Idea to ipo venture capital startup royse - may 10 2020

© 2020 Haynes and Boone, LLP
Idea to IPO
Prepare Your Startup for
Venture Capital Investment
#startup #ideatoipo
1
Roger Royse
@rroyse00

© 2020 Haynes and Boone, LLP© 2020 Haynes and Boone, LLP
Disclaimer
No information contained in this presentation is to be construed as legal advice.
No information contained in this presentation is intended or related to any
particular factual situation. Nothing herein forms an attorney-client relationship. If
legal advice or other expert assistance is required, the services of a competent
professional should be sought.
2

Sources of Funding
 Founders – savings, IRAs, credit cards, mortgage equity
 Debt Financing
 Government Grants
 Friends and Family
 Angels or Seed Investors
 Institutional (VC or Private Equity)
 Alternative Financing:
o Rewards-Based Crowdfunding
o JOBS Act Crowdfinancing
o ICOs, STOs, IEOs
o Royalty Financing
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Source: Fundable

Founders
 77% of startups rely on personal savings for their initial funds
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Source: Wells Fargo/Gallup Small Business Index

Debt Financing
 Bank Debt
 Security
 Personal Guarantees
6

Government Grants
 Free Money from the Government
https://www.usa.gov/grants
https://www.aprise.org/
7

Friends and Family
 38% of startup founders raised money from their
friends and family
 $23,000 was the average amount invested by
friends and family per startup
8

Angels
 Angels
 Angel Groups
 Angel Funds
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Venture Capital
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Should You Take Venture Capital?
 Must give up Equity
 No near term cash flow
 Risky
 Illiquid
 Can the business scale?
 Explosive growth
 Huge market
20

Venture Capital Economics 2/20 Formula
 2% management fee on committed capital
 20% carried interest
 7 to 10 year terms
 LPS want 2 1/2 to 3 times investment return
 VC fund must earn 3 to 4 times investment to
return that amount
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Venture Capital Economics – Expected Performance
 50% lose money
 20% – 30% are singles or doubles
 The rest must be home runs (10X to 100X)
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Company VC Fit
 Large potential market
 First Mover or first to market advantage
 Long term scale over short term profits
 Not able to service debt
 Traction!
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Venture Capital Economics – Management
 Venture capital will participate in management
 Board seats
 Board Observer
 Management rights letter (for VCOC exemption)
 Seven to ten year term (and longer)
 Precludes small investments
 Board meetings
 Management
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Venture Capital Metrics
 Team
 Domain expertise
 Technical co-founders
 Technology or product
 Solve problems, address pain points
 Customer validation
 Market size
 Must be a huge market
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Picking a VC
 Reputation
 Likelihood of closing
 Stage of fund
 Size of Fund
 How much dry powder?
 Is there a fund 2, fund 3 etc.?
 Are they litigious?
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Structuring For Venture Capital
 Business Model
 Choice of Entity
 Cap Table
 Vesting
 Debt
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CASHFLOW COMPARISON: LICENSING VS. MANUFACTURING
POSITIVE
CASHFLOW
NEGATIVE
CASHFLOW
IDEA GENERATION DEVELOPMENT COMMERCIALIZATION SALES / REALIZATION
PRODUCT LAUNCH
MANUFACTURING
L.ICENSING
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Choice of Entity
 Limited Liability Company (LLC)
 S Corporation (S Corp)
 C Corporation (C Corp)
 Foreign Corporation
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Advantages of a C Corporation
1. Operating Agreements
2. S Elections
3. Suspended Losses
4. 704(c) Allocations
5. Venture Capital
6. QSB Stock
7. Stock Option Plans
8. LLC Debt
9. Reorganizations
10. Fringe Benefits
11. Audits and Liabilities
12. Contingent Allocations
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Qualified Small Business Stock – 1202 and 1045
General Requirements
 Original issue
 Five-year holding period
 100% post-Sept. 27, 2010
 C Corporation issuer
 Up to $10 million or 10 times basis exclusion
 1045 Rollover treatment
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 $50 million Gross
Assets Test
 Active Business Test
 No significant
redemptions
Note: California does not follow federal income tax treatment of QSB stock under
I.R.C. § 1202.

VC Considerations
1. QSBS
2. VC’s LPA will not allow investment in a
passthrough
1. Tax exempt investors want to avoid UBTI
2. Foreign investors want to avoid ECI
3. VC wants to be able to manage losses
1. No K-1’s showing losses
32

Founder’s Equity
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 Vesting
 Equal Percentages
 Subjective
 Formula

Advisors
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FAST Model
Valuation
Milestones and
Deliverables
Vesting Stock v.
Options

Currency
 Options
 NSOs
 ISOs
 Extended NSOs
 RSUs
 Restricted Stock
 Phantom Plan Units
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Vesting
 Who should vest
 How long?
 Acceleration?
 Change of control
 Termination without cause
 Double and single triggers
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The VC’s View of Vesting
VC will require unvesting shares so vesting period could be 8 years
Fund life can be 7 to 10 years
Most exits are M&A - Fewer and longer IPOs
Extended Option exercise periods
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Class F Supervoting Stock
Special class of common that has super voting rights
Facebook, Google Snap
May be negotiated away in institutional round
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Transfer Restrictions
 Right of First Refusal (ROFR)
 Lock Ups
 Co-Sale Rights
 Drag Along
 Buy Sell
 Rule 144
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SAFEs and Convertible Notes
 Convertible Notes
 Debt obligations that convert to preferred stock
 SAFE
 Convertible equity
 Conversion feature
 Valuation Cap
 Sets a maximum valuation at which note will convert
 Discount
 Early investors get a discount to the preferred price
 Change of Ownership
 Investors convert to common or get a multiple on a sale of the
company prior to a priced financing round
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Cap Table
 Common Stock
 Options
 Warrants
 Convertibles
 Preferred Stock
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Capitalization
42
Founders 5,000,000 38% 5,000,000 45%
Stock Pool 2,000,000 15% n/a
Series A 3,000,000 23% 3,000,000 27%
Series B 3,000,000 23% 3,000,000 27%
total 13,000,000 100% 11,000,000 100%
Fully Diluted % Issued %

Effect of Valuation Caps
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Founders 4,000,000 100% 4,000,000 100%
Stock Pool 0 0% n/a
total 4,000,000 100% 4,000,000 100%
Company sells a $1,000,000 SAFE with a $4,000,000 pre money valuation cap
That means that the SAFE will take 20% of the capitalization ($1,000,000/$5.000,000)

Capitalization
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Founders 4,000,000
50% 5,000,000 63%
Stock Pool 1,000,000
13% n/a 0%
SAFEs 1,000,000
13%
2,000,000
25%
Series A 2,000,000
25% 3,000,000 38%
8,000,000 100%
10,000,000 100%

Other Diligence Issues
 IP Rights
 Patents
 Invention Assignments
 Licenses and ownership
 Data security
 Employment Claims (Homejoy)
 Tax Claims
 Regulatory
 Litigation
 Claims by prior employer
 Entrenched Management
 Material Agreements
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Staged Financings
 Enough to get to next valuation event
 2X
 1 to 2 years
 Up vs Down rounds
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Pitch Deck
 Market Size
 Team
 Product
 Go To Market Strategy
 Financials
 Financial Plan
 NOT VALUATION
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Executive Summary
 Team
 Projections
 Market
 Industry
 IP and Patents
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Term Sheets
 Valuation
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Money –The Priced Round
 VC or Institutional Investor
 Preferred Stock
 Valuation Methods
 Score Card
 Venture Capital Method
 Berkus Method
 Cayenne Calculator
 Risk Factor Summation
 Negotiation
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Money –The Priced Round
 More Valuation Methods
 (Patents + People) x $1 Million
 Comparables
 Discounted Cash Flow
 Market Multipliers
 Discount to Public Companies
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Participation
 Participating preferred stock returns its investment and
then shares pro rata in proceeds of a sale
 Non-participating convertible preferred stock either gets a
return of its investment or its pro rata share of proceeds
 Participation may be capped at a multiple of the
investment
 Conversion to common – auto-conversion and majority
vote
52

Dividends
 Preferred will have a dividend preference.
 A cumulative dividend on preferred shares must be paid
before any other dividends on common.
o If the company can't pay out a cumulative dividend in a
year, the amount is carried forward.
o Common in private equity deals, not in venture
 Non-cumulative is only paid when as and if declared.
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Liquidation Preference
 Who gets paid first and how much?
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Example of Liquidation Preference
 1X Non participating convertible preferred
 $1,000,000 invested for 10%
 Ex 1: Exit (sale) of company for $5,000,00
 Ex 2: Sale for $20,000,000
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Board Representation
 Size of board
 Founder-friendly boards
 Role of the Board
 Observers
 Indemnification
 Insurance
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Board rights
 Indemnification
 D&O Insurance
 Right to designate
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Protective Provisions
 Class vote or majority vote
 Delaware law
 Separate vote for later investors
 Do the interests of different
investors diverge?
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Protective Provisions
Standard:
 Right to veto or block certain corporate
actions
 Sale of the company
 Amendment to the company’s certificate or
bylaws so as to adversely alter or change the
rights of preferred stock
 Increase or decrease in the number of
authorized shares of preferred or common
 Authorization or issuance of equity security
having a preference over, or being on a parity
with, preferred stock
 Redemption of shares of preferred stock or
common stock
 Declaration or payment of dividends
 Change in the authorized number of directors
of the company
Other:
 Hiring, firing or change in the compensation of
officers
 Any transaction with any director, executive or
employee of the company
 Incurrence of indebtedness in excess of
$[____]
 Change in the principal business of the
company or the entering into any new line of
business
 Any purchase of a material amount of assets
of another entity
 Option plan increase
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Information Rights
 Financial statements and other information
 Thresholds
60

Registration Rights
 Requires a company to list the shares publicly so
that the investor can sell
 Demand rights
 Piggyback rights
 S-3 rights
61

Common restrictions: Co-Sale Rights, ROFR, Drag
Along
 Co Sale and Tag-Along Rights – right to participate in a
sale
 Right of First Refusal – right of company (first) and
investors (second) to require shares to be offered to each
of them before a third-party sale
 Drag Along – right to force shareholders to sell in an exit
 Board, common and preferred approvals
 Small shareholder carveout
62

Founder Vesting
 Term, milestones, commencement
 Acceleration
 Single and double triggers
 Fire the Founder
63

Pro Rata rights
 Right to maintain, right to participate
 Major investors
 Limited by amount of money company wants to raise
64

Option Plan
 Increased pre money
 409A valuations
 Extended exercise periods for NSOs
65

Redemption Rights
 Feature of Preferred Stock
 Right to put stock to company, usually after a period of time and
over time
 Is effectively a right to force a sale of the company
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Anti-Dilution
 Broad-based weighted average
 Narrow-based weighted average
 Full ratchet
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Exclusivity
 No-shop
 30 to 60 days
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NonBinding
 30 day no shop
 Confidentiality
 Is it really nonbinding?
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Planning for later rounds
 Overly favorable terms
 Valuation planning and down rounds
 Reverse splits
 Cap table management
 Fire the CEO
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Corporate Venture Capital
 Strategic objectives
 Less operational involvement
 Tight of first refusal, right of first offer, right of first look
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Troubled Company Terms
 Forced conversion to common
 Full ratchet
 Uncapped participating preferred
 Insider rounds
 Low valuations
 Down rounds
 Trigger anti dilution protection unless waived
 Pay to play
 requires existing investors to invest on a pro rata basis
in subsequent rounds or they lose preferential rights
(anti-dilution, liquidation preferences, voting rights)
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Successful Exits
 IPO
 Sale or Acquisition
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Unsuccessful Exits
 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and
creditors?
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Other Unsuccessful Exit Issues
 Tax Liability
 Personal Liability
 Tax
 Employment
 Fiduciary Claims
 Securities Law Claims
 Contractual
 Pierce the veil and creditor claims
 Serial Entrepreneurs and failed companies
75

AUSTIN
600 Congress Avenue
Suite 1300
Austin, TX 78701
United States of America
T +1 512.867.8400
F +1 512.867.8470
CHARLOTTE
101 S. Tryon Street
Suite 2250
Charlotte, NC 28280
T +1 980.771.8200
F +1 980.771.8201
CHICAGO
180 N. LaSalle Street
Suite 2215
Chicago, IL 60601
T +1 312.216.1620
F +1 312.216.1621
DALLAS
2323 Victory Avenue
Suite 700
Dallas, TX 75219
T +1 214.651.5000
F +1 214.651.5940
DALLAS - NORTH
2505 North Plano Road
Suite 4000
Richardson, TX 75082
T +1 972.739.6900
F +1 972.680.7551
DENVER
1050 17th Street
Suite 1800
Denver, CO 80265
T +1 303.382.6200
F +1 303.382.6210
FORT WORTH
301 Commerce Street
Suite 2600
Fort Worth, TX 76102
T +1 817.347.6600
F +1 817.347.6650
HOUSTON
1221 McKinney Street
Suite 2100
Houston, TX 77010
T +1 713.547.2000
F +1 713.547.2600
LONDON
1 New Fetter Lane
London, EC4A 1AN
United Kingdom
T +44 (020) 8734 2800
F +44 (020) 8734 2820
MEXICO CITY
Torre Esmeralda I, Blvd.
Manuel Ávila Camacho #40
Despacho 1601
Col. Lomas de Chapultepec,
DF 11000
Mexico City, Mexico
T +52.55.5249.1800
F +52.55.5249.1801
NEW YORK
30 Rockefeller Plaza
26th Floor
New York, NY 10112
T +1 212.659.7300
F +1 212.918.8989
ORANGE COUNTY
600 Anton Boulevard
Suite 700
Costa Mesa, CA 92626
T +1 949.202.3000
F +1 949.202.3001
PALO ALTO
525 University Avenue
Suite 400
Palo Alto, CA 94301
T +1 650.687.8800
F +1 650.687.8801
SAN ANTONIO
112 East Pecan Street
Suite 1200
San Antonio, TX 78205
T +1 210.978.7000
F +1 210.978.7450
SHANGHAI
Shanghai International
Finance Center, Tower 2
Unit 3620, Level 36
8 Century Avenue, Pudong
Shanghai 200120, P.R. China
T +86.21.6062.6179
F +86.21.6062.6347
THE WOODLANDS
10001 Woodloch Forest Drive
Suite 200
The Woodlands, TX 77380
T +1 713.547.2100
F +1 713.547.2101
WASHINGTON, D.C.
800 17th Street NW
Suite 500
Washington, D.C. 20006
T +1 202.654.4500
F +1 202.654.4501
76

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