How to Raise a Little Money Without Spending a Lot

Transcription

1 How to Raise a Little Money Without Spending a Lot Benjamin M. Hron bhron@mccarter.com Rick M. Lucash rlucash@mccarter.com

2 Overview Securities Used in Raising Capital Convertible Debt Common Equity Series Seed Preferred Stock Structures Used in Raising Capital Rule 506 Private Placements Securities Crowdfunding Rewards Crowdfunding*

3 Securities Used in Raising Capital What is a Security? Ownership interest in a common enterprise where the holder is led to expect profits solely from the efforts of others. Examples: stocks, convertible debt, options

4 Securities Used in Raising Capital Convertible Debt Common Equity Series Seed Preferred Stock

5 Convertible Debt in a Nutshell Loan that can be converted to stock Usually simpler/cheaper than equity financing But seed equity getting simpler/standardized Best for: friends, family and solo angels when valuation is difficult to ascertain <$1M raise

6 Convertible Debt Terms Loan to (Debt of) the Company Principal and interest repayable at future date/circumstances Term/due date: 1 2 years Cash payment of principal and interest is likely a fail scenario Interest rate: 6-10% Accrues until maturity

7 Convertible Debt Terms May convert to equity By whom (investor or company) Acquisition, Financing, Option of Investor, At Maturity, Option of Company (rare) Conversion typically comes with a benefit: discount off next round or warrants Conversion discount: 15-25% Increases every 3 6 months Optional: Cap on conversion value

8 Convertible Debt Pros & Cons Pros Puts off discussion of valuation Less costly than preferred stock financing Cons Interests of company and investor not aligned Good or bad for entrepreneurs?

9 Common Equity in a Nutshell Same stock as founders Usually valuation is the main issue negotiated Low cost Best for: Friends and family Small raise

10 Common Equity Pros & Cons Pros Simple Low Cost Interests of Company and Investors aligned Cons No investor protection (can backfire on company) Good or bad for entrepreneurs?

11 Preferred Equity in a Nutshell Equity with preferences over Common Stock Variety of possibilities adds complexity/cost Especially if there s no lead investor Best for: Financings of $500K-$1M From angels or micro-vcs With clear lead investor

12 Preferred Equity Terms Control Terms Voting Rights and Board Seats Investor Protective Provisions Information Rights Vesting of Founders' Equity ROFR and Co-Sale Drag-Along

13 Preferred Equity Terms Economic Terms Valuation and the Option Pool Shuffle Dividends Liquidation Preferences Anti-dilution Pre-emptive Rights and Pay-to-Play Redemption Rights Registration Rights

14 Preferred Equity Pros & Cons Pros Valuation? Interests of company and investors aligned Cons Pricey and time consuming Expensive capital Good or bad for entrepreneurs?

15 Structures Used in Raising Capital Structure driven by applicable laws Dual Federal/State Securities Regulation Prohibit offer or sale of securities unless the securities are registered (ex. IPO) an applicable exemption is available Exemptions Exempt Securities/Transactions Separate state exemption required absent preemption Consequences of Non-Compliance

16 Structures Used in Raising Capital Rule 506 Private Placements Traditional 506 financings (Rule 506(b)) New 506 financings (Rule 506(c)) Securities Crowdfunding Rewards Crowdfunding*

17 Rule 506 Private Placements Most financings conducted under Rule 506 Usually limited to Accredited Investors Natural Person with Net Worth (w/ or w/o spouse) >$1M (excl. home) Income >$200K in past 2 years and current year Joint income >$300K in past 2 yrs and current yr Director, executive officer or general partner Business in which all the equity owners are accredited investors Entities with > $5M in assets Preempts state securities laws

18 Rule 506 Private Placements in a Nutshell 506(b) (already in effect) No $$$ limit If offers & sales limited to accredited investors: No limit on # of investors No affirmative disclosure obligation Up to 35 sophisticated investors No general solicitation/advertising permitted Best for: Any sale of securities to a select group of accredited investors

19 Rule 506 Private Placements in a Nutshell 506(c) (not yet available) Still no $$$ limit Sales limited to accredited investors: No limit on # of investors No affirmative disclosure obligation Must use reasonable steps to verify investor status General solicitation/advertising permitted Best for: Sale of securities to accredited investors if using general solicitation

20 Rule 506 Private Placements Pros & Cons Pros Minimal regulatory requirements Well understood/accepted Cons Limited to accredited investors (effectively)

21 Securities Crowdfunding in a Nutshell Small investments from many people Securities Crowdfunding is not legal yet Framework created by 2012 JOBS Act SEC rules due January 2013; expected?? Probably won t be finalized until (at least) 2014 Companies may sell equity or convertible debt Best for: Sales of securities to masses

22 Securities Crowdfunding in a Nutshell Companies may raise up to $1M in 12 mo. Federal preemption of state securities laws No wealth thresholds for investor participation does impact amount that can be invested Limited disclosure requirements Partly determined by amount of financing Some ongoing reporting required Companies required to use approved portals

23 Securities Crowdfunding Pros & Cons Pros Larger pool of potential investors Cons Potential for hundreds of shareholders creates corporate governance and record-keeping issues May scare off some VCs, at least until best-practices are established

24 Rewards Crowdfunding in a Nutshell Small donations from many people Rewards for different donation levels Not regulated by securities laws, but Laws applicable to sales of goods may apply Must pay applicable taxes Third-Party Site takes fee and/or % of donations Best for: Companies with a product to sell

25 Rewards Crowdfunding Pros & Cons Pros No securities law issues Cons Can you deliver? Backers have no stake in future success

26 Final Thoughts Type of Security and Structure Drive Costs Ways to reduce costs: Stick close to standard terms Start with a detailed term sheet Have a strong lead investor Avoid piecemeal closings

27 McCarter & English LLP Questions? Benjamin M. Hron Rick M. Lucash