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Funding for Early Stage Startups

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Obtaining funding for early stage startups can be challenging. The array of funding options available to entrepreneurs can be confusing and fraught with pitfalls.

The speaker will discuss the most common funding options available to early stage startups, what financing instruments are appropriate at various stages of a company life cycle, and the latest trends relevant to early stage financing.

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Funding for Early Stage Startups

  1. 1. © Copyright 2017 by K&L Gates LLP. All rights reserved. Presented by Stan Lewandowski stan.lewandowski@klgates.com 650.798.6743 January 26, 2017 Silicon Valley Startup: Idea to IPO Funding for Early Stage Startups
  2. 2. These materials have been prepared solely for educational purposes. The presentation of these materials does not establish any form of attorney-client relationship with the author or K&L Gates. Particular legal issues should be addressed through consultation with your own legal counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. © K&L Gates LLP 2017. Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, please be advised that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed within. klgates.com 2
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  4. 4. INTRODUCTIONS § Stan Lewandowski, Esq., Partner (Emerging Growth/Corporate/M&A) § Works primarily in the Silicon Valley and SF offices of K&L Gates in Palo Alto § Advised clients (issuers and investors) in more than 100 closed angel and venture capital financings klgates.com 4
  5. 5. OVERVIEW § The startup lifecycle § Latest VC financing data (as of 12/31/2016) § Latest trends relevant for early stage companies § Most commonly used funding vehicles available to and used by early stage startups 5
  6. 6. THE STARTUP LIFECYCLE § Idea § Sketches, rough prototype § Proof of concept § MVP or MVVP § Building § Capital raising § Scaling § Maturity and exit klgates.com 6
  7. 7. THE U.S. VC FUNDING SCENE § 2014 § $68.9B – Aggregate Deal Value § 10,550 – Number of Closed Deals § 2015 § $79.3B – Aggregate Deal Value § 10,468 – Number of Closed Deals § 2016 § $69.1B – Aggregate Deal Value (second annual total after 2015 in the past 11 years) § 8,136 - Number of Closed Deals Source: PitchBook 7
  8. 8. THE U.S. VC FUNDING SCENE Source: PitchBook 8 $29.1 $35.5 $37.2 $26.5 $31.2 $44.3 $40.6 $44.8 $68.9 $79.3 $69.1 3,301 4,292 4,707 4,458 5,411 6,771 7,987 9,326 10,550 10,468 8,136 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* $0 $10 $20 $30 $40 $50 $60 $70 $80 $90 0 2,000 4,000 6,000 8,000 10,000 12,000 Deal value ($B) # of deals closed US VC activity by year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* Deal value ($B) 29.08 35.55 37.16 26.48 31.18 44.30 40.63 44.82 68.86 79.26 69.11 # of deals closed 3,301 4,292 4,707 4,458 5,411 6,771 7,987 9,326 10,550 10,468 8,136 Company count 3,067 3,953 4,328 4,136 4,966 6,233 7,365 8,548 9,656 9,742 7,751 *As of 12/31/2016
  9. 9. THE U.S. VC FUNDING SCENE Source: PitchBook 9 US VC activity (#) by round size 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* Under $500K 259 430 559 768 1,090 1,409 1,875 2,258 2,404 2,198 1,544 $500K-$1M 219 304 382 434 558 765 918 1,042 1,109 1,079 806 $1M-$5M 1,013 1,333 1,464 1,449 1,744 1,995 2,302 2,785 3,063 3,197 2,716 $5M-$10M 686 779 823 659 654 737 800 888 969 988 927 $10M-$25M 639 781 817 577 630 728 734 769 897 975 866 $25M+ 248 336 318 205 260 354 373 404 636 709 606 *As of 12/31/2016 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* 0% 20% 40% 60% 80% 100% $25M+ $10M-$25M $5M-$10M $1M-$5M $500K-$1M Under $500K
  10. 10. THE U.S. VC FUNDING SCENE Source: PitchBook 10 0.75 0.95 4.50 5.28 10.25 10.00 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* $0 $2 $4 $6 $8 $10 $12 Angel/Seed Early VC Later VC
  11. 11. THE U.S. VC FUNDING SCENE Source: PitchBook 11 1.67 1.74 9.43 10.75 28.28 26.92 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* $0 $5 $10 $15 $20 $25 $30 Angel/Seed Early VC Later VC
  12. 12. MOST ACTIVE ANGEL/SEED/EARLY STAGE INVESTORS IN Q4 2016 Source: Pitchbook 12
  13. 13. TRENDS § Pre-Seed - new Seed § Seed – new Series A § Series A - new B § Where does the capital for early stage startups come from? klgates.com 13
  14. 14. U.S. FINANCING ECOSYSTEM § Incubation – up to ~$150K § Pre-Seed – up to ~$500K § Seed - $1M to $5M § Series A – $4-5M to $15M § Series B – over $15M klgates.com 14
  15. 15. TERM SHEET AND ITS ROLE § AKA LETTER OF INTENT (LOI), MEMORANDUM OF UNDERSTANDING (MOU) § Sets out the key terms of a transaction agreed on in principle by the parties § Outlines the timetable and obligations of the parties during negotiations § Contains some legally binding terms (confidentiality, exclusivity, transaction expenses and more) klgates.com 15
  16. 16. MOST COMMONLY USED FUNDING VEHICLES § Friends, Family and … (FFF) § Convertible Promissory Notes (Notes) § Simple Agreements For Equity (SAFEs) § Keep It Simple Agreements (KISSes) § Other Options (crowdfunding, grants, etc.) 16
  17. 17. CONVERTIBLE PROMISSORY NOTES § Debt instruments with a conversion into equity feature § Features § Maturity date § Interest § Mostly, automatic conversion into equity in a qualified financing § Conversion discount (~20%) or a valuation cap (max. pre-money valuation), or… § Premium on acquisition (1X+) 17
  18. 18. CONVERTIBLE PROMISSORY NOTES § Conversion Options – Automatic Conversion § Upon Qualified Financing § What is a Qualified Financing? § Discount § Valuation Cap § Fully Diluted Capitalization § What if the valuation cap in the note is lower than that agreed by the company and the investors? 18
  19. 19. CONVERTIBLE PROMISSORY NOTES § Conversion Options – Automatic Conversion § If No Qualified Financing or Acquisition Before Maturity Date § Conversion into Common Stock at a Pre-Agreed Valuation Cap on a Fully Diluted Basis 19
  20. 20. SAFE (CONVERTIBLE EQUITY) § Convertible equity instrument § No debt features § Interest § Maturity 20
  21. 21. SAFE (CONVERTIBLE EQUITY) § Four available versions § Price cap, no discount (no minimum amount for conversion) § Discount, no price cap (no minimum amount for conversion) § Price cap and discount § Most favored nation (MFN) provision (no price cap or discount but MFN treatment, minimum amount for conversion) 21
  22. 22. SAFE (CONVERTIBLE EQUITY) § Price Cap, no Discount (no minimum for conversion) § Price cap = valuation cap § Conversion into Standard Preferred Stock or Safe Preferred Stock § Same or different price per share 22
  23. 23. SAFE (CONVERTIBLE EQUITY) § Discount, no Price Cap (no minimum for conversion) § Discount rate = [100 - the discount]% § Conversion into shares of Standard Preferred Stock based on principal amount divided by price of Standard Preferred Stock sold in Equity Financing 23
  24. 24. SAFE (CONVERTIBLE EQUITY) § Price Cap and Discount § Conversion into number of shares of Preferred Stock equal to: § The principal amount divided either by: § Safe Price (valuation cap/capitalization of company), or § Discount Price (standard price of stock sold in Equity Financing x discount rate), whichever results in a greater number of shares 24
  25. 25. SAFE (CONVERTIBLE EQUITY) § Most Favored Nation (MFN) provision § (no price cap or discount but MFN treatment, minimum amount for conversion) § What’s the benefit? § Amendment of existing documents to reflect better terms offered to investors purchasing issuer’s convertible securities in the future 25
  26. 26. SAFE (CONVERTIBLE EQUITY) § Now, what if: § Company is acquired by another person before conversion of your principal amount into preferred stock? § You can elect to: § Receive your money back, or § Automatically receive shares of common stock equal to the principal amount divided by FMV of company’s common stock, if you fail to elect receipt of cash 26
  27. 27. SAFE (CONVERTIBLE EQUITY) § Now, what if: § Company terminates its operations, liquidates, dissolves or winds up before conversion of your principal amount into preferred stock? § You will: § It depends 27
  28. 28. SAFE (CONVERTIBLE EQUITY) § Now, what if: § Your investor asks for participation rights as part of its investment? § Few options are available 28
  29. 29. KISS DOCUMENTS § Two versions § Debt § Equity (more favorable to the issuer) 29
  30. 30. KISS DOCUMENTS § Comparison of Debt and Equity Versions (substantially similar, except for interest and maturity) § Treatment in financing § Conversion into preferred stock in a qualified financing round (~$1M, for instance) at a price that’s lesser of cap or discount 30
  31. 31. KISS DOCUMENTS § Comparison of Debt and Equity Versions (substantially similar, except for interest and maturity) § Treatment in acquisition § You elect to either convert principal into shares of common stock at a valuation cap or multiple of investment plus interest (2X) 31
  32. 32. KISS DOCUMENTS § Comparison of Debt and Equity Versions (substantially similar, except for interest and maturity) § Treatment at maturity § If not converted in equity financing or part of an acquisition, then, on or after maturity, the majority in interest will elect to either convert into Series Seed Preferred Stock at a cap OR demand repayment from issuer 32
  33. 33. KISS DOCUMENTS § Comparison of Debt and Equity Versions (substantially similar, except for interest and maturity) § Most favored nation treatment § Right to exchange the existing instrument for one issued subsequently to other investors on terms more favorable than the terms of the instruments issued to existing investors if such subsequent issuance occurs before conversion or repayment of the existing instrument 33
  34. 34. KISS DOCUMENTS § Comparison of Debt and Equity Versions (substantially similar, except for interest and maturity) § Information and participation rights § Rights for “Major” Investors? Who is Major Investor? § What are the rights? § Information § Participation (pro rata, 1X+ investment amount) 34
  35. 35. OTHER OPTIONS TO SECURE CAPITAL § AngelList (https://angel.co) § Crowdfunding (www.kickstarter.com) § Factoring (selling AR) § Customer financing § Grants 35
  36. 36. THANK YOU For Further Questions Please Contact: Stan Lewandowski Partner, K&L Gates LLP (650) 798-6743 E-mail: stan.lewandowski@klgates.com klgates.com 36

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