citing research statistics from Harvard Business Business Harvard from statistics research Citing bleak. as just are startups for statistics Working School Business Harvard in article 2011 a Ghosh, Shikhar lecturer senior School estimates. sobering following the offered Knowledge 74. S 74. 2020] 2020] O that most startups disappoint or fail. According to the Administration, only only Administration, Business Small the to According fail. or disappoint startups most that operation. of years five first the survive businesses small of half about involves much greater uncertainty. Practically speaking, when a startup lacks a meaningful meaningful a lacks startup a when speaking, Practically uncertainty. greater much involves their and estimates startup’s the on reliant more become often analysts history, operating biases, accompanying 77. 77. founders-can-bounce-back (citing statistics from research by Shikhar Ghosh, a senior lecturer at Harvard at Harvard lecturer a senior Ghosh, Shikhar by research from statistics (citing founders-can-bounce-back Business School). are left withthe difficult task picking of the winnersthe from losers. stable reach Investors and must projections profit their achieve will startups young which determine more is determination this Making not. will most that well full knowing growth, evaluate. to results performance actual lack companies when challenging rate available on “instruments that are considered to have virtually no possibility of default, default, of possibility no virtually have to considered are that “instruments on available rate at 276–90. 276–90. at D 76. 42208-tul_55-3 Sheet No. 67 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 67 42208-tul_55-3 42208-tul_55-3 Sheet No. 67 Side B 05/15/2020 10:30:18 M K note 1, 80 C Y a r p AMODARAN u s note 4, at 35– 4, at note , a r p which must be be must which u s , 84 ALUATION V and present their own 83 ALUATION IDE OF V S ARK D [Vol. 55:469 55:469 [Vol. The benefit of the multiple-scenario multiple-scenario the of benefit The 85 AMODARAN ON see also also see D When valuing cash flows that extend far far extend that flows cash valuing When 79 see also also see A LAW REVIEW A LAW S note 1, at 265. 1, note at 290–96. 1, note ) 5/14/2020) 9:45 AM a a r r p p note 15, at 361–63; 361–63; at 15, note TUL u u note 55, at 183. 55, note ELETE a s s r D a , , r p p u OT OT The Capital Asset Pricing (CAPM), Model for example, s u note 69, at 184 (referencing the twenty-year Treasury bond); D bond); Treasury the twenty-year at 184 (referencing 69, note note 69, at 183; at 183; 69, note N s , 81 , a O a r r p (D p LISS u u s s ALUATION ALUATION , , V V &B note 4, at 35–36 (referencing the ten-year Treasury bond). ALUATION iii. Terminal Value Problems Problems Value Terminal iii. UBLISHER a V P MITH MITH r IDE OF IDE OF IDE OF ICULITA ICULITA p S S ,S u s FOR FOR , &N &N at 266. 266. at Since young startups’ stocks arenot publicly traded,there areno price ARK ARK MITH D D S 82 RATT RATT ee ee ee id. ee id. ee NVESTMENT J - FINAL S Recognizing the challenges in developing the risk premium, some analysts try to try analysts some premium, risk the developing in challenges the Recognizing S Using a terminal value to complete a young startup’s DCF analysis presents serious serious presents analysis DCF startup’s a young complete to value terminal a Using The challenging part of estimating a discount rate for a young startup is the risk risk the is startup young a for rate discount a estimating of part challenging The S S ALUATION . . . . V 81 83 84 85 RCUTT RCUTT fluctuations to compare to the overall market. Proxies can be used for the price of the the of price the for used be can Proxies market. overall the to compare to fluctuations young startup’s stock, but those proxiesare oftencomplicated accountrisk for directly in their free cash flow forecasts. example, flow For cash rather free thanforecast multiple forecast may analyst an flows, cash free of set possible a single, scenario. each to probabilities assign and scenarios separately estimated. estimated. separately measures a stock’s risk by examining its price fluctuations in comparison to the overall overall the to comparison in fluctuations price its examining by risk stock’s a measures market. into the future, such as when valuing a company, most analysts use the rate from a long- a from rate the use analysts most company, a valuing when as such future, the into bond). Treasury States United twenty-year or ten-year the (e.g., bond Treasury term 36. 36. P 80. 79. P 79. such as United States Treasury obligations.” Treasury States United as such 488 488 O approach is it reduces the risk premium, making the discount rate easier to calculate. The The calculate. to easier rate discount the making premium, risk the reduces it is approach with up coming and scenarios multiple generating of challenge the is however, downside, probabilities. thoughtful ON problems. As noted above, the stable growth method is commonly used to calculate calculate to used commonly is method growth stable the above, noted As problems. startups. young for suited well not is it However, a company. valuing when value terminal years, ten (e.g., time a long for firm growth a stable become not may startup A young twenty years,more). or Thismeans the analyst need may to project free cash cash far flows free into late-year The estimates. thoughtful generate to ability her future—beyond the same the and analysis, thoughtful than rather pure conjecture, be may projections flow for accounts often value terminal matters, Compounding rate. discount the for true holds is it that notes Damodaran Professor value. overall startup’s young a of portion large a of 100% than more even or 100%, 90%, for account to value terminal the for unusual “not challenges. Moreover, CAPM does not capture the startup’s failure risk, failure startup’s the capture not does CAPM Moreover, challenges. premium. With a traditional DCF analysis, the risk premium tries to capture all the young young the all capture to tries premium risk the analysis, DCF a traditional With premium. startup’suncertainty. A singlenumber seeksaccount to all for the ways the forecasted free a is This future. projected singular analyst’s the than different turn out could cash flows approaches Standard outcomes. potential of distribution the addressing for technique blunt for estimatingrisk the premium at least (or a portion therisk of premium) arenot well startups. young for suited at 75–104. at 82. I 82. 42208-tul_55-3 Sheet No. 67 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 67 42208-tul_55-3 42208-tul_55-3 Sheet No. 68 Side A 05/15/2020 10:30:18 , titive titive INANCE 489 489 takes a different different a takes !F Most investorsMost are 87 AHOO 90 , Y y r mma AVOIDABLY DIFFICULT The buyersand sellers benefit from an N Su U The averagetrading volume Apple’s for S I S This means the valuation analysis is driven by a by driven is analysis valuation the means This 86 note 15, at 349. 15, note ) 5/14/2020) 9:49 AM a The cost to make a trade is very low—usually just a just low—usually very is a trade make to cost The r note 69, at 189. at 69, note p u note 1, at 266. at 266. 1, note a TARTUP s Each share Apple of common stock is identical. r ELETE a , p S r D u p s u G , OT OT LISS s N , N O &B EMUS (D &R MITH MITH G YOU G ALUATION ,S N iv. Summary of the DCF Challenges Challenges DCF the of Summary iv. V UBLISHER If the comparable transactions took place in a competitive market, it is is it market, a competitive in place took transactions comparable the If P RCUTT RCUTT 88 MITH ,O FOR FOR ,S IDE OF at 191. 191. at VALUI S common stock is over twenty-five million shares. million twenty-five over is stock common Numerous buyers and sellers: Well-informed and sellers: buyers an as well as stocks, traded publicly for system disclosure mandatory extensive rating credit analysts, research as (such intermediaries market of array Additionally, transactions. inform also that press) financial the and agencies, available. freely is prices transaction and quotes stock about information Homogenous items: items: Homogenous Buyers and sellers are independent, profit-maximizers: profit-maximizers: independent, are sellers and Buyers independent, profit-maximizers. They act in their own best interests to generate generate to interests best own their in act They profit-maximizers. independent, returns. investment Low transactionLow costs: 89 URPHY ARK ee, e.g. ee, ee id. ee id. x x x x x J - FINAL S S Apple’s common stock, which trades onprovides a compe NASDAQ, good Valuing young startups with DCF modelsis unavoidably difficult forinvestors. Apple Inc. (AAPL): Relative valuation (also referred to as “comparable valuation”) “comparable as to referred (also valuation Relative D 2. Relative Value Value Relative 2. M K . . . C Y 89 87 86 RCUTT RCUTT reasonable to assume that past buyers and sellers, in the aggregate, agreed to an appropriate appropriate an to agreed aggregate, the in sellers, and buyers past that assume to reasonable and buyers numerous (a) are: market competitive a for characteristics Typical price. the of merits the about informed well is sellers and buyers the of each (b) sellers; sellers and buyers the (d) (or fungible); homogeneous are items traded the (c) transaction; exchange an making for costs transaction the (e) and profit-maximizers; independent, are are low. 88. M 88. the current value of a young [startup].” a young of value current the 90. 90. 2020). 2, Jan. (last visited https://finance.yahoo.com/quote/AAPL?p=AAPL&.tsrc=fin-srch 2020] 2020] O market example. calculation that comes fromnumbers thatmay be little morethan guesswork. approach than a DCF analysis. Rather than directly estimate an asset’s intrinsic value, the the value, intrinsic asset’s an estimate directly than Rather analysis. DCF a than approach same the priced have others how at looking by value measures method valuation relative to sellers and buyers self-interested of experience and wisdom the uses It assets. similar or value. estimate They must project very uncertain free cash flows, usually before the startup has made its its made has startup the before usually cash flows, free uncertain very must project They this for accounts that rate discount appropriate an with up come must They sale. first itself is that value terminal a estimate must they finally, And uncertainty. extreme dependenton free cash flow projectionsand the discountrate, and that will likelyvalue. overall the account startup’s of portion a substantial for

42208-tul_55-3 Sheet No. 68 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 68 42208-tul_55-3 42208-tul_55-3 Sheet No. 68 Side B 05/15/2020 10:30:18 M K C Y . The similar 93 note 69, at 191 at 69, note a r p u s , 95 EMUS [Vol. 55:469 55:469 [Vol. A ratio analysis allows for apples- for allows analysis ratio A 92 &R ଶ ଶ ܲ RCUTT RCUTT ܧܸ ,O ൌ ଵ ଵ ݐ݁ݏݏܽݎ݈ܽ݅݉݅ݏ݋݂݁ܿ݅ݎ݌ݏ݈݁ܽܵ ܲ URPHY ܧܸ A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM 91 ݁ܿ݅ݎݓ݅ݐ݄݌ݏݐ݈݁ܽ݁ݎݎݐ݄ܽݐܿ݋݈ܾ݁ܽ݅ݎܸܽ es with a Ratio Analysis Analysis Ratio a with es TUL ELETE u D while a buyer looking fora 3,000 square foothome knows OT OT 94 N O (D dizing Val dizing r = Economic variable for item 2 2 item for variable Economic = = Expected price for item 2 = Economic variable for item 1 1 item = for variable Economic = Observed price for item 1 UBLISHER P tanda ݐ݅݋ ൌܽݎݑܽݐ݅݋݈ܸ݊ܽ S FOR FOR 2 1 a. small sales commission. sales small 2 1 EV P EV P at 205. 205. at J - FINAL Because Apple’s common stock involves identical items trading on a highly a highly on trading items identical involves stock common Apple’s Because Ratios allow analysts to standardize values by correlating asset prices to the common common the to prices asset correlating by values standardize to analysts allow Ratios Any variable that correlates with price can used be inratioa analysis. In theabove What if an analyst wants to use past sales of a comparable item to value something something value to item a comparable of sales past use to wants analyst an if What Where . Id. Id.. 92 93 RCUTT RCUTT variable. The price-per-square-foot ratio used in the real estate industry offers one of the the of one offers industry estate real the in used ratio price-per-square-foot The variable. foot, square $250 per to $200 for selling are neighborhood a in homes If examples. clearest a buyer looking for a 2,000square foot home knows to be prepared for prices in the range, $500,000 to $400,000 to be prepared for prices in the $600,000 to $750,000 range. $750,000 to $600,000 the in prices prepared for be to = feet square 2,000 x 94. foot square $250 per and = $400,000; feet square 2,000 x foot square $200 per $500,000. = feet square 3,000 x 95. foot square $250 per and = $600,000; feet square 3,000 x foot square $200 per $750,000. 91. The Apple examplelargely came fromM 490 490 O real estate example, square-footage isthe variable.The underlying where assumption situation is thatthe comparable a to applied be then can price and variable the between ratio equation: following the with expressed be can relationship This known. is variable the only assets’ sales price is divided by the variable. the by divided is price sales assets’ that is not identical? Assume homebuyer a wants to compare home prices in a neighborhood. Somehomes are biggerthan others and sellfor higher prices,and most of therecent sales were for bighomes. Can thehomebuyer use the big-home sales to price a analysis. ratio a use could She Yes. sale? small-home competitive market, its announced stock price provides a reasonable estimate of its value. value. its of estimate reasonable a provides price stock announced its market, competitive Similar analyses can be done for barrels of crude oil, bushels markets. of soybeans, competitive on trading or any otheritems identical to-apples comparisons between comparable, but different assets. It evaluates relationships relationships evaluates It assets. different but comparable, between comparisons to-apples variables. relevant more or one and assets similar of price sales the between 42208-tul_55-3 Sheet No. 68 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 68 42208-tul_55-3 42208-tul_55-3 Sheet No. 69 Side A 05/15/2020 10:30:18 491 491 ܸܽݎܾ݈݅ܽ݁ ݄ܵܽݎ݁݌ݎ݅ܿ݁ AVOIDABLY DIFFICULT ݁ܿ݅ݎ݌ݏ݈݁ܽݏ݋݉݌ܽ݊ݕܥ N ܸܽݎܾ݈݅ܽ݁݌݁ݎݏ݄ܽݎ݁ U S I S ) 5/14/2020) 9:49 AM note 1, at 107. 107. 1, at note TARTUP ELETE a S r D p u G OT OT s N , N O blic Companies with Ratios Ratios with Companies blic (D u G YOU G One reason ratio analysis is so popular for public companies is that is that companies public for popular so is analysis ratio reason One  ݐ݅݋ ൌܽݎݐ݋ܿ݇ݒ݈ܽݑܽݐ݅݋݊ܵ ALUATION ing P ing N 96 V UBLISHER u  ݐ݅݋ ൌܽݎ݋݉݌ܽ݊ݕݒ݈ܽݑܽݐ݅݋݊ܥ P FOR FOR IDE OF VALUI b. Val : Alpha recently acquired Beta in an M&A transaction for $100 million. At the time time the At million. $100 for transaction M&A an in Beta acquired recently Alpha : : Alpha’s stock trades on NASDAQ for $30.00 per share. Alpha projects it will will it projects Alpha share. per $30.00 for NASDAQ on trades stock Alpha’s : S ARK J - FINAL Ratios, also referred to as multiples, are commonly used to value public companies companies public value to used commonly are multiples, as to referred also Ratios, M K Example next net income of $5 million generate would Beta that projected Alpha the transaction, of net year’s next twenty-times of ratio price-to-earnings a at Beta purchased Alpha year. income. Example price-to-earnings a at trading is stock Alpha’s year. next earnings-per-share of $2.00 generate ratio of fifteen-timesnext year’searnings-per-share. C Y RCUTT RCUTT and their financial instruments. In fact, ratios are probably the dominant public company the company public dominant probably are ratios fact, In instruments. financial their and method. valuation D 96. 2020] 2020] O Ratios can be used to generate valuation ratios for shares of stock or entire companies. companies. entire or stock of shares for ratios valuation generate to used be can Ratios theratios are to easy calculate,andrelevant the data is plentiful many (see Figure And 3). Thereare companies. entire of sales for as well as sales stock for prices reported publicly publicly also value—are book and revenues, earnings, as variables—such possible reported. 3 Figure companies valuing for Ratios 42208-tul_55-3 Sheet No. 69 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 69 42208-tul_55-3 42208-tul_55-3 Sheet No. 69 Side B 05/15/2020 10:30:18 M K This 97 C Y 98 100 [Vol. 55:469 55:469 [Vol. A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM note 69, at 206. at 69, note note 1, at 110. 110. 1, at note a TUL r ELETE a p r D u p s u , OT OT s N , O ratios are examples of non-earnings ratios. ratios. non-earnings of examples are ratios EMUS (D 99 &R Identify comparable stocks or companies with identifiable prices and and prices identifiable with companies or stocks comparable Identify Adjust and apply the ratios to the company being valued. valued. being company the to ratios the apply and Adjust Calculate earnings ratios for the comparable stocks or companies. companies. or stocks comparable the for ratios earnings Calculate ALUATION V iii. How a Ratio Analysis Works Works Analysis a Ratio How iii. ii. Non-Earnings Ratios Ratios Non-Earnings ii. i. Earnings Ratios Ratios Earnings i. UBLISHER P RCUTT RCUTT ,O FOR FOR IDE OF : Alpha is considering buying another company, Beta. Before commencing serious serious commencing Beta. Before : company, another buying is considering Alpha Step 1—Identify comparables with known valuations and profit forecasts. forecasts. profit and valuations known with comparables 1—Identify Step years— few last the within sold were that companies similar four identified Alpha letus call them Companies These and B, C, D. companies A, involved similar results. and sizes, market profiles, product S Step 1— profit forecasts. Step 2— Step 3— URPHY ARK x x x x J - FINAL Ratios can be generated using variables generated (a) in the past (“trailing ratios”), ratios”), (“trailing past the in (a) generated variables using generated be can Ratios Using a ratio to value a company normally involves a three-step process. a three-step involves normally company a value to ratio a Using While earningsratios make themost intuitive sense, since they clearly correlate with Earnings ratios are widely used for valuing public stocks and companies. stocks public for valuing used widely are ratios Earnings The following example uses forwardratios PE recent from comparable-company Example value potential Beta’s for feel a get to analysis ratio PE a conducted Alpha negotiations, range. RCUTT RCUTT and websites financial most ratios, PE forward and current 97. of relevance valuation greater the Despite newspaper stock tables report trailing PE ratios. This likely stemsresults. Currentfrom theand ease forward ofratios PE findingrequire and using projecting historical futureresults, whichD is a more challenging 98. exercise. (b) in the current year (“current ratios”), or (c) in the next few years (“forward ratios”). ratios”). (“forward years few next the in (c) or ratios”), (“current year current the in (b) future (and the performance future on based be should valuations stock/company Because tool. valuation appropriate more the usually are ratios forward and current residual), 492 492 O as assets company’s the of value net the represents value” 99. “book ratios, value book of purposes For makes sense because the benefit stocks and the use companies generateratios (PE) forinvestors are future Price-to-earnings profits. issuer’s the from come that flows cash number. profit bottom-line the is which income-per-share, net or income net company’s Earnings other thannet income are before also used for ratio (earnings EBIT analyses.and For example,amortization) EBITDA and depreciation, tax, interest, before (earnings employed. commonly are ratios tax) and interest investor cash flows, any variable thatcorrelates with price can used. be Price-to-revenue and price-to-book value reported onits balance sheet. 100. M sales to value a target company in an M&A transaction. transaction. M&A an in company target a value to sales 42208-tul_55-3 Sheet No. 69 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 69 42208-tul_55-3 42208-tul_55-3 Sheet No. 70 Side A 05/15/2020 10:30:18 101 but x 102 D 18 $540 $540 million $30 million $30 million 493 493 ps u t x r C 15 ta $300 $300 With this information, information, this With S million $20 million $20 million ng u Yo r x B 24 $1,680 million AVOIDABLY DIFFICULT $70 million $70 million N ations fo ations u U S Comparable Company PE Ratios Ratios PE Company Comparable $50 million $50 million $70 million $20 million $30 million I S $300 million million $300 million $540 $1,000 million million $1,000 million $1,680 x note 1, at 311–16, for a thoughtful discussion of the many the many of discussion a thoughtful at for 311–16, 1, note Acquisition Price Price Acquisition A a 20 r ) 5/14/2020) 9:49 AM Projected Next-Year Net $1,000 million p u $50 million $50 million Income at the Time of the Sale Sale the of Time at the Income TARTUP s ELETE , S D at 219. at 219. G OT OT , N N O (D ALUATION V note 61 a G YOU G r p The comparable companies sold for between fifteen-times between twenty-four- for and sold companies comparable The N u UBLISHER s year’s net net year’s - P IDE OF S FOR FOR Acquisition price price Acquisition of multiple a as next income Company B Company C Company D Company price Acquisition net Next-year’s income Company A Company B Company C Company D Company A Company VALUI e. Challenges in Using Relative Val Relative Using in Challenges e. In addition to knowing the companies’ acquisition prices, Alpha also knows their their knows also Alpha prices, acquisition the companies’ knowing to addition In projected next-yearincome net at the time the of sale. Step 3—Adjustand apply the comparable valuationratios theasset to being valued. times next-year’sincome. net examined Alpha the comparable companies more carefully andeighteen-times to of believesratio that Beta valuation is a better use to than Company want C, but therefore not as may good as Alpha B. Company twenty-times next-year’s $72 net be income. could Alpha forecasts Beta for Beta’sincome for netrange next valuation possible a result, a As million. $4 be will year million. $80 to million Step 2—Calculate valuation ratios for the comparables. comparables. the for ratios valuation 2—Calculate Step companies. comparable the for ratios valuation generated Alpha ARK Alemany, Alemany, ee x x J - FINAL See D S Relative valuations present several problems for young-startup valuations, young-startup for problems several present valuations Relative Despite near ubiquitous use in the public markets, relative valuation is not well well not is valuation relative markets, public the in use ubiquitous near Despite M K . . C Y RCUTT RCUTT 102 101 2020] 2020] O While that statement may be a bit strong, it is undeniable that using relative valuations is is valuations relative using that undeniable is it strong, a bit be may statement that While challenging for startupsingeneral and extremely challenging for young startups.

suited for young startups. One textbook goes so far as to say, “It is is “It say, to as far so goes textbook finance entrepreneurial One startups. young for suited a startup.” of value the estimate to method comparable the use to impossible almost 42208-tul_55-3 Sheet No. 70 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 70 42208-tul_55-3 42208-tul_55-3 Sheet No. 70 Side B 05/15/2020 10:30:18 : M K 106 C Y : 105 note 61, 223–24. at a r p u s ௡ ሻ [Vol. 55:469 55:469 [Vol. note 15, at 367–68. 15, note ͳ൅ݎ ሺ a eceipt when they exit theirinvestment. r p u s , ݐ݅݉ܽݐ݁݀݁ݔ݅ݐݒ݈ܽݑ݁ݏܧ LISS &B note 15, at 367; Alemany, 367; Alemany, at 15, note A LAW REVIEW A LAW a S r ) 5/14/2020) 9:45 AM p MITH MITH u s note 1, at 270. 270. 1, at note , TUL ,S ELETE a r D p The startup sells itself to another company. The acquirer acquirer The company. another to itself sells startup The LISS u OT OT MITH s N note 1, at 315. The future valuation would then need to be discounted back to back discounted be to need then would valuation future The 315. at 1, note , S s &B O a r rk (D p u  ݋݉݌ܽ݊ݕݒ݈ܽݑ݁ ൌܥ s MITH MITH The startup conducts an IPO and creates a publicsecondary market , see also also see target rate of return (or discount rate) (or discount return rate target of period when the exit takes place place takes exit the when period ,S ALUATION 103 = = V UBLISHER P MITH ALUATION FOR FOR IDE OF V at 270–71; 270–71; at a. How It Wo a. How The venture capitalmethod measures the present value of thestartup’s S for its stock on a liquid . Pre-IPO investors can sell their startup market. secondary established newly the on stock purchases all, or substantially all, of the startup in exchange for cash or publicly publicly or cash for exchange in startup the of all, substantially or all, purchases stock. traded r n at 270; S 270; at 104 ARK ee id. ee id. IDE OF IDE OF J - FINAL (1) exits. IPO (2) exits. Acquisition steps four involves generally method capital venture the with a startup Valuing S 3. Venture Capital Method Method Capital 3. Venture some analyses, valuation relative and DCF by presented challenges the to Due Investors buy startup stock to make money, and the most common way to make that that make to way common most the and money, make to stock startup buy Investors where S . Id. . ARK RCUTT RCUTT 104 106 investors use analternative approach—the venture capital method—for valuing startups. suffers from the same forecasting and uncertainty problems discussed earlier for DCFs. Thereare commontwo exit strategies for startup investments. money is to sell the stock and collect capital gains. The venture capital method seeks to to seeks method capital venture The gains. capital collect and stock the sell to is money r cash investors’ the of value present the calculate problems. operating firm’s “the forecasting by revenues and profits 103. current of lack the overcome analysts Some results later in the life cycle and . . use. these revenuesforward and earnings the as basis valuation.for In effect, we will estimate the value of the business in five years, using revenues or earnings from that point in time.” D two problems particularly standout. The first is a lack of appropriate comparable comparable appropriate of lack a is first The standout. particularly problems two However, startups. private other be should startups young for comparables The companies. hard are projections profit and data pricing traded, publicly not are comparables such since analyses ratio variables, and prices comparable Without obtain. to impossible) often, (or, ratio their for companies traded publicly use to try may analysts Some done. be cannot along enough far are that startups mature for appropriate only is this However, analyses. reasonable—which is companies public to them comparing that cycle development their in ratio a in used normally variables the lack startups young Second, startups. young excludes analysis. They do notthemselves have meaningfulrevenues and their earningsare almost negative. certainly 494 494 O present value. Forecasting a young startup’s future results and using them for the ratio analysis can work, but it estimated exit value. The formula for the venture capital method is method capital venture the for formula The value. exit estimated 105. 105. D

42208-tul_55-3 Sheet No. 70 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 70 42208-tul_55-3 42208-tul_55-3 Sheet No. 71 Side A 05/15/2020 10:30:18 VC VC 495 495 ps ps u t r ta S ng ng u ଷ Since the exit is not expected not expected is exit the Since ing Yo ing ͳǤ͵ͷ million to $216 million. million. $216 to million u Val r AVOIDABLY DIFFICULT N VC believes that will forVC ready TechCo be Three comparable companies experienced experienced companies comparable Three U ͳͺͲ݈݈݉݅݅݋݊ݐ݋̈́ʹͳ͸݈݈݉݅݅݋݊̈́ S I S ൌ ௡ ሻ ) 5/14/2020) 9:49 AM ܧܸ note 1, at 270. 270. 1, at note ͳ൅ݎ TARTUP ELETE ሺ a S r D p u G OT OT s N , N ൌ ̈́͹͵Ǥʹ݈݈݉݅݅݋݊ݐ݋̈́ͺ͹Ǥͺ݈݈݉݅݅݋݊ O (D VC judged TechCo to be a later stage company and determined thirty- determined and company stage later a be to TechCo judged VC e Capital Method Challenges fo Challenges Method Capital e Discount the exit value backto present value using target a rate of discount rate discount Estimate how much funding the startup needs to reach an exit event. event. exit an reach to needs startup the funding much how Estimate Estimate whenthe exitwill occur. Estimate the startup’s exit value, frequently using a PE ratio. ratio. PE a using frequently value, exit startup’s the Estimate G YOU G 107 exit value value exit the period when the exit value occurs ALUATION N ur = = = V UBLISHER P FOR FOR  ݐݒ݈ܽݑ݁ ൌ݊݁ݏ݁ݎܲ IDE OF VALUI b. Vent : A venture capital firm (VC) is considering whether to invest in TechCo. Following Following TechCo. in invest to whether considering is (VC) firm : capital venture A S Step 1— Step 2— Step 3— return. return. Step 4— EV r n five percent to bethe appropriate discount rate. to occur for three years, the exit value must be discounted back to present value. Venture Venture value. present to back discounted be must value exit the years, three for occur to of stage startup’s the on based tables rate-of-return develop commonly firms capital development. the acquisition exit in three years. years. three in exit acquisition the that acquisitionexits projects withinthe VC last year. Those companiesincome. sold multiples PE at net ranging one-year forward twenty-four-times to twenty-times from Therefore, exit. of time the at million $9 be will income net one-year forward TechCo’s $180 from range to projects value exit future TechCo’s estimates that TechCo needs $10 million of funding to reach an exit event. VC believes believes VC event. an exit reach to funding of $10 million needs TechCo that estimates exit. acquisition an be will event exit the Step 1—Estimate how much funding TechCo needs to reach an exit event. event. exit an reach to needs TechCo funding much how 1—Estimate Step Step 4—Discount the exit value back to present value. present to back value exit the 4—Discount Step Step3—Estimate TechCo’s exit value. Step 2—Estimateexit the will occur. when ARK where x x x x J - FINAL The above example assumes that VC’s $10 million investment is enough to fund the the fund to enough is investment million $10 VC’s that assumes example above The The venture capital method provides anadvantage over a DCF analysis by reducing The following exampleprovides a simplified look at valuing a startup with the M K Example the pursue to ability TechCo’s and product TechCo’s for market the of analysis detailed a determinations: following the made VC opportunity, If VC decides to make the $10 million investment, it will want to receive an ownership stake stake ownership an receive to want will it investment, million $10 the make to decides VC If fourteen to million) million/$87.8 ($10 percent eleven least at of range the in TechCo in million). million/$73.2 ($10 percent x x x x C Y RCUTT RCUTT 107. 107. D 2020] 2020] O startup through its exit. If additional funding is necessary to achieve the exit event, the the event, exit the achieve to necessary is funding additional If exit. its through startup dilution ownership the for account must they because complicated more get calculations experience. would VC that

venture capital method. method. capital venture 42208-tul_55-3 Sheet No. 71 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 71 42208-tul_55-3 42208-tul_55-3 Sheet No. 71 Side B 05/15/2020 10:30:18 M K For For C Y 114 ail. The model 108 urn and lose their their lose and urn [Vol. 55:469 55:469 [Vol. 115 A LAW REVIEW A LAW S e Capital Method Method Capital e ) 5/14/2020) 9:45 AM The more confidence the analyst has in the startup usually assumes a moderate performance level. There There level. performance moderate a assumes usually Stated more frankly, the chosen discount rate may be be may rate discount chosen the frankly, more Stated ur is usually the same as the venture capital method’s exit exit method’s capital venture the as same the usually is 109 TUL usually assumes a worst-case scenario. Not only does the the does only Not scenario. worst-case a assumes usually ELETE 110 D note 15, at 368. 368. at 15, note 369. at 15, note 111 OT OT a a r r N 113 p p O u u s s (D , , LISS LISS &B &B iation of the Vent the of iation UBLISHER 112 r P sideways scenario success scenario success failure scenario scenario failure MITH MITH MITH FOR FOR a. Va example, investors might recoup some or all their invested capital and possibly possibly and capital invested their all or some recoup might investors example, return. additional a modest receive even invested capital. invested startup failachieve to an exit event,investors receive noret The The The event. isno successful exit event, but the startupnot does completely f ,S ,S at 369. 369. at MITH MITH ee id. x x x J - FINAL S The venture capital method also presents an optimism bias challenge. bias optimism an presents also method capital venture The S The accounts for each scenario by assigning it a probability probability a it assigning by scenario each for accounts method Chicago First The The First Chicago method is a variation of the venture capital method that seeks to to seeks that method capital venture the of variation a is method Chicago First The 4. First Chicago Method . Id.. Id.. Id.. . Id.. Id.. . RCUTT RCUTT 109 110 111 112 114 115 113 projects a single, positive future event—the startup achieving an exit event—even though though event—even exit an achieving startup event—the future positive a single, projects reaching its exit event, the lower the discount rate. The less confidence the analyst has, the the has, analyst the confidence less The rate. discount the lower the event, exit its reaching the to importance critical rate’s discount the despite However, rate. discount the higher the guide to and experience” “intuition than more little often is there analysis, valuation analyst’s discount-rate decision. 108. 108. S the profit projection period. With a DCF analysis, the analyst must project the company’s company’s the project must analyst the analysis, a DCF With period. projection profit the free cashin flows perpetuity. When usingthe venture is capital (which method, year the analyst exit need anticipated the for ratio) earnings an (assuming profits project only analyst the shorter, is period projection the While future). the in years seven to three often the has still analyst the means that startups, young For model. profit a build still must uncertain. highly be to likely are profits future when model profit a building of challenge young defines which sales, reliable without companies for projections profit Developing shortened. is period projection the when even task difficult inherently an is startups, 496 496 O little more than guesswork. guesswork. than more little weight. The investor must conduct a valuation for each scenario and assign a probability probability a assign and scenario each for a valuation conduct must investor The weight. that event may not occur. Recall that most young startups fail and never achieve a achieve never and fail startups young most that Recall occur. not may event that for tool primary the is return) rate of target rate (or discount The exit. successful bias. optimism the counteracting reduce the optimism bias. Rather than forecast one possible scenarios: outcome, three the forecasts venture capitaliteration common A scenarios. multiple forecasts method sideways. and failure, success, 42208-tul_55-3 Sheet No. 71 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 71 42208-tul_55-3 42208-tul_55-3 Sheet No. 72 Side A 05/15/2020 10:30:18 497 497 $0 Weighted Value Value Weighted ଷ $5 million to to $10 million $5 million $54 million to $64.8 million million $64.8 to $54 million $59 million to $74.8 million million $74.8 to $59 million ͳǤͳ͹ AVOIDABLY DIFFICULT N 50% 50% 30% 30% 20% U ͷͻ݈݈݉݅݅݋݊ݐ݋̈́͹ͶǤͺ݈݈݉݅݅݋݊̈́ S I Probability Probability ൌ S ௡ note 69, at 67–87. 67–87. at 69, note a ) 5/14/2020) 9:49 AM r ܹܸ p u s TARTUP ሺͳ ൅ ݎሻ ELETE , S D ൌ ̈́͵͸Ǥͺ݈݈݉݅݅݋݊ݐ݋̈́Ͷ͸Ǥ͹݈݈݉݅݅݋݊ G OT OT EMUS N N $0 O million million Total weighted value value weighted Total million of funding to reach an exit event, which will take place in in place take will which event, exit an reach to funding of million &R (D The First Chicago method forces the analyst to break the valuation valuation the break to analyst the forces method Chicago First The $216 million $216 million $180 million to to $180 million 116 discount rate discount G YOU G Expected Value Value Expected weighted value the period when the scenarios are valued $10 million to $20 $20 to $10 million RCUTT N = = = UBLISHER P ,O  ݐݒ݈ܽݑ݁ ൌ݊݁ݏ݁ݎܲ FOR FOR VALUI : VC is once again considering whether to invest in TechCo. VC estimates that that estimates VC TechCo. in invest to whether : considering again once is VC URPHY WV r n M ee where J - FINAL S As noted earlier, a major drawback of the venture capital method is its focus on a a on focus its is method capital venture the of drawback major a earlier, noted As M K . If VC decides to make the $10 million investment, it will want to receive an ownership stake stake ownership an receive to want will it investment, million $10 the make to twenty- decides to VC If million) million/$46.7 ($10 percent twenty-one least at of range the in TechCo in million). million/$36.8 ($10 percent seven TechCo will need $10 $10 need will TechCo three years. Followingdetaileda analysis future) the of the in market years for three TechCo’s(each product scenarios three and TechCo’s valued VC opportunity, the pursue to ability probabilities. them and assigned Example C Y Success scenario Failure scenario Sideways scenario RCUTT RCUTT 116 to its occurrence.The venture capital method can usedbe investment, to determineof loss the a total success involves scenario failure the anticipates investor the If scenario. thenit can valued be $0. at Finally, the sideways scenario can valued be several different method, capital venture the or valuation, relative a analysis, DCF a with including ways, the how shows example following The inputs. model less-optimistic assuming but works. weighting probability 2020] 2020] O single, uncertain event. The analyst must then use a discount rate that is often quite high quite often is that rate discount a use then must analyst The event. uncertain single, about information useful aggregates then rate discount The uncertainty. the for account to various to prey fall can which number, single a in it hides and outcomes future potential the biases andproblems. problem into its individual parts and expressly analyze each factor. This method accounts accounts method This each factor. analyze expressly and parts individual its into problem a As outcome. possible a single only forecasts analyst the if than uncertainty more for Chicago First the employing when rate discount lower a use should analysts result, be should component risk the since method, capital venture the to compared method, smaller. 42208-tul_55-3 Sheet No. 72 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 72 42208-tul_55-3 42208-tul_55-3 Sheet No. 72 Side B 05/15/2020 10:30:18 M K C Y ps ps u t r ta S ng ng u ing Yo ing u [Vol. 55:469 55:469 [Vol. Val r requires building a young startup’s profit profit startup’s young a building requires requires building a similar profit model as as model profit a similar building requires A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM requires comparing the young startup’s performance to to performance startup’s young the comparing requires age Investment Investment age TUL ELETE D ur 117 requires building the young startup’s profit model in in model profit startup’s young the building requires OT OT N O (D UBLISHER st Chicago Method Challenges fo Challenges Method Chicago st P r FOR FOR b. Fi A ten, be analysis may DCF which reached, is period growth stable the until (or perpetuity the from, start to record track a Without future). the into years more or twenty, requires also analysis DCF A guesswork. than more little be may forecasts such guides normally that data the without but premium, risk the estimating companies. public for analysis A relative valuation lack startup’s young The transactions. comparable or companies comparable ratio the run to needed of operating data performancemeans thereare few, if any, meaningful performance comparables. the lacks startup young the Moreover, analysis. A venture capital method analysis analysis method capital venture A a requires This value. exit its determining for exit its of time the at model a profit building requires still but analysis, a DCF for than model profit shorter rate. discount a with up coming and model A First Chicago method analysis analysis method Chicago First A more for account to analyst the allows but method capital venture the for the as problems forecasting same the from suffers It outcomes. potential at 8. at ation Challenges Disco Challenges ation x x x x u J - FINAL A valuation model’s accuracy depends on the quality of its data. If the collected collected the If data. its of quality the on depends accuracy model’s valuation A The First Chicago method requires building a similar profit model to the venture venture the to model profit similar a building requires method Chicago First The Left unaddressed, the young-startup valuation challenge discourages investment. If If investment. discourages challenge valuation young-startup the unaddressed, Left a three- is analysis valuation every of foundation the used, is method what matter No (1) information; Collect and (2)model; valid economically an through information the Run (3) Interpret the results. . Id. RCUTT RCUTT 117 informationguesswork, is then is too the so valuationresult. the In caseyoung of startups, valuation robust run to necessary data the lack they means history operating of lack their always will startups young valuing uncertainty, extreme their with coupled When analyses. be unavoidably difficult. 498 498 O capital method. The venture capital method forecasting challenges apply equally to the the to equally apply challenges forecasting method capital venture The method. capital more for account to analysts allow does method Chicago First The method. Chicago First most the if However, easier. exercise model-building the make can which uncertainty, useful a generate to struggles still analysis the guesswork, largely remains data important result. D. Val rational investors cannot confidently value a company, they are less likely to invest. invest. to likely less are they a company, value confidently cannot investors rational Because entrepreneurs few have enoughresources to self-finance young-startup less their startups through formations, startup fewer to leads capital investment less profitability, failures. young-startup more and growth, step process:

42208-tul_55-3 Sheet No. 72 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 72 42208-tul_55-3 42208-tul_55-3 Sheet No. 73 Side A 05/15/2020 10:30:18 . - RIV UNDS UNDS F ENTURE P V , 6 J. P -U TATE OF THE S EFERRED 499 499 TART AND D , HE S T in , Investors can demand ATCHING NVESTORS I Why were Specialized Specialized were Why :M 122 ends and Developments and ends r Investors can simply choose HALLENGE WITH C NVESTING NDIVIDUAL NDIVIDUAL I ,I Investors can make their investment As venture capital firms exitedthe et: Recent T Recent et: NGEL 120 AVOIDABLY DIFFICULT rk ,A N ALUATION e Capital: The Decade Ahead Decade The e Capital: U NSTRUMENTS S V I ur I S OBINSON NTREPRENEURS Vent E e Capital Ma J. R ur QUITY QUITY ) 5/14/2020) 9:49 AM TARTUP E -S Angels enabled startups to grow to a point where they they where point a to grow to startups enabled Angels OBERT OBERT TARTUP ELETE S UIDE FOR FOR UIDE D 121 G &R G OT OT OUNG N N HE Y O . and Vent . Angel (D —T S 402, 421 (Donald L. Sexton & John D. Kasarda eds., 1992). 1992). eds., D. John Kasarda & Sexton L. 421 (Donald 402, G YOU G SNABRUGGE note 26, at 8. The U. O N a The shift was not a temporary trend, but instead reflected a systematic systematic a reflected instead but trend, temporary a not was shift The UBLISHER r P p AN AN OMPANIES note 3, at 23. at 3, note u V 119 s C a , r FOR FOR P p VALUI Beginning in the late 1980s, they largely abandoned early investing and shifted shifted and investing early abandoned largely they 1980s, late the in Beginning u bargain-basement the justify to well that all prices perform when to need investing. not do companies Investors portfolio their demandthat such low prices could they since approach, this resist to likely are Entrepreneurs investment. company. the away giving as it view notto invest in young startups. venture capital method. method. capital venture high a creates approach an Such analysis. speculative highly on based decisions likelihood of investors overpaying for theirinvestments. Scenario 1—Throw caution to the wind. wind. the to caution 1—Throw Scenario startups. young in investing 3—Avoid Scenario Scenario 2—Only invest at bargain-basement prices. prices. bargain-basement at invest 2—Only Scenario ARK s -U 49–52 (2000). 49–52 (2000). VERCOMING THE 118 ; M NTREPRENEURSHIP ANDLER x x x 7, 13 (2003). E TART J - FINAL Priced equity transactions dominated the startup funding model until the mid-2000s. the until model funding startup the dominated transactions equity Priced Until the mid-2000s, scenario 3 was frequently the choice for Specialized Startup Startup Specialized for the choice frequently 3 was scenario mid-2000s, the Until The young-startup valuation challenge is not a mere nuisance. It is a much more more a much is It nuisance. mere a not is challenge valuation young-startup The S M K . Id.. C Y III. O III. RT OF OF RT APITALISTS QUITY RCUTT RCUTT 119 Entrepreneurs, friends and family, angels, and venture capital firms have traditionally traditionally have firms capital venture and angels, family, and friends Entrepreneurs, 122. 122. Sohl, seed investing market, angels filled the role. During the 1990s, angels and venture capital capital venture and angels 1990s, the During role. the filled angels market, investing seed firms operateda complimentary in relationship, wherethe angels provided “a kind ‘farm of portfolios.’” venture of system 120. Jeffrey E. Sohl, Sohl, E. 120. Jeffrey E Investors. Through much of the 1980s, venture capital firms actively invested in young in invested young actively firms capital 1980s, the venture of much Through Investors. startups. A serious and fundamental challenge that does not lend itself to easy fixes. This article spent spent article This fixes. easy to itself lend not does that challenge fundamental and serious problem. this demonstrate to startups for analysis valuation fundamental explaining time are they if However, impressive. look that startups young for built be can models Yes, Using decisions. investment guiding for useful very not are they data, fanciful on built several creates decisions investment make to analyses valuation highly-speculative optimal. is which of scenarios—none investing 118. S C WITH WITH 2020] 2020] O changethe in venture way capital firms operated. 121. J. Timmons Sapienza, & Harry A. Jeffrey could attract venture capital interest. However, angel investors also began migrating from from migrating began also investors angel However, interest. capital venture attract could 2000s. early the during rounds later to rounds financing earlier Startup Investors leaving the young-startup investment market? An inability to confidently confidently to inability An market? investment young-startup the leaving Investors Startup could investors these If factor. a significant likely was opportunities investment the value migration. mass the for reason no been have would there deals, price accurately to later stages. later to 42208-tul_55-3 Sheet No. 73 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 73 42208-tul_55-3 42208-tul_55-3 Sheet No. 73 Side B 05/15/2020 10:30:18 EW EW 123 M K N C Y control control . 1405, 1407 1405, . 127 REATES that limit limit that C EV 124 .L.R APITAL note 125, at 41–59. 41–59. at 125, note C AND a r p u s , , 61 V , s ENTURE r V ERNER OW [Vol. 55:469 55:469 [Vol. &L :H OMPERS OMPERS of Angel Investo Angel of r NVENTION I All companies present investors these with 125 Staging provides venture capital firms with improved access improved with firms capital venture provides Staging A LAW REVIEW A LAW ONEY OF OF ONEY S ) 5/14/2020) 9:45 AM zzling Behavio zzling , M u TUL ELETE D o) P o) S ERNER OT OT L Stagingallows venturereplace capital firms to projectionsaboutthe startup receive liquidation preferences andother downside economic ot N N If the startup’stheir managers company, more want money for they better work O 128 OSH (D note 124, at 1407, 1411–16; G 1411–16; 1407, at 124, note a The ( &J r p u s UBLISHER P OMPERS OMPERS and incentivize the startup managers to run their companies companies run their to managers startup the incentivize and FOR FOR 130 129 A. G receive board representation. representation. board receive Creates incentives. hard and meet the targeted milestones. with facts. likely will firm capital venture the since Reduces information particularly asymmetries.information, confidential most startup’s the to Reduces uncertainty. Reduces This strategy allows venture capital firms to stage their investments, their stage to firms capital venture allows strategy This 23 (2001). 23 (2001). AUL AUL J - FINAL Even under the traditional funding model, many startup investors have learned to to learned have investors startup many model, funding traditional the under Even 126 x x x illion, which is calculated as the post-money valuation minus the investment. EALTH RCUTT RCUTT them a junior right to the residual. Because preferred stockholders collect their share of the residual first, first, residual the of share their collect stockholders preferred Because residual. the to right junior a them management must generate excess profits that exceed the liquidation residual.preference before having any right to the 128. Venture capital firms obtain substantial control over their portfolio companies. This control generally generally control This companies. portfolio their over control 128. substantial obtain firms rights). capital voting Venture class (e.g., rights voting special and seats board receiving from stems 129. stock. common over preference a liquidation has stock Preferred having before reach must management that bar 130. a tangible sets preference liquidation the example, For any right to the startup’s future profits. The startup’s managers typically own common stock, which provides

problems, but startupsarean extreme case. Venture capital firms mitigate the preferred problems by convertible receiving on heavily relies that strategy a contract employing stock. 126. Ibrahim (2008), (2008), 126. Ibrahim their portfolio companies, portfolio their investors’ willingness to commit funds. commit to willingness investors’ (2008) [hereinafter Ibrahim (2008)] (“Start-up investments are rife with uncertainty, information asymmetry, and asymmetry, information uncertainty, with rife are investments (“Start-up (2008)] Ibrahim [hereinafter (2008) potentialagency coststhein form potential of opportunismentrepreneurs.”). by 125. P protections, W financed startups by buying stock. When investors purchase stock, they buy a percentage a percentage buy they stock, purchase investors When stock. buying by startups financed company. the for valuation pre-money a on agreeing requires first which startup, the of Both value. a and “post-money” a “pre-money” between 123. difference the understand should Readers is valuation its pre-money However, percent). $5 (or million/twenty-five is $20 million valuation” “post-money 500 500 O successfully. tailor their investment contracts to address various startup investing challenges. Venture Venture challenges. investing startup various address to contracts investment their tailor capital firmsandtheir use convertible of preferred stock offers the classic example. are investments Startup difficult. mature—is or young in startups—whether Investing problems agency and asymmetry, information uncertainty, by plagued If an investor wants to buy ten percent of a startup for $1 million, it must first determine determine first must it million, $1 for a startup of percent ten buy to wants investor an If young-startup the to susceptible are rounds equity Priced million. $9 worth is startup the valuation challenge because investments shouldnot take place if the parties cannotagree deferred- using began Investors Startup Specialized mid-2000s, the In valuation. the on problem. this overcome to instruments equity 127. Venture capital firms usually stage their investments. Rather than fully fund the startup up front, they they front, up startup the fund fully than Rather investments. a milestone. their to 127. stage startup usually the firms finance to capital meant is financing capital Each rounds. venture the multiple over funding milestone, the partial meet to provide it fails If funding. more receives it milestone, the achieves startup the If firm can abandon the investment. Staging helps reduce the uncertaintywhile and also information creating asymmetry an incentive problems, for management to do good work. before an investment round, while post-money valuation is company’s valuation after the investment. Assume investment. the after valuation is company’s valuation post-money while round, an investment before The company’s $5 million. a for in company ownership percent twenty-five representing stock buys investor an $15 m 124. Ibrahim, M. Darian measure a company’s value, but they do so at different times. Pre-money valuation is a company’s valuation 42208-tul_55-3 Sheet No. 73 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 73 42208-tul_55-3 42208-tul_55-3 Sheet No. 74 Side A 05/15/2020 10:30:18 note note a r Victoria p u 2015, and and 2015, s ee S at 1171 1171 at 10 (July 10, 10 (July Convertible Convertible 501 501 Id. Nevertheless, Nevertheless, OOK illion in 135 . 1 (Dec. 2018), 2018), 1 (Dec. . B 134 ORP ITCH .C , P NS I 2016, $48.0 b $48.0 2016, ONITOR M EPOSIT EPOSIT illion in .D . 1169, 1173 (2010). Ibrahim explains: explains: Ibrahim (2010). 1173 . 1169, ENTURE ENTURE ED EV AVOIDABLY DIFFICULT , F N .L.R U 2017, $46.2 b $46.2 2017, LL S I -NVCA V URVEY I S S note 15, at 52. 15, note a illion in r p u , 2010 U. s ) 5/14/2020) 9:49 AM , ITCHBOOK ENDING ENDING L TARTUP ELETE LISS S D e Capital G &B OT OT Young startups, however, are not built for such traditional traditional such for built not are however, startups, Young 2018, $46.5 b $46.5 2018, Revenue-based loans (also referred to as “royalty financing”) are a form of N N ur O 132 USINESS USINESS ., 2Q 2019 P (D MITH MITH B ,S Select lenders, such as specialty banks and venture debt firms, Bernthal, Bernthal, firms, debt venture and banks as specialty such lenders, Select illion in G YOU G N MITH MALL MALL Id. UBLISHER Debt as as Vent Debt S otes otes P N ally ARHUNI ET AL FOR FOR r 2014. 2014. Venture debt does not mean debt from angel investors or VCs that is commonly converted converted commonly is that VCs or investors angel from debt mean not does debt Venture of point the to developed have that start-ups to loans mean debt venture does nor equity; to attractivenesstraditional to lenders. Instead, back.” it venture paying of means debtas traditional defined no have that here isloansstart-ups to early rapid-growth stage, (footnote omitted). omitted). (footnote T VALUI FDIC S Venture debt. 8, at 798, provide traditional loans to startups that have obtained venture capital funding. Darian M. Darian funding. capital venture obtained have that startups to loans traditional provide 798, at 8, Ibrahim, Revenue-based loans. Revenue-based debt. In exchange for a loan, the startup promises to pay the lenderrevenues. a percentage In other of defined,words, the future startup commits to paying a royalty until the loan is repaid. tible tible r The US startup market would not be what it is today without the convertible- the without today is it what be not would market startup US The IZAR IZAR andarelargely excluded fromthe small-business-lending market. ee gene J - FINAL 2018 Venture capital firms’ convertiblepreferred stock contractstrategy has been Deferred-equity instruments do address the young-startup valuation challenge. challenge. valuation young-startup the address do instruments Deferred-equity Convertiblenotes, safes, and the KISSare all contractual instruments.This means Traditional debt instruments, such as standard bank loans, are a primary funding tool tool funding a primary are loans, bank standard as such instruments, debt Traditional S illion in x x 131 M K 133 . . C Y RCUTT RCUTT 132 134

thereare debta few instruments that startups canto use fund their growth. https://www.fdic.gov/bank/historical/sbls/full-survey.pdf (“The survival and growth of small businesses depends depends businesses small of growth and survival (“The https://www.fdic.gov/bank/historical/sbls/full-survey.pdf incredibly successful. It allows venture capital firms and other professional startup startup professional other and firms capital venture allows It successful. incredibly each dollars of billions of tens invest thoughtfully to syndicates) angel as (such investors year. 131. N 2020] 2020] O debt 135. In additional to convertible notes, other startup debt instruments include venture debt and revenue-based revenue-based and debt venture include instruments debt 135. startup other notes, convertible to additional In loans. Convertible notes, safes and the KISS allow investors to thoughtfully invest in young young in invest thoughtfully to investors allow KISS the and safes notes, Convertible determine rounds funding Future investment. of time the at them valuing without startups investors point, that At history. operating an has and mature more is startup the when value premium. risk and performance future startup’s the estimate better can provides III Part substantially. potentially and them, modify can investors and issuers that generala description the of different instruments as they are the used to the intraditional contribution startup positive a are versions” “classic these why explains and market in 2016, CF Regulation of promulgation the with However, market. startup traditional from capital raise to instruments deferred-equity using began also issuers crowdfunding differs often interests deferred-equity of version” “crowdfunding The public. general the from the classic version,and those differences are discussedin Part IV. Conve A. preferred-stock strategy. However, for all the problems it mitigates, convertible preferred preferred convertible mitigates, it problems the all for However, strategy. preferred-stock require rounds priced as challenge, valuation young-startup the not address does stock startup. the valuing $44.6 b $44.6 2019), https://pitchbook.com/news/reports/2q-2019-pitchbook-nvca-venture-monitor. Late-stage venture capital capital venture Late-stage https://pitchbook.com/news/reports/2q-2019-pitchbook-nvca-venture-monitor. 2019), b $84.5 totaled investments for livelihood businesses. on access to credit, and banks are the most common source of external credit for small firms.”). firms.”). small for credit external of source common most the are banks and credit, to access on 133. They lack the excess cash flow needed for principal and interest payments and they also generally lack generally also they and payments interest and 133. principal for needed flow cash excess the lack They assets. securable meaningful 42208-tul_55-3 Sheet No. 74 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 74 42208-tul_55-3 42208-tul_55-3 Sheet No. 74 Side B 05/15/2020 10:30:18 It GO 136 137 OST M K Id. P , te Usete C Y u UFF OOLEY t-Up) , H r es ta (Aug. 5, 2015), 2015), 5, (Aug. S ur , C _9295908; Scott Scott _9295908; tage tage (Nov. 21, 2017), 2017), 21, (Nov. S ng Vent u A qualified equity equity qualified A eed- S . 2, 2010), J. (Dec. EAPFUNDER EAPFUNDER Yo T r 141 s Going the Royalty Ro S REATORS , L tible Debt ur r heet ( heet note 6, at 161. However, the earlier earlier the However, 161. 6, at note , C S otes ene a r N ALL r Convertible notes are debt debt are notes Convertible m p r ep r u nancing fo nancing s 142 tible ),andis it oftentheir first external [Vol. 55:469 55:469 [Vol. r , W Ent Young startups commonly use them them use commonly startups Young e Capital — 139 ur ps u 138 note 8, at 804. 8, note GO, https://www.cooleygo.com/convertible-debt/ ”), the entire balance then outstanding under under then outstanding balance the entire ”), t- a r estions: Conve estions: r Loans u Instead, they hope to be repaid with shares repaid shares with be to hope they Instead, p ta k u S

s r OOLEY ote Financing Te Financing ote 143 N nding via Conve via nding , C u ed Q k A LAW REVIEW A LAW iff in Town: Royalty Fi tible r r S Bernthal, ) 5/14/2020) 9:45 AM he Next Financing Next S ew Thing in in Vent Thing ew tible Debt TUL N ELETE www.huffpost.com/entry/theres-a-newold-sheriff-i_b r Conve Upon the Company’s next sale of its preferred stock in a single a single in stock preferred its of sale next Company’s the Upon D e to Pay Bac Pay e to see also also see u ently As OT OT ew-Old ew-Old u N N O eq note 138. 138. note r (D s a F a ’ on Conve r r native Financing Option fo Option Financing native e p r r 4 Benefits of Raising F u at 161–62; 161–62; at s ime r The Id. P Convertible notes are used when a young startup is close to ready for a for a ready to close is startup a young when used are notes Convertible UBLISHER e of Reven e of r P An Alte 140 ha S FOR FOR 4 (2018), https://www.fenwick.com/FenwickDocuments/Convertible-Note-Financing-Term- https://www.wsj.com/articles/SB10001424052748704679204575646940403312602; Cliff Ennico, Ennico, Cliff https://www.wsj.com/articles/SB10001424052748704679204575646940403312602; The Financing: Royalty https://www.creators.com/read/succeeding-in-your-business/11/17/royalty-financing-the-new- thing-in-venture-capital. Silchenko, https:// 22, 2017), (Feb. Austin, a at 3(“[I]nvestorsat in convertible note financingsgenerally not will permit prepayment, a since EXIS EXIS J - FINAL Convertible notes are short-term loans (e.g., one to three years) that convert to equity equity to convert that years) three to one (e.g., loans short-term are notes Convertible 1. Automatic Conversion if a Qualified Equity Financing Occurs Occurs Financing Equity Qualified a if Conversion Automatic 1. N transaction or in a series of related transactions, in each case occurring on or before the Maturity Date, Maturity the before or on occurring case in each transactions, related of a series in or transaction foranaggregate on gross owing purchaseamounts other any price or paid interest toaccrued the Companyand of amount ofnoless than principal the [One Million(excluding Dollars ($1,000,000)] “ (the sale) such in converted Notes all each Note shall automatically be cancelled and converted into shares of the Company’s capital stock. stock. capital the Company’s of shares into converted and cancelled be automatically shall Note each Conversion in Next Financing. . Id. . . Id.. EXIS RCUTT RCUTT 141 143 Kristine M. Di Bacco & Doug Sharp, L to raise modest sums (e.g., $500,000 to $1.25 million $1.25 to $500,000 (e.g., sums modest raise to https://www.cooleygo.com/frequently-asked-questions-convertible-debt/ (last visited Feb. 22, 2020) [hereinafter [hereinafter 2020) 22, Feb. visited (last https://www.cooleygo.com/frequently-asked-questions-convertible-debt/ Werner—FAQs]. 140. Werner—Primer, meaningful venture-capital equity round. round. equity venture-capital meaningful 142. Here is the automatic conversion provision from a form term sheet posted by Fenwick & West LLP: West & Fenwick by posted sheet term a form 142. from provision conversion automatic the is Here https://www.leapfunder.com/blog/article/benefits-of-convertible-notes (“Convertible notes are financial are financial notes (“Convertible https://www.leapfunder.com/blog/article/benefits-of-convertible-notes years.”). for scene start-up the of heart the at been have which products 139. Peter Werner, (last visited Feb. 22, 2020) [hereinafter Werner—Primer] (“Many early stage companies use convertible debt for debt convertible use companies stage early (“Many Werner—Primer] 2020) [hereinafter 22, Feb. visited (last initialtheir fundraising.”); notesare one suchdebt option, and theonly meaningful debtoption for young startups. 502 502 O funding round. funding

in a few scenarios. The standard scenario calls for automatic conversion if the startup startup the if conversion automatic for calls scenario standard The scenarios. a few in mature. notes the before financing equity qualified a conducts 136. eligible are They not loans. revenue-based or debt venture for eligible not are generally startups Young for venture debt becausethey are not yet mature enoughtohave pre-existing venture capitalinvestors.are not eligible And they for revenue-based loans becausethey are largely pre-revenuecompanies. 137. (2014), Green & Coyle 2005. to prior existed notes Convertible versions were for classic bridge financings and were not specifically tailored for young-startup financings. financings. young-startup for tailored specifically not were and financings bridge classic for were versions 138. 138. Werner, Peter instruments,meaning the startup cash—in mustrepay with the principal repaid and be pay interest. to look However, not do investors note convertible debt, traditional unlike prepayments. prohibit should notes the fact, Sheet-Seed-Stage-Startup.pdf [hereinafter Sample Convertible Note Term Sheet]. Sheet]. Term Note Convertible Sample [hereinafter Sheet-Seed-Stage-Startup.pdf Convertible notes started becoming a popular option for seed investors around 2005, around investors seed for option popular a becoming started notes Convertible financing. seed for a staple become since have and financing is often definedas a priced round of preferred stock thatmeets a certain raised). cash new size of million $1 as (such threshold was around 2005 that convertible notes were modified to resemble their current form and began to be used to for be used and began form their current resemble to modified were notes convertible 2005 that around was financings. standalone 42208-tul_55-3 Sheet No. 74 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 74 42208-tul_55-3 42208-tul_55-3 Sheet No. 75 Side A 05/15/2020 10:30:18 ., TR note note a r Wanted Wanted p r .C u What Is a Is What s Eve DUC u 503 503 (Apr. 7, 2012), 2012), 7, (Apr. (Oct. 27, 2017), 2017), 27, (Oct. (Oct. 3, 2018), 2018), 3, (Oct. :E LOG B RUNCH LUB ything Yo ything C r C UNDERA ECH Eve 146 Werner—Primer, NVEST , F I ,T ) UNDERS k EED , S s ,F see also also see r rk aid to As to aid Financing? To complete the example, assume assume example, the complete To ime r r r 145 AVOIDABLY DIFFICULT e Af r N U t We otes P otes S A simple example is helpful for illustrating illustrating for helpful is example simple A u N I e Them fo e Them u S ccessful venture. Convertiblenotes give young 144 p Iss tible tible u ) 5/14/2020) 9:49 AM t r r Examples and How It Wo Examples If, prior to the Maturity Date, TechCo consummates a a consummates TechCo Date, Maturity the to prior If, ta note 6, at 158–61. at 158–61. 6, note TARTUP — S ELETE a S

D r Conve ote p ur $500,000. $500,000. G — N eed Financings (B Financings eed OT OT u s S N N O otes The notes carry an interest rate of five percent per year. Unpaid Unpaid year. per percent five of rate interest an carry notes The tible ote ote (D ld Yo N r u N ho The notes mature in eighteen months (the “Maturity Date”) unless repaid repaid unless Date”) “Maturity (the months eighteen in mature notes The S G YOU G tible Conve N r tible tible UBLISHER r P FOR FOR ote and and ote t Conve t VALUI : TechCo issued convertible notes to a group of angels. Here are the key terms: terms: key the are Here angels. of group a to notes convertible issued TechCo : Principal amount: amount: Principal Maturity: Maturity: or converted earlier. earlier. converted or Interest rate: rate: Interest principal. the to added is interest Automatic conversion: conversion: Automatic convertiblepreferred stock financing of at least $1 million,then stock. theprincipalpreferred convertible the plus of shares into converts automatically interest unpaid u N Coyle & Green (2014), (2014), & Green Coyle ee Conve ee x x x x J - FINAL What if the notes mature without a conversion having occurred? Notes can address address can Notes occurred? having conversion a without mature notes the if What Assume TechConeeds cover to money the manufacturing forcosts newly its S S Another common scenario is for the startup to be bought before a qualified equity equity a qualified before bought be to startup the for is scenario common Another tible 3. Notes Reach Maturity Maturity Reach Notes 3. 2. Change of Control Control of Change 2. r M K . . Example C Y RCUTT RCUTT 145 146

fromhigh-qualitya future stock offering. https://fundersclub.com/learn/convertible-notes/convertible-notes-overview/convertible-note-acquisition- 2020). 22, Feb. visited (last merger/ prepaymentcould prevent them from convertingthe noteina financing, mergerasset or sale.”). 2020] 2020] O https://www.seedinvest.com/blog/startup-investing/how-convertible-notes-work; Meredith Turits, Turits, Meredith https://www.seedinvest.com/blog/startup-investing/how-convertible-notes-work; Conve startups more runway to achieve important milestones, such as meaningful sales, that make make that sales, meaningful as such milestones, important achieve to runway more startups attractive. and feasible more rounds equity priced developed product. Without the $500,000, TechCo could not produce and sell its product, product, its sell and produce not could TechCo $500,000, the Without product. developed additional with TechCo provides money the Obtaining down. shut to have soon would and su a be can it prove to resources and time https://www.fundera.com/blog/what-is-a-convertible-note; Scott Edward Walker, Walker, Edward Scott https://www.fundera.com/blog/what-is-a-convertible-note; to Know Abo TechCo conducted a qualified equity financing after twelve months. TechCo raised $3 $3 raised TechCo months. twelve after financing equity qualified a conducted TechCo $1 a into translated that valuation pre-money million $10 a at round A Series a in million price per share. After one year, the outstandingprincipal plus interest for thenotes would $525,000 the financing, equity a qualified consummated TechCo $525,000. Because be receive will holders Note stock. preferred convertible A Series into converts automatically $525,000/$1). (or shares 525,000 financing occurs. The notes should include a provision allowing for the note holders to to holders note the for allowing provision a include should notes The occurs. financing of option the have may holders example, For transaction. control of a change from benefit original the of percent 100 (e.g., premium a plus repayment immediate demanding (a) conversion at a pre-set stock common to notes their converting (b) or balance) principal consummated. is transaction control of change the before just rate https://techcrunch.com/2012/04/07/convertible-note-seed-financings/; https://techcrunch.com/2012/04/07/convertible-note-seed-financings/; 138. 138. the automatic conversion. conversion. automatic the 144. 144. Kellner, Aaron 42208-tul_55-3 Sheet No. 75 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 75 42208-tul_55-3 42208-tul_55-3 Sheet No. 75 Side B 05/15/2020 10:30:18 eed LOG M K S B C Y vey 2012: vey 2012: 152 Sur 2012 APSHARE , C ms r If thenotes include a eed Financing eed Financing ote Te ote S LLP (Mar. 25, 2013), 2013), 25, (Mar. LLP N 151 Therefore, note holders EST 150 tible r &W [Vol. 55:469 55:469 [Vol. otes: Conve otes: N ENWICK ENWICK tible , F r ies r st u A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM Barry J.Barry Kramer StevenLevine, & S. e Ind TUL ELETE r If the valuation cap is $5 million, but the valuation from from valuation the but million, $5 is cap valuation the If D see alsosee OT OT 153 oftwa N The valuation cap limits the price at which the notes convert convert notes the at which price the limits cap valuation The S The Basics of of Conve Basics The O note 138. 138. note note 138. 138. note note 139. Receiving the option is the superior alternative for investors because it because investors 139.for note alternative is the superior option the Receiving (D a a a r r r p p The discountgrants note holders a price reduction when converting Noteholders receive interest from the notes, but the interest rates p u u u s s s Because startups few have the cashrepay tothe notes, and calling the 149 UBLISHER P 147 ], which found median interest rates on convertible notes of 6.0 percent, 5.5 percent, and 5.5 and percent, 5.5 percent, 6.0 of notes convertible on rates interest median found which ], FOR FOR However, the threat of dissolution hangs over any convertible note deal. deal. note convertible any over hangs dissolution of threat the However, vey Discount. financing. equity qualified the in equity to debt their the qualified equity financing is higher than $5 million, the notes convert at the the at convert notes the million, $5 than higher is financing equity qualified the valuation. million $5 Valuation cap. cap. Valuation would notes convertible the which at value maximum a sets It equity. into convert, “regardless the of actual value agreed the to by issuer and thenew investors.” equity twenty percent discount and the qualified equity financing is priced at $1.00 $1.00 at priced is financing equity qualified the and percent discount twenty per share,thenote holders convert theirnotes to stock at $0.80 per share. Discounts are commonly inthe fifteen to twenty-five percentrange. 148 Hannah Bloomfield, Sur This range assumes the notes also include a valuation cap. Discount rates are likely to be higher in higher be to likely are rates Discount cap. a valuation include also notes the assumes range This ee x x J - FINAL Issuers prefer convertible notes without a discount or valuation cap, but investors investors but cap, valuation or discount a without notes convertible prefer Issuers S The above discussion left out two of the most hotly negotiated issues in most most in issues negotiated hotly most the of two out left discussion above The Id. 4. Discounts and Valuation Caps Caps Valuation and Discounts 4. . Id. . . . Id.. net/Digital Media and Media net/Digital r RCUTT RCUTT 148 150 153 Inte notes could force the startup into bankruptcy and possible dissolution, noteholders noteholders dissolution, possible and bankruptcy into startup the force could notes equity find to time more startup the give and date maturity the extend to agree commonly investors. usually insist on including a discount and a valuation cap in their notes. notes. their in cap valuation a and a discount including on insist usually

are usually too low to compensate for the additional risk. additional the for compensate to low too usually are 147. 147. Werner—FAQs, preventsthe startup from strategically delayinga financing orchange ofcontrol date. transactionmaturity until after the 149. Werner—Primer, this scenario in a few ways. Some notes may call for the issuer to repay immediately the the immediately repay to issuer the for call may notes Some ways. few a in scenario this of option the holders note the give others while notes, the on interest and principal pre-set at a equity into notes the converting or repayment immediate demanding conversion rate. 504 504 O Financing Financing https://www.fenwick.com/publications/Pages/Seed-Finance-Survey-2012.aspx [hereinafter [hereinafter https://www.fenwick.com/publications/Pages/Seed-Finance-Survey-2012.aspx percent in 2010, 2011, and 2012, respectively. respectively. 2012, and 2011, 2010, in percent 151. Werner—Primer, (July 13, 2018), https://www.capshare.com/blog/the-basics-of-convertible-notes-part-1-convertible-note-terms/ 2018), https://www.capshare.com/blog/the-basics-of-convertible-notes-part-1-convertible-note-terms/ 13, (July higher carry can notes Convertible required. (“Convertiblelegally rate notes interest are alowest debt instrument the or zero andto are set legally be will required interest to carrythe interest. However, most of the time rule.”); the not it’s but rates, interest 152. 152. cases where there is novaluation cap. convertible note deals: the discount and the valuation cap. Note holders invest before the the before invest holders stock Note cap. valuation preferred the to and discount the convert deals: note notes convertible the If risk. more assume they so stockholders, preferred for compensated not are they example), TechCo above the in (as adjustment any without risk. additional the 42208-tul_55-3 Sheet No. 75 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 75 42208-tul_55-3 42208-tul_55-3 Sheet No. 76 Side A 05/15/2020 10:30:18 90% 90% 90% 90% 2012 2012 505 505 note 138. note a 82% 82% 83% 83% 2011 2011 r p u s 83% 83% 67% 67% 2010 2010 The note holders convert using using convert holders note The 155 Werner—Primer, AVOIDABLY DIFFICULT N U note 144. 144. note see also also see note 150, which found the following for 2010–12. 2010–12. for following the found which 150, note S a Assume convertible noteholders invested $1 a I r r S p p u u 156 s s , Usually, the discount or the valuation cap applies applies cap valuation the or discount the Usually, ) 5/14/2020) 9:49 AM vey 154 Sur note 6, at 164; 6, note TARTUP ELETE a S D r p G The valuation cap ($6 million) is lower than the actual valuation valuation actual the than lower is million) ($6 cap valuation The OT OT u s N N O The notes have a pre-money valuation cap of $6 million. note 138;note Kellner, The conversion formula calls for the notes to convert at a twenty twenty a at convert to notes the for calls formula conversion The (D a r p eed Financing Financing eed u S The notes will convert at a twenty percent discount to the pre-money pre-money the to discount percent twenty a at convert will notes The s G YOU G N Divide the valuation cap($6 million) the by actual valuation ($10 million), Multiply the preferred stock price ($1) by the Step 1 percentage (sixty (sixty percentage 1 the Step by ($1) price stock preferred the Multiply UBLISHER P FOR FOR VALUI : Considerthe aboveTechCo example,and assume the following additional facts: It raised $25 million from a venture capital syndicate at a $50 million pre- $50 million a at syndicate capital a venture from million $25 raised It owns syndicate capital venture The share. per price $5 a and valuation money Discount: financing. equity qualified the in realized valuation Valuation cap: cap: Valuation The $1 price per share must be reduced by the twenty percent discount (twenty (twenty discount percent the twenty by reduced be must share per price $1 The is share per price –$1 holders’ or note $0.20), is The $1 $0.80. of = percent $0.20 $0.80. Step 1: 1: Step percent. sixty equals which The note holders will receive 656,250 shares (or $525,000/$0.80). (or $525,000/$0.80). shares 656,250 receive will holders note The Step 2: Step $0.60. of share per price adjusted an in results which percent), The note holders will receive 875,000 shares (or $525,000/$0.60). (or $525,000/$0.60). shares 875,000 receive will holders note The eceiveboth protections. Coyle & Green (2014), (2014), & Green Coyle see also 2012 also see ; ee Percentage of deals that convert at a discount to the the next to a at discount convert that deals of Percentage valuation round equity is conversion on valuation which in deals of Percentage capped x x x x x x x x J - FINAL While convertible notes generally defer the need for a valuation analysis, discounts discounts analysis, valuation a for need the defer generally notes convertible While S M K . Id. . Example Recall that TechCo conducted a qualified equity financing after twelve months, raising $3 $3 raising months, twelve after financing equity qualified a conducted TechCo that Recall that valuation pre-money million a $10 at round stock preferred A a Series in million translatedinto a$1 price pershare. The outstanding principalplus interest for the notes was $525,000. calculation: Discount discount. percent ($10 million), so the note holders’ price per share must be adjusted. be must share per price holders’ note the so million), ($10 Valuation cap calculation: calculation: cap Valuation In this case, the valuation cap calculation is more favorable for the note holders, so the notes notes the so holders, note the for favorable more is calculation cap valuation the case, this In cap. valuation the using convert would C Y RCUTT RCUTT 154 156 whichevermethod proves more favorable. when converting the notes to equity, but not both. not but equity, to notes the converting when normally r normally 155. 155. Werner—Primer, 2020] 2020] O and valuation caps partially reintroduce it. As noted above, these provisions try to account account to try provisions these above, noted As it. reintroduce partially caps valuation and relied mostly notes convertible of rate forms Early risk. discount the early-investment with holders’ note the for disappointed often were holders note the However, discounts. on when the startup proved very successful. million in a young startup. The notes carried a five percent interest rate and included a included and rate interest percent five a carried notes The startup. young a in million would startup young the investment, million $1 the for But discount. percent twenty-five to forced been have would and development product its complete to able been have not round. stock preferred A Series a conducted startup the later, year One down. shut 42208-tul_55-3 Sheet No. 76 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 76 42208-tul_55-3 42208-tul_55-3 Sheet No. 76 Side B 05/15/2020 10:30:18 M K C Y [Vol. 55:469 55:469 [Vol. (Jan. 18, 2018), https://medium.com/@taw/valuation- 2018), 18, (Jan. Instead, the parties are more likely to use use to likely more are parties the Instead, 158 EDIUM 280,000 shares of Series A preferred stock (or (or preferred stock A Series of 280,000 shares A LAW REVIEW A LAW , M S ) 5/14/2020) 9:45 AM TUL ELETE D note 6, at 164. 164. 6, at note Andnote the holders protect want to themselves from OT OT ation Caps ation a N r u p O 159 u s Val (D UBLISHER P little of the company if the qualified equity financing generates a favorable favorable a generates financing equity qualified the if company the of little FOR FOR One solution is to run a number of scenarios that allow the issuer and the the and issuer the allow that scenarios of number a run to is solution One , Wilson, Tom 5 million shares of Series A preferred stock, representing roughly 33.3 percent percent 33.3 roughly representing stock, preferred A Series of shares million 5 company. the of The notes’ conversion price would be $1 per share. This comes from dividing dividing from comes This share. $1 per be would price conversion notes’ The or twenty million million/$50 ($10 valuation actual the by cap valuation the that percentage. ($5) by share price stock preferred the multiplying and percent) The startup did not make any principal or interest payments, so the outstanding outstanding the so payments, interest or principal any make not did startup The $1,050,000. was notes the for interest plus principal Thenote holders wouldreceive 1,050,000 shares Series of A preferred stock, company. the of percent 7 almost represents which The note holders receive $1,050,000/$3.75), which represents less than two percent of the company. company. the of percent two than less represents which $1,050,000/$3.75), 160 Consider the outcome if the note holders had obtained a pre-money valuation cap cap valuation pre-money a obtained had holders note the if outcome the Consider ee, e.g. ee, x x x x J - FINAL S Coyle & Green (2014), (2014), Green & Coyle The valuation cap involves a value judgment. The issuer wants to set the valuation valuation the set to wants issuer The judgment. a value involves cap valuation The The note holders are undoubtedly happy the startup succeeded, and their investment investment their and succeeded, startup the happy undoubtedly are holders note The 157 . . Id.. Id.. . RCUTT RCUTT 158 159 160 157 caps-ee7918aa6d13. caps-ee7918aa6d13. 506 506 O

investors to see the potential outcomes as they try to reach an agreement (see Table 2). 2). Table (see agreement an reach to try they as outcomes potential the see to investors of $10 million. million. $10 of informal methods. The issuer wants to avoid the cap being so low that it deters future future deters it that low so being cap the avoid to wants issuer The methods. informal holders note the feel they (because financing equity a qualified into buying from investors arereceiving too much). receiving too valuation. capat high a amount, while Chicago investors First a or DCF wanta a low as amount.(such However,analyses itdoes valuation not appear formal use that investors or issuers decision. this inform to analysis) method was positive. At the same time, they are probably disappointed that they own less than two two than less own they that disappointed probably are they time, same the At positive. was percent the startupof despite theirinvestment beinga condition precedent its to convertible success. for feature a common becoming caps valuation to led outcome of type This debt. 42208-tul_55-3 Sheet No. 76 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 76 42208-tul_55-3 42208-tul_55-3 Sheet No. 77 Side A 05/15/2020 10:30:18 Cap 61.5% 61.5% 77.4% 68.6% 62.5% 47.6% 74.1% 62.5% 78.9% 69.8% 62.5% 47.6% 75.0% 63.2% 80.0% 70.6% 61.5% 61.5% 47.1% 72.7% With the the With Valuation Valuation 507 507 Cap Equity Financing after the Qualified Qualified the after 64.5% 64.5% 83.3% 73.2% 62.5% 47.6% 76.9% 64.5% 83.3% 73.2% 62.5% 47.6% 76.9% 64.5% 83.3% 73.2% 62.5% 62.5% 47.6% 76.9% Valuation Valuation Founders’ %Founders’ Ownership the Without Cap 7.7% 7.7% 9.7% 8.6% 6.3% 4.8% 7.4% 6.3% 7.9% 7.0% 6.3% 4.8% 6.3% 5.3% 6.7% 5.9% 7.7% 7.7% 5.9% 9.1% With the the With Valuation Valuation AVOIDABLY DIFFICULT N U Ownership Ownership S I S Note Holders’ % Holders’ Note Cap Equity Financing Equity 3.2% 3.2% 2.8% 2.4% 6.3% 4.8% 3.8% 3.2% 2.8% 2.4% 6.3% 4.8% 3.8% 3.2% 2.8% 2.4% 6.3% 6.3% 4.8% 3.8% after the Qualified Qualified the after Valuation Valuation Without the the Without ) 5/14/2020) 9:49 AM TARTUP ELETE S D G OT OT N N Amount Amount Invested $5 million $5 million $5 million $5 million $5 million $5 million $5 million $5 million $5 million $5 million $5 million O $10 million $10 million $10 million $10 million $10 million $10 million $10 million $10 million $10 million $10 million $10 million (D G YOU G N UBLISHER Qualified Equity P Valuation Financing Assumptions Assumptions Financing $20 million $20 million $30 million $30 million $10 million $10 million $20 million $20 million $30 million $30 million $10 million $10 million $10 million $20 million $20 million $30 million $30 million $10 million $10 million $20 million Pre-Money Pre-Money FOR FOR VALUI Note holders purchased $1 million of convertible notes that do not accrue interest. interest. accrue not do that notes convertible of million $1 purchased holders Note J - FINAL As noted earlier, venture capital firms use a sophisticated contract strategy involving involving strategy contract sophisticated a use firms capital venture earlier, noted As For investors, the valuation cap analysis is much simpler than what is required for a a for required is what than simpler much is analysis cap valuation the investors, For 5.Rights Control M K Cap x C Y $8 million $8 million $8 million $8 million $8 million $8 million $8 million Valuation Valuation $10 million $10 million $10 million $10 million $12 million $12 million $12 million $12 million $12 million $12 million $10 million $10 million $10 million $10 million RCUTT RCUTT Table 2 Analysis Scenario Cap Valuation Sample Simplified Assumption: priced equity transaction and can be accomplished without performance projections. projections. performance without accomplished be can and transaction equity priced their limit reasonably can investors value, intrinsic investment’s the determine than Rather investment the if table the on leave to willing are they much how determining to analysis 2. Table like tools with accomplished be can which successful, very be to proves convertible preferred stock to reduce uncertainty, information asymmetry, and agency agency and asymmetry, information uncertainty, reduce to stock preferred convertible 2020] 2020] O 42208-tul_55-3 Sheet No. 77 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 77 42208-tul_55-3 42208-tul_55-3 Sheet No. 77 Side B 05/15/2020 10:30:18 M K C Y Part III.B,Part a r inf note 150. The survey found: found: The survey 150. note Moreover, note holders are not not are holders note Moreover, a r [Vol. 55:469 55:469 [Vol. p 162 u 163 s , vey the negotiations can take time and energy energy and time take can negotiations the Sur 166 and, onceagain, increase legal fees.address To 4 (Sept. 2018), https://www.ycombinator.com/documents/ https://www.ycombinator.com/documents/ 2018), 4 (Sept. 169 Id. A LAW REVIEW A LAW S Keepingtrack accrued of interest payments can also ) 5/14/2020) 9:45 AM UIDE G eed Financing Financing eed 167 S Receiving control rights is a focal point of that strategy. strategy. that of point focal a is rights control Receiving TUL ELETE otes otes . D SER N note 6, at 166. 166. 6, at note note 6, at 165. 165. 6, at note 161 U OT OT a a (Aug. 27, 2010, 7:29 PM), https://twitter.com/paulg/status/22319113993. https://twitter.com/paulg/status/22319113993. PM), 7:29 2010, 27, (Aug. N r r p p O u u AFE see 2012 see tible tible s s note 139 (D ] (scroll down the page and select the Safe User Guide link). Guide User Safe the and select page the down (scroll ] r a ,S r WITTER p UIDE u However, the notes’ debt features were not viewed favorably by by favorably viewed not were features debt notes’ the However, s G note 8, at 806. 806. 8, at note note 38. note 144; note UBLISHER and increase legal costs. Finally, convertible notes can trigger state state trigger can notes convertible Finally, costs. legal increase and a a r P r a SER r p 164 p p u u U 168 notes 127–30 and accompanying text. s u OMBINATOR s FOR FOR a The maturity date is often the biggest problem. Convertible notes should only only should notes Convertible problem. biggest the often is date maturity The s , C r p AFE Board seats were granted in 72.5 percent, 70 percent, and 73 percent of preferred stock seed seed stock preferred of 73 percent and 70 percent, percent, 72.5 in granted were seats Board respectively. 2012, and 2011, 2010, in financings in financings seed note convertible of 0 percent and 4 percent, percent, 8.3 in granted seats Board respectively. 2012, and 2011, 2010, u Y 165 natives to Conve to natives ee, e.g. ee, ee s ee r J - FINAL S S S Convertible notes take a different approach to the control issue. Rather than directly directly than Rather issue. control the to approach a different take notes Convertible By 2010, convertible notes had become a crucial financial instrument for funding funding for instrument financial a crucial had become notes 2010, convertible By x x . . . . . “Convertible a 2010 tweet, in announced notes Combinator Y of have the founder Graham, won. Paul RCUTT RCUTT 169 167 161 164 166. 166. Werner—FAQs, be a nuisance a be be used when the young startup and the potential note investors can confidently project confidently can investors note potential the and startup young the used when be development significant need that startups young For soon. round A Series a conducting enough them not give may notes convertible round, A a Series for ready are they before extended, be can dates maturity While time. 168. Coyle & Green (2014), (2014), Green & 168. Coyle everyone. While Y Combinator subsequently switched to safes as its investment instrument of choice, see see choice, of instrument investment its as to safes switched subsequently Y Combinator While shareholders untilnotesthe convert.Therefore, they do notreceive fiduciary duty or other convert. notes their until protections shareholder state and generate significant legal fees. legal significant generate and these concerns, investors and their attorneys developed alternatives to convertible notes. notes. convertible to alternatives developed attorneys their and investors concerns, these many early investors have continued to use convertible notes and made them a mainstream funding instrument instrument funding a mainstream them made and notes convertible use to continued have investors early many startups. young for (2014), Green & 165. Coyle Venture capital firms commonly obtain substantial control over the startup by demanding demanding by startup the over control substantial obtain commonly firms capital Venture notes Convertible investment. their of part as rights voting special and seats board generallynot do provide their holders with such controlrights. deal. note Board seatsconvertible a and partof class voting typically not are rights Every investment so far in this YC batch (and there have been a lot) T has (@paulg), Graham beenPaul done on a convertible note.” problems that plague startups. plague that problems 508 508 O [hereinafter S grant their holders control rights, convertible notes push the startup to conduct a qualified qualified a conduct to startup the push notes convertible rights, control holders their grant equity financing with date sophisticated a firm establishes date investors. maturity notes’ The The investors. note holders sophisticated the to thengiven rights piggyback on the possible risk or financing, equity a qualified conduct must startup the which by subsequent the ensures definition financing equity qualified notes’ andthe bankruptcy, investors areappropriately sophisticatedand will insist on a proper level of controls protections. and B. Alte young-startups. lending regulations that limit flexibility limit that regulations lending 162. 162. Walker, 163. 163. Bernthal, 42208-tul_55-3 Sheet No. 77 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 77 42208-tul_55-3 42208-tul_55-3 Sheet No. 78 Side A 05/15/2020 10:30:18 174 rity date SEC Investor 509 509 Finally, if the the if Finally, 170 . (Mar. 1, 2016), 1, 2016), . (Mar. 177 see also also see EV note 7, which conducted note 8, at 806–09. 806–09. at 8, note a r .R a p r u US p s u s .B ARV , H Thus, in addition to eliminating the 175 AVOIDABLY DIFFICULT N Any priced preferred stock round triggers triggers round stock preferred priced Any U Coyle & Green (2018), (2018), Green & Coyle S 176 I s Really Do r S note 7, at 45–48; Bernthal, Bernthal, 45–48; 7, at note t see see t u Like convertible notes, safes allow investors to to investors allow safes notes, convertible Like a ato r r B p u 173 ) 5/14/2020) 9:49 AM s note 167, 8–13. Y Combinator’s safe forms are available at are available safe Y 8–13. forms Combinator’s 167, note TARTUP ELETE a S D p Accele r u and continuesto be one of themost prestigiousaccelerators note 7, at 46. 7, at note p t G OT OT u r a s N r N ta 172 note 167, at 4. 4. at 167, note p , O S u a s (D r p UIDE u s sions sions G , Y Combinator launched the first accelerator program in Cambridge, Cambridge, in program accelerator first the launched Combinator Y What What r G YOU G N 171 UBLISHER Coyle & Green (2018), (2018), Green & Coyle SER UIDE P U G at 58. at note 10. ally FOR FOR r a note 14. note r SER Id. VALUI a. Conve AFE p a U r S u p u s AFE ee s ee gene ee J - FINAL A safe isinvestment an contractthat convertsto stock a triggering if event, suchas S S S Carolyn Levy, a Y Combinator partner (and lawyer), is credited with inventing the the inventing with credited is lawyer), (and partner Combinator a Y Levy, Carolyn S Safes also typically include a liquidity event provision if the issuer is sold or or sold is issuer the if provision event liquidity a include typically also Safes Safes have comparable conversion mechanisms to those found in convertible notes notes convertible in found those to mechanisms conversion comparable have Safes 1. Safes 1. Safes note 173. 173. note M K . Id...... a r C Y p RCUTT RCUTT 177 173 170 171 175 u defining an “Equity Financing,” which is its version of a qualified equity financing. Y Combinator’s Safe Forms, Safe Combinator’s Y financing. equity a qualified of its version is which Financing,” an “Equity defining s administrativerequirements number that come with the a debt instrument, expands This safesdo not put financing. young equity qualified a conducting for clock the on startups of young startupsthat canthe use instrument. a qualified equity financing, occurs. financing, equity a qualified and seed investors. a survey of startup lawyersmatu a add to “like in the lawyers startup United some that States found survey The and space. Canada finance regarding startup early-stage the in the types of investment contracts they see the SAFE.”to 176. For example, Y Combinator’s version of the safe does not include a minimum size threshold when when threshold size a minimum include not does safe the of 176. version Combinator’s Y example, For https://hbr.org/2016/03/what-startup-accelerators-really-do. https://hbr.org/2016/03/what-startup-accelerators-really-do. The developers’ goal was to preserve the note’s deferred-equity features while eliminating eliminating while features deferred-equity note’s the preserve to was goal developers’ The alternatives. popular two are KISS the and Safes obligations. repayment its first safe in 2013. in safe first 2020] 2020] O 172. 172. Ian Hathaway, acquire stock in a future priced equity round while deferring valuation to that future round. round. future that to valuation deferring while round equity priced a future in stock acquire caps. valuation and discounts contain routinely safes notes, convertible like And However, unlike convertible notes, safes are not debt and do not require repayment. Since Since repayment. require not do and debt not are safes notes, convertible unlike However, before time unlimited startups give generally safes obligation, repayment no is there financing. equity qualified a accomplish to needing company liquidates before a conversion event, safe holders are given a claim on the the on claim a given are holders safe event, a conversion before liquidates company conducts an IPO before a qualified equity financing occurs. The liquidity event provisions provisions event liquidity The occurs. financing equity a qualified before IPO an conducts grant theholders safe theright to stock or cash in those circumstances. an automatic conversion. conversion. automatic an with a qualified equity financing remaining the baseline conversion scenario. If the startup startup the If scenario. conversion baseline the remaining financing equity qualified a with convert automatically safes the round, priced a in stock preferred selling by capital raises threshold size minimum a include not do generally safes However, stock. preferred into financing. equity qualified a defining when https://www.ycombinator.com/documents/ [hereinafter Y Combinator’s Safe Forms]; Forms]; Safe Combinator’s Y [hereinafter https://www.ycombinator.com/documents/ during 2005 during Massachusetts Bulletin, 174. Coyle & Green (2018), (2018), Green & 174. Coyle 42208-tul_55-3 Sheet No. 78 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 78 42208-tul_55-3 42208-tul_55-3 Sheet No. 78 Side B 05/15/2020 10:30:18 M K C Y Safe Safe 3.2% 3.2% 2.8% 2.4% ownership ownership Investor % Investor (Sept. 2018), 2018), (Sept. valuation is $20 $20 is valuation Safe Safe valuation is $15 $15 is valuation Shares Shares The valuation cap 500,000 500,000 500,000 500,000 Investor issued to issued 180 afe afe OMBINATOR e-money 0.5 0.5 0.5 0.5 S safes. rate Safe Safe r money (cap/pre- post-money post-money valuation) p conversion conversion [Vol. 55:469 55:469 [Vol. , Y C safe that alters investors’ valuation valuation investors’ alters that safe e-money e-money r

p shares shares ments Implied founder 10 million 10 million 10 million u 178 illion pre-money valuationcap.TechCo did not issue While the post-money versus pre-money safe safe pre-money versus post-money the While post-money New New 181 share) share) shares shares $1 per investor investor 5 million million 5 (assumes (assumes 10 million A LAW REVIEW A LAW 7.5 million million 7.5 S ) 5/14/2020) 9:45 AM TUL illion ELETE illion illion D ation Caps, and the Post-Money Post-Money the and Caps, ation afe Financing Doc Financing afe OT OT u S N valuation $15 m $20 m The original safes were Post-money O $17.5 m $17.5 (D 179 nts, Val u illion UBLISHER P equity Amount Amount qualified financing $5 million invested in $10 m $7.5 million million $7.5 FOR FOR : Safe The Investor”). (the “Safe an accelerator to of safes round an original issued TechCo Carolyn Levy,Carolyn b. Disco ee illion illion illion J - FINAL S Safes routinely include a discount and valuation cap. The argument for including including for argument The cap. valuation and discount a include routinely Safes a introduced Combinator Y In 2018, A post-money valuation cap gives safe investors more certainty about their future future their about certainty more investors safe gives cap valuation post-money A . Id. . . Id. . Example . valuation $10 m $10 m $10 m Pre-money RCUTT RCUTT 178 180 181 Table A change so long as the post-money valuation exceeds the cap. Assume the same facts as above except the the safes as the above except thefacts cap. same Assume exceeds valuation as the long so post-money change B). Table (see cap valuation post-money a $10 million included for pre-money safes, as well as most convertible notes, is based on the qualified equity equity qualified the on based is notes, convertible most as well as safes, pre-money for agreed valuation company’s ais valuation Pre-money valuation. pre-money financing’s before an investment. Assume an investor stock buys representing twenty-five percent company’s The million. $5 for a in company ownership million (or $5 million/twenty-five percent). However, its However, percent). million/twenty-five $5 (or million If, however, the valuation cap is a post-money cap, the Investor’sSafe ownership percentage in TechCo will not startup’s residual up to the amount they invested. they amount the to up residual startup’s 510 510 O in the qualified equity financing (see Table A). A). Table (see financing equity qualified the in 179. 179. https://www.ycombinator.com/documents/. https://www.ycombinator.com/documents/.

ownership percentage and insulates them from dilution risk from future safe rounds and and rounds safe future from risk dilution from them insulates and percentage ownership financing. equity qualified the of size the million, which is calculated as the post-money valuation minus the investment. investment. the minus valuation post-money the as calculated is which million, any further safe rounds and eventually conducted a qualified equity financing at a $10 million pre-money pre-money a $10 million at financing a equity qualified conducted and eventually rounds safe further any raised is money much how of a function be will TechCo in percentage ownership Investor’s Safe The valuation. Investor purchased $250,000 of safes that included a $5 m included that safes of $250,000 purchased Investor discounts and valuation caps is even stronger for safes than for convertible notes since safe safe since notes convertible for than safes for stronger even is caps valuation and discounts wait to have may and startup the against claim a debt of protection the have not do holders a safe’s determining for analysis valuation The financing. equity a qualified for longer note. a convertible for that to comparable be should cap valuation and/or discount is cap valuation lower and/or discount higher a risk, more carries safe the if Although justified. cap analysis somewhat. analysis cap 42208-tul_55-3 Sheet No. 78 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 78 42208-tul_55-3 42208-tul_55-3 Sheet No. 79 Side A 05/15/2020 10:30:18 Safe Safe 2.4% 2.4% 2.4% 2.4% ownership ownership Investor % Moreover, Moreover, 511 511 . (May 1, 2019), 2019), 1, (May . 184 AW L Safe Safe Shares 375,000 375,000 437,000 500,000 (May 17, 2017), 2017), 17, (May Investor issued to issued ILLS H EDIUM 0.5 0.5 rate Safe Safe 0.667 0.667 0.571 ILICON ILICON , M money it does not change a safe’s a safe’s not change does it (cap/post- valuation) ds conversion conversion , S r AFE 182 S note 182. note p Boa AVOIDABLY DIFFICULT a u r t N shares shares r p Implied founder u 10 million 10 million 10 million ta s U S S I Some Specialized Startup Investors felt they they felt Investors Startup Specialized Some S s Post-Money ’ 183 New New ies A shares shares investor investor r 5 million million 5 ) 5/14/2020) 9:49 AM 10 million per share) share) per 7.5 million million 7.5 e (assumes $1(assumes S note 167, at 1–6 for a discussion of the advantages of the post-money post-money the of advantages the of a discussion 1–6 for at 167, note t Use YC e- TARTUP ’ a ELETE r r S D P p ldn u illion G u illion illion OT OT s , N N ho note 167, at 1–6; Ancer, 1–6; at Ancer, 167, note O S a valuation (D r UIDE $15 m $20 m Post-money ps ps $17.5 m $17.5 p G u u t s otections otections r , r G YOU G ta SER S N U illion UBLISHER UIDE P G AFE equity Why , Ancer, José Amount Amount qualified financing $5 million FOR FOR invested in $10 m ,S $7.5 million million $7.5 SER VALUI c. Less P on the Board before closing their Series A.”). A.”). Series their closing before Board the on U only AFE ee, e.g. ee, ee, e.g. ee, illion illion illion J - FINAL What may be most important about the post-money safe is what it demonstrates demonstrates it what is safe post-money the about important most be may What S S S Safes generally offer holders less protections than convertible notes. Safes are not not are Safes notes. convertible than protections less holders offer generally Safes M K . . . C Y valuation $10 m $10 m $10 m Pre-money RCUTT RCUTT 182 184 183 Table B about Specialized Startup Investors’ strength and sophistication. The post-money post-money The sophistication. and strength Investors’ Startup Specialized about valuation feature is dilution very any pro-investor.absorb to holders) It protects stock common the other safe (and investors founders the from causes subsequentand dilution avoid. Investors Startup Specialized the fundamental features. Both safe versions are deferred-equity instruments that derive their their derive that instruments deferred-equity are versions safe Both features. fundamental requires stock preferred underlying the Valuing issuances. stock future from value with risk associated the and assessing performance operating future the startup’s projecting that defer to investors safe its and startup the allow forms safe both and performance, that determine to required analysis the Finally, financing. equity qualified a future to valuation versions. post-money and pre-money the for comparable is cap valuation the https://austinstartups.com/pre-series-a-startup-boards-a309f1dd533f (“The majority of companies we see have see we companies of majority (“The https://austinstartups.com/pre-series-a-startup-boards-a309f1dd533f

because safes are not debt and do not require repayment, they lack the inherent control control the lack inherent repayment, they require not do and are not debt safes because conduct to startup the push to date maturity no is There notes. convertible with associated to notes the calling potentially of cudgel the there is nor financing, equity a qualified encourage the startup’s management teamtake toadvice. Thisreduced control, when coupled withthe fact young startups sell safes earlier in their cap. life cycle valuation than convertible lower and/or discount higher a justifies often notes, distinction is important for issuers and investors, and issuers for important is distinction were not getting a good enough deal from their safe investments, so they modified the modified they so investments, safe their from enough deal good a not getting were standard formimprove to their dealat the expense the of issuers’ founders. 2020] 2020] O current equity shares, so the default rule is that they do not provide holders with voting voting with holders provide not do they that is rule default the so shares, equity current as such rights, control special investors safe the grant contractually can parties The rights. norm. the be to appear not does that but rights, voting class or seats board https://siliconhillslawyer.com/2019/05/01/startups-shouldnt-use-yc-post-money-safe/, for an explanation of of explanation an for https://siliconhillslawyer.com/2019/05/01/startups-shouldnt-use-yc-post-money-safe/, issuers. to presents safe post-money the disadvantages Founders safe; Josésafe; Ancer, 42208-tul_55-3 Sheet No. 79 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 79 42208-tul_55-3 42208-tul_55-3 Sheet No. 79 Side B 05/15/2020 10:30:18 M K that that C Y If the the If 187 (Sept. 19, 2017), 2017), 19, (Sept. EDIUM When the prospective , M ote N The future cash flows come come flows cash future The tible r [Vol. 55:469 55:469 [Vol. And there is an equity version equity an is there And note 7, at 48. 48. at 7, note a 186 r p u s tion of the Conve the of tion u A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM Cash Flows Flows Cash r TUL ELETE , the Evol the , D SS OT OT N O (D . AFE v. KI v. AFE S al and Investo and al note 186; Coyle & Green (2018), (2018), Green & Coyle 186; note rr UBLISHER note 11. 11. note note 11 The two KISS versions raise the same valuation issues as convertible convertible as issues valuation same the raise versions KISS two The a P r a a p r r u p p 188 s FOR FOR u u s s note 7, at 47. 47. at 7, note Qualified equity financing triggers an automatic conversion. conversion. automatic an triggers financing equity Qualified qualified equity financing (or ) occurs, the notes/safes convert convert notes/safes the occurs, round) A Series (or financing equity qualified or discount the by adjusted (as valuation round A Series the on based equity to the for flows cash immediate generate not does conversion The cap). valuation investor,receiving but the preferred stock makes futurecash flows more probable. Future cash flows come from a future exit event. exit future a from come flows cash Future from the startup achievingIPO an acquisition exit or exit,at which point the stock. their out cash can stockholders) preferred (now holders note/safe former Preferred stockholders value the future cash flows. flows. cash future the value stockholders Preferred preferred stockholders value when the date startup later this at for the Series stockholders round, A they preferred to value available the flows cash future theremore is information.The startup shouldhave operatingresults this by in price stock The future. its about uncertainty less be should there and point flows cash the of value present the reflect should financing equity qualified the those sharesproject receive. to Thenote holders takethe price set the by Series cap). valuation or discount the by adjusted (as investors round A a r p ation Defe ation that is comparable to a convertible note. a convertible to comparable is that u x x x u s J - FINAL Deferred-equity instruments provide young startups and their investors with an with investors their and startups young instruments provide Deferred-equity 500 Startups, another prestigious , decided to establish its own its own establish to decided accelerator, startup prestigious another Startups, 500 2. The KISS 185 RCUTT RCUTT 187. 187. Raiten, notes and safes. This article treats the debt version of the KISS as though it is functionally functionally is it though as KISS the of version debt the treats article This safes. and notes is it though as KISS the of version equity the and note convertible a to identical safe. a to identical functionally C.Val important advantage. At a time when a reasonable valuation determination may not be may determination valuation a reasonable when a time At advantage. important round funding a future to valuation defer to parties the allows equity deferred possible, remains goal investment ultimate The value. to easier and mature more is startup the when investment’s the than greater value present a with flows cash future purchase same: the qualified a conduct will startup the whether on focus investors analysis, valuation other equity financing. The cash flow and valuation progression can be broken downas follows: is like a safe. like is 188. 188. Coltella, 185. 185. Raiten, Green & Coyle https://medium.com/centrally/safe-vs-kiss-the-evolution-of-the-convertible-note-4859d42a867d; (2018), 186. 186. Coltella, Giorgia deferred-equity instruments in 2014 to compete with convertible notes and safes. 500 and safes. notes convertible with compete to in 2014 instruments deferred-equity two are There Security). Simple It Keep (the KISS the called are instruments Startups’ interest and date maturity a includes which version, debt a is There KISS. the of versions rate, 512 512 O purchase price. However, the process for identifying and measuring the future cash flows flows cash future the measuring and identifying for process the However, price. purchase or arun DCF to performance operating future startup’s the projecting of Instead changes.

42208-tul_55-3 Sheet No. 79 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 79 42208-tul_55-3 42208-tul_55-3 Sheet No. 80 Side A 05/15/2020 10:30:18 513 513 § 401(m) (1956). CT CT A ROWDFUNDING AND ?C ECURITIES .S NIF result, a As when issuers offer VERYONE . Companies can sell securities to to securities sell can . Companies 189 E QUITY AVOIDABLY DIFFICULT N -E U IGHT FOR S I R S EFERRED D ) 5/14/2020) 9:49 AM TARTUP ELETE S D NSTRUMENTS NSTRUMENTS G OT OT I N N O (D QUITY QUITY G YOU G -E N UBLISHER P FOR FOR VALUI the public (accessing its immense capital resources) but must first register the the register first must but resources) capital immense its (accessing public the Path 1—heavily regulated public offering public regulated 1—heavily Path EFERRED D x J - FINAL Improving capital access for young startups is a critical matter for policymakers, and and policymakers, for matter critical a is startups young for access capital Improving instruments financial as instruments deferred-equity discussed has article this far, So Projecting whether a young startup will successfully conduct a qualified equity equity qualified a conduct successfully will startup young a whether Projecting issuers of type the of because market startup traditional the in works equity Deferred RE M K A C Y RCUTT RCUTT IV. deferred-equity instruments allow risky, young startups to raise much needed capital capital needed much raise to startups young risky, allow instruments deferred-equity withouttransferring an improper level of thatrisk to investors. deferred-equity instruments have been a positive addition to the classic seed investing investing seed classic the to addition a positive been have instruments deferred-equity market. But are they right for everyone? and contracts. However,they also qualify as securities. 189. It is reasonable to assume that all (or essentially all) safes and convertible notes qualify as securities under securities as qualify notes 189. and convertible safes all) (or essentially all that assume to federal under reasonable assecurities is It are defined which contracts,” as “investment qualify should Safes law. and state federal financing should be manageable for Specialized Startup Investors. It does not require require not does It Investors. Startup Specialized for manageable be should financing a whether identifying require only should It projections. performance detailed generating venture attract to tend that startups successful of characteristics the has startup young suggest to not is This sales. proven missing only is and rounds priced in investors capital that predicting whether a young startup will conduct a futurequalified should equity Investors financing Startup is Specialized that a determination is it However, matter. a trivial for models valuation uncertain highly developing than easier is and make to able be history. operating no with companies if the off pay to designed are instruments The market. the populate that and investors eligible venture-capital of pool a having so capital, venture institutional raises startup issuers isa condition precedent to these condition a instrumentsalso is A serving Series their the function. for Having firms, high- capital venture as such investors, quality precedent.Thenote holders entrust the valuation functionreaches to those it subsequent once startup investors, the value thoughtfully can who investors of a pool be must there so the Seriesround. A If the subsequentinvestors not are competent conditions valuers, both thehas model market startup traditional the Because down. breaks completely precedent—venture-capital eligible issuersandhigh-quality Series investors—the A 2020] 2020] O There are several categories of notes that are not securities, Reves v. Ernst & Young, 494 U.S. 56, 64–68 (1990), (1990), 64–68 56, 494 U.S. & v. Ernst Young, Reves are not securities, that notes of categories are several There the non- any of to a resemblance have they do nor categories those any of within fit do not notes convertible but notes. of categories security

and sell deferred-equity instruments to investors, they must comply with federal and state state and federal with comply must they investors, to instruments deferred-equity sell and securities. their selling for paths two had have companies Historically, laws. securities and state law. 15 U.S.C. § 77b(a)(1) (federal definition); and see section 401(m) of the Uniform Securities Act Securities Uniform the of 401(m) section and see definition); (federal 77b(a)(1) § 15 U.S.C. law. state and (1) an is there where contract investment an is instrument An definition. state the of an example for 1956 of are to profits and (4) those profits; of an expectation (3) with in a enterprise; (2) common of money; investment notes Convertible 298–99 (1946). 293, 328 Co., U.S. Howey W.J. SEC v. of others. the efforts from solely come as defined are which are “notes,” notes convertible the Moreover, contracts. as investment also qualify should securities under federal and state law. 15 U.S.C. § 77b(a)(1) (federal definition); and see section 401(m) the of 401(m) and section see definition); (federal § 77b(a)(1) 15 U.S.C. law. and state under federal securities U definition. state the of an example for 1956 of Act Securities Uniform 42208-tul_55-3 Sheet No. 80 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 80 42208-tul_55-3 42208-tul_55-3 Sheet No. 80 Side B 05/15/2020 10:30:18 , 194 M K nding eement eement C Y u Many Many r In fact, 200 owdf r 196 imple Ag S note 14. note a r ities in C When Specialized Specialized When p ur u s 191 ec S

’ Joseph Green and John John and Green Joseph 227.100(a)(3). 227.100(a)(3). AFE 197 S in a transaction that is regulated regulated is that a transaction in Companies can sell securities in in securities sell can Companies [Vol. 55:469 55:469 [Vol. o-called o-called 192 S ‘ t u This skepticism came from two factors. factors. two from came skepticism This The authors had two main concerns. First, First, concerns. main two had authors The 199 198 ned abo . r 195 A LAW REVIEW A LAW AFE S S ) 5/14/2020) 9:45 AM note 13. TUL ELETE AFE AFE a D r , https://wefunder.com/faq/securities#SAFE (last visited Mar. 8, 2020). 2020). 8, Mar. visited (last , https://wefunder.com/faq/securities#SAFE S note 13, at 174. 13, note note 13, at 169, 177–80; SEC Investor Bulletin, Bulletin, Investor SEC 177–80; at 169, 13, note p OT OT u , https://republic.co/crowdsafe (last visited Mar. 8, 2020); 2020); 8, Mar. visited (last , https://republic.co/crowdsafe )(C)’s funding portal provision.C.F.R.17§ a a s EC Rightly Conce Rightly EC N r r S p p O www.reuters.com/article/bc-finreg-crowdfunding-safe-idUSKBN18S63M. u u and submit to substantial SEC oversight. While costly, heavy heavy costly, While oversight. SEC substantial to submit and s s ot-so- y: y: (D r EFUNDER N 190 EPUBLIC , W , R and the amount sold to any individual investor is subject to purchase purchase to subject is investor individual any to sold amount the and UBLISHER P AFE AFE) Commenta S S 193 FOR FOR , Securities Act section 4(a)(2), 15 U.S.C. § 77d(a)(2), and Rule 506(b) and (c) of Regulation D, Regulation of (c) and 506(b) Rule and § 77d(a)(2), 15 U.S.C. , 4(a)(2), section Act Securities ity ( owd owd regulation helps reduce the public’s exposure to fraud and improper risk. and improper to fraud exposure helpspublic’s reduce the regulation offering. private regulated 2—lightly Path cheaper private offerings. Since the public faces less exposure, less regulation regulation less exposure, less faces public the Since offerings. private cheaper most The limited. is capital to access companies’ the However, needed. is investors sophisticated to selling to companies restrict to is limitation common registration. by afforded protections the need not do who transaction StartupInvestors purchase classic deferred-equity instruments, those are Path 2 transactions. u r Green & Coyle (2016), (2016), Coyle & Green nding and the (June 1, 2017), https:// 2017), 1, (June u e Eq ee, e.g. ee, ee x J - FINAL S Regulation CF provides issuers with an additional option. Issuers can raise up to to up raise can Issuers option. additional an with issuers provides CF Regulation S The C It was not long after Regulation CF took effect that crowdfunding issuers began began issuers crowdfunding that effect took CF Regulation after long not was It ur t . u owdf F r r EUTERS RCUTT RCUTT 191 200. Green & Coyle (2016), (2016), Coyle & 200. Green limitations of $2,200 to $107,000 based on the investor’s annual income and net worth. net and income annual investor’s the on based $107,000 to $2,200 of limitations Venture capital firms favor technology companies with high-growth trajectories. high-growth with companies technology favor firms capital Venture fo less heavily than a registered offering, but more heavily than a private offering. A A offering. private a than heavily more but offering, registered a than heavily less registered or a broker through exclusively conducted be must transaction CF Regulation portal, funding 199. 199. Green, Joe Coyle investigated the practice of crowdfunded safes and wrote a December 2016 essay, 2016 essay, a December and wrote safes crowdfunded of practice the investigated Coyle C 190. the SEC. with statement a registration must file issuer the a transaction, register § To 77e. 15 U.S.C. Registration statements provide detailedinformation about the issuerand the offering. (c). and § 230.506(b) 17 C.F.R. 227.100(a)(1). § 192. C.F.R. 17 JOBS The 78c(a)(4). § 15 U.S.C. brokers. as register 193. generally must intermediaries securities Historically, throughSecuritiesAct, 4(a)(6)(C), Actintroduced section registered a new category of securities intermediary, a “funding portal,” for section 4(a)(6) crowdfunding transactions. 15 U.S.C. § 77d(a)(6)(C). Regulation CF Rule 514 514 O 198. 198. 197. 197. ofthe crowdfundingissuers were “[n]on-tech startupsbusiness with modelsthat are less $1,070,000 from the public in a twelve-month in a the period public from $1,070,000 twelve-month Issuers and funding portals (or brokers) must satisfy several investor safeguards, such as as such safeguards, investor several satisfy must brokers) (or portals funding and Issuers the of time the at disclosure detailed with investors, potential and investors, providing offeringand annual on an basis thereafter. safes are designed for issuersthat are expected to conduct priced venture capitalrounds in crowdfunding the of few “exceedingly believed authors the However, future. near the so.” do to able be actually would companies Republic and Wefunder both have their own safe templates. safe own their have both Wefunder and Republic using deferred-equity instruments to raise capital from public investors. public from capital raise to instruments deferred-equity using R 100(a)(3) implements section 4(a)(6 section implements 100(a)(3) 194. 17 C.F.R. § 227.100(a)(2). 227.100(a)(2). § 194. C.F.R. 17 227.201–03. §§ 195. C.F.R. 17 (2016), Coyle & 196. Green 42208-tul_55-3 Sheet No. 80 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 80 42208-tul_55-3 42208-tul_55-3 Sheet No. 81 Side A 05/15/2020 10:30:18 the 202 515 515 A few months after the the after months few A 204 AVOIDABLY DIFFICULT N U S I S ) 5/14/2020) 9:49 AM For the issuers that were technology startups and had had and startups technology were that issuers the For TARTUP 201 ELETE S D 205 note 14. note G OT OT a N N r O p u s (D G YOU G In addition In to their issuer concerns, Greenand Coyle were also N UBLISHER 203 P FOR FOR 206 VALUI at 175. 175. at 169. at J - FINAL Despite these concerns, crowdfundingissuers have continued issue to deferred- The Study captured 205 funded deals, of which seventy-one were safe offerings and and offerings safe were which seventy-one of deals, 205 funded captured Study The M K . Id. . Id. Id. . . Id. C Y RCUTT RCUTT 201 202 203 204 the maximumoffering size listedtheFormC. on 206. One caveat about the data collection: The funding amounts for some of the Wefunder deals may be may deals Wefunder the of some for amounts 206. funding how The and collection: raised, data the issuer about each caveat much One how companies, funded of a list provides portals the of Each exaggerated. the all aggregate deals to appears it information, this lists Wefunder when However, attracted. it investors many have may Study the in deals Wefunder 2019 the of some result, a As Wefunder. on done ever has issuer the exaggerated dollar amounts. This author tried the total a C-U Form tofile must disclosing issuer clear each up § 227.203(a)(3), 17 theC.F.R. 203(a)(3), problem CF Rule Regulation of by few reviewingHowever, deadline. each offering issuer’s the after days Form business five C-U. within Peroffering the in sold securities of amount author This C-U. Form their filed Study the during offering CF a Regulation completed that issuers Wefunder the materially not does deals and Wefunder the of number a small affected only numbers exaggerated the believes maximum the exceeded amount funding reported the deals, Wefunder the of a few For numbers. overall the affect amount with funding reported the replaced the Study those cases, In C. Form issuer’s on the stated size offering twenty-two were convertible note offerings (see Table 5). The ninety-three deferred-equity deferred-equity ninety-three The 5). Table (see offerings note convertible were twenty-two size deal median a and $331,891 of size deal average an with million, $30.6 totaled deals $200,240. of equity instruments unabated. Is that good or bad? On one hand, valuation deferral could could deferral valuation hand, one On bad? or good that Is unabated. instruments equity capital. the raise to the forum used of regardless investors its and startup young any benefit be may setting crowdfunding the in instruments deferred-equity using hand, other the On investors’ the and offerings crowdfunding conducting issuers of types the to due improper expose could offerings deferred-equity CF Regulation level. sophistication unsophisticated investorsto aninappropriate level of risk.To get a clearer picture of theissue, this author examined all the Regulation CF deals fundedthrough the Republic, chosen were portals funding three These 2019. during portals and Wefunder StartEngine, because they are three the of most popular portalsand because Republic and Wefunder closely therefore are and interests deferred-equity of forms own their developed have deferred-equity. with associated Green and essay, Coyle the SEC issuedan investor bulletin urgingissuers to “[c]autious be [c]rowdfunding.” in SAFES of likely to attract VC investment.” VC attract to likely 205. SEC Investor Bulletin, Bulletin, Investor 205. SEC 2020] 2020] O concerned that the safes contained “terms thatarelikely to frustrate theability ofinvestors to sharein theupside successful of crowdfunding companies.” authors believed they suffered from an adverse selection problem. Due to the higher costs costs higher the to Due problem. selection adverse an from high-growth suffered they offerings, believed CF authors Regulation for requirements disclosure additional and the in Investors Startup Specialized from capital raising prefer should startups technology “because offerings CF Regulation turn to only issuers These market. startup traditional financing venture traditional raise to struggle still may they and options, other no have they road.” the down

“business models which, at first blush, would appear attractive to VC investors,” VC to attractive appear would blush, first at which, models “business 42208-tul_55-3 Sheet No. 81 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 81 42208-tul_55-3 42208-tul_55-3 Sheet No. 81 Side B 05/15/2020 10:30:18 11 35 15 23 M K C Y $437,633 $437,633 $279,787 $211,534 $170,726 $340,317 $340,317 $229,573 $332,181 $288,547 Wefunder Wefunder $2,326,872 $2,326,872 $4,982,722 $4,982,722 $10,065,548 $10,065,548 $11,911,098 $11,911,098 6 7 — — — — 68 $59,399 $59,399 $72,961 $72,961 $74,980 $287,680 $287,680 $183,078 $103,369 $510,730 $510,730 $1,098,465 $1,098,465 [Vol. 55:469 55:469 [Vol. First, many of the ninety-three ninety-three the of many First, $19,562,265 $19,562,265 StartEngine StartEngine 207 4 — — — 36 — — — — — A LAW REVIEW A LAW S $496,740 $496,740 $124,185 $147,124 $367,440 $367,440 $171,742 Republic ) 5/14/2020) 9:45 AM $13,227,829 $13,227,829 TUL ELETE D OT OT N O (D UBLISHER P s FOR FOR r Most of the issuers appear unlikely ever to raise money from venture capital capital venture from money raise to ever unlikely appear issuers the of Most firms. The instruments’ terms are very issuer friendly. The instruments are far more more far are instruments The friendly. issuer very are terms instruments’ The investments. high-risk such for expect would one than issuers to favorable The issuer-friendly terms raise concerns that Regulation CF investors lack the the lack investors CF Regulation that concerns raise terms issuer-friendly The their of terms and risks the internalize and understand to sophistication investments. e u x x x J - FINAL The Study lends support to Green’s and Coyle’s concern about crowdfunding crowdfunding about concern Coyle’s and Green’s to support lends Study The The Study examined the deferred-equity issuers and the terms of their instruments. instruments. their of terms the and issuers deferred-equity the examined Study The Average Median Total funding amount amount funding Total Average Median deals of Number amount funding Total Average Median deals of Number amount funding Total Number of deals deals of Number amount funding Total Average Median deals of Number Equity (common or (common Equity preferred) Other Table 5 5 Table 2019 During Funded Deals of Summary Safes notes Convertible RCUTT RCUTT Based on that review, this author concludes that most of the deferred-equity offerings in in offerings deferred-equity the of most that concludes author this review, that on Based the Study are very risky investments that concludes: author not do appear this to offer specifically, investors More risk. the enough offset upside to potential 207. Venture capital firms want companies with a potential to be worth hundreds of millions of dollars, or or dollars, of millions of hundreds worth be to potential a with 207. companies want firms capital Venture better yet billions of dollars. This requires large markets that present many years largeof profit/free cash flow 516 516 O

A. The Iss The A. issuers’ ability to conduct future, priced venture capital rounds. Venture capital firms firms capital Venture rounds. capital venture priced future, conduct to ability issuers’ market large address that models business with startups technology in invest generally future. rapid-growth a suggest and opportunities 42208-tul_55-3 Sheet No. 81 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 81 42208-tul_55-3 42208-tul_55-3 Sheet No. 82 Side A 05/15/2020 10:30:18 & 209 Effects of 517 517 NNOVATION NNOVATION I ignal? ignal? S FOR FOR . NSTIT I Raising a Regulation CF CF Regulation a Raising owd a Positive a owd Positive 211 r LANCK P AX AX AVOIDABLY DIFFICULT , M N U S election I S S Is Wisdom of the C the of Wisdom Is ) 5/14/2020) 9:49 AM A recent A study focused on the German venture capital e Capital TARTUP 210 ELETE S ur D note 13, at 175–76. at 175–76. 13, note G OT OT a N r N p O u s (D ent Vent ent u G YOU G bseq N Michael Maximilian Mödl, UBLISHER Su P ally r FOR FOR Even amongthetechnology issuers, many appear to lack venture capital-style 10–12, 25–29 (Aug. 1, 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3222461. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3222461. 1, 2018), (Aug. 25–29 10–12, VALUI 208 at 26–27. 26–27. at at 175. 175. at ee gene J - FINAL S Greenand were Coyle concerned that even those issuersthatarguably have business The Study could not directly measure the presence of an adverse selection problem, problem, selection adverse an of presence the measure directly not could Study The M K . Id.. . . Id. C Y owdfinancing on owdfinancing r OMPETITION OMPETITION RCUTT RCUTT 209 210 211 C but it could consider the issuers’ financial results to see if they shed some light on whether whether on light some shed they if see to results financial issuers’ the consider could it but the Of future. the in candidates capital venture attractive be to likely are companies the ninety-three deferred-equity issuers, be not most lacked should substantial profits revenuesand and were revenues of lack The 7). and 6 Tables (see unprofitable definition, by that, startups young for intended are instruments Deferred-equity surprising. issuers of number the is surprising somewhat is What histories. operating meaningful lack that issuers of number the as well as million), $1 even (or $500,000 above revenue with generatedprofits in their mostrecent fiscal years.There were eighteen different issuers during income net of $50,000 or revenues of $500,000 than more generated either that their mostrecently completed equity fiscal Deferred year. Whilehaving setting. a meaningful operating deferred-equity the history in be is not may it factor, positive a normally the lack companies such because valuation defer to investors their and issuers allows a company Once analysis. valuation traditional for required histories operating meaningful round could discourage venture capital firms from even considering such issuers for future future for issuers such considering even from firms capital venture discourage could round funding rounds. models and growth trajectories that may interest venture capital firms will suffer from an an from suffer will firms capital venture interest may that trajectories growth and models offering. deferred-equity CF a Regulation conduct they if problem selection adverse 3D printing services, foreign-language teaching services, and several niche eCommerce eCommerce niche several and business services, plans or growth teaching potential. For example, foreign-language there areissuers services, providing printing 3D outsourced a in invest will firms capital venture whether Predicting apps. phone and websites do simply issuers the of many However, call. subjective admittedly an is issuer particular notappear to venture be capital-style companies. deferred-equity issuers were not technology companies. Roughly one-quarter of the issuers issuers the of one-quarter Roughly companies. technology not were issuers deferred-equity spirit or beer specialty companies, cookie healthy (including industry food the in were producers, catering companies, and grocery delivery companies), appareland beauty that explained and Coyle sectors. Green nontechnology similar other or industry, more and investment VC for candidates be to likely less “are companies nontechnology rely that companies or . . . founders the for businesses lifestyle either into evolve to likely additional support to profits reinvested and loans) bank as (such financing debt on growth.” opportunities the startup. for (2016), Coyle & 208. Green 2020] 2020] O C Regulation CF is a funding option of last resort for such technology companies, meaning meaning companies, technology such for resort last of option funding a is CF Regulation the offering signalsto future venture capitalinvestors thatthese issuers arenot strong investment. of worthy companies market explains, “there is strong indication that venture investors perceive crowd money money crowd perceive investors venture that indication strong is “there explains, market preference a lower have andtherefore quality overall a start-up’s signal for negative aas diligence.” due further for firms such-funded forselecting 42208-tul_55-3 Sheet No. 82 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 82 42208-tul_55-3 42208-tul_55-3 Sheet No. 82 Side B 05/15/2020 10:30:18 M K $0 C Y $15,205 $15,205 $30,940 $30,940 $51,186 $374,540 $374,540 $688,841 ($76,232) ($76,232) Median Median ($143,501) ($143,501) $1,920,425 $1,920,425 Revenues (July 8, 2019), 8, 2019), (July (Losses) (Losses) AGE Median Profits Profits Median S $0 UNDING F $79,599 $79,599 $407,648 $407,648 $379,625 $690,850 Average Average $89,511 $89,511 $2,638,011 $2,638,011 Revenues ($367,286) ($367,286) ($444,518) (Losses) [Vol. 55:469 55:469 [Vol. Average Profits Profits Average 8 4 93 32 38 11 AUNCHOPEDIA BY Issuers , L Number of 93 81 12 A LAW REVIEW A LAW Issuers S ) 5/14/2020) 9:45 AM s Hate Debt Number of r TUL ELETE D OT OT N p Investo O u t r (D ta S Why UBLISHER P FOR FOR This makes intuitive sense because the venture capital firms want their investment investment their want firms capital venture the because sense intuitive makes This J - FINAL The most surprising financial data was the issuers’ debt levels. Startups seeking to to seeking Startups levels. debt issuers’ the was data financial surprising most The 212 Issuers with revenues above $250,000 $250,000 above revenues with Issuers and up to $500,000 $500,000 above revenues with Issuers and up to $1 million million $1 above revenues with Issuers Table 6 6 Table offering before year fiscal recent most in issuers deferred-equity for Revenues issuers All revenues no with Issuer up and $0 above revenues with Issuers $250,000 to All issuers issuers All Issuers withoutnet income Issuers with net income Table 7 7 Table Profits (losses) deferred-equity for recent issuers most fiscal in year before offering RCUTT RCUTT raise their first formal venture capital round are normally not burdened by significant significant by not burdened normally are round capital venture formal first their raise debt. 212. 212. Lettich, Tony https://fundingsage.com/why-startup-investors-hate-debt/. https://fundingsage.com/why-startup-investors-hate-debt/. has a meaningful operating history, a traditional valuation analysis should generally be be generally should analysis valuation traditional a history, operating meaningful a has deferred- use to chose issuers these of some why about questions raising thus possible, event. funding their for interests equity 518 518 O

dollars to fund growth, not repay creditors. The issuers in the Study, however, exhibited exhibited however, Study, the in issuers The creditors. repay not growth, fund to dollars had percent, thirty or issuers, the of Twenty-six 8). Table (see levels debt significant combined short-term and long-term debt exceeding $500,000 intheir mostrecent fiscal year. Having substantial debt wouldnot be troublingif theissuer alsohad substantial assetsto offset the debt.This was generally not the casethe forissuers inthe Study. Over sixty leastat were that obligations had debt $500,000 above debt with issuers the of percent that obligations debt had issuers those of seven and assets, total their of amount the twice venture imagine to difficult is It assets. total their of amount the ten-times least at were profile. debt of type that with companies in investing firms capital 42208-tul_55-3 Sheet No. 82 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 82 42208-tul_55-3 42208-tul_55-3 Sheet No. 83 Side A 05/15/2020 10:30:18 3 1 3 4 0 11 Total Total Assets at least at least Number 10x their their 10x of Issuers Issuers of with Debt 519 519 4 7 9 0 10 30 their their Total Total Assets Number of Issuers Issuers of with Debt at least 2x 2x at least $0 $66,246 $66,246 $371,847 $371,847 $750,811 $165,000 $165,000 AVOIDABLY DIFFICULT $1,787,197 $1,787,197 N U Median Debt S I S $0 ) 5/14/2020) 9:49 AM TARTUP $85,198 $85,198 ELETE Debt S $747,065 $747,065 $565,782 $565,782 $369,489 D Average Average $2,561,977 $2,561,977 G OT OT N N O (D of 12 14 93 19 35 13 G YOU G N Issuers UBLISHER Number P FOR FOR VALUI $0 to to to 1 1 - -term long-term deferred-equity + debt for recent most fiscalin issuers year term + term term + term + term term + term term term term term term term term term - - - - from from from J - FINAL Another indication that many of the issuers will likely struggle to conduct a future a future conduct to struggle likely will issuers the of many that indication Another - - - - - M K C Y RCUTT RCUTT before offering offering before long long long long $500,000 $500,000 million $1 debt above above debt million $1 debt debt debt debt debt debt Issuers with short Issuers with short All issuers issuers All Issuers with short no or term long Issuers with short Issuers with short Table 8 8 Table Short to $250,000 $250,000 to $250,00 $500,00 ventureround is theirprior capitalraising history. Two-thirds of the issuers in the Studyhadraised least at one convertible noteand/or significant. round safe were in the three rounds years preceding prior those their of many And 9). Table (see offering CF Regulation venture a future if equity startup’s the on claims more the offerings, prior the bigger The investment capital venture discourage can claims additional These occurs. round capital 2020] 2020] O 42208-tul_55-3 Sheet No. 83 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 83 42208-tul_55-3 42208-tul_55-3 Sheet No. 83 Side B 05/15/2020 10:30:18 M K C Y equity equity 5 31 10 16 offerings offerings their prior prior their deferred- offering than in than in offering current Reg CF CF Reg current raising less from from less raising Number Issuers of Raised Raised $360,000 $360,000 $175,000 $684,000 [Vol. 55:469 55:469 [Vol. Median Median Amount Amount $1,699,029 $1,699,029 Raised $843,585 $843,585 $180,272 $715,974 Amount Amount Average Average $2,276,787 $2,276,787 A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM TUL prior convertible note or safe offerings in the three three the in offerings safe or note convertible prior ELETE 9 of 35 17 61 D OT OT Issuers Number N O (D UBLISHER P equity equity - FOR FOR -equity issuers with -equity -equity -equity J - FINAL The Study also examined the terms thedeferred-equity of instruments issuedthe in The seventy-one safe deals were split roughly evenly between the Wefunder and and Wefunder between the evenly roughly split were deals safe seventy-one The 1. Safes 1. Safes The Instruments’ Terms Instruments’ The offerings offerings Issuers that raised up to to up raised that Issuers in prior $500,000 deferred offerings Issuersraised that up and $500,000 above prior in million $1 to deferred offerings Issuersraised that in million $1 above deferred prior All issuers that that issuers All prior a conducted offering deferred-equity Table 9 9 Table Deferred years before the Regulation CF offering CF Regulation the before years RCUTT RCUTT B. B. because theymean the venture capital firmhas to ownership share thecompany’s complex futuremore cash create flows also offerings convertible Prior parties. more with feature. attractive an not is which through, sift to firm capital venture a for structures 2019 the than sums larger for were offerings convertible prior the of most Finally, are that companies thriving of picture a paint not does This offering. CF Regulation ascending the capital-raising food chain for attract to settle more to moneyhaving from and deeper pockets. popular less becoming are that issuers of picture a paints it Rather, capital wherever they can findit, whichdoes not well bode for future venture capital rounds. 520 520 O ninety-three Regulation CF offerings. offerings. CF Regulation ninety-three Republic portals. Each funding portal provides issuers with its own template for a safe. safe. a for template own its with issuers provides portal funding Each portals. Republic 42208-tul_55-3 Sheet No. 83 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 83 42208-tul_55-3 42208-tul_55-3 Sheet No. 84 Side A 05/15/2020 10:30:18 eceive the 521 521 where reputationsare 214 illion post-money valuation that 213 AVOIDABLY DIFFICULT N U S I illion)and multiplying the preferred ($1) price stock S ) 5/14/2020) 9:49 AM TARTUP ELETE S D If the issuer raises capital by selling preferred stock in a in stock preferred selling by capital raises issuer the If note 13, at 174. 13, note G OT OT a If the issuer sells itself or conducts an IPO (a “liquidity event”) event”) “liquidity (a IPO an conducts or itself sells issuer the If N r N p O u s (D G YOU G N UBLISHER P FOR FOR VALUI : Assume TechCo sold $200,000 of safes to an accelerator (the “Safe Investor”). The safes The safes (the “Safe Investor”). to an accelerator of safes $200,000 TechCo sold : Assume priced round (with no minimum size threshold), the safe automatically converts converts automatically safe the threshold), size minimum no (with round priced a few with stock preferred issued the to identical is that stock a shadow to preference). liquidation the as (such exceptions Liquidity event. Liquidity r automatically holders safe the occurs, round stock a preferred before amount cash a (b) or safes the for paid originally price purchase the (a) of greater the before immediately stock common into safes the converting on based have also may holders safe The ratio. conversion defined the at event liquidity the choicereceive to their considerationin stock. by the actual valuation ($5 million/$10 m million/$10 ($5 valuation actual the by that percentage. by 400,000 to equates share per $0.50 by multiplied investment $200,000 Investor’s Safe The shares. The safes’ conversion price is $0.50 per share, which comes from dividing the valuation cap cap valuation the dividing from comes which share, per $0.50 is price conversion safes’ The J - FINAL (1) financing. Equity (2) this which exploit, could issuers that a loophole have does safe Combinator Y The The Wefunder SAFE and the Crowd SAFE mostly copy the Y Combinator safe’s safe’s Combinator Y the copy mostly SAFE Crowd the and SAFE Wefunder The x x M K The preferred stock from the qualified equity financing includes a . Each share share Each preference. a liquidation includes financing equity qualified the from stock preferred The stockholders the preferred If TechCo liquidates, preference. a $1 liquidation has stock preferred of get theirinvestment back before only common investing despite stockholders preference liquidation receive a $400,000 receives it anything. stock, preferred of If shares the400,000 SafeInvestor receives $200,000. Example ain stock preferred sells TechCo subsequently cap. valuation post-money $5 million a include has a $10 m financing equity qualified The financing. equity qualified translates into a $1 price per share. This means the Safe Investor’s safes will convert into 400,000 400,000 into convert will Investor’s safes the Safe This means ashare. per $1 price into translates stock. preferred of shares C Y RCUTT RCUTT This excess liquidation preference would be a windfall for the safe holders, so the shadow stock often limits the the limits often stock shadow the so holders, safe the for windfall a be would preference liquidation excess This amount. investment holders’ the safe to preference liquidation (2016), Coyle & 214. Green Wefunderhas the “Wefunder andSAFE” Republic has the “Crowd SAFE.”Both in converts safe Combinator Y standard A safe. Combinator Y the on based are templates instances: main two 213. If the valuation cap is significantly below the subsequent equity financing’s valuation, the safe holders holders safe the valuation, financing’s equity subsequent the below 213. significantly is cap valuation the If company. in the invested they what exceeds far that preference a liquidation receive would 2020] 2020] O article refers to as the “Common Stock Loophole.” The equity financing conversion is only only is conversion financing equity The Loophole.” Stock “Common the as to refers article could Issuers round. stock a common not by round, stock preferred a future by triggered event liquidity a until conversion avoid to Loophole Stock Common the use theoretically the in unlikely is outcome an such However, rounds. stock common doing only by involve always almost rounds capital venture priced because market startup traditional investors capital require finding venture would loophole the Exploiting stock. preferred loophole the exploiting Moreover, doubtful. is which stock, common take to willing managers’) its (and issuer’s the hurt would which agreement, safe the of spirit the violates world a “clubby” in operate startups Traditional reputation.

important to obtaining funding. Young startups that raise capital from Specialized Startup Startup Specialized from capital raise that startups Young funding. obtaining to important Investorsarethe types companies of that also can tap the formal venture capitalmarket for their Series A round. Such issuersare unlikely to risk theirreputation, Loophole. and foreclose Stock their Common the exploit to access, capital venture 42208-tul_55-3 Sheet No. 84 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 84 42208-tul_55-3 42208-tul_55-3 Sheet No. 84 Side B 05/15/2020 10:30:18 , 4, M K ASH ample ample D section C Y S TEALTH O T ity ISCOUNT u SAFE] (scroll (scroll SAFE] OWN e Eq &D ur t u AMPLE AP F S r C document under the C) (May 13, 2019), 2019), 13, C) (May C) (June 14, 2019), 14, C) (June nt nt EFUNDER EFUNDER eement fo eement u r ALUATION C) 2019), 28, (May ORM ORM (F A “Liquidity Event” is defined as as defined is Event” “Liquidity A –V [Vol. 55:469 55:469 [Vol. (F imple Ag C) (July 16, 2019), 2019), 16, C) (July S 217 ORM Itisnot clear whether eliminating the (F AFE: S

216 r ation Cap & Disco Cap & ation u TATEMENT ORM S nde TATEMENT u (F ORPORATIONS S C Wef A LAW REVIEW A LAW S Like the Y Combinator safe, the Wefunder SAFE ) 5/14/2020) 9:45 AM TATEMENT ations - Val - ations r S FOR FOR FFERING 215 TUL po ELETE r FFERING D page to the SAFE OT OT s Co ., O r r N TATEMENT O NC S AFE AFE ., O nde (D S u

NC FFERING r I AFE fo AFE ,I Fo S r

PP EFUNDER r nde fo A ii. Exceptions Exceptions ii. i. Basic ConversionFeature u r UBLISHER P nde u ., O ,W ime O r ARIBU PP FOR FOR C C Wef FFERING FFERING A a. Wef subheading). Legal P Legal EFUNDER ee ee J - FINAL S Additionally, one issuer completely eliminated the Equity Conversion feature, feature, Conversion Equity the eliminated completely issuer one Additionally, If theissuer does sell preferred stock ina priced round, Wefunder SAFEs A issuers few modified the Wefunder SAFE’s basic conversion feature.Three S With a few exceptions,With few a Wefunder the had SAFEsinthe Study identical conversion . . eements ., O r ACHINE RCUTT RCUTT 217 216 NC https://www.sec.gov/Archives/edgar/data/1777610/000167025419000363/documents_list.htm. https://www.sec.gov/Archives/edgar/data/1777610/000167025419000363/documents_list.htm. meaning its safes only convert for a Liquidity Event. Liquidity a for convert only safes its meaning “Equity Financing” definition was a conscious decision by the issuer or a mere editing editing mere a or issuer the by decision a conscious was definition Financing” “Equity error. https://www.sec.gov/Archives/edgar/data/1776303/000167025419000344/documents_list.htm; D https://www.sec.gov/Archives/edgar/data/1776303/000167025419000344/documents_list.htm; automatically convert,although into nonvoting convert WefunderSAFEs preferred stock. Like a Combinator Y safe, thereno is minimum sizethreshold for the preferred stock conversion. trigger to offering includes the Common Stock Loophole. While traditional startups are unlikely to exploit exploit to unlikely are startups traditional While Loophole. Stock Common the includes who unclear is It issuers. CF Regulation for true be not may same the loophole, the explained As rounds. financing equity future their for to turn will issuers CF Regulation CF Regulation If issuers. these in interested be not may firms capital venture earlier, be may investors such offerings, CF Regulation through capital seek to continue issuers comfortabletaking common stock over preferred stock. issuers’ safes called for an automatic conversion if an Equity Financing occurs. However, However, occurs. Financing Equity an if conversion automatic an for called safes issuers’ exactly unclear it making Financing, Equity an for definition the eliminated issuers these conversion. Financing Equity the triggers what down the I M 215. 215. W conversionapproach. Eachhas conversionprovisions for equity financingsand liquidityeventsthat are similar to the Combinator Y safe. However,the Wefunder and SAFE the haveCrowd SAFE features some do that warrant discussion. 522 522 O https://wefunder.com/faq/legal-primer (last visted Feb. 22, 2020) [hereinafter W 2020) [hereinafter 22, Feb. visted (last https://wefunder.com/faq/legal-primer https://www.sec.gov/Archives/edgar/data/1777899/000167025419000395/documents_list.htm. https://www.sec.gov/Archives/edgar/data/1777899/000167025419000395/documents_list.htm. https://www.sec.gov/Archives/edgar/data/1781213/000167025419000406/documents_list.htm; S https://www.sec.gov/Archives/edgar/data/1781213/000167025419000406/documents_list.htm;

and select the the select and Ag features. Because the Wefunder modeled is SAFE afterCombinatorthe Y safe, it converts Event.” An “‘Equity a “Liquidity Financing” or an “Equity of occurrence the upon principal the with transactions of series or transaction fide a bona means Financing’ Stock Preferred and sells issues Company the which to pursuant raising capital, of purpose valuation.” pre-money a fixed at 42208-tul_55-3 Sheet No. 84 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 84 42208-tul_55-3 42208-tul_55-3 Sheet No. 85 Side A 05/15/2020 10:30:18 (Mar. 3, owner of the of owner , SEC 523 523 eal r which provides that 224 that instructs the SEC to to SEC the instructs that ities: Get the Facts ur 223 ec S

ur AVOIDABLY DIFFICULT N .—The Commission shall, by rule, exempt, exempt, rule, by shall, Commission .—The Holding Yo U . S ities This is a significant change from the standard standard the from change significant a is This I ur S 218 requires issuers with a class of equity securities to eet name eet r ) 5/14/2020) 9:49 AM 221 Thus, the investor is the beneficial owner of the securities, and the and securities, the of owner beneficial the is investor the Thus, tain sec st or (b)500 or more shareholders of record whoare not r Id. note 215, at 4. at 215, note TARTUP 222 ELETE a S r D p G u OT OT s N N O (D SAFE, SAFE, sons holding ce holding sons r If the issuer determines, in its sole discretion, that its securities are G YOU G The Wefunder SAFE gives the issuer a right to repurchase the safe to to safe the repurchase to right a the issuer gives SAFE Wefunder The N pe iii. Repurchase Provision to Prevent Section 12(g) Registration Registration 12(g) Section Prevent to Provision iii. Repurchase 220 UBLISHER r 219 AMPLE P S FOR FOR VALUI sion fo sion shareholders record of accredited investors. u 15 U.S.C. § 78l(g)(6) (internal citations omitted). omitted). citations (internal § 78l(g)(6) 15 U.S.C. EFUNDER EFUNDER ee Excl J - FINAL (1) and assets; total in million $10 than more has issuer The (2) The issuerhas a class equity of securities with either (a) more than 2,000 S The defaulthave Wefunderunique SAFE anot does feature presentthe Y in Exchange Act section 12(g)(1) section Act Exchange Becomingreporting a company is extremely expensive,and companies few want to M K Sec. 12. Registration Requirements for Securities. for Securities. Requirements Registration 12. Sec. (g) . . . (6) conditionally unconditionally,or securities acquired subsection. pursuantthis to an of offering provisions undermade the section1933 from of Act Securities the of 4[(a)](6) . Id. . C Y RCUTT RCUTT 219 securities issued in a section 4(a)(6) offering are not included in the section 12(g)(1) record record 12(g)(1) section the in included not are offering 4(a)(6) a section in issued securities register them under the Exchange Act and become a reporting company if two conditions conditions two if company a reporting become and Act Exchange the under them register are met: a change control of transactionan or IPO. 218. 218. W 2020] 2020] O brokerage firm is the shareholder of record. record. of shareholder the is firm brokerage 223. 2003), http://sec.gov/investor/pubs/holdsec.htm. This means the brokerage firm will hold the securities in its in the securities hold will firm brokerage the This means http://sec.gov/investor/pubs/holdsec.htm. 2003), name,andnot in the namethe of investor. exempt section 4(a)(6) securities from section 12(g)’s provisions. The SEC implemented implemented SEC The provisions. 12(g)’s section from securities 4(a)(6) section exempt 12g-6, Rule Act Exchange with mandate 12(g)(6) its section prevent registration under section 12(g) of the Securities Exchange Act of 1934 (the (the 1934 of Act Exchange Securities the of 12(g) section under registration prevent Act”). “Exchange template and the issuer did not explain the reasoning behind it. it. behind reasoning the explain not did issuer the and template 220. 15 U.S.C. § 78l(g). 78l(g). § 220. U.S.C. 15 78l(g)(1). § 221. U.S.C. 15 beneficial The owners.” “beneficial than rather record” of 222. “shareholders on focuses 12(g)(1) Section Combinator safe. Combinator likely to be held by enough record holders to require registration under section 12(g), the the 12(g), section under registration require to holders record enough by held be to likely market fair the (b) price or (a) purchase the of greater the for a safe repurchase can issuer However, issuer. the by chosen appraiser an independent by determined as safe the of value if an equity financing occurs within threemonths after repurchasea safe andthe equity the pay must issuer the holder, safe the for price better a generated have would financing difference to the formerholder. safe do so until conducting their IPO. The JOBS Act made it easier to avoid section 12(g) 12(g) section avoid to easier it Act made JOBS The IPO. their conducting until so do 12(g) section to (6) paragraph new a adding by registration 224. 17 C.F.R. § 240.12g-6. 240.12g-6. § 224. C.F.R. 17 owner is the investor who purchased the security, and the person one typically thinks of as the the as of thinks typically one person the and security, the purchased who investor the is owner security.The shareholder most firm, a brokerage record, of through in contrast, securities buys investor an is the when party example, For in agent. whose transfer nameits the or securitiesissuer the of are heldon the books brokerage firms willhold those securities in 42208-tul_55-3 Sheet No. 85 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 85 42208-tul_55-3 42208-tul_55-3 Sheet No. 85 Side B 05/15/2020 10:30:18 (2) (2) M K C Y 225 Considering Considering 226 2020) (scroll down the down (scroll 2020) C) (Aug. 16, 2019), 16, (Aug. C) C/A) (Dec. 3, 2018), 2018), 3, C/A) (Dec. ORM (F ORM [Vol. 55:469 55:469 [Vol. (F TATEMENT S TATEMENT TATEMENT S and another issuer increased the threshold to $15 FFERING A LAW REVIEW A LAW S 227 ) 5/14/2020) 9:45 AM TUL ELETE D FFERING , https://republic.co/crowdsafe (last visited Feb. 6, $25 million; and (3) has engaged an SEC-registered transfer transfer SEC-registered an engaged has (3) and million; $25 , LLC, O OT OT N O (D EPUBLIC AFE AFE OYAGES ,R LLC, O S V afe S i. Basic Conversion Feature UBLISHER owd owd P r owd owd ORLD PIRIT PIRIT r S FOR FOR W b. C 228 LUE WO ee The C ee The J - FINAL The Crowd SAFE appears eliminateto Loophole,The SAFECommonthe Crowd the Stock but SAFE a Crowd If feature. “roll-over” its is feature SAFE Crowd distinct most The Because of Rule 12g-6, it is not clear that Regulation CF issuers truly need the the need truly issuers CF Regulation that clear not is it 12g-6, Rule of Because S Each of the Crowd SAFEs in the Study had identical had the conversion Study in features the SAFEs two with Crowd Each of RCUTT RCUTT the average size of the 2019 Republic safe offerings was only $367,447 and only eight of and only $367,447 only was offerings safe the 2019 Republic of size average the $1 the offerings, their in $500,000 than more raised issuers SAFE Crowd thirty-six the millionthreshold could be a significant barrierto conversion.Moreover, one of the issuersincreased the threshold to $3 million instrument’s language does leave some ambiguity. An equity financing conversion is is conversion financing equity An ambiguity. some leave does language instrument’s million. $1 least at raises that sale Securities” “Equity an conducts issuer the if triggered to appear would which stock, preferred or common as defined are Securities Equity “CF into converts it convert, does SAFE Crowd a when However, loophole. the eliminate Shadow Series” shares. CF Shadow Series shares are defined as “Preferred Equity Stock thatisrelevant the in issued Stock Preferred of shares the to respects all in identical deal stock a preferred only that suggests definition Series Shadow CF The Financing.” stock. preferred into convert only to appear safes since safe, the trigger would to discretion, sole its at option, the has it financing, equity qualifying a conducts issuer equity later a to conversion the postpone or liquidity a stock If into safes event. the convert immediately liquidity a or again) postponed be can conversion (where financing event occurs, the safes must converted. be Subsequent conversions are done basedthe on roll- the of purpose the that explains Republic financing. equity first the from price stock page for the linkstothe Crowd SAFE exampletemplates). 227. T https://www.sec.gov/Archives/edgar/data/1741141/000114420419040347/tv527723_ex99.pdf. https://www.sec.gov/Archives/edgar/data/1741141/000114420419040347/tv527723_ex99.pdf. repurchase provision. Sinceissuers have sole discretion right to decide issuer’s the for true holds when same The right. the the abusing provision for potential is there triggered, is guarantee. price three-month a holders safe giving only and appraiser the choose to agent. The rule also includes a two-year transition period for issuers that subsequently subsequently that issuers for period transition two-year a includes also rule The agent. threshold. asset total million $25 the exceed has total assets not exceeding C-AR Form on report 225. an annual file must CF offering a in Regulation securities sold has that issuer An § 227.203(b). 17 C.F.R. report. by the covered year the fiscal of the end after 120 days than later no 226. holder count if the issuer: (1) is current in filing its Regulation CF annual reports, annual CF Regulation its filing in current is (1) issuer: the if count holder 524 524 O https://www.sec.gov/Archives/edgar/data/1754776/000175477618000004/thephluidproject_formca.pdf. https://www.sec.gov/Archives/edgar/data/1754776/000175477618000004/thephluidproject_formca.pdf. 228. B million. exceptions that mentioned are Like below. WefunderCrowdfunder SAFEs, SAFEs occurs. Event” “Liquidity or Financing” “Equity an if stock nonvoting into convert $1Combinator includeCrowd SAFEs However, a Y safes, unlike Wefunder or SAFEs conversion. financing equity an trigger to threshold size minimum million 42208-tul_55-3 Sheet No. 85 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 85 42208-tul_55-3 42208-tul_55-3 Sheet No. 86 Side A 05/15/2020 10:30:18 The safe However, However, 231 525 525 232 229 AVOIDABLY DIFFICULT N U S I , https://republic.co/crowdsafe (last visited Feb. 22, 2020). 2020). 22, Feb. visited (last https://republic.co/crowdsafe , S ) 5/14/2020) 9:49 AM sion Avoidance Avoidance sion EPUBLIC r , R TARTUP 230 ELETE S D note 13, at 177–78. G OT OT a N r N p O u s (D G YOU G N UBLISHER P oblems with Conve with oblems afe: Clean Cap Table Cap Clean afe: r S FOR FOR VALUI owd owd c. P c. r J - FINAL Thisarticle posits anotherharmful dividend scenario. The issuer could avoid The C The Wefunder SAFE the to (due Loophole) Common Stock and the SAFE Crowd safe where a scenario envision Coyle and Green essay, 2016 their in However, M K Imagine a . . . company that raises capital in a crowdfunding offering using a SAFE. The The SAFE. a using offering crowdfunding a in capital raises that . company . . a significant Imagine generating starts which service, or product a launch to capital that uses company cash flow before the company needs additional capital. The company is able to usethat cash flow distributing to obtainstart to bank profits financing healthy and may even havesufficiently profits have to also reinvest may in growing company the that business. point, some At is extremely that a path following business, This (the founders). owners its to profits those in continue could businesses, small and startups non-tech norm—for the If common—perhaps sell. to needing or capital equity additional needing ever without perpetuity in fashion this no earning securities, their hold to continue would holders SAFE the happen, to were that interest, receiving no dividends and never seeing any return of their problem.” original “dividend investment.the this call We cap “messy avoid CF Reg under fundraising as startups helps represented be It to table. cap your campaign on Republic item your in line one investors all allows SAFE Crowd The table” concerns,legal save reduce fees, and the time spent structuringterms the their of financing. at convert IPO, automatically don’t acquisition, they event––an SAFE, liquidity traditional a a at Unlike convert only control. of investors change or SAFE, Crowd the With subsequentequity financing. too.) work, This ensuresthat investors make can are never be––we the on to captable them as individuals. like you’d unless is, (That C Y RCUTT RCUTT 231. The dividend would make the issuer a less attractive acquisition candidate, since it would have fewer fewer have would it since 231. candidate, acquisition attractive a less issuer the make would dividend The assets, but that could be addressed by lowering the acquisitionits and price to performance its in match dealing the fair and dividend 232. faith good of a duty payment. party each upon imposes contract “Every over provisionis to allowissuers a clean cap table. 229. 229. 2020] 2020] O conversion until reaching a liquidity event—most likely a sale of the company. Shortly Shortly company. the of a sale likely event—most liquidity a reaching until conversion before the sale is consummatedand conversion takes place, base. theissuer shareholder could declarea existing its to residual its of a portion distribute and dividend 230. Green & Coyle (2016), (2016), Coyle & 230. Green investors duty would not fiduciary be entitled by blocked be to thatnot dividend, would dividend since the they are declare to not shareholders. ability board’s issuer the Moreover, concerns since, once again,the safe holdersare dealing. not shareholders. fair and faith A pre-sale good dividend of could covenant implied issuer’s the violate possibly

(due to the minimum-size threshold, the roll-over feature, and possibly the Common Stock the Stock Common possibly and feature, roll-over the threshold, minimum-size the to (due Loophole) allow issuersavoid to conversion. That that Is a problem? dividends. pay At first glance,the startups answer few market, startup traditional the In no. be to seem may meansinvestors only receive cash flows when the startup achieves a liquidity event(sale of the company or IPO),at which point theinvestors can selltheir stock for cash. Since conversionavoidance not is possible whena liquidity event occurs, investorsnotdo appear harmed. be to investors could be harmed by conversion avoidance. 42208-tul_55-3 Sheet No. 86 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 86 42208-tul_55-3 42208-tul_55-3 Sheet No. 86 Side B 05/15/2020 10:30:18 M K C Y 4 3 7 7 15 35 Id. Number of Issuersof . 1981). Comment d to section . section to d Comment 1981). NST Recall that discounts and and discounts that Recall I 233 AW AW [Vol. 55:469 55:469 [Vol. .L M 234 Valuation Caps No valuation cap cap valuation No Below $5 million $5 million Below $40 million and above above and $40 million § 205 (A $5 million to below $10 million $10 million below to million $5 $20 million to below $40 million $40 million below to million $20 $20 million below to million $10 Average valuation cap was $11.6 million million $11.6 was cap valuation Average A LAW REVIEW A LAW S ONTRACTS ) 5/14/2020) 9:45 AM C ation Caps Caps ation TUL OF ELETE u ) D OT OT 1 4 1 2 1 19 10 32 N O ECOND Issuers (D (S Number of nts and Val and nts u UBLISHER P ESTATEMENT ESTATEMENT FOR FOR d. Disco 10% 10% 12% 15% 20% 22% 25% 30% J - FINAL There were twenty-two convertible note deals in the Study, fifteen of which were were which of fifteen Study, the in deals note convertible twenty-two were There 2. Convertible Notes 2. Convertible The Study alsoraised concernsabout the discounts and valuation caps employed by No discountNo Discount Rate Average was 13.1 discount percent Table 10 10 Table Discounts and caps valuation for the safe issuers RCUTT RCUTT cap. 233. valuation the and discount the both from to benefit investors early-bird allowed deals few A 234. Table investors. to early-bird caps or rates valuation discount more favorable offered of issuers the Some 10does notaccount forany early-bird incentives. 205 explains that “evasion of the spirit of the bargain” is bad faith behavior that violates the duty. duty. the violates that behavior faith bad is bargain” the of spirit the of “evasion that explains 205 valuation caps aremeant to compensate investorsfor theadditional risk they incur by premium risk the is cap valuation and/or discount The round. priced the before investing issuers includes issuers—which Riskier dollars. earlier-stage raise to pay must issuer the and discounts higher pay offering—should qualified future a conduct to likely less are that (see deals safe high the on discounts very the that found Study the However, frequently caps. valuation were lower have caps valuation the while nonexistent to low generally were to deals) seventy-one the of nineteen (in percent zero from ranged Discounts 10). Table the Regarding percent. 13.1 rate of discount average an with deal) one percent (in thirty The more. or million $20 of cap a or cap no either had deals the of fourteen caps, valuation million. was $11.6 cap average the and million, $70 was cap valuation highest

conducted through Wefunder and seven through StartEngine. There was less uniformity uniformity less was There StartEngine. through seven and Wefunder through conducted amongthe convertiblenote deals than the deals. safe issuers. SAFEs WefunderCrowd generally and SAFEs included features, both with them. for favorable more is whichever using investors enforcement.” R the duty of good faith and fair dealing is not well defined and would require a court to to court a require would and defined well not is dealing fair and faith good of duty the analyze the specific facts andcircumstances of the dividend. Clearly prohibitingpre-sale dividendswould be a betterapproach for safe investors. 526 526 O 42208-tul_55-3 Sheet No. 86 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 86 42208-tul_55-3 42208-tul_55-3 Sheet No. 87 Side A 05/15/2020 10:30:18 527 527 1 2 3 2 1 11 Number Issuers of AVOIDABLY DIFFICULT N U S I S ) 5/14/2020) 9:49 AM TARTUP ELETE S D G OT OT N N O Up to $500,000 $500,000 to Up No sizeNo threshold Above $3 million $3 million Above (D sions sions r G YOU G N UBLISHER P Above $500,000 and up to $1 million million $1 to up and $500,000 Above Above $1 million and up to $2 million million $2 to up and million $1 Above million $3 to up and million $2 Above FOR FOR VALUI a. Conve Table 11 11 Table notes convertible the for thresholds Size SizeQualified threshold be to a Financing J - FINAL Like classic convertible notes, the convertible notes in the Study generally convert convert generally Study the in notes convertible the notes, convertible classic Like The convertible notes could define the issuer’s subsequent capital stock offering as as offering stock capital subsequent issuer’s the define could notes convertible The the but notes, convertible for problematic is avoidance conversion safes, with As Of the twenty notes with a Qualified Financing conversion provision, they generally generally they provision, conversion Financing a Qualified with notes twenty the Of M K C Y RCUTT RCUTT including any equity securities (common or preferred), preferred stock only, or common common or only, stock preferred preferred), or (common securities equity any including issuing by conversion avoid to ability the has issuer the limited, is option the If only. stock a form stock of thatdoes not triggerthe Qualified Financing as definition.the Financing Of twentynotes a Qualified defined ten provision, conversion Financing a Qualified with including any equity securities. However, several thosenotes of went state on to thenotes to as ambiguity creating financing, triggering the in issued stock preferred the into convert stock. preferred to solely limited actually is Financing Qualified a whether problem is different. Themain problem note for convertible notes convertible a stems on rate from whathappens interest the if Because converting. without maturity reach notes the off pay simply and conversion avoid to wish may issuers 12), Table (see low typically is low-interest unsecured, are notes convertible that Considering matures. it when loan the CF Regulation many for strategy profitable most the be could loan the repaying loans, issuers. 2020] 2020] O to preferred stock (or a shadow stock that resembles the issued securities but with with but securities issued the resembles that stock a shadow (or stock preferred to equity a qualified conducts (a) issuer the if rights) voting no as such modifications conversion Financing Qualified financing (referredinclude as a “Qualified to not Financing” did innotes) the or experiences (b) notes a change the of two However, control. of provisions and convert only if a change control of occurs. defined a Qualified Financing as a transaction, or series of transactions, in which the issuer issuer the which in transactions, of series or transaction, a as Financing a Qualified defined raises a stated cash threshold stock. from a sale the of capital issuer’s as capital stock. qualifies This means what there(b) are and threshold; size the (a) define: to variables key two included notes nineteen other The threshold. size a include not did notes twenty the of One size including notes the of six with million, $7 to $250,000 from ranging thresholds size for easier it make thresholds size Higher 11). Table (see million $1 above thresholds issuers avoidto conversion. 42208-tul_55-3 Sheet No. 87 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 87 42208-tul_55-3 42208-tul_55-3 Sheet No. 87 Side B 05/15/2020 10:30:18 , . , T ’ NC I M K EP OWER D P C Y HENOMIX OMEFREE ISE OOKIE OOKIE C) (Nov. 30, 2018), 2018), 30, (Nov. C) The other notes either either notes other The ORM 235 (F C) (Nov. 9, 2018), 9, 2018), C) (Nov. 2 2 2 4 9 2 1 C/A) (Apr. 19, 2019), 2019), 19, C/A) (Apr. [Vol. 55:469 55:469 [Vol. C/A) (Apr. 18, 2019), 2019), 18, C/A) (Apr. C/A) (Dec. 19, 2018), 2018), 19, (Dec. C/A) C/A) (Aug. 30, 2018), 2018), 30, (Aug. C/A) ORM Number Issuers of TATEMENT (F ORM S (F ORM ORM ORM (F (F (F A LAW REVIEW A LAW FFERING FFERING S ) 5/14/2020) 9:45 AM TATEMENT TATEMENT ., O S TUL ELETE TATEMENT TATEMENT D NC S 2% 3% 4% 5% 6% 8% 12% 12% OT OT N ,I TATEMENT O TATEMENT TATEMENT TATEMENT TATEMENT S S S Interest Rate (D ARMS F FFERING FFERING Table 12 12 Table notes convertible the for rates Interest FFERING UBLISHER P FOR FOR LEMENT FFERING FFERING FFERING E ), O B & ee J - FINAL In the Regulation CF market, the incentives for issuers to avoid conversion and treat treat and conversion avoid to issuers for incentives the market, CF Regulation the In S In the traditional startup market, issuers generally do not have an incentive to reach reach to incentive an have not do generally issuers market, startup traditional the In . . LLC, O .,., O O RCUTT RCUTT CIS 235 MISTERB NC NC https://www.sec.gov/Archives/edgar/data/1759313/000167025419000243/documents_list.htm; C https://www.sec.gov/Archives/edgar/data/1759313/000167025419000243/documents_list.htm; automatically convert to stock at maturity or give note holders the option to convert. The The convert. to option the holders note give or maturity at stock to convert automatically the Because rate. discount or cap valuation note’s the on based typically is rate conversion (discussed low rates high discount the and generally were Study the in caps valuation H https://www.sec.gov/Archives/edgar/data/1759704/000167025418000574/documents_list.htm; https://www.sec.gov/Archives/edgar/data/1741500/000166516018000869/wise_offeringscreen.pdf. https://www.sec.gov/Archives/edgar/data/1741500/000166516018000869/wise_offeringscreen.pdf. the convertible notes as low interest loans are less clear. First, reputation is unlikely to play play to unlikely is reputation First, clear. less are loans interest low as notes convertible the are issuers CF Regulation Most market. CF Regulation the in role enforcement same the raising are they why is which market, capital venture the to outsiders be to likely reputation their risk to willing more be may they so place, first the in capital CF Regulation to issuers for it easy make Study the in notes the of most Second, loan. interest low a for pay to issuer the require simply notes the of Six loans. interest low as instruments the treat the principal andinterest ifnote the reaches maturity. maturity without converting. These issuers want to cooperate with the venture capital capital the venture with cooperate to want issuers These converting. without maturity community, raisea priced venture capitalround, and reap the benefits of beinga venturecapital-backed company. If these issuersreach maturity without converting, it is because thingshave gone wrong. Just as safe issuers the in in the traditional issuers note that startup market unlikely is are it unlikely conversions, safe avoid to reputation their risk to to community capital venture the in reputation their risk would market startup traditional give often setting traditional the in notes convertible Moreover, loan. interest low a get or repayment immediate demanding (a) of maturity reaching upon option the holders note beneficial be to likely is that rate conversion pre-set a at equity into note the converting (b) notes the repay and conversion avoid to sought strategically issuer an If holders. note the to at the stock to notes their convert and payment refuse could holders note the maturity, at favorable pre-setrate. LLC, O ( I I S 528 528 O https://www.sec.gov/Archives/edgar/data/1757804/000167025418000530/documents_list.htm; SFO84, https://www.sec.gov/Archives/edgar/data/1757804/000167025418000530/documents_list.htm; https://www.sec.gov/Archives/edgar/data/1748804/000167025418000603/documents_list.htm; W https://www.sec.gov/Archives/edgar/data/1748804/000167025418000603/documents_list.htm; https://www.sec.gov/Archives/edgar/data/1755119/000167025419000226/documents_list.htm; P https://www.sec.gov/Archives/edgar/data/1755119/000167025419000226/documents_list.htm; 42208-tul_55-3 Sheet No. 87 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 87 42208-tul_55-3 42208-tul_55-3 Sheet No. 88 Side A 05/15/2020 10:30:18 . ., LA NC NC I O ORM I ODAY The The (F LEMENT FFERING 238 .L.T ,O ERIGLIF ERIGLIF US AWAIIAN AWAIIAN NC 529 529 TATEMENT S US I , ABA:B note 235. a 2010/01/09_oest/. 2010/01/09_oest/. r FFERING C) (Aug. 16, 2018), 2018), 16, (Aug. C) p u C) (June 3, 2019), 3, C) (June s spective r MARTGURLZ MARTGURLZ C), C) (Nov. 19, 2018), 2018), 19, (Nov. C) ORM , LLC, O s Pe ’ (F r ORM ORM (F (F This author surprised very was to owe rr OMEFREE ORM ORM 237 AVOIDABLY DIFFICULT (F note 235; 235; S note C) (May 13, 2019), 2019), 13, C) (May a N r p TATEMENT TATEMENT U TATEMENT u S s S S I note 235; note H TATEMENT TATEMENT S a S r p C/A), 6,C) 2019), (May u s FFERING ORM TATEMENT TATEMENT ) 5/14/2020) 9:49 AM FFERING S C), C), (F ORM ation Caps Caps ation TARTUP (F ELETE u S while four of the notes give issuers the right to prepay the the prepay to right the issuers give notes the of four while ,O D ORM FFERING .LLC,O (F G OT OT NC 236 CIS N N S O ,I ., O (D FFERING ORM TATEMENT NC S (F nts and Val and nts AMES TATEMENT TATEMENT G YOU G u S G HENOMIX egotiating the Loan Commitment: The Bo N www.americanbar.org/groups/business_law/publications/blt/ TATEMENT TATEMENT N UBLISHER ,I ., O S P epayments epayments r FFERING ITE ORP FOR FOR BOON C R FFERING VALUI b. P c. Disco ), O note 235; P 235; note ., O B a r & UN NC ee p J - FINAL S One of the notes prohibited prepayment and two of the notes were silent regarding regarding silent were notes the of two and prepayment prohibited notes the of One As a general rule, convertible notes should prohibit issuers from prepaying the loan. loan. the prepaying from issuers prohibit should notes convertible rule, a general As Finally, the same concerns about low discounts and high valuation caps that applied applied that caps valuation high and discounts low about concerns same the Finally, ,I u s M K . C Y FFERING FFERING REWING REWING RCUTT RCUTT TATEMENT TATEMENT ARMS 236 MISTERB https://www.sec.gov/Archives/edgar/data/1674519/000167025418000555/documents_list.htm; SFO84, https://www.sec.gov/Archives/edgar/data/1674519/000167025418000555/documents_list.htm; https://www.sec.gov/Archives/edgar/data/1737125/000167025419000326/documents_list.htm; V https://www.sec.gov/Archives/edgar/data/1737125/000167025419000326/documents_list.htm; below), the conversion option may provide note holders little solace. solace. little holders note provide may option conversion the below), https://www.sec.gov/Archives/edgar/data/1748769/000167025418000377/documents_list.htm; E https://www.sec.gov/Archives/edgar/data/1748769/000167025418000377/documents_list.htm; https://www.sec.gov/Archives/edgar/data/1774003/000167025419000368/documents_list.htm; H https://www.sec.gov/Archives/edgar/data/1774003/000167025419000368/documents_list.htm; prepayment, which probably means those issuers lack a prepayment right. prepayment a lack issuers those means probably which prepayment, see broad prepayment rights in any of the notes, let alone forty percent of them! them! of percent forty alone let notes, the of any in rights prepayment broad see ( O S F C/A), B 2020] 2020] O (Jan. 20, 2010), https:// 2010), 20, (Jan. https://www.sec.gov/Archives/edgar/data/1774921/000167025419000339/documents_list.htm. https://www.sec.gov/Archives/edgar/data/1774921/000167025419000339/documents_list.htm. 237. D notes in advance of a change of control transaction. control of a change of advance in notes

to the Regulation CF safes apply equally to the convertible notes in the Study (see Table Table (see Study the in notes convertible the to equally apply safes CF Regulation the to an with percent twenty to percent zero from ranged discounts note convertible The 13). $40 to million $1.9 from ranged caps valuation while percent, 15.2 of discount average million. $9.7 of cap valuation average an with million remaining ten notes only allow prepayment if the holders consent. consent. holders the if prepayment allow only notes ten remaining 238. Oest, N. John Itisthe same issue as the conversion avoidance problem.If prepayments are allowed, issuers can strategically repay thenotes before anattractive conversion event occurs. Rather than to sharethe right company’s free the cash flows withmore issuers shareholders, give issuer the Study can the in notes the of Five loan. interest low the prepay simply time, any at notes the prepay 42208-tul_55-3 Sheet No. 88 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 88 42208-tul_55-3 42208-tul_55-3 Sheet No. 88 Side B 05/15/2020 10:30:18 M K C Y 2 0 5 9 6 Number of Issuers Issuers of [Vol. 55:469 55:469 [Vol. ValuationCaps Below $5 million $5 million Below $30 million and above above and $30 million $5 million to below $10 million $10 million below to million $5 $20 million to below $30 million $30 million below to million $20 $20 million below to million $10 Average valuation cap was $9.7 million million $9.7 was cap valuation Average A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM TUL ELETE D OT OT 1 1 1 3 5 1 N 10 O Issuers (D Number of UBLISHER P FOR FOR A priced equity round triggers an automatic conversion; conversion; automatic an triggers round equity priced A The deferred-equity investors’ future cash flows come from an exit event— exit an from come flows cash future investors’ deferred-equity The equity priced the after place takes company—that the of a sale likely most and round; High-quality investors in the priced price that equity taking round investors valuethe future deferred-equity the cash with flows event, exit projected a from their for them compensates that cap valuation or a discount by (adjusted risk). additional teps? teps? S 5% 20% 20% 10% 10% 15% 7.5% 7.5% x x x 17.5% 17.5% J - FINAL What should be done about the Regulation CF deferred-equity market? As explained explained As market? deferred-equity CF Regulation the about done be should What Valuation deferral works in the traditional startup market because the investors in in investors the because market startup traditional the in works deferral Valuation identifying/measuring for process the about concerns substantial raises Study The ext N Discount Rates No discount rate rate discount No RCUTT RCUTT Average was 15.2 discount percent Table 13 13 Table Discountsand valuation caps for the convertibleissuersnote C. 530 530 O earlier, valuation deferral does not change investors’ ultimate goal of purchasing valuable valuable purchasing of goal ultimate investors’ change not does deferral valuation earlier, future cash flows. It just changes the process for identifying andmeasuring the future cash this: like looks ideally which flows, the priced equity round tend to be venture capital firms that can thoughtfully value the the value thoughtfully can that firms capital venture be to tend round equity priced the deferred-equity classic the Additionally, startup. more-mature the for flows cash future instrumentsare generally pro-investor contracts that thoughtfullyaccount for therisk that investments. these with comes issuers The market. CF Regulation the in instruments deferred-equity for flows cash future the (a) eliminates which firms, capital venture from capital raise ever to unlikely appear baseline conversion eventand (b) the sophisticated investors who can counted be on to Regulation the makes alone problem That flows. cash future issuer’s the value thoughtfully instruments the of probability the lowers It questionable. highly market deferred-equity CF ever producing cash flows for investors. flows. cash And future ifthe a conversion measuring does accurately occur,investors itlowers subsequent the the of probability Assuming thoughtful some investors can get over thismajor problem, should they receive very investor-friendly instruments instruments’ the to account Despite forthis protection. additional downside more riskand providing by potential upside more investors with investment obtain consistently issuers CF Regulation that shows Study the risk, abundant termsinvestors from that are extremely issuer-friendly andthat increase the investors’risk 42208-tul_55-3 Sheet No. 88 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 88 42208-tul_55-3 42208-tul_55-3 Sheet No. 89 Side A 05/15/2020 10:30:18 239 244 ility; (b) Both tasks 242 531 531 243 StartEngine, and 246 Id. Republic, 245 . “Quantitative suitability requires a broker with a broker requires suitability “Quantitative AVOIDABLY DIFFICULT Id. N ial .05(a) r U S I S y Mate r ) 5/14/2020) 9:49 AM note 13, at 180–81 n.36. at 180–81 13, n.36. note a r TARTUP p ELETE pplementa S u D s Su G OT OT N N O FINRA offers FINRA the following description: (D )(C). )(C). Brokers are the standard intermediary securitiesfor transactions. Exchange Act 241 G YOU G note 241, at at 241, note a N r UBLISHER p P u s , FINRA, https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111 (last visited Feb. visited (last https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111 FINRA, , , FINRA, https://www.finra.org/industry/suitability (last visited Feb. 22, 2020). 2020). 22, Feb. visited (last https://www.finra.org/industry/suitability FINRA, , , FOR FOR VALUI Rule 2111. Rule le 2111 le le 2111 le itability 240 u u J - FINAL Su R The suitability duty would require some adaption for funding portals. Funding Funding portals. funding for adaption some require would duty suitability The To address the problem, this article recommends that the SEC or FINRA impose a impose FINRA or SEC the that recommends article this problem, the address To The duty is intendedto prevent broker’s from pushinginappropriate investments on R M K rule. suitability the violates itself according understanding an customer, the such and of lack product The the 2111. both Rule to of understanding firm a have must Brokers to basis reasonable a have person reasonable believe associated or a firm through recommended a that requires 2111 Rule transaction obtained FINRA orinvestment information the on strategybased involvingis This a security or securities customer. the for suitable is diligence of the firm or associatedperson to ascertainthe customer’sinvestment profile...... C Y RCUTT RCUTT 22, 2020). 2020). 22, 242. suitab basis 243. (a) reasonable components: three as having duty the suitability describes FINRA 240. FINRA is not a governmental organization. It is a national securities association that is registered with registered is that association 240. securities a is national It organization. a governmental is not of FINRA jurisdiction the under fall brokers However, § 78o-3. 15 U.S.C. 15A. section Act Exchange per SEC the become brokers registered that mandates § 15 78o(b)(8), U.S.C. 15(b)(8), section Act Exchange because FINRA § 240.15b9- 17 C.F.R. 15b9-1. Rule Act Exchange in forth set exemptions limited to subject FINRA, of members 1. 241. heavily regulatedregister entities that 78o(a)(1), must 15SEC,§the with U.S.C. and become membersof were portals funding burden, regulatory heavy brokers’ about to Due concerns § 78o(b)(8). 15 U.S.C. FINRA, a broker in activities the all engage may not portals Funding intermediary. securities an additional as introduced may engage in, but they are also less-heavily regulated. 246. LLC. Portal OpenDeal name is legal Its suitability duty on funding portals that host Regulation CF deferred-equity offerings. deferred-equity CF Regulation host that portals funding on duty suitability exposure. exposure. portals are a new form of securities intermediary introduced by the JOBS Act and and Act JOBS the by introduced intermediary securities of form new a are portals must transactions CF Regulation transactions. CF Regulation facilitate to CF Regulation portal. funding a or a broker either through conducted be customer when taken together in light of the customer’s investment profile.” investment the customer’s of in light together taken when customer customer-specific suitability; and (3) quantitativeof suitability.a series that believing for basis reasonable a have to account a customer’s over control facto de or actual the for unsuitable and excessive is not isolation, in viewed when if suitable even transactions, recommended 244. 239. when funding portals for duty a the idea of suitability and Coyle considered Green 2016 essay, their In (2016), Coyle Green & safes. offering 2020] 2020] O vulnerable for investors. basis reasonable The a brokerhave must can (a) know broker the the so customer investment (“customer-specific the know (b) and suitability”) obligation). basis” “reasonable (the customer that for suitable is it believing

This suitability duty could be similar to the one that brokers typically owe customers but but customers owe typically brokers that one the to similar be could duty suitability This in captured is duty suitability broker standard The setting. CF Regulation the to adapted FINRA require the broker use reasonable diligence. For example, it would be unsuitable for a for unsuitable be would it example, For diligence. reasonable use broker the require erosion principal of risk substantial a with investment speculative a recommend to broker be also would It retirement. for funds limited with widow(er) eighty-five-year-old an to fail. to designed are that investments anyone to recommend to a broker for unsuitable section 3(a)(4), 15 U.S.C. § 78c(a)(4), defines a broker as any person (including legal entities), other than a bank, a bank, than other entities), legal (including person any as a broker defines § 78c(a)(4), 15 U.S.C. 3(a)(4), section are Brokers others.” of account the for in securities transactions effecting of business the in “engaged is that 245. 15 U.S.C. § 77d(a)(6 § U.S.C. 245. 15 42208-tul_55-3 Sheet No. 89 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 89 42208-tul_55-3 42208-tul_55-3 Sheet No. 89 Side B 05/15/2020 10:30:18 250 M K C Y , FINRA, , FINRA, le 2360(b)(19) u R , FINRA, le 2370(b)(19) le u R relating to this mandatory 253 [Vol. 55:469 55:469 [Vol. and Regulation CF Rule 402(a) Rule CF Regulation and The SEC could expand Rule 402(b) 402(b) Rule expand could SEC The Most importantly for this article’s article’s this for importantly Most 249 252 251 le 2310(b)(2) le u For Regulation CF deferred-equity instruments, instruments, deferred-equity CF Regulation For A LAW REVIEW A LAW 254 S ) 5/14/2020) 9:45 AM 247 TUL ELETE D , FINRA,, https://www.finra.org/about/funding-portals-we-regulate(last OT OT late N u R , O (D UBLISHER talsReg We P r FOR FOR The instruments are designed to generate positive results from a subsequent a subsequent results from positive generate to designed are instruments The equity financing led sophisticated by subsequent investors that on depends who can properlymechanism value deferral the valuation entire The issuer. issuers the of most Yet, investors. sophisticated by priced financing equity Despite performing some broker-like functions,funding portals arenot nding Po nding 248 u ee, e.g. ee, x J - FINAL FINRA has experience tailoring suitability obligations to specific investment types, types, investment specific to obligations suitability tailoring experience has FINRA F FINRA’s Rule 2111 does not apply to funding portals. It only applies to brokers and and brokers to applies only It portals. funding to apply not does 2111 Rule FINRA’s S . RCUTT RCUTT 254 recommendation, Rule 402(b)(1) allows funding portals to “[d]etermine whether and whether “[d]etermine to portals funding allows 402(b)(1) Rule recommendation, 4(a)(6) section on reliance in securities sell and offer to issuer an allow to terms what under .” . . . platform its . through . . Act Securities the of visited Feb. 22, 2020). The FINRA list includes OpenDeal Portal LLC (which operates under the the name under operates (which LLC Portal OpenDeal includes list FINRA The 2020). 22, Feb. visited “Republic”), StartEngine Capital LLC, and Wefunder Portal LLC. to makepre-clearing deferred-equity issuers mandatory,rather than permissible. portals FINRA funding on duty suitability a impose then could so this should not be a burdensome task for FINRA. FINRA Rule 2111 sets forth the forth the 2111 sets Rule FINRA task for FINRA. a burdensome be not this should so direct as such instruments, complex more certain for However, duty. suitability general suitability additional developed has FINRA futures, and options, programs, participation requirements that brokers must satisfy. preclearance obligation. Like brokers, funding portals are FINRA members and subject to to subject and members FINRA are portals funding brokers, Like obligation. preclearance authority. its rule-making 247. 247. Wefunderare all funding portals. 532 532 O this author suggests the suitability duty focus primarily on the reasonable basis obligation, obligation, basis reasonable the on primarily focus duty suitability the suggests author this funding that not is problem The component. suitability customer-specific the than rather portals arehosting high-risk investmentspoorly are instruments that some of its customers deferred-equity CF may Regulation not the of understand. many that is problem The designedand offerno investor,regardless of sophistication,much chance for success. brokers. Moreover, Exchange Act section 3(a)(80) section Act Exchange Moreover, brokers. prohibit funding portals from offering investment advice or recommendations, which are are which recommendations, or advice investment offering from portals funding prohibit or advising from prohibited While duty. suitability 2111 Rule the for triggers the funding permitting harbor safe a contains 402(b) Rule CF Regulation recommending, activities. similar certain in engage to portals dealers. 248. Dealers are defined in Exchange Act section 3(a)(5), 15 U.S.C. § 78c(a)(5), generally as any person, other other any person, as generally 248. § 78c(a)(5), 15 U.S.C. 3(a)(5), section Act Exchange in defined are Dealers a as regular part of account own her for securities and selling of buying in the a is business who bank, than business. One 3(a)(80). sections 249. Act two Exchange are there error, typographical a to Due portals.” § 78c(a)(80). “funding 15 U.S.C. defines one and companies” growth “emerging defines 227.402(a). § 250. C.F.R. 17 227.402(b). § 251. C.F.R. 17 227.402(b)(1). § 252. C.F.R. 17 them. to apply would duty same the 253. platforms, CF Regulation established brokers If http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=8469 (last visited Feb. 22, Feb. visited (last http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=8469 programs); participation direct for standards suitability additional (establishing 2020) http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6306 (last visited Feb. 22, Feb. visited (last http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6306 options); for standards suitability additional (establishing 2020) http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6309 (last visited Feb. 22, Feb. visited (last http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6309 futures). security for standards suitability additional (establishing 2020) 42208-tul_55-3 Sheet No. 89 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 89 42208-tul_55-3 42208-tul_55-3 Sheet No. 90 Side A 05/15/2020 10:30:18 have have 256 533 533 AVOIDABLY DIFFICULT . N U S I S ial .05(a) ONCLUSION r C V. ) 5/14/2020) 9:49 AM y Mate r TARTUP ELETE S D It is not clear that all of the current batch of Regulation CF CF Regulation of batch current the of all that clear not is It G OT OT N N 255 O pplementa (D Su G YOU G N UBLISHER investors.In general, what constitutesreasonable diligencedepending will vary on, P note 241, at at 241, note FOR FOR some a r VALUI appear unlikely to ever accomplish such an offering. offering. an such accomplish ever to unlikely appear Most of the instruments allow issuers an unacceptably broad ability to avoid avoid to ability broad unacceptably an issuers allow instruments the of Most conversion, which can exploited be issuers.by Some of the convertible notes are essentially high-risk, low-reward low-reward high-risk, essentially are notes convertible the of Some avoidance conversion to due instruments low-reward are They instruments. a low- of that to reward their limit may that rights prepayment and/or features risk. more far with but loan, unsecured interest, p Thirty-six of the forty deals (or ninety percent) funded through Republic were safes. safes. were Republic through funded percent) (or ninety deals the of forty Thirty-six convertible or safes were Wefunder through funded percent) sixty (or deals eighty-four the of Fifty notes. u s The reasonable-basis obligation at requires for suitable is recommendation a the that member diligence, reasonable or on associatedbased to believe, basis person to have a reasonable least investment or the security with associated risks and of complexity the things, other among strategyandthe member’sassociatedor person’s familiaritythe with security investment or or member the provide must diligence reasonable person’s the associated or with member’s A strategy. associated rewards and risks potential the of understanding an with person associated a recommending when an understanding of The lack such or strategy. security recommended security or strategy violates the suitability rule. , x x J - FINAL In a well-functioning market, reasonable investors are less likely to invest in in invest to likely less are investors reasonable market, a well-functioning In A suitability duty would also help to correct a conflict of interest that currently currently that interest of conflict a correct to help also would duty suitability A To allow issuers to sell deferred-equity instruments through their platforms, funding funding platforms, their through instruments deferred-equity sell to issuers allow To x x M K C Y le 2111 le RCUTT RCUTT u companies when they cannot confidently value the opportunity, which reduces vital vital reduces which opportunity, the value confidently cannot they when companies by solution a partial offer instruments Deferred-equity startups. for young fundraising capital-eligible venture in invest thoughtfully to Investors Startup Specialized allowing a contractual provide They investment. of time the at them valuing without startups young cash expected the value directly than Rather problem. intractable otherwise an to solution a allow instruments deferred-equity startup, young a in investing from come that flows venture as such investors, sophisticated highly by priced is financing—that equity future 255. This suggestion is based on Supplemental Material .05(a) to Rule 2111, which explains: explains: which 2111, Rule to .05(a) 255. Material Supplemental on based is suggestion This 2020] 2020] O R plagues the Regulation CF market. Because issuers are the ones paying the funding portals, portals, funding the paying ones the are issuers Because market. CF Regulation the plagues Republic that surprise no as come should It issuers. their to likely is loyalty first portals’ the issuers, deferred-equity on substantially depend businesses whose Wefunder, and deferred-equity instruments would pass that standard. standard. that pass would instruments deferred-equity developed very issuer-friendly deferred-equity instruments that they actively market to to market actively they that instruments deferred-equity issuer-friendly very developed worst-designed the eliminate to portals funding forcing to addition In investors. and issuers funding requiring by interest of conflict the reduce would duty suitability a instruments, deferred-equity allowing before interests investors’ to consideration due give to portals their through to platforms. sell instruments 256. period: time Study’s the During portals would need to have a reasonable basis to believe, based on reasonable diligence, diligence, reasonable on based believe, to basis reasonable a have to need would portals would diligence Reasonable investors. some least at for suitable are instruments such that and risks the potential of understanding an with portals funding the provide to need instruments. the of rewards 42208-tul_55-3 Sheet No. 90 Side A 05/15/2020 10:30:18 Side A 05/15/2020 Sheet No. 90 42208-tul_55-3 42208-tul_55-3 Sheet No. 90 Side B 05/15/2020 10:30:18 M K C Y [Vol. 55:469 55:469 [Vol. A LAW REVIEW A LAW S ) 5/14/2020) 9:45 AM TUL ELETE D OT OT N O (D impose a suitability duty on funding portals that host Regulation CF CF Regulation host that portals funding on duty a suitability impose UBLISHER P FOR FOR J - FINAL Finally, this article closes with a message to policymakers outside the United States. States. United the outside policymakers to message a with closes article this Finally, If the story ended there, deferred-equity instruments would be a resounding success. success. resounding a be would instruments deferred-equity there, ended story the If RCUTT RCUTT Finding seed funding solutions for young startups is a critical matter for policymakers policymakers for matter critical a is startups young for solutions funding seed Finding around the world,not just the United States.The lessons this from article apply to any important an are instruments Deferred-equity market. startup meaningful a with country that startups young in invest to Investors Startup Specialized by used when tool financing However, investors. sophisticated highly involving financings equity future for eligible are general the from capital raise to startups young by used when tool dangerous a also are they to lead not should market startup traditional in a role positive equity’s Deferred public. crowdfunding a in role negative their And setting. a crowdfunding in regulation lenient market. startup traditional a in regulation greater to lead not should setting deferred-equity offerings. It is important to note that crowdfunding remains a relatively relatively a remains crowdfunding that note to important is It offerings. deferred-equity new phenomenon. Regulationrelationship CFissuers integrated more and a offeringsdevelop could may look issuers very CF different Regulation in example, a For few years. the current of criticism strong article’s This community. capital venture the with advantage An years. few a in outdated look could market deferred-equity CF Regulation offerings CF Regulation future If adaptability. its is solution suitability proposed the of investor- more and capital venture raise to opportunities meaningful with issuers involve obstacle. an be not would duty a suitability terms, friendly However, their spread to the Regulation CF market does not appear to be positive. This This positive. be to appear not does market CF Regulation the to spread their However, Republic, the through funded deals the deferred-equity of examination article’s transfers risk improper of a picture paints 2019 during portals Wefunder and StartEngine, that recommends article this problem, the address To investors. public unsophisticated to the SEC FINRA or capital firms—value the cash flows. The deferred-equity investors then take the price set set price the take then investors deferred-equity The flows. cash the firms—value capital investment The cap). valuation or discount any for (adjusted investors sophisticated the by startup’s young the projecting from changed thus is investors deferred-equity for decision unavoidably are (which uncertainty their for accounting and flows profits/cash future predicting to history) operating meaningful no has startup young the when tasks difficult be should (which offering stock high-quality a future, conduct will startup the whether become have instruments Deferred-equity Investors). Startup Specialized for manageable positively have and market startup traditional the for tool financing important an decade. last the over explosion financing seed States’ United the to contributed 534 534 O 42208-tul_55-3 Sheet No. 90 Side B 05/15/2020 10:30:18 Side B 05/15/2020 Sheet No. 90 42208-tul_55-3