UNDERSTANDING ANGEL INVESTING IN NEW BUSINESSES

Transcription

1 UNDERSTANDING ANGEL INVESTING IN NEW BUSINESSES First Run Broadcast: December 18, 2012 Live Replay: April 15, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) The start-up capital for most businesses is provided not only by their founders but also by angel investors either friends and family of the founders or professional investors who put capital, or other resources, into the company at its earliest stages. The capital provided by these angel investors is essential to starting and growing the business. But as the company grows, their angel investment is often replaced by borrowing from banks, larger equity investments from institutional investors or investment funds, or simply by internally generated cash flow. The challenge is protecting the interests of early investors as the company grows and those interests are displaced by those of others. This program will provide you with a practical guide to structuring angel investments depending on the type of investors involved, drafting the essential documents for the deal, anticipating changes to the structure of the company, and common traps of friends and family investments. Structuring and drafting angel investments in businesses Differing structures friends and family and professional investors Common problems in friends and family investments Essential terms in angel investment documents preferred returns, non-dilution, control, non-competition Choice of entity considerations given nature of business, type angel investors, and future plans of the company Anticipating future investments and how that impacts early angel investors Speaker: James C. T. Linfield is a partner in the Broomfield, Colorado office of Cooley, LLP, where he is Partner-in-Charge of the firm s Colorado offices. His practice focuses on representation of public and private technology companies and venture capital funds, with an emphasis on corporate finance, mergers and acquisitions and strategic alliances. He has deep experience advising start-ups, venture-backed companies, public entities and investors across a wide variety of industries, including biotechnology, medical devices. Earlier in his career, he served as Chief Financial Officer and General Counsel of a biotechnology company. He is a member of the board of directors of the Deming Center for Entrepreneurship at the University of Colorado. Mr. Linfield earned his A.B., magna cum laude, from Harvard College and his J.D., magna cum laude, from Harvard Law School.

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4 Angel Investing Jim Linfield Cooley LLP (720) / jlinfield@cooley.com 2012 Cooley LLP, Five Palo Alto Square, 3000 El Camino Real, Palo Alto, CA The content of this packet is an introduction to Cooley LLP s capabilities and is not intended, by itself, to provide legal advice or create an attorney-client relationship. Prior results do not guarantee future outcome.

5 Topics Importance of Angels as Capital Source JOBS Act Update The Mysteries of Valuation LLC or C-Corp? Convertible Debt or Stock? Typical Terms Looking Ahead: Anticipating Future Rounds Common Problems in Angel Financings

6 Importance of Angel Investing Venture Industry Continues to Contract Venture: $24B in 2,900 deals (2011) Angel: $20B in 62,000 deals (2010)

7 Who Are The Angels? Very heterogeneous population Investments range from $10,000 to $1 million+ Friends, family, former co-workers, random acquaintances Family offices, superangels, micro-funds Levels of domain expertise investment experience and sophistication vary widely

8 Where to find them? Existing relationships Networking Various organized angel groups around the country (Band of Angels, Life Science Angels, Rockies Venture Investors, many others) Incubators and accelerators (Y Combinator, TechStars) Online: AngelList, others

9 Update on JOBS Act Crowdsourcing Regulations from SEC due January 2013, likely to be delayed Raising small amounts of money from large numbers of small investors will make sense for only a small percentage of businesses General Solicitation Proposed rule was due by 7/5, was issued on 8/29 Backlash from some in Congress, consumer groups Chairman Schapiro punted on SEC action until after her retirement in December 2012 Main focus of debate is what is required for Company s reasonable belief that purchasers are accredited Existing Regulation D provisions for transactions not involving general solicitation will remain in effect

10 The Mysteries of Early-Stage Valuation Valuation is THE #1 ISSUE in the negotiation between founder and investor Other deal terms are important, but not as critical as valuation in Angel rounds. Why is valuation important? Ownership Angels often don t stage their investments so % owned after first close is subject to dilution through multiple rounds VC Signaling Is valuation reasonable? If Angel group is expecting to attract VC round, there are problems with both high and low valuations

11 Terms - Valuation There is no secret or standard or particularly enlightened approach to valuations Leave the MBAs behind; valuation methods such as discounted cash flow don t predict startup valuations

12 Terms - Tech Startup Method of Valuation Commonly used in private companies Simple to apply: Three Easy Rules Speculate on the value of the company at a future point in time based on recent M&A exits Decide what percentage of the company the investor has to own to get the desired return on investment Convert that future value into present value and ownership

13 Typical Metrics

14 Pre-Money / Post-Money Valuation

15 Valuation Option Pool Pre-Money VCs always make option pool pre-money The reserve amount is typically based on anticipated headcount growth This time horizon is usually about as far as the CEO and the investors can reasonably foresee the future (12-24 months) The reserve amount is usually assessed and replenished with each financing Much less common in angel rounds

16 Choice of Entity: C Corp. v. LLC C Corp LLC Taxation Taxed Separately Flow-through Losses Add to NOL Passed through to investors Profits Taxed to company Taxed to owners Distribution Dividends may be taxable Distributions generally not taxable Equity Incentives Founders stock or options Profits Interest or options Employee Taxes W-2 withholding K-1 self-employment Investors Conversion of Debt Any person or entity can be a stockholder No income to company or stockholders Flow-through of income problematic for funds that have Foundations or CRTs as LPs (due to LBT1); foreign investors may avoid Debt-financed losses taken by members can be recaptured on conversion of debt

17 Convertible Debt or Equity?

18 Have notes won? Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note. - Paul Graham (Y Combinator), August 2010 Best for seed is convert w/ cap (*need* cap). Gives investors economic rights but not control rights and keeps legal fees down. The only advantage of equity over convert w/ cap is investor control, which you don't want/need. Let great people do their thing. - Chris Dixon (Hunch; Founder Collective), August 2010

19 Have notes won? I have been doing venture capital for 25 years now and have also done many angel investments personally along with my wife. We have never done a convertible debt round. I don't like convertible debt for a host of reasons. It used to be that convertible debt was a lot easier and cheaper to do legally. But with non-negotiated light series A docs from most top venture law firms out there, you can do a Series A Preferred for less than $5000. I am a sophisticated investor. I do this for a living. I can negotiate a fair price with an entrepreneur in five minutes and have done that for a seed/angel round many times. - Fred Wilson (Union Square Ventures), August 2010

20 Have notes won? Have convertible notes really won? And if so is that good for startups? Good for investors? I think the answers to these questions are that 1) it s not at all clear that this trend is as definitive as Graham suggests; 2) it s a mixed bag for entrepreneurs (more positive in the short run, potentially negative in the long term); and 3) it s clearly not a positive trend for early-stage investors. - Seth Levine (Foundry Group), August 2010

21 Choice of Investment Instrument Convertible Debt Common Stock Series Seed Preferred a/k/a Preferred Lite Series A Preferred

22 Convertible Debt Convertible into next round at a discount (typically 10-30%) If mandatory conversion, Qualified Financing must be defined (by reference to size of financing or price or both) Interest typically at 6-8% Maturity typically 6-24 months Conversion price may be capped In rare instances, may be secured by assets or subject to negative pledge (may be a bad sign)

23 Is a convertible note right for you? Pro Postpones setting of valuation to later time (when it may be higher) Simple Company Perspective Con No board seats, usually no protective provisions Investor Perspective Debt is debt Conversion discount on conversion to preferred results in liquidation premium to investor Pro Investor gets guaranteed discount to next equity round Con Conversion discount may not fairly reflect risk Risk that deal is retraded at next round Perverse incentive regarding equity round valuation?

24 Common Stock Simplest form of angel investment Aligns investors and management s interests Biggest drawback from company standpoint: no pricing flexibility for employee stock

25 Series Seed Preferred Also known as preferred lite Descoped version of traditional Series A documents In theory, provides foundation for later preferred rounds For example, see

26 Typical Terms of Preferred Stock Series Seed Series A Dividend Noncumulative Noncumulative or accruing Liquidation Preference Nonparticipating Nonparticipating or Participating with Cap Antidilution Protection None or Weighted Average Weighted Average Protective Provisions Limited More extensive Redemption None Sometimes

27 Control Issues Protective Covenants Seed or Lite = No block on M&A or financing; limit to changes adversely affecting Series Seed Key Issue Restriction on related party transactions outside ordinary course Series A: more extensive protective provisions Board Composition and Representation Series Seed often gets a board seat

28 Other terms Right of First Refusal and Co-Sale Preemptive Rights Drag-Along Pay to Play Registration Rights Information Rights No shop clause Expenses

29 Founder Issues Founder and Employee Vesting Entanglements with prior employers? Noncompetes Technology Diligence

30 Anticipating Later Rounds You are setting precedent: it s very hard for the company to improve terms after seed round Pay careful attention to amendment and waiver provisions (majority rule, if you can) Avoid giving early investors blocking rights on future financings Protective provisions Amendment and waiver provision Consider including drag-along provision from the beginning If formed as LLC, provide for possible conversion to C Corp in future and consider tax issues resulting from debt, treatment of profits interests

31 Common Problems Wrong turns on the road to exemption The Rule 504 trap Do they really have to be accredited? Dealing with unsophisticated investors Use of unregistered finders Board composition

32 The Road to Exemption First decision point: limit offering to accredited investors, or permit unaccredited investors? If all investors are (really) accredited, Life Is Good Companies seeking to raise from unaccredited investors are often tempted by Rule 504 exemption

33 The Rule 504 Trap Rule 504 permits sale of up to $1 million in 12 months to unlimited number of unaccredited investors But: application of general integration principle can create problems for companies engaged in continuous fundraising Six month hiatus not a viable option for many companies Important for client to understand, at the beginning, how integration principle limits utility of Rule 504 and plan accordingly Once a company has blown Rule 504, no easy way out 4(2) fallback? Rescission offer?

34 Is That Investor Really Accredited? The ease of dealing only with accredited investors makes Rule 506 a very attractive alternative... But: Dodd-Frank mandated change in accredited investor definition to exclude home equity in determining $1M net worth Effect was to significantly constrict the number of qualifying accredited investors some former members of that club have been kicked out Companies that start down this road sometimes want to reconsider, in light of difficulties in fundraising, or appeals from interested (but unaccredited) investors Very hard to add unaccredited investors once you d had a first closing with accredited investors

35 Dealing With Unsophisticated Investors The more stockholders a company has, the greater the likelihood of problem investors Mismatch of expectations, lack of understanding of risks and timelines One (of many) reasons why crowdsourcing won t take off

36 Use of Unregistered Finders Use of unregistered finder can create significant legal exposure for company and finder Finder s contract may be unenforceable Possible rescission claim for investors in offering that used unregistered finder SEC s current view is that transaction-based compensation is indicative of broker-dealer relationship, requiring registration Door to finder exception opened in Paul Anka no action letter SEC tried to slam the door shut by refusing to issue no-action letter in Bromberg, Machey & Wall, P.L.C. ( BMW ) in 2010 In SEC v. Kramer, a Federal District Court (M.D. Fla.) questioned SEC s position on transaction-based compensation; on appeal to 8 th Circuit Form D requires disclosure of payments to brokers or finders

37 A Cautionary Tale on Use of Unregistered Finders A small public company, Neogenix Oncology, made payments to finders that were not registered broker-dealers SEC regional office sent letter asking questions about the payments (which had been disclosed in 10-K, but not on Form D) triggering an internal investigation by company counsel and leading company to note reasonable possibility of loss contingency for rescission claim under ASD 450 with potential liability up to $30M preventing company from raising more capital and leading company to file Chapter 11.

38 Board Composition Companies raising angel capital sometimes are too eager to use board seat as an inducement for an investor to invest Later need to restructure board when institutional investors come in invest can result in awkward conversations, hurt feelings It is often easier to get people on boards than off Use advisory boards as an alternative