Accelerator Curriculum 2012 Module: Capitalization

Accelerator Curriculum 2012 Module: Capitalization Andrew Ritten Faegre Baker Daniels LLP 8993441

Bio Andrew Ritten Joined Faegre Baker Daniels corporate group in 1993 Education: Yale University B.A. History, cum laude (1985) Northwestern University School of Law J.D., cum laude (1992) Law clerk for Hon. Frank J. Magill, U.S. Court of Appeals, 8th Circuit (1992-93) Practice focuses on: Mergers and Acquisitions Private Equity Renewable Energy Joint Ventures Venture Capital General Corporate Counseling 2

About Faegre Baker Daniels January 2012 combination of legacy firms Faegre & Benson and Baker & Daniels builds upon existing strengths and shared values to create one of the 75 largest law firms headquartered in the U.S. Full-service law firm with more than 800 legal and consulting professionals worldwide. FaegreBD Consulting, our national advisory and advocacy division located in Washington, D.C., integrates public policy efforts with the rest of the firm s legal services. Guiding Principles Core Values Faegre Baker Daniels focuses on client service and results, with the following core values paramount and guiding us in all that we do: Honesty and integrity Excellence Hard work Teamwork and collaboration Mutual respect and firm mindedness Diversity and inclusion Service to our communities 3

Firm Geography From offices in the United States, Europe and Asia, Faegre Baker Daniels has served clients in more than 60 countries. Serving clients coast to coast from offices in Colorado, Illinois, Indiana, Iowa, Minnesota and Washington, D.C. Serving clients internationally from London, Beijing (regulatory and government center) and Shanghai (financial center) 4

Energy, Resources and Clean Technology Industry Group Faegre Baker Daniels lawyers focused on the energy, resources and clean technology industries have the needed breadth and depth of legal and policy experience to represent a wide array of companies including: Energy Resources Clean Technology Utilities Natural gas Petroleum producers and refiners Electric transmission and pipelines Biofuels Wind Solar Geothermal Oil Gas Mining Water Renewable energy, including biofuels, wind, solar and geothermal Smart grid/energy efficiency Air, water and waste Transportation Carbon capture Green building Sustainable and organic products Our firm regularly sponsors leading industry events; and our lawyers are actively involved in key industry associations, publish in a variety of legal and industry related publications, and have been speakers at numerous industry conferences and seminars. 5

Capitalization Who is this man? 6

Capitalization What Are the Two Big Questions? 7

How much is my company worth? 8

How much do I get to keep? 9

Capitalization: Presentation Roadmap Fundamental Financing Concepts Debt / Equity / Other Different Types of Equity Common Stock / Preferred Stock / Options / Other Equity Concepts Lingo / Buzzwords Capitalization Evolution The Typical Venture Capital Model 10

Capitalization Fundamental Financing Concepts 11

Fundamentals: Debt Characteristics Investor Return: Interest rate fixed, floating Time: Term - amortization schedule Availability: Credit line or revolver Collateral: Secured vs. unsecured Liability: Personal guarantees Nature of Obligation: Must be repaid Conclusion Usually not readily available to start-ups with limited collateral and no operating history 12

Fundamentals: Equity Characteristics Investor Return: Capital appreciation Time: Usually no specific duration, but investors have liquidity expectations Availability: Securities law compliance Collateral: None required Liability: None required Nature of Obligation: Permanent capital Conclusion Usually only way for start-ups to obtain necessary capital 13

Fundamentals: Convertible Debt Characteristics Provides investor with lots of optionality Choice is ALWAYS investor s Conversion ratio Observations Relatively uncommon Sometimes used with Angel Investors when future financings are anticipated May convert at discount to next financing round price 14

Fundamentals: Grants Characteristics Investor Return: The betterment of humanity or development of a market Time: Just make sure to apply on... time Availability: Hard to come by, but go for it! Collateral: None required Liability: None required Nature of Obligation: Gratitude (and big ideas) required of recipients Conclusion Application process is time consuming and there may be strings attached such as specific reporting requirements, but by all means, get some if you can! 15

Capitalization Types of Equity Instruments 16

Equity Interest: Types of Rights Economic Rights Statutory: Holders get the remainder after all other obligations met Contract: Liquidity, preferences, dividends, etc all are negotiated Governance Rights Statutory: Fundamental corporate events; default rules for director election Contract: Negotiated rules for director election All subject to the Golden Rule 17

Types of Equity Interest: Common Stock Economic Rights Fundamental, foundational equity interest This is where you start No special rules Governance Rights One share; one vote Cumulative voting But, consider Stockholder Agreement Transferabililty Death / disability Liquidity 18

Types of Equity Interest: Preferred Stock Economic Rights Liquidation Preference Usually initial investment (1X) before Common Sometimes dividends mandatory vs. discretionary Convertible to Common Usually initially at 1:1 with adjustments for subsequent issuances (anti-dilution) Mandatory vs. discretionary conversion Participation - Have cake and eat it, too? 19

Types of Equity Interest: Preferred Stock Governance Rights Rights to director positions or observer status Veto powers over certain corporate / structural actions Otherwise votes along with Common Various other contractual rights Receipt of information Registration Rights of first refusal Liquidity 20

Types of Equity Interest: Preferred Stock Conclusions Preferred stock is complicated!!! Lots of legal, practical and economic consequences Know what you excel at: Focus on your business Get legal counsel 21

Types of Equity Interest: Warrants Economic Rights Right to purchase a pre-determined number of shares at a pre-determined price during a finite period of time Often given in connection with subordinated debt financing as equity kicker Usually contain anti-dilution protection Often contain information rights Heavily negotiated - get legal counsel Governance Rights None until exercised 22

Types of Equity Interest: Stock Options Economic Rights Right to purchase a pre-determined number of shares at a pre-determined price during a finite period of time Almost always given as incentive to employees Usually vest (i.e., become exercisable) on a time or milestone based schedule Governance Rights None until exercised 23

Types of Equity Interest: Stock Options Tax Treatment of NSOs (default situation) No tax upon grant (unless Option is deeply discounted) Spread between Exercise Price and FMV at time of Exercise is Ordinary Income Subject to withholding and payroll taxes Company gets compensation deduction Holder has tax bill with no liquidity Spread between FMV at Exercise and Sale Price is Capital Gain Long-term Capital Gain if stock held post-exercise for > 1 year 24

Types of Equity Interest: Stock Options Tax Advantages of ISOs No tax upon Grant (ISO qualification rules prevent discounting) No Ordinary Income Tax upon Exercise No withholding or payroll taxes But in AMT calculation, treated like NSO Entire Spread between Exercise Price and Sale Price is Long-Term Capital Gain Ordinary Income converted to LT Cap Gains (subject to application of AMT) Time of tax Payment deferred No liquidity issue 25

Types of Equity Interest: Stock Options ISO Requirements ISO Plan must comply with Internal Revenue Code Shareholder approval of Plan No more than $100,000 of Shares may vest in any One Year and qualify for ISO treatment Two Year Holding Period from Date of Grant One Year Holding Period from Date of Exercise 26

Types of Equity Interest: Equity-like Incentive Arrangements Economic rights with no governance rights - ever Liquidity event cash bonus Stock Appreciation Right Allows employees to get the spread Always ordinary income treatment But watch out exercise price treatment in waterfall? 27

Capitalization Equity Concepts 28

Equity Concepts Authorized Shares Maximum number of shares that Board has authorization to issue without further approval by the Shareholders and the refiling of the Certificate of Incorporation Authorized Common Stock Authorized Preferred Stock Initially, Blank Check Preferred Eventually, multiple series (Series A Round, Series B Round, etc.) 29

Equity Concepts Outstanding Shares Votes and shares from investment proceeds Outstanding Common Stock Founders Initial Employees Exercised Options Outstanding Preferred Stock VCs Angels Strategic Investors Eventually they will converge at liquidity event (IPO or sale) 30

Equity Concepts As Converted Outstanding Shares Outstanding Common Stock Outstanding Preferred Stock on an As-Converted basis Each Series multiplied by its Conversion Ratio Rights to Acquire Shares Convertible Notes (debt) Warrants Options Incentive Stock Options ( ISO ) Non-Statutory/Non-Qualified Stock Options ( NSOs ) 31

Equity Concepts Down Round Round of financing in which Company valuation is lower than valuation at previous financing Anti-dilution kicks in Ratcheting Method of anti-dilution protection for existing series of Preferred Stock Full-ratchet vs. weighted average Heavily negotiated 32

Equity Concepts Fully Diluted Shares Common Stock Preferred Stock on an As Converted basis Rights to Acquire Shares Convertible Notes assuming all converted Interest generally ignored until actual conversion Outstanding Warrants assuming all exercised Exercise price generally ignored Outstanding Options assuming all exercised Exercise price and vesting generally ignored Shares Reserved for Future Option Grants under Option Plan ( Option Pool ) 33

Equity Concepts Fully Diluted Shares (cont.) Hierarchy of Terms (smallest to largest) Outstanding Shares of one Series (e.g., Series A Preferred) Outstanding Shares of all Series of that Class (e.g., all Preferred series) All Outstanding Shares on an As-Converted Basis Fully Diluted, but just with Outstanding Rights to Acquire Shares Fully Diluted with Outstanding Rights to Acquire Shares, plus Reserved Option Pool Authorized Shares 34

Capitalization Evolution of the Capitalization of a Venture-Backed Company 35

Evolution: Overview Stages in the Capitalization Life of a Venture-Backed Company 1. Founders 1A. Initial Employees 2. Initial Investors Friends & Family; Angels 2A. Option Plans 3. Initial Institutional Round ( Series A ) VCs; Angels 4. Second Institutional Round VCs; Strategics 5. Third Institutional Round VCs; Strategics 6. Fourth/Final/Mezzanine Institutional Round - Late Stage/Mezzanine/P.E. funds; Strategics 7. Liquidity Event: Sale or IPO 36

Evolution: Stage 1 Founders Who? Actual founders Relatives of actual founders Beware of casual promises forgotten founders Consideration for Stock Intellectual Property Hard assets Cash Services Taxable 37

Evolution: Stage 1 Stockholder Role Payment Value Payment Form Common Shares % Alex Leader $ 2,250 IP 2,250,000 56.25% Bernie IP Creator $ 1,250 IP 1,250,000 31.25% Cass BD/Mktng $ 500 Bus Plan 500,000 12.50% $ 4,000 4,000,000 100.00% Valuation $ 0.001 per share $ 4,000 enterprise valuation 38

Evolution: Stage 1A Initial Employees Differences from Founders Payment for Stock Pricing IRC 409A and ASC Topic 718 Vested or Unvested Stock or Options 100% 80% VESTED 60% 40% 20% 0% 0 6 12 18 24 30 36 42 48 Months 39

Evolution: Stage 1A Stockholder Role Payment Form of Payment Actual Common Fully Diluted % Alex CEO 2,250,000 2,250,000 43.6% Bernie VP, R&D 1,250,000 1,250,000 24.2% Cass VP, BD 500,000 500,000 9.7% Daryl Engineer $ 1,032 Cash 103,226 103,226 2.0% Evelyn Office Manager $ 258 Cash 25,806 25,806 0.5% Reserve 1,032,258 20.0% $ 1,290 4,129,032 5,161,290 100.0% Valuation $ 0.01 per share $ 41,290 enterprise valuation 40

Evolution: Stage 2 Initial Investors Friends & Family; Angels Securities Law Issues Accredited Investors Convertible Debt rather than Stock Avoids Need to Settle on Valuation of Company Simplifies Documentation Nominal Interest; No Security Warrants or Discount upon Conversion Time to Set up Option Plan Budget for 12 to 18 months of Hires 41

Evolution: Stage 2 Securityholder Payment Form of Payment Actual Common Options Convertible Notes Fully Diluted Percent Alex 2,250,000 2,250,000 43.6% Bernie 1,250,000 1,250,000 24.2% Cass 500,000 500,000 9.7% Daryl 103,226 103,226 2.0% Evelyn 25,806 25,806 0.5% Optionees 300,000 300,000 5.8% Option Plan Reserve 732,258 732,258 14.2% Angels $500,000 Cash _ $ 500,000?? $500,000 4,129,032 1,032,258 $ 500,000 5,161,290 100.0% Valuation $ 0.05 per share $ 721,452 enterprise valuation (excluding Option Plan Reserve) 42

Evolution: Stage 3 Initial Institutional Round ( Series A ) VCs and Angels Conversion of Angel Convertible Debt Discount Conversion? Option Plan Increase 15% to 25% (include outstanding options?) VCs take Majority of Board Professional CEO? Determining Subsequent Option Exercise Prices Fair Market Value of Common Stock IRC 409A ASC Topic 718 43

Evolution: Stage 3 Securityholder Payment Form of Payment Actual Common Options Preferred Stock Fully Diluted Percent New CEO 1,598,698 1,598,698 10% Alex 2,250,000 2,250,000 14% Bernie 1,250,000 1,250,000 8% Cass 500,000 500,000 3% Employees 129,032 129,032 1% Optionees 1,032,258 1,032,258 6% Option Plan Reserve 2,000,000 2,000,000 13% Angels $ 500,000 Notes 1,094,998 1,094,998 7% VC 1 $ 2,500,000 Cash 4,379,994 4,379,994 27% VC 2 $ 1,000,000 Cash 1,751,998 1,751,998 11% $ 4,000,000 5,727,730 3,032,258 7,226,990 15,986,978 100% Valuation $0.5708 per share Preferred Pre-Money Valuation $ 5,000,000 $0.08 per share Common Post-Money Valuation $ 9,125,000 (including Option Plan Reserve) 44

Evolution: Stage 4 Second Institutional Round ( Series B ) VCs and Strategics Desirability of New Investor to Price Round Hopefully Higher Price Relation/Priority of New Series Further Option Plan Increase 15% to 20% Possibly more VCs on Board More New Senior Executives Venture Debt or Equipment Lease Line Warrants 45

Evolution: Stage 4 Holder Payment Form of Payment Actual Common Options/ Warrants Series A Series B Fully Diluted % Dollars In % CEO 1,598,698 Founders 4,000,000 300,000 Employees 129,032 Optionees 2,732,258 1,598,698 5.3% $ 127,896 0.9% 4,300,000 14.3% $ 4,000 0.0% 129,032 0.4% $ 1,290 0.0% 2,682,258 9.1% $ Option Plan Reserve 2,000,000 2,000,000 6.7% $ Angels Notes 1,094,998 1,094,998 3.6% $ 500,000 3.5% VC 1 $ 4,000,000 Cash 4,379,994 4,796,527 9,176,521 30.6% $ 6,500,000 46.0% VC 2 $ 2,000,000 Cash 1,751,998 2,398,264 4,150,261 13.8% $ 3,000,000 21.2% VC 3 $ 4,000,000 Cash Venture Lender [Credit Line] 4,796,527 4,796,527 16.0% $ 4,000,000 28.3% 50,000 50,000 0.2% $ $ 10,000,000 5,727,730 5,082,258 7,226,990 11,991,318 30,028,296 100.0% $ 14,133,186 100.0% Valuation $0.8339 per share Preferred Pre-Money Valuation $15,000,000 $0.12 per share Common Post-Money Valuation $25,041,697 46

Evolution: Pre-Liquidity Event How Much Does Each Group Get to Keep? (Fully-Diluted Percentage) Standard Model? Sample Deal VCs 50% 64.0% Options 20% 15.8% Others 10% 5.9% Founders 20% 14.3% Total 100% 100% 48

Evolution: Pre-Liquidity Event How Much Does Each Group Put In? (Actual Dollars and Percentage) Dollars Percentage VCs $14,000,000 99% Options $0 0% Others $129,186.9% Founders $4,000.1% Total $14,133,186 100% 50

Evolution: Pre-Liquidity Event How Much Do Founders Get Out? (Actual Dollars and Return) Founders $4,000 Dollars In Dollars Out Return Approx. $2.5 - $3 Million 625x 750x 51

Accelerator Curriculum 2012 Module: Capitalization Andrew Ritten Faegre Baker Daniels LLP 8993441