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How to Raise Seed Funding for Your Startup Convertible Notes and SAFEs

  1. © Copyright 2023 by K&L Gates LLP. All rights reserved. How to Raise Seed Funding for Your Startup: Convertible Notes and SAFEs Idea to IPO Jason Putnam Gordon, K&L Gates LLP March 23, 2023
  2. IMPORTANT CAVEATS  Today’s Discussion is General Information – Not Legal Advice  We will be discussing rules and exceptions. Those rules, exceptions, and exceptions to the exceptions may not be applicable to your situation.  You need to retain competent legal counsel to review all facts and circumstances before weighing in with advice.  Off-the-cuff answers to your questions are not, and should not be taken, as legal advice.  Do not provide me with any information you desire to be confidential. 2
  3. OVERVIEW  My Background  Structural Considerations  Considerations When Pitching Investors  Financing Options  Key Terms and Considerations for Convertible Securities  Overview of Valuation and Dilution  Common Pitfalls  Q&A 3
  4. Background  Venture Capital and Emerging Growth Company attorney- practicing law since 2005.  My office is in San Francisco, but I work with companies throughout the US and the world.  I love working with entrepreneurs on financings, as outside counsel, and on exits. 4 Jason P. Gordon Partner +1.415.882.8124
  5. Review of Audience Survey 5
  6. Structural Considerations  Typically a Delaware C-Corp.  Startup Financing Life Cycle  See cing_cycle.svg 6
  7. CONSIDERATIONS WHEN PITCHING INVESTORS  Know your audience different investors have different objectives  Compliance with securities laws. 7
  8. FINANCING OPTIONS  Convertible Debt/Equity  Also known as bridge notes  Convertible debt is the parent of convertible equity, which can also be known as a SAFE Instruments  Y Combinator developed the SAFE  Venture Rounds (different presentation)  Series Seed and Series A 8
  9. CONVERTIBLE SECURITIES  Convert to future equity securities at a negotiated discount to a future qualified equity financing  This avoids valuing the company  Far less expensive than a venture round like a Series Seed or Series A round 9
  10. CONVERTIBLE SECURITIES (CONT.)  Maturity*  Interest Rate*  Conversion Terms  Amendment Terms, e.g., majority in interest  Remaining Terms  It’s not that common to negotiate these  (*For Convertible Notes, not SAFEs) 10
  11. MATURITY*  Generally up to 18-24 months  Should be trying to time this with some cushion when you’ll have a venture round.  Pay attention to California Financing Law, which applies to persons “engaged in the business of a finance lender or broker.”  Make sure the financing fits into an exemption. 11
  12. INTEREST RATE*  Can be as low as AFR.  Otherwise, imputed interest issues.  Can be as high as 10% in CA  Double check the usury laws. 12
  13. CONVERSION TERMS  Mandatory conversion at a discount of price paid in Next Qualified Financing  Series Seed/A needs to meet the definition of a “Qualified Financing”  Equity financing  Minimum size, e.g., “$2,000,000”  Discount has to be reasonable or later investors will not go for it. 20-25% is typically reasonable. 13
  14. CONVERSION TERMS CONT.  Conversion Price Cap  Conversion upon a change of control/sale  Optional Conversion upon maturity or something less than a qualified financing 14
  15. STRUCTURE  Convertible Notes – Generally one or two documents (in addition to corporate authorization and/or side letters)  Purchase Agreement and a Convertible Security  SAFEs – Generally one agreement (in addition to corporate authorization and/or side letters) 15
  16. CHOOSING THE PATH FOR YOUR COMPANY  Convertible Securities  Upsides:  Most common; cheaper, simpler;  No valuation of the company, nearly impossible at this early stage, and helps maintain a low FMV for stock options/restricted stock  Downsides (At least for Convertible Notes)  This is debt and may be required to be paid at some point  Extra liquidation preference above all other equity, unless otherwise handled 16
  17. FOUNDATIONAL BASICS – VALUATION AND DILUTION  Pre-money valuation – the value of the company before the next round of investment.  Post-money valuation – the value of the company after the round of investment.  Fully-diluted basis – all common stock issued and outstanding, plus all securities that can be converted to common, plus (typically) the shares reserved for equity compensation. 17
  18. FOUNDATIONAL BASICS – VALUATION AND DILUTION  Very Simple Example (not factoring in the option pool or any other equity)  Pre-money $10,000,000  10,000,000 shares split among three equal founders  Founder A = 3,333,333 shares or 33% 18
  19. FOUNDATIONAL BASICS – EXAMPLE CONTINUED  Basic Example without Convertible Securities  Investment $3,000,000 at $1.00/share ($10,000,000 pre- money/10,000,000 outstanding shares) (Post-money is $13,000,000)  Founder A = 3,333,333 of ~25% with a paper value of $3,333,333 19
  20. FOUNDATIONAL BASICS – EXAMPLE CONTINUED  Basic Examples with Convertible Securities  If there had been $450,000 convertible security with 25% discount only, holder would have received 600,000 shadow shares. $450,000/((1-.25)*$1.00)  This example ignores the circular math: in determining the price the new money will pay and on which the discount will be applied, the investor will include the shadow shares in the fully diluted basis.  If there had been a $450,000 convertible security with $5MM cap only, holder would have received 900,000 shares. $450,000/($5,000,000/10,000,000)  This example also ignores that the investor will include the shadow shares in the fully diluted basis, which will change the price per share the investor pays. 20
  21. COMMON PITFALLS  Non-Compliance with Securities Laws  Finders  Thinking that there are “standard” terms  Side Letters  Failure to obtain proper corporate authorization 21
  22. Questions/Comments
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