Fockler-Spring 2016-Venture Capital

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VENTURE CAPITAL OUTLINE

PROFESSOR FOCKLER
SPRING 2016
INTRODUCTION TO WORLD OF VENTURE CAPITAL

I. Silicon Valley Overview


a. SV really began with the traitorous eight leaving Shockley Semi Conductor to form Fairchild Semi
Conductor (lead by Robert Noyse)
b. Fairchild created the integrated circuit
c. Fairchild spawned a number of successor companies

II. The Silicon Valley Model


a. The trade-off
i. Founders give away control of idea to get money to develop idea
ii. Investors let Founders spend that money with minimal oversight
iii. As founders have less ownership, valuations tend to rise
b. The fundamental economics
i. Sell high to investors
ii. Sell low to employees
c. Typical SV company characteristics
i. Simple corporation formed in Delaware.
ii. Founders/employees get Common at ridiculously low prices
iii. Investors buy Preferred Stock in multiple funding rounds at increasing prices
iv. Founders run the Company on day-to-day basis (until pushed out)
v. Company burns cash like crazy, spending it first on R&D and then on Sales,
vi. Hopefully, company has IPO or sale at very high valuation
1. BUT most don’t and fail

III. What is a VC?


a. VCs invest, monitor, and exit
b. A VC has five main characteristics
i. Financial intermediaries
1. It takes investors’ capital and invests directly in portfolio companies
2. VCs do NOT use their own capital
ii. Investing only in privately held companies (illiquid investments)
1. VCs are alternative investments 🡪 versus traditional investments in stocks and bonds
iii. Active role in aiding and monitoring companies

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iv. Exit objectives
1. Primary goal is to maximize financial return by existing through a sale or IPO
2. VCs are not looking for strategic alliances
3. But long time frame for return 🡪 funds last about 10 years
v. Funding internal growth of companies
1. Investment proceeds are used to build new businesses, not acquire existing ones
c. Organization
i. A VC is an investment pool (funds of $10M - $2B) organized as a limited partnership (LP)
ii. Funded by investors of their own as Limited Partners
1. Pension funds, university endowments, alternative investment funds, wealthy families,
previously successful entrepreneurs
2. Note: angel investors use their own money, VC’s use other peoples money
iii. Managed by professional managers as General Partners
1. Organized as a firm of GPs managing multiple Funds with overlapping investing periods
2. GPs are compensated through:
a. Management fee based on funds under management
b. Plus “carried interest” of 20-30% of profits
c. Sometimes also a parallel “Affiliates” fund just for themselves
d. Terms vary with prestige of Fund and track record of previous funds
d. Operation and motivation
i. Ten-year life for each Fund
1. Five years to invest
2. Five years to harvest
ii. Raising a new Fund depends on results of last one
iii. One Fund may see thousands of Business Plans per year, but invest in less than 10 (5?)
iv. Must have possibility of 10x return within five years on $5-20 million total investment or it’s
not worth their time
v. IPO, M&A, or Bust 🡪 Traditionally a “Homers” business
1. 7 of 10 investments fail
2. 2 break even or have modest returns
3. 1 drives the whole fund’s return
vi. M&A makes up much more of overall liquidity events (about 5x more in 2014)
1. But getting to an IPO takes about 7 years and also about 7 years to get to an M&A event
2. IPOs are must lucrative exits, but are harder to do
a. A typical IPO underwritten by a top investment bank will sell at least $50M in
new stock and have total equity value of at least $200M
3. Sale to a strategic buyer is easier to come by
e. Differences from Private Equity
i. Much earlier stage investments
ii. Limited information available to make investment decision
1. New idea/market
2. No publicly available information
iii. Companies need much more than just cash 🡪 they need operational skill of VCs
iv. Investment terms look the same on the surface
1. But the points of emphasis and economics are very different
2. Much more about control and less about fines economic points
v. No use of leverage debt
vi. Any cash generated by Companies will be plowed back into development and marketing rather than
paid out to investors as interest
vii. Investments are not liquid
1. Stock not publically trade
2. Must create own public market
viii. Generally, less obscene returns in absolute dollars

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1. But targets are mind-boggling in percentage terms
ix. Even failures are different 🡪 Not with a bang but with a whimper

IV. Venture Backed Companies


a. Most companies do not fit the profile for the VC model
b. What do companies need to have in order to attract VCs?
i. Market size
1. Big enough to make realization of desired returns possible, but not so big that larger
corporations will step in quickly
ii. Barriers to entry
1. Technology
2. Patents
3. Experience/expertise that can’t be replicated easily
iii. Validation/analogue to existing winners
iv. Team
1. Can you be trusted to handle $5M with only once-a-month oversight?
2. VC needs to be able to add trustworthy team members if needed
c. Other Characteristics of VC-Backed Companies
i. Need for large amounts of capital 🡪 amounts that can come only from Institutional Investors
ii. Potential for rapid growth with large target market
iii. Employees motivated through equity participation
iv. Need for additional contributions of experience and expertise
v. Based on foundational bargain of Silicon Valley
1. sell High to Investors
2. sell Low to Employees
d. Companies attractive to VCs might be at different stages of growth
i. Seed/startup stage 🡪 this is a premarketing stage where the capital needed is relatively small and
needed to prove a concept
1. If concept is successful, company may build product, do market research, build a
management team, and develop a business plane
ii. Early stage 🡪 companies completing development where products are mostly in testing or pilot
production (products may even be commercially available)
1. Probably in business 3 years or less
2. Has key management in place
3. Networking capabilities of VCs most useful to companies in this stage
iii. Expansion / mid stage 🡪 company is in need of working capital, is producing and shipping and has
growing A/R and maybe inventory
1. VCs offer strategic advice to these companies
iv. Later stage 🡪 company has a fairly stable growth rate, but may or may not be profitable
1. Considering IPO or sale

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V. The Lawyer’s Role
a. Business objectives trump scoring negotiating points
b. Pace is rapid and demanding
c. Basic legal questions
i. How do you divide
1. the control of and
2. the profits, if any,
3. from a barely formed business:
a. that has limited personnel and cash resources,
b. that operates in a rapidly changing cut-throat environment,
c. and whose entire existence is premised upon doing something that no one else has
done before?
ii. Do rules of fiduciary duties work for a situation where the owners are the ones actually
making the management decisions
1. Those rules were developed for a situation where the owners and managers of a business
are greatly disintermediated
d. Lawyers wear many hats:
i. Master of the forms, rules and procedures
ii. Somewhat experienced voice on merits of the business idea
iii. Counselor re business issues in general
iv. Source of investment leads
v. Educator of Founders
vi. Marriage counselor among Founders
vii. Only adult in the room
viii. Sometimes also an Investor

STARTING A NEW TECHNOLOGY VENTURE

I. Characteristics of a good VC-backed Startup


● New Idea ● Barriers to entry
o New idea vs. faster/cheaper/better o Intellectual property rights – patents, copyrights
o Necessary but not sufficient o Technology and business milestones already met
o “First mover advantage”
● Attractive market o “Unfair advantage”
o Big and getting bigger
o Room for growth and/or consolidation with no ● Strong management team
dominant player o Deep technical knowledge
o Vulnerable to a disruptive technology o Overwhelming drive to succeed
o Big enough to make desired returns possible o Preferably already experienced in startups
o Presence of similar companies to validate o Preferably already successful in a startup
opportunity o Malleability to allow VCs to build a team around
o Ability to pivot from original idea to one that
● Compelling product will actually succeed
o Customers crying for a solution
o Proprietary technology ● Clear path to liquidity (i.e., “exit” for the VC)
o Differentiated from others in market o IPO
o Favorable pricing margins o Sale to dominant player in market

II. Distinguish: Apps v. Technologies v. Full Blown Companies


a. Web portal for all things relating to hairpieces
b. App to actively manage tax withholding

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c. Website selling eco-friendly, healthy ingredient dog food
d. Biometric measurement device that sticks on back of high-end watches
e. Oil filters for cars and trucks that last the life of the vehicle
Pre-Formation Issues

I. Leaving previous employers


a. Fiduciary duty of employees
i. Do no harm (act in employer’s best interest)
ii. Don’t usurp corporate opportunities
b. Departing employee should review all forms and materials in her personnel file for provisions that may limit
future entrepreneurial activities
i. A new company would be greatly hindered by threat of a lawsuit by the former employer
ii. Even without certain contractual restrictions, an employee’s position at the former company will
have an impact on what the employee can legally do when thinking about forming a new venture
1. E.g., key employees (execs, officers, directors) and skilled employees (engineers,
marketing specialists, sales reps) owe a duty of loyalty to the company 🡪 fiduciary duty that
requires no harm to company or usurpation of corporate opportunity
2. During period of employment, these workers cannot actually compete with or solicit
employees from the employer
c. If new venture does NOT compete with employer
i. Employee is essentially free to do whatever (rent offices, hire employees that are NOT coworkers,
retain attorneys, etc.) provided that:
1. Employee does NOT use the employer’s resources
2. All activities are conducted after working hours
a. Line is blurry when employee is key employee whose hours aren’t defined
(vacation may be only truly free time)
d. If new venture does compete with employer
i. Activities more restricted 🡪 cannot prepare or plan for new venture if doing so would interfere with
job responsibilities (duty of loyalty)
ii. Cannot do ANYTHING related to actual operation of competing venture while still employed by
employer

e. Solicitation of Coworkers
i. Entrepreneur can be liable if his conduct leads coworkers to violate any restrictive covenants of
their employment agreement
1. Tort of intentional interference with contract
2. Misappropriation of trade secrets
ii. No-raid clauses 🡪 agreements that employee cannot solicit coworkers
iii. Distinction drawn b/w soliciting coworkers and telling them about future plans

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iv. Key employees 🡪 even in the absence of a no raid clause, a key employee who induces another
employee to move to a competitor is liable for breach of fiduciary duty
v. Good strategy 🡪 tell people you are leaving to start a new business and give them a phone number
1. This way the entrepreneur does not solicit
f. Contractual restrictions
i. No moonlighting
1. A no-moonlighting clause prohibits the employee from engaging in any business activities
(even after hours) unrelated to the employee’s job with the employer
ii. Non-compete
1. Reasonable in time, place and scope for legitimate purpose
2. But not in California
iii. Non-solicit
iv. Non-disclosure agreement
1. Prohibits employee from using or disclosing any of the employer’s trade secrets (e.g.,
customer list) without authorization
2. Prohibition often continues for a period of time after the employee quits
3. Unauthorized use or disclosure of an employer’s trade secrets is generally prohibited
during and after employment
a. All courts will enforce an agreement not to disclose trade secrets belonging to
a former employer
4. Trade secret 🡪 info that is not generally known nor readily ascertainable in the industry
and that provides a business with a competitive advantage
a. Two factors used to determine if trade secret exists
i. Value of information to business and competitors (nonobvious, provides
competitive advantage)
ii. Amount of effort made to maintain secrecy of information
5. Inevitable disclosure doctrine 🡪 some courts will enjoin a former employee from working
for a competitor firm for a limited period of time if the former employer can prove that the
new employment will inevitably lead the employee to rely on former employer’s trade
secrets
v. Invention assignment agreement
1. These agreements requires the employee to assign to the employer all inventions
conceived, developed, or reduced to practice by the employee while employed by the
company
2. May provide for the assignment of inventions not only during the time of employment
but also within a year after termination of employment
3. Consideration?
g. LEAVE ON GOOD TERMS
i. Entrepreneur should be honest about reasons for leaving
ii. May be appropriate to offer employer opportunity to invest in new venture
1. Easy funding, generates good will b/w the parties, may allow entrepreneur to hire
coworkers

II. Intellectual property matters


a. Do you own the idea?
b. Employee Invention Assignment Agreements
c. Even without such an agreement, prior employer owns idea if:
i. Developed on employer’s time
ii. Developed using employer’s resources – computer, cellphone, library, subscriptions
iii. Reasonably related to employer’s current and anticipated business
d. § 2870 of the California Labor Code 🡪 invention assignment agreement shall not apply to an invention that
the employee developed entirely on his or her own time without using the employer’s equipment, supplies,
facilities, or trade secret information except for those inventions that either:

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i. Relate at the time of conception or reduction to practice of the invention to the employer’s business,
or actual / anticipated research or development of the employer; or
ii. Result from any work performed by the employee for the employer.
e. Consultants may own what they develop, even if paid for it by someone else
III. Allocating equity among founders
a. Considerations in allocating Founders’ equity
i. Original idea and IP contribution
ii. Leadership and organizational duties
iii. Future in Company
1. CEO/CTO/CFO/Other VPs/Non-officers
b. “Co-Founder” vs. “Employee” vs. “Consultant”
c. Vesting before the VCs require it

IV. Business Model decisions


a. Business model
b. Capital needs
c. Anticipated sources of investment
d. Target exit strategy

V. Building a team
a. Allocation of roles among founders
b. Working for “sweat equity”
c. Beyond the Founders
i. Employment contracts
ii. “Consultants” who are really employees

Forming the Business Entity

I. Types of Business Entities


● Sole proprietorship ● Limited liability company (“LLC”)
o Simple o Same characteristics as limited partnerships
o No limitation on liability
o Tied to particular individuals ● S corporation
o Hard to raise capital
o Single level of taxation
o Hard to compensate employees with equity
▪ Company’s SHs pay fed income tax on the taxable
● General partnership income of the S-Corp’s business based on their pro-
rata stock ownership
o Same characteristics as sole proprietorship
o Very simple structure
o No Institutional Investors
● Limited partnership (only have one GP) o Employees can get equity, but also get K-1s
o Single level of taxation (pass through taxation) o Sometimes too simple a structure -- Employees and
Investors get the same stock and pay the same price
▪ i.e., owners pay tax on their allocation of the
o Company’s SHs pay fed income tax on the taxable
partnership’s income income of the S-Corp’s business based on their pro-rata
▪ Investors don’t like LLCs b/c it complicates their stock ownership
personal tax situation since investors would have to pay
tax on income even if no cash was distributed to them ● C corporation
o Infinitely flexible in terms of equity interests o Subject to fed income tax as an entity
▪ But Infinite flexibility requires custom drafting and ▪ Its SHs are not subject to tax unless the corp pays
analysis amounts to them in dividends, salary, etc.
o “Capital Account” accounting o Simple structure with well-defined, well-known rules
o VCs will not invest o Traditional Options for Employees

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o Employee equity possible, but in weird form o Double taxation, though losses may be usable against
later profits
o Relatively inflexible forms of equity interests

II. Factors Affecting Choice of Entity for VC-Backed Company


a. Need for large amounts of capital over sustained period of time
i. All cash generated by business will be plowed back into development, then marketing and sales
ii. Amounts that generally can come only from Institutional investors
b. Employees compensated through equity
c. Need for additional contributions of experience and expertise
d. Desire to sell equity low to employees and high to investors
e. No need for custom or tax-advantaged structures

III. Resulting Typical VC-Backed Company Structure


a. Delaware “C” corporation
i. SHs have limited liability for the debts and liabilities of the corp
ii. Allows for convertible preferred stock (most common VC investment)
iii. Stable and well established law related to c-corps
iv. BUT, corporate formalities required and double taxation
b. Founders/employees get Common Stock at ridiculously low prices
c. Investors buy Preferred Stock in multiple funding rounds at hopefully increasing prices
i. Key point is Company valuation, i.e. percentage ownership
ii. Most other terms fairly standard and not heavily negotiated
d. Founders at some point turn over day-to-day basis to “CEO-type” executive (in most cases)
e. Additional employees are added to fill out team as needed
f. Board split between Founders and VCs, usually in VCs favor
g. Target is a liquidity event, either IPO or M&A

IV. Factors Leading to Choice of a Non-Corporate Entity


a. This would be for companies that are not good prospects for VC funding
b. Business Plan issues
i. Ability to generate cash in near term
ii. Ability to be profitable in near term
iii. Modest target market size or modest target revenues in larger market
iv. Team has adequate experience, expertise, connections, etc. for what it plans
c. Investor issues
i. Modest expectations
ii. Interest in/ability to use tax losses currently
d. Structural matters
i. Founder control
ii. Broad equity incentives not needed
1. No pressure for liquidity
2. No difficulty with obscure tax forms
3. Big cash bonuses
iii. Need for customizable interests
V. Corporate Naming Issues
a. Two important aspects of naming
i. Marketing 🡪 company’s name or brand can be central to the business strategy or product marketing
ii. Legal 🡪 selecting a name that infringes on trademarks exposes corp to liability

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b. Three almost completely separate regimes for corporate names:
i. Official name in records of state of incorporation
1. There can only be one company in each state with a given name
2. Availability of name in other states where doing business?
ii. Trademarks
1. Can someone stop you from using this name?
2. Can you stop someone else from using this name?
iii. Internet domain name
1. watch out for cybersquatters
c. Holding one of the above does not mean you hold the others

VI. State of Incorporation


a. State of incorporation governs:
i. Fiduciary duties of the Board of Directors
1. Duty of Care
2. Duty of Loyalty
ii. Indemnification of officers and directors
1. Corporation can pay damages and legal defense costs if sued for corporate actions 🡪 pretty
much in all states after Van Gorkem
2. Except where breach of Duty of Loyalty
iii. Exculpation of directors
1. Directors are insulated from liability for monetary damages for breach of Duty of Care, but
NOT duty of loyalty
b. Important differences b/w CA and DE
i. Votes required on mergers and charter amendments
1. Delaware 🡪 Majority of all shares; majority of Preferred
2. California 🡪 Plus majority of Common (i.e., requires the approval of a majority of the
outstanding shares of each class of the corporation)
ii. Business Judgment Rule – when burden of proving fairness shifts from Board to plaintiff:
1. Delaware (less strict):
a. Approval by majority of disinterested Directors,, OR
b. Approval by majority of stockholders
2. California (more strict):
a. Disinterested Directors must also constitute majority of Board
b. Approval by majority of disinterested stockholders
iii. Nomenclature
1. Delaware: “Stockholders” and “Certificate of Incorporation”
2. California: “Shareholders” and “Articles of Incorporation”
c. If you are on the company side or the BoD side, there are provisions that push you to DE law. If you
are a SH, it would push you to wanting to be CA incorporated
d. Traditional benefits of Delaware:
i. Well documented and understood body of corporate law
ii. Sophisticated judges who specialize in such matters
iii. Court system organized for rapid responses
e. But does it matter for a private company? Most of the matters above apply to public companies.
i. § 2115 of the CA corporate code subjects some foreign corporations to CA law
1. Is this section enforceable generally?
2. DE courts won’t enforce this, but we don’t have a CA case yet
ii. Problematically, DE courts are currently skeptical of VC-backed companies, especially those from
SV
f. What does matter:
i. To lawyers 🡪 DE doesn’t take time to read filed documents before confirming filing
ii. To clients 🡪 Non-Californians worry that CA may be flakey

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VII. Basic Incorporation Actions and Documents
a. Corporate Charter (aka certificate or articles of incorporation) 🡪 public document that amounts to a contract
b/w the corporation and the state
i. Includes basic items such as company’s name, address, nature of business, description of stock,
gives snapshot of capital structure
ii. Establishes legal existence of corporation (and legal name)
iii. Establishes number of shares and fundamental rights and preferences of corporation's capital stock
iv. Defines any limits on duties and obligations of officers and directors
1. e.g., Exculpation of directors from monetary damages for breach of fiduciary Duty of Care
(not Duty of Loyalty)
v. Various other fundamental organizational structures and authorizations
1. For example, size of Board of Directors in some cases
vi. Amendment requires both Board and stockholder approval
b. Bylaws 🡪 internal document that sets forth the details regarding governance rules of the corp
i. Focuses on internal corporate procedures
1. e.g., organizational matters like the size of the board
ii. Substantial restatement of applicable state law
1. Often written to provide maximum flexibility
iii. Can generally can be amended with Board approval alone
1. At least in Delaware
2. Other states may require SH approval
c. General Timeline
i. Attorney collects necessary information usually in Questionnaire and prepares documents based
thereon; questionnaire asks for the following
1. Name of Corporation
2. Address of Corporation
3. General description of business
4. Names of Founders
5. Who will be the Board of Directors
6. Who will be the Officers
7. How will the initial equity be divided percentage-wise
8. What are the terms of the initial equity
9. A lot of other administrative information, like individuals’ addresses and taxpayer ID
numbers
ii. Incorporator (generally the Founder) executes Certificate of Incorporation
iii. Certificate filed with Secretary of State
iv. Incorporator adopts Bylaws and appoints first Board
v. Board holds first meeting or acts by Unanimous Written Consent to appoint Officers and complete
organizational matters
vi. Company issues stock to Founders in exchange for business plan and IP
vii. Copy of Certificate filed with any other states where Company will do business
d. First Board Meeting
i. Appoints Officers and grants them authority
1. Must have President/CEO, Treasurer/CFO, Secretary
2. Can have others, like Vice Presidents and Chairman of the Board

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ii. Ratifies adoption of Bylaws
iii. Approves initial stock issuances to Founders
1. In exchange for contribution of cash, business plan, IP, everything else relating to business
2. This is done through the Founders Stock Purchase Agreement
3. Stock subject to Company right of repurchase if Founder leaves (“Vesting”)

VIII. Roles of Directors, Officers, and SHs


a. Board of Directors
i. Centralized supervisory body that directs business and affairs of corporation
ii. Bound by fiduciary duties of care and loyalty 🡪 under a legal duty to act in the best interest of the
corporation and its SHs
1. Breach of duties results in personal liability to directors, though they may be indemnified
by the corp for breach of duty of care
2. Duty of care 🡪 director must exercise a degree of skill, diligence, and care that a reasonably
prudent person would use in similar circumstances
3. Duty of loyalty 🡪 avoid self dealing
4. Hard to show breach of duty of care b/c of business judgment rule
a. Presumption that in making a business decision, the directors of a corporation
acted on an informed basis in good faith and with an honest belief that the action
was taken in the best interest of the company
iii. Boards of Directors can act in two ways:
1. Duly noticed meeting where a quorum is present
a. Majority vote of Directors present wins
b. DE quorum = majority of total number of authorized directors
2. Action by Unanimous Written Consent
a. All Directors must sign and not effective until last one does

b. Officers
i. Run day-to-day affairs of corporation
c. SHs
i. Usually only have influence over extraordinary corporate actions (merger, sale, amendment to
charter)

IX. Transferring the IP


a. Identify and transfer the intellectual property into Company
i. Clean IP pedigree is crucial to success of business and attracting funding
b. Proper way to transfer IP:
i. Assign to Company as consideration for Founders’ stock
1. Both specifically identified IP
2. Plus “everything else relating to the business”
ii. Assignments by all involved in business
1. Avoid the “Forgotten Founder” problem later 🡪 go back and find anyone who had any
involvement with the company and no longer does, make sure they assign their rights
2. This is why it is important to incorporate early
c. Everyone should still sign Employee Invention Assignment Agreements
d. Explicit assignments needed from consultants

X. Hiring Employees
a. Company needs to file an SS-4 with the IRS to get an EIN

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Initial Equity Matters

I. Basic Concept of Stock


a. Stock is the currency by which ownership of Company is denominated and transferred
i. Share in appreciation in Company’s value and risk of Company’s failure
ii. Ownership of stock is not, however, ownership of Company’s actual property
b. Stock must be created in Certificate of Incorporation before it can be issued
i. Stockholder approval required to create stock but not to issue it
c. Rights and obligations of stock as defined in Certificate of Incorporation are inherent in the stock
i. Benefit and bind all holders automatically
d. Once created, Board of Directors has exclusive authority to issue stock

II. Founder’s Stock


a. First step in capitalizing a start-up Company
i. Usually common stock
ii. Note: the term “Founders’ Stock” has no legal meaning
b. Consideration 🡪 Typically issued in exchange for IP, technology, hard assets, past services or nominal cash
i. Future services not valid consideration (note that past services are valid consideration)
ii. When issued in exchange for property, the exchange is tax free under IRC § 351, if
1. Property is transferred solely in exchange for stock, AND
a. Found otherwise taxed on excess payment
2. Immediately after transfer, the transferor or group of transferors must own at least 80% of
the stock and voting power
c. Usually subject to “Vesting” (“Restricted Stock”)
i. VCs will demand it
ii. Founders should want it on each other
III. Stock Pricing
a. At founding:
i. IRC § 351 tax-free exchange if done as part of initial organization of Company
ii. So long as stockholder was a real contributor to preincorporation business
b. Thereafter
i. Price must be at least current Fair Market Value
1. Restricted Stock: any discount is taxable as Ordinary Income
2. Options: any discount creates tax problems that can eliminate all potential value of Option
(Tax Code Section 409A)
ii. Also taxable if consideration is:
1. Past services – taxable as Ordinary Income
2. IP or other property – taxable as Capital Gain
c. Takeaway 🡪 always price the stock at FMV

IV. Vesting
a. Idea 🡪 starting the company is only the beginning; to earn the right o participate in future rewards of the
company, the founder/employee should have to continue working for the company for some period of time
b. Common cliff vesting over 4 years
i. Vest a portion of the stock at the time of issuance

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ii. Vest an additional portion after one year
iii. Vest the remaining stock monthly over the next 36 months
c. Vesting = the company has the right to repurchase Founder/employee stock at original purchase price upon
termination of employment
i. Repurchase right declines progressively over time
1. Founders 🡪 on a monthly basis over a four-year time period
2. For non-founders, usually a one year cliff before monthly vesting starts (with vesting
starting at 25%)
d. Typically NOT tied to the circumstances of termination
e. Key item in negotiations between Founders and Investors
i. How much should be “unvested”
ii. Should vesting accelerate on certain types of termination or other events, like a change in control?
f. But Founders need to consider benefits of vesting with respect to each other

V. Types of Employee Equity


a. At formation, it is best to issue restricted stock outright rather than grant options
i. This is b/c stock can be issued at low price during that time
ii. But as the value of the stock increases, options are better b/c it allows employees to participate in
the growth of the business without putting up cash, paying immediate taxes, or risking their capital
b. Restricted Stock
i. Company’s right to repurchase the stock declines progressively as the shares vest
ii. Restricted Stock: any discount to FMV is taxable as Ordinary Income
c. Options
i. Option 🡪 Right to buy fixed number of shares at fixed price that can be exercised at any time up to a
specified expiration date
1. Usually right to exercise option increases progressively or “vests” over time
a. Generally over 4 years with a 1 year cliff
b. Flip side of Restricted Stock
2. Two types of options 🡪 ISOs and NSOs, with the difference being tax treatment
ii. Tax events in the life of an Option
1. Grant of Option
2. Exercise of Option
3. Sale of shares received upon exercise of Option
d. Incentive Stock Options (“ISOs”)
i. These are created by the tax code 🡪 they are options granted to employees (not nonemployee
directors or consultants, who can only receive NSO) and the exercise price is at least FMV
ii. Requirements
1. ISO Plan that complies with Tax Code

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2. Shareholder approval of Plan
3. Employees only
4. Special rules for 10% stockholders
5. No more than $100,000 of Shares may vest in any One Year
6. Two Year Holding Period from Date of Grant
7. One Year Holding Period from Date of Exercise

iii. Tax Advantages of ISOs


1. Grant: No tax (no different from NSOs)
a. Again, exercise price must be at least equal to the Fair Market Value of the
underlying Common Stock on the date of Grant (but for different complex Tax
Code reasons)
i. §409A imposes heavy consequences if the exercise price is less than the
FMV of the stock on the date of grant
ii. Board must have a reasonable basis for determination of FMV and usually
hires an independent firm to appraise company value
2. Exercise: No Ordinary Income Tax at this time
a. No withholding or payroll taxes
b. But spread between Exercise Price and FMV at time of Exercise is counted for
Alternative Minimum Tax purposes
3. Sale of Underlying Shares: Entire Spread between Exercise Price and Sale Price is Long-
Term Capital Gain
a. Ordinary Income converted to Long-Term Cap Gains 🡪 BUT ONLY IF
i. Employee held the stock for more than 1 year from exercise date of
option, AND
ii. Employee held the stock more than 2 years from when the option was
grated
iii. Otherwised taxed as ordinary income
b. Cash proceeds from sale available to pay tax
c. Time of tax payment deferred (Time Value of Money)
e. Non-statutory (or “Non-qualified”) Stock Options (“NSOs”)
i. Tax Treatment of NSOs (default situation)
1. Grant: No tax
a. But exercise price must be at least equal to the Fair Market Value of the
underlying Common Stock on the date of Grant
2. Exercise: Spread between Exercise Price and FMV at time of Exercise is Ordinary Income
a. Subject to withholding and payroll taxes
b. This means that appreciation in the value of the stock from the option’s grant date
through the exercise date is taxed as ordinary income
3. Sale of Underlying Stock: Spread between FMV at time of Exercise and sale price is
Capital Gain
a. Long-term Capital Gain if stock held for more than 1 year

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VI. § 83(b) Elections
a. Generally, an individual who receives stock (not options) in connection with the services is taxed at ordinary
income rates to the extent the FMV of the stock exceeds the amount paid for it
i. However, if the stock is subject to a substantial risk of forfeiture, the taxable event is delayed
until the risk of forfeiture lapses
ii. Restricted stock (i.e., stock that is subject to vesting) is subject to a substantial risk of forfeiture
b. Thus, if a founder is issued stock that will vest over a period of time, she recognizes taxable income on each
vesting date equal to the difference b/w the FMV of the stock on the date it becomes vested and the purchase
price paid (which was usually when the stock was granted earlier)
i. If the stock increases in value, this could result in the founder having to pay huge tax bills without
having the benefit of being able to sell the stock
c. § 83(b) election allows the founder to pay tax at the time the stock is purchase in an amount equal to what
would be due if the stock was not subject to vesting
i. i.e., if the founder pays FMV at the time the stock is purchase, she will not owe any tax
ii. Once the election is made, subsequent vesting of the stock will not be taxable 🡪 it is ignored
iii. Must be filed within 30 days of the initial purchase of the shares
1. Likewise, if an employee early exercises an option, the election must be filed within 30
days of that exercise
d. Generally, you want to file this
i. Might not be advantageous if the stock is being offered at a big discount upfront, b/c you would
owe tax on the different right away.

Building the Cap Table

I. Overview
a. As a founder, your idea is worth about 7.5% of the company

b. Authorized Stock
i. “Authorized Shares”

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1. Share number set forth in Certificate of Incorporation
2. Maximum number of shares that Board has authorization to issue without further approval
from stockholders
ii. “Authorized Common Stock”
1. Common Stock share number in Certificate of Incorporation
iii. “Authorized Preferred Stock”
1. Preferred Stock share number in Certificate of Incorporation
2. Initially, Undesignated or “Blank Check” Preferred
iv. “Designated Preferred Stock”
1. Preferred Stock whose rights and preferences have been defined in the Certificate of
Incorporation
2. Usually issued in, and designated by, series

c. Outstanding Stock
i. “Outstanding Shares”
1. Entitled to vote and share in proceeds from acquisition
ii. “Outstanding Common Stock”
1. Founders
2. Initial Employees
3. Exercised Options
4. Converted Preferred Stock
iii. “Outstanding Preferred Stock”
1. VCs
2. Angels
3. Strategic Investors
d. Other Stock Terms
i. “Shares Issuable under Outstanding Rights to Acquire Shares”
1. Shares issuable upon conversion of outstanding Convertible Notes
2. Shares issuable upon exercise of outstanding Warrants
3. Shares issuable upon exercise of outstanding Options
ii. “Option Reserve”
1. Shares in option plan reserved for issuance upon exercise of options that may be granted in
the future
iii. “Vested Shares/Options”
1. Shares/options that holder has right to keep notwithstanding termination of employment
e. Total Stock Terms
i. “As Converted Outstanding Shares”
1. Outstanding Common Stock + Outstanding Preferred Stock on an “As-Converted” basis
a. Each Series of preferred multiplied by its Conversion Ratio
2. Generally the total number of votes that can be cast by stockholders
ii. “Fully Diluted Shares”
1. As Converted Outstanding Shares + Shares Issuable under Outstanding Rights to Acquire
Shares + Option reserve (in VC financings)
2. In VC Financings, also includes the Option Reserve
3. In M&A, generally includes only the Vested Shares/Options with respect to any
shares/options that are subject to vesting

II. Expanding Pie Theory

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a. As additional stockholders are added, there are more slices to the pie, and each Founder holds less of the
corporation
b. As the corporation creates value, each slice of the pie is worth more
c. Everything depends on the which of the above happens faster

III. Stages of a VC-Backed Company


a. 1. Founders issuances of initial stock
i. 1A. Initial employees get equity
b. 2. Friends & Family/Angels round – probably Convertible Debt
i. 2A. Option Plan set up
c. 3. First institutional round (“Series A”) – Angels, VCs
d. 4. Second institutional round (“Series B”) – VCs
e. 5. Third institutional round (“Series C”) – VCs; Strategics
f. 6. Fourth/final/mezzanine institutional round (“Series D”) –Late Stage/Mezzanine/P.E. funds
g. 7. IPO

IV. Formation and Founders’ Issuances


a. Founders 🡪 Based on Relative contributions, casual promises, and Forgotten Founders
b. Consideration for Stock 🡪 hard IP, all other rights in “the Business”, cash, services
i. Services are taxable
c. Stage 1A – Initial Employee Equity Issuances
i. Restricted Stock vs. Options
ii. Form of consideration
iii. Remember tax implications discussed above
iv. Pricing
1. Tax Code Section 409A
a. Company bears burden of proving FMV correct
b. Unless obtains valuation from independent expert
2. Accounting Rule 123R
a. Black-Scholes value of Option is a financial statement expense
b. Company also bears burden of proving FMV correct unless valuation from
independent expert
V. Stage 2 – Friends & Family/Angel Round
a. Securities Law issue 🡪 generally only Accredited Investors
b. Probably Convertible Debt rather than stock
i. Avoids need to agreed upon valuation of Company at this time
ii. Simplifies documentation
iii. Nominal interest rate
iv. No security/collateral
v. No expectation of repayment
vi. Convertible into Preferred Stock issued in first Institutional round
1. Generally at a 10% to 20% discount
2. Or else holder gets warrants to purchase that Preferred Stock
c. Time to set up Option Plan
i. Budget for 12 to 18 months of new hires
VI. Stage 3 – Series A Round
a. VCs and Angels
b. Conversion of Angel Convertible Debt
i. Discount on conversion?
c. Option Plan reserve increase
i. 15% to 25% (including or in addition to outstanding options?)

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d. VCs may take majority of Board
e. Professional CEO may be demanded by VCs
f. Effect of Preferred Stock price on Fair Market Value of Common Stock and thus on setting of
exercise prices for subsequent Option grants
i. Sale to outsider is best indicate of current FMV
ii. But stock being sold is Preferred not Common, so some discount may be appropriate

VII. Stage 4 – Series B Round


a. VCs and Strategic Investors
i. Desirability of new outside investor to determine “fair” price for round
ii. Hopefully a higher price
b. Relation to/priority of new Series
c. Further Option Plan increase?
i. Generally to keep around 15% to 20%
d. Possibly more VCs on Board
e. More new senior Officers?
f. Often followed by Venture Debt or Equipment Lease Line financing
i. Warrants for most recent type of Preferred Stock often issued to Lender to lower interest rate
VENTURE CAPITAL FINANCINGS

Sources of Funding

I. What are VC’s looking for?


a. Big market with big pain
b. Product that solves pain – new idea
c. Barrier to other solutions
d. Team to do it
e. Exit path – how can the VC get money back in 5-7 years
i. VCs expected to generate at least a 20% return for their investors, so Venture capitalists
generally are not interested in investing unless the expected return is in the range of 35% to
45% compounded annually.
ii. VCs are usually looking for an enterprise that has the potential to grow to a significant size
quickly and to general generate an annual return on investment in excess of 40% over a
period of 3-5 years

II. What companies need VC funding?


a. Those that burn a lot of cash
i. Silicon Valley startups are always unprofitable
1. At least for a very long time
2. Even at IPO in many cases
3. Profitability does not mean positive cash flow
ii. Not bad management, but by design
1. Profits and cash all used for additional development, expansion and just general growth
b. Thus, SV companies will need to go for a very long time before they are self-sustaining
i. So they must raise lots of invested capital
c. Generally need a new financing every 12 to 24 months
i. In (hopefully) ever-increasing dollar amounts raised

III. VC Funding
a. Take the money 🡪 having a minority position in a well-financed start-up is preferable to being firmly in
control of a venture that goes bankrupt because it was underfinanced
b. Advantages to VC Funding
i. Best source of capital

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1. Access to substantial amounts relatively quickly
2. Deep pockets for later funding rounds/not just 1M in the beginning but they plan to
continue
ii. Best source of all-round non-monetary assistance – “Smart Money”
1. Experience with startups
2. Expertise in industry sector
3. Contacts within VC ecosystem
iii. Sophisticated investors
1. Understanding of possibility of failure
2. Clear what their objectives are
iv. Prestige of being able to attract VC funding
c. Disadvantages to VC Funding

d. Disadvantages to VC Funding
i. Loss of control
1. At least partial, sometimes total
ii. Possibly loss of job
iii. Dilution
1. Although consider time to market lost if raise less money
iv. Potentially conflicting objectives between Founders and VCs
1. Target of liquidity event
2. Time horizon to that liquidity
3. Growth rate necessary to achieve liquidity with that time
v. Typical investors rights and preferences – e.g., liquidation preference, anti-dilution provisions, veto
powers

IV. Other sources of funding


a. Angels/Angel Groups
i. These are harder to find than VCs
b. Incubators/Accelerators
i. Usually only last about 6 months
c. Strategic investors
i. Will sign an NDA whereas VCs won’t
d. Friends and family
i. May not understand that the company is likely to fail
e. Self-funding
f. Bank loans/Credit cards/Second mortgages
g. Government grants
h. General solicitation of Accredited Investors
i. This is a Rule 506(c) offering under Reg D 🡪 but must verify that all purchasers are accredited
investors
i. Crowd-funding
j. Non-equity crowd-funding

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20
non-equity = kickstarter

V. Lifestyle Companies
a. Funding your business off of your customers
b. NRE
i. Customers give you money ahead of time to develop a product
ii. This is how everyone got working capital back the 80's
iii. The idea of giving away equity for working capital came in the 90's
c. Founders have more benefit from these types of companies
i. “A startup’s job is to grow big enough to provide a good return to its investors. A lifestyle
company’s job is to provide a great quality of life to its owners.”

Seeking VC Funding

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I. VC Mating Dance
a. Network and get introduced to a VC
b. VCs will focus on three things 🡪 viability of the concept, size of the opportunity, and the team
c. Courtship process typically takes 2-3 months
i. Means you should engage more than 1 VC at a time

II. Materials to attract VC Interest


a. Executive Summary
i. One page 🡪 Easy to read and navigate
ii. Topics to hit:
1. What does the Company do?
2. What is the market, including size, growth rate and where it’s going?
3. What makes you different?
4. How far along are you?
5. How much are you trying to raise?
iii. Enable VC to fit you into their context immediately
1. But also start to answer the question “Why you?”
iv. This just starts the dialogue – it’s not a Ph.D. thesis
b. PowerPoint business presentation
i. 10-15 slides
ii. No more words than necessary
iii. Don’t waste time on the obvious
iv. Same substantive points as Exec Summary, only now you get 1-2 slides per point rather than 1-2
sentences
1. Third party-sourced market data
2. Revenue model
3. Differentiators
v. No more than one slide on the people
vi. Focus on previous companies and experience that VCs will recognize immediately
c. Business Plan
i. Purposes
1. Convey to others (i.e. Investors) what you (will) do
a. Force yourself to figure out how you will do it
2. Demonstrate to others (i.e. Investors) that you really do know what and how to do it -- and
in fact will be able to do it – Even when every assumption in the document is likely to be
wrong
3. No one expects what’s in the plan to come to pass 🡪 They want to know if you will be able
to adapt when that happens
ii. Resources
1. Other business plans/IPO prospectuses
2. Advisors
3. Local library/bookstore/the Internet
4. But entrepreneur has to write it themselves
iii. Contents
1. Company purpose
2. Problem your addressing

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3. Your solution
4. Challenges to your solution
5. Market size and dynamics
6. Competition and why you’re different
7. Product
8. Business model (i.e. how do you make money)
9. Team
10. How much money do you need, and what you are going to do with it

d. Financial projections (include in business plan)


i. Income statement and balance sheet
ii. Cashflow projections
iii. How will funding be spent and accelerate growth?
iv. How long does the funding take you and how much more will you need then?
v. Don’t do this:
1. “The market is $50B, but we’re being really conservative.”
2. “We assumed we’ll get only 6%, and then we cut that in half.”
3. “That’s still revenues of $300M/year 4 years after founding.”
vi. Everyone knows the projections won’t come true – it’s the process and thinking that counts 🡪
VCs are testing you
e. Back-up materials
i. VCs will ask for this if they are interested
ii. Put together detailed information on:
1. Market background
2. Technology background
3. Risk assessment
4. Competitive landscape
5. References
6. Potential industry/other experts
7. Whatever else the VCs ask for

III. Which VCs to Target


a. Who invests in this space, but hasn’t already invested in a competitor?
b. Different VCs prefer to invest in different stages of the business life cycle
i. Seed stage (raw start up): invest $50k to $1M
ii. Early stage (product in beta testing or just being shipped): invest $1M to $10M
iii. Later stage (product is fully developed or being sold and generating revenue): invest $10M to $30M
iv. Mezzanine (financing round before an anticipated exit)
c. Find a VC that specializes in your industry
d. Look at VentureSource for VC fund data and comparable company data
e. Can they invest in future rounds?

IV. Decoding VC Speak


a. What they say:
i. “We’re interested, but we need answers to 30 more questions.”
ii. “We’re interested, but it’s a little too early for us. Call when you’ve achieved XXX.”
iii. “We’ll interested, but we’re currently fully invested.”
b. What they mean (maybe):
i. “We actually are interested, but we need some more info.”

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ii. “We’re interested in someone else in the space, but want to use you to get free information that we
can use for them.”
iii. “We’re not interested.”
1. “. . . unless you come up with something great or the guys across the street invest.”
2. Or “No.”

V. VC Due Diligence Scrutiny


a. Business due diligence by the VCs and their advisors
b. Legal due diligence by their lawyers

Fundamental Concepts in VC Financings

I. Typical Company Structure


a. Delaware “C” corporation
b. Business plan requires raising lots of capital by selling Preferred Stock to Institutional Investors
i. Multiple rounds of funding at increasing prices per share
c. Founder and employees are incentivized with equity at prices lower than paid by Investors
d. Founders run the Company initially with “experienced executives” gradually brought in
e. But Investors have ultimate control
i. Majority of Board of Directors
ii. Veto powers over key corporate actions
iii. Hiring and firing of CEO
f. All have one goal: go big or go home

II. Dual Class Stock


a. Common stock 🡪 founders, managers, and employees
i. Compensatory purpose
ii. Low price
iii. Residual rights
b. Preferred stock 🡪 investors
i. Investment purpose
ii. High price
iii. Preferences and senior rights
c. “Preferred” Stock must have some preferred position and rights over Common to support the crucial price
differential:
i. Dividend preference
ii. Liquidation preference
iii. Anti-dilution protection
iv. Board seats
v. Veto powers
d. But in other ways, Preferred Stock is really just dressed-up Common
i. Convertible to Common
ii. Dividends never actually get paid
iii. Votes with the Common on most matters
iv. Automatically converts to Common on an IPO
e. Compare VC preferred stock to other types of stock:
i. Public Company and even PE Preferred Stock are completely different animals
1. Dividends are real terms, Incremental returns are part of the economics, Minority stock
positions, Probably don’t control Board, VCs are not just pure financial investors (PE Not
interested in building companies or ideas)

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ii. VC Preferred Stock is not intended as standalone financial instrument
1. The detailed economic terms are really not for financial purposes, but to:
a. Justify a price differential, and
b. Give the VC some extra measures of protection and control

III. Division of Economics and Valuation


a. “Valuation” is the language VCs use to discuss percentage ownership
b. There are two different ways to discuss valuation
i. Pre-money valuation 🡪 what the investor is valuing the company at today, before investment,
ii. Post-money valuation 🡪 pre-money valuation plus the contemplated aggregate investment amount.
c. Always assume value is being discussed on a fully-diluted basis

d. Example
i. What the VCs say:
1. We’ll put $2 million in at a $3 million Pre-Money Valuation
2. We need to have 40% of the Fully Diluted Shares in exchange for our investment of $2
million
ii. What they mean in either case:
1. Pre-Money Valuation i fdilutions $3 million
2. Post-Money Valuation is $5 million
3. VCs get 40% of Company = 40% of Post-Money Fully Diluted Shares
4. Founders keep 60% of the Company
a. Less if the VCs also specify an Option Plan Reserve/ less if the VCs specify a
post deal reserve for future employee issuances
5. All on a Fully Diluted basis
e. Terminology
i. Fully Diluted Shares = Outstanding Common, plus common issuable upon conversion of
outstanding Convertible Securities or exercise of outstanding Options, plus common available for
future Option grants
ii. Pre-Money Valuation = What the Company is worth immediately before the VC investment (Pre-
Money = Pre-Deal)
iii. Post-Money Valuation = Pre-Money Valuation + Amount Invested
iv. Post-Money Option Plan Reserve Percentage = Portion of Fully Diluted Shares after financing
reserved for future issuances of equity for employees (so the company can compensate and
motivate future employees)
1. VCs always want reserve to be increased before their investment rather than after, to
avoid being affected by the dilution
a. This is because VCs base ownership on a fully diluted basis, so all shares are
factored in
b. Any subsequent increases will generally require their approval
c. If found has any leverage, they should try to get VCs to increase the option pool
after funding
i. Could also try to get a higher pre-money valuation so that the founders’
ownership percentage is not as diluted
2. Founders must balance of dilution with need for adequate reserve for anticipated hires
without having to go back to the VCs to soon
a. Create option granting budget over next 18 months, plus some cushion for
particular key hires
b. Reserve will be increased in next financing round, in any case
3. Usually between 15% and 20% of Fully Diluted Shares
a. Closer to 15% if most executive positions already filled

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f. How to actually value a company
i. Discounted Cash Flow Method
1. Method
a. Estimate future cashflows in and out
b. Then discount each to its present value using an appropriate discount rate that
reflects both:
i. Time-value of money
ii. Risks of the venture
c. Add up the discounted cashflows to get net present value
2. Problem
a. SV Startups generally don’t generate positive cashflows for a long time
i. All cash generated is plowed back into the business, they don’t give back
to investors really, so no outflow
b. Risk discount rate is highly determinative of the result (But also highly uncertain,
can screw up calcuation)
3. So, the errors are likely to overtake the result, this is not good for VCs

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a.example: 8 mil t or minus 1 million. the +/- creates a wide range.
i. If VC puts in 2 million +/- 500 thousand. And the valuation is 4 mil +/- 1
million, then the valuation is possibly +/- 8 million
ii. Comparisons to Comparable Company Metrics
1. Method
a. Find out various financial metrics of comparable companies whose valuation is
known
b. Derive ratios between those metrics and companies’ valuations
c. Apply those ratios to the Company’s metrics to calculate Company’s valuation
2. Problem
a. It’s difficult to find comparable companies with known valuations
b. It may even be difficult to find any truly comparable companies, regardless of
whether valuation is known
c. It’s also difficult to get financing information about them
i. Information is usually available only for public companies, but how
comparable are they to a raw startup?
3. So, the errors are likely to overtake the result, this is not good for VCs

iii. Comparison to Comparable Company Valuations


1. Method
a. Find out prices of recent private financings by comparable companies
b. Adjust those prices for any differences between those companies and the Company
2. Problem
a. Difficult to find comparable companies at the same particular stage
b. It’s very difficult to get accurate prices for private financings
3. So, the errors are likely to overtake the result, this is not good for VCs
iv. Venture Capital Method
1. Six deceptively easy steps
a. Estimate total investment in Company by VC over time
b. Project/Estimate future size of Company’s market at VC’s desired time of exit
c. Determine value of Company at that time, based upon estimated share of market
d. Determine percentage of Company VC needs to own at that time to get target
return
e. Break down Company’s funding needs into likely funding rounds over time
f. Juggle timing, pricing and amounts raised in each round, including present round,
to arrive at desired percentage at time of exit
2. Example:
a. VC anticipates investing $20M total in Company over time
b. VC projects Company’s market will be $1.5B in 5 years
c. VC estimates Company will have 20% market share at that time and thus a
valuation of $300 million (VC estimates the market will ascribe 1.00 of balue for
1.00 of revenue)
d. VC targets 5X return
e. So, when all investing done, VC needs to hold 33% of Company
f. VC maps out likely times and amounts Company will need new funding
g. VC calculates price for each funding round, including first round, to end up with
33% of Company in 5 years
3. BUT the errors are likely to overtake the result

v. The 50% Method


1. VC says pre-money valuation = funding needs of the company, this gives them 50% of the
post-money valuation
2. This is Fockler’s method

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g. What realistically affects valuation?
i. Most reliable way to drive up the price is having multiple term sheets on the table
ii. If you don’t need money immediately can get to cash flow neutral, you can probably add 10-20% of
your valuation
iii. Valuation is subjective and all market driven
1. What is a VC willing to pay?
2. Can you get a second VC willing to pay more?
iv. But it’s the Number One issue in a financing

Positive factors affecting valuation (increasing price) Offsetting factors affecting valuation (decreasing price)
● Technology and business milestones met ● VCs’ expertise, contacts and therefore ability
to add value
● Size of market opportunity
● VCs’ prestige and track record
● Current fundraising environment in general
● Extent to which the Company needs the
● “Hotness” of space
money immediately
● Founders’ prestige, experience and track record ● Absence of any other funding alternatives
● Deal terms (don’t vary much, thus doesn’t affect
price much)
● Multiple termsheets (competition btw investors)

● Extent to which Company doesn’t need the money


immediately

h. Determining how much to raise


i. Double the amount you think you need
1. what milestones do you need to achieve
2. how much will it cost to achieve them
ii. Balance need to raise this amount against the resulting dilution
1. dilution comes with loss of economics, loss of control, tradeoff with risk mitigation
iii. #1 Rule 🡪 take the money

IV. Allocation of Control


a. Board of Director Seats
i. Board is charged with overseeing the management of the company’s business affairs
ii. One or more Board seats reserved for Preferred
1. Sometime one for each Series
2. Built into the Certificate of Incorporation
iii. Stockholders all agree to elect the VCs’ designee[s] to those seats 🡪 contractual right in Voting
Agreement
iv. VCs will usually hold at least as many seats as the Founders, if not an outright majority of the
Board
1. 1 VC, 1 Founder/CEO, 1 independent person with industry expertise
2. 2 VCs, CEO, 1 other Founder, 1 independent person
3. Are “independent” directors really independent of the VCs? They tend to side with the VCs
that gave them the seat
b. Voting as stockholders
i. Preferred votes with the Common on all matters on which the Common gets to vote
ii. Percentage ownership is not just how economics are allocated but also how voting control is
allocated
1. Percentage of Total Voting Power = Percentage ownership

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iii. When voting together, Preferred and Common each have one vote (on an as-converted to Common
basis)
1. Only actual outstanding shares count
2. Options don’t vote
3. So when looking at voting, we are looking at “as converted shares outstanding”
iv. Class votes mandated by law
1. Preferred and common vote separately and must separately approve the following:
a. Amendments to the Certificate of Incorporation
b. Liquidations
c. Mergers – at least in California
v. Series votes rights mandated by law (Series A preferred v. Series B preferred)
1. Amendments to the Certificate of Incorporation that change the rights of that Series
adversely in a way different than for other Series
2. Generally amendments of Class rights are OK, while amendments of Series rights may not
be, even if same result
vi. Voting rights negotiated in Certificate of Incorporation – “Protective Provisions”
1. There are certain actions for which the company must obtain the approval of the holder of
preferred stock voting as a separate class, even if the preferred stock represents a minority
of the outstanding shares
a. Acquisition/sale of Company
b. Creation/issuance of equal or senior securities
c. Amendments of Certificate that change rights of Preferred
d. Dividends or stock repurchases
e. Sometimes other stuff that get into control of management
i. Incurrence of debt over a specified level
ii. Related party transactions
iii. Change in size of Board
iv. Increases to the Option Plan
v. Changes in Business Plan
2. Generally, Class votes are OK; Series votes are blocking rights
a. Don’t want to allow each series to have to vote a majority on these changes b/c
then a single investor (the largest in a given series) has blocking power
b. If there are no series votes, the company has greater flexibility
c. The interests of each series may differ due to different pricing, different risk
profiles, and a false need for overall control 🡪 this could make passing a proposal
difficult

V. Exits
a. Upside Exits 🡪 IPO or acquisition
i. Preferred converts to Common
ii. Valuation/percentage ownership is what matters
b. Downside Exits 🡪 Acquisition or liquidation
i. Preferred gets first claim on proceeds – “Liquidation Preference”
1. How big is the preference?
2. What is its priority vs. other Classes and Series?
3. How are the proceeds distributed after the Liquidation Preference has been satisfied?
ii. Liquidation preference is what matters here
c. And nobody gets anything if the Company fails

Securities Laws

I. Two fundamental principles

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a. Every Sale of a Security in the U.S. must be approved by both Federal and State governmental
authorities or must come under Exemptions under both entities’ laws
i. Relevant rules:
1. Section 5 of the Securities Act of 1933
2. SEC regulations and rules
3. Blue Sky Laws of individual states
ii. Translation 🡪 sell only to:
1. People and entities rich enough that they should know how to protect themselves (Rule 506
under Regulation D)
a. People with > $1 Million net worth
b. People with > $200,000 net income in each of three successive years
c. Entities with >$5 Million in assets
2. Family and friends where the relationship is so close that they can be expected to get
adequate information about the Company that way
a. And so that it’s reasonable to say that a “public offering” is not involved (Section
4(2) of the Securities Act of 1933) because the people are close enough around
you
b. Any Omission or Misstatement of a Material Fact in connection with the Purchase or Sale of a
Security is a violation of the law
i. Relevant Rules
1. Section 11 and 12 of the Securities Act of 1933
2. SEC Rule 10b-5 and other regulations and rules
3. Blue Sky Laws of individual states
ii. Translation
1. Is this something that the average investor would want to include among the things to
consider in making an investment decision?
2. If you think it might make them reconsider investing, that’s exactly what you have to
tell them

II. Federal Private Placement Exemptions


a. § 4(a)(2)
i. Section 5 of the Securities Act of 1933: Every sale of stock in U.S. must be registered with SEC,
unless exempt
ii. Section 4(a)(2): “The provisions of Section 5 shall not apply to transactions by an issuer not
involving any public offering.”
iii. SEC v. Ralston Purina (1953):
1. Availability of Section 4(a)(2) depends on “whether the particular class of persons affected
need the protection of the Act. An offering to those who are shown to be able to fend for
themselves is a transaction ‘not involving any public offering.”
2. Thus, the “exemption question turns on the knowledge of the offerees . . . . The focus of
inquiry should be on the need of the offerees for the protections afforded by registration.”
iv. Still have to comply with state Blue Sky Laws
b. Rule 504 – Small Offerings
i. Sales to anyone
ii. Total sales can’t exceed $1 million in any 12 month period
c. Section 3(a)(11) – Intrastate Offerings
i. Sales only to purchasers in one state
d. Regulation S – Foreign Offerings
i. Sales only to non-US purchasers
e. Rule 701 – Service Provider Equity
i. Employees, consultants, directors under a “compensatory benefit plan”

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ii. Dollar and share limits based on Company assets and shares outstanding
iii. Disclosures to recipients required if over $5 million
f. Rule 506(b) 🡪 Most VC deals done under this safe harbor
i. Unlimited dollar amount
ii. Unlimited purchasers who are Accredited Investors
1. Must have “reasonable basis to conclude” they are Accredited
iii. Up to 35 purchasers who are not Accredited Investors
1. Specified disclosure requirements if any Unaccredited Investors
2. Such disclosure, if given, must go to all
iv. No General Solicitation or General Advertising
v. State Blue Sky Laws preempted
g. Rule 506(c)
i. Unlimited dollar amount
ii. Unlimited purchasers who are Accredited Investors
iii. State Blue Sky Laws preempted
iv. General Solicitation and General Advertising permitted
v. But no Unaccredited Investors
vi. Issuer must take affirmative steps to verify that all purchasers are Accredited Investors
1. Beyond mere “reasonable basis to conclude”
2. Pay stubs, bank/brokerage account statements, tax returns
3. This is why VC’s don’t take advantage of this 🡪 too burdensome
a. And verification is a separate step 🡪 if an investor is not verified, company could
lose exemption even if the investor turns out to be accredited
vii. Problems with this exemption
1. Accredited Investor verification hassles and risks
2. Need to be able to prove adequate verification process
3. Likely to attract less sophisticated investors
a. Still no specific disclosure requirements, but likely to need more formal and more
extensive disclosure materials
b. Disclosure also likely to need to be written for laymen
c. And more likely to be questioned after the fact
4. Likely to cause legal and administrative hassles later:
a. Lots of little stockholders
b. Many of them unsophisticated
5. No mixing/matching with Section 506(b)
6. Loss of Section 4(2) exemption fallback
viii. Is anyone using it?
1. Maybe just as protection from inadvertent General Solicitation/Advertising in formerly
506(b) offerings
a. Referrals through attenuated networks of contacts
b. Large Angel group presentations
c. Pitch Events and Demo Days
d. Company FaceBook pages and Twitter feeds
e. Interactions with “normal” advertising/marketing activities
2. Both General Solicitation/Advertising for a financing and General Solicitation/Advertising
for a presentation regarding a financing are covered
h. Crowdfunding
i. Up to $1 million within a 12 month period
ii. Anyone can invest
1. BUT: potential for too many stock holders that are probably unsophisticated
iii. Must be through independent Internet-based “Portals”
1. BUT: this is procedural overhead

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iv. Limits on each Investor’s total Crowdfunding investments in any year tied to income/net worth 🡪
Each investment must be small
v. Company must provide significant amount of disclosure
1. E.g., audited financing statements
2. BUT: this is more procedural overhead and expense
vi. States can’t add extra requirements, but can police deals
vii. Public offering-type strict liability (unlike in private offerings)
1. These companies are probably the least likely to be able to provide full and fair disclosure
viii. SEC has put out proposed rules, but not yet adopted

Term Sheet Major Terms

I. Overview
a. Rights inherent in the preferred stock 🡪 rights built into the company’s certificate of incorporation
b. Preferred stock gets special rights and downside protections
c. Since a company may need multiple rounds of funding, they should consider how the rights granted to first
round investors will affect future negotiations
i. It is unusual for investors in subsequent rounds to accept fewer rights than were granted in a prior
round
d. Remember, a lot of the terms the preferred stock gets are there to justify for tax purposes that the preferred
is worth more than the common stock
e. Most important terms
i. Valuation
ii. Liquidation preference
iii. Founders stock/option vesting
iv. Voting/Vetoes/Board control
v. Operational/Administrative Hassles
vi. Everything else

Typical Term Sheet Terms


Pricing terms Terms relating to rights Terms relating to Other terms
inherent in Preferred Stock contractual rights
● Pre-Money Valuation ● Expenses of
● Dividend rights ● Information rights transaction
● Amount being raised
● Liquidation Preference ● Registration rights ● Exclusivity/no
● Post-Financing Option
shopping the
Reserve ● Conversion rights and ● Pre-emptive rights
deal/confidentiality
Anti-dilution adjustments
● Price per Share ● Right over sales of
● Voting rights stock by Founders
● Percentage being sold
to Investors ● Board representation ● Required vesting terms
for Founders’ stock
● Resulting Cap Table ● Protective provisions
and options

II. Liquidation preferences (inherent)


a. Upon sale (acquisition, dissolution, or other liquidation of the company, the liquidation preference provides
that the preferred must be paid some amount of money before common gets anything
i. Downside protection for investors
b. 1X Liquidation Preference 🡪 If Company liquidates or gets acquired, Preferred get their initial investment
back first

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i. Anything other than 1X is rare, at least in early rounds
ii. If the proceeds aren’t large enough to cover the Liquidation Preference in full:
1. Preferred takes it all, shared based upon total amount each invested
2. Common gets zero
c.

d. Liquidation Preference b/w different series of preferred (rights of subsequent series)


i. Two possibilities
1. All series paid pari passu 🡪 all series have the same priority and share in the 1X liquidation
preference in relation to their pro-rata ownership
2. Senior Liquidation Preference 🡪 one series has a preference over the others
a. The senior series gets back their investment in full before even other Preferred get
anything
b. But strong tendency for later Series to have same priority as early Series
e. What If the proceeds exceed the aggregate Liquidation Preference of all Preferred, who gets that excess?
There are 3 types of preferred liquidation rights:
i. Participating Preferred
1. Preferred gets investment back first as Liquidation Preference
2. Preferred and Common share remainder on as-converted basis
ii. Non-Participating Preferred
1. Preferred gets investment back first as Liquidation Preference
2. Common gets remainder (i.e., all proceeds in excess of the liquidation preference
3. At some point, it becomes more economic for Preferred to convert to Common
iii. Hybrid or Capped Preferred
1. Preferred gets investment back first as Liquidation Preference
2. Preferred and Common share remainder on as-converted basis up until Preferred has
received some multiple of their original investment (usually 2X or 3X)
3. Common gets remainder
4. At some point, it becomes more economic for Preferred to convert to Common

III. Dividends (inherent)


a. 6% to 10% per annum
b. Generally Preferred also gets to participate in any dividends on Common
c. What happens if dividends are not paid?
d. “Cumulative”: all prior years’ unpaid dividends must be paid at some point
i. Generally part of Liquidation Preference upon acquisition
ii. Sometimes, though rarely, part of automatic conversion upon IPO
e. “Non-cumulative”: unpaid prior years’ dividends go away
f. In reality, no one ever expects them to be paid
i. No one is looking for 6% to 10% annual return even if paid

IV. Conversion (Inherent)


a. Optional conversion at choice of stockholder at any time
b. Automatic conversion upon certain events such as IPO

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i. Theory is that Company is now successful enough that Investors don’t need the protection of the
Preferred Stock rights
ii. There might be certain criteria that the IPO must meet to auto convert
1. E.g., firm underwriting, offering must raise a certain amount of money, etc.
iii. May also be automatically converted upon a vote of some specified percentage of the preferred
stock (either majority or supermajority)
c. Initially convertible one-for-one
i. But rate is subject to adjustment upon certain events
ii. “Anti-dilution protection”
iii. Conversion ratio = initial preferred purchase price divided by the conversion price

V. Anti-Dilution Protection (Inherent)


a. Basic idea 🡪 investor uses anti dilution provision for protection in case future shares are issued at a lower
price that what they paid
i. Normally, preferred stock converts on a 1:1 basis, but anti dilution clauses adjust this ratio in
subsequent rounds that are priced lower (down rounds) so that the number of shares of common
issuable upon conversion of preferred stock represents the same % ownership (on an as-converted
basis) as existed prior to the down round
ii. E.g., investor buys series A for $1.00/share, but series B goes for $0.50/share. If there is anti
dilution protection, the series A’s conversion ratio to common is increased from 1:1 so that the
investor can keep ownership from being diluted by cheaper shares
b. Two types of anti-dilution provisions:
c. Structural Anti-Dilution
i. Conversion rate adjustments to preserve relative economics between Preferred and Common when
Company undertakes certain corporate actions/events
ii. For example, stock splits and reverse stock splits
1. Conversion rate adjusted proportionately
2. Alternately, Preferred could be split itself to maintain one-to-one conversion rate
iii. E.g., if there is a 5:1 stock split the conversion prices is reduced by 1/5. So if tit was $1.25 prior to
the split, the conversion price will be $0.25 after, so that the number of shares issuable upon
conversion increases proportionately with the effect of the split
d. Price-based Anti-dilution
i. Price protection for Investors 🡪 Conversion rate adjustments if Company sells stock at a lower price
than paid by Investors
1. Price-based Anti-dilution adjustments to Conversion Rates are done through changes in the
Conversion Price
2. Adjustments lower the Conversion Price, which increases the Conversion Rate
ii. Some types of stock issuances are generally excluded 🡪 Employee option plan, stock acquisitions,
stock in non-financings
iii. Pay to play provisions 🡪 preferred stock holders lose the benefit of price-based antidilution if they
fail to buy their pro rata share of any subsequent down rounds
iv. Two types of price-based anti-dilution adjustments:
v. Full Ratchet
1. Full repricing down to price at which new shares sold
a. Occurs if ANY stock is sold at a lower price
2. Old Investors get upon conversion number of Common shares they would have received if
their investment had been at lower price
a. i.e., Conversion price of prior round (the share price it was issued at) is reduced to
the purchase price of the new round
3. Viewed as unfair for three reasons
a. First, it pushes most of the dilution onto the common shareholders.

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b. Second, the Series B investors end up buying less of the company than they
bargained for, which can push down their price even further and lead to more
dilution and more adjustments.
c. Third, and perhaps most unfairly, all of the Series A stock is repriced regardless of
the size of the issuance of Series B stock
4. Rarely used for more than a limited time period
a. Might be appropriate to have full ratchet for 6-12 months with reversion to
weighted average thereafter
b. E.g., due diligence suggests company is overvalued and may need cash sooner
than expected; some foreseeable event may be occurring soon that could have a
big valuation impact (patent filing); mezzanine investors may be concerned
company is overvalued and down round will be necessary if public market
window closes
vi. Weighted Average
1. Vast majority of VC deals use a weighted average approach
2. Partial adjustment to an average of new and old prices, taking into account amount invested
at each price
a. It is an adjustment to the conversion price based on the relative amount of the
company being sold at a lower price
3. Old investors get upon conversion number of Common shares based upon blended price
between two financings
4. Two types of Weighted Average anti-dilution:
a. Narrow-based 🡪Only actually outstanding shares (including as converted
Preferred) included in calculation
b. Broad-based 🡪 Quasi-fully diluted shares (outstanding options but not Option
Plan Reserve) included in calculation

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VI. Voting and protective provisions (Inherent)
a. Voting rights
i. Preferred votes with the Common on all matters
ii. Preferred votes on an as-converted to Common basis
1. 1 vote for each shares of Common issuable upon conversion at time of vote 🡪 so this would
take into account anti-dilution adjustments
b. Board Seats
i. Board seats generally reserved for each Series of Preferred 🡪 Built into the Certificate of
Incorporation
ii. All major stockholders agree to elect the VCs’ designee[s] to those seats 🡪 contractual right in
Voting Agreement

c. Protective Provisions
i. In addition to votes required by law, preferred consent as a separate class is required on add’l
matters:
1. Amendment of Certificate of Incorporation to change authorized number or rights of
Preferred shares
2. Creation of shares having dividend or liquidation rights equal (“pari passu”) or superior to
existing Preferred
3. Any merger, reorganization or sale of substantially all assets
4. Dividends and stock repurchases (other than unvested shares)
5. Increase in Option Plan Reserve
6. Change in size of Board
7. Sometimes, operational matters
a. Incurrence of debt over a specified level
b. Changes in Business Plan

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ii. Generally required vote threshold is simple majority of Class/Series
1. But sometimes higher threshold set, especially if there is one large Investor that controls a
majority of entire Class/Series
iii. In addition to Class votes, sometimes additional Series votes are required on some matters
1. Can provide one set of Investors a blocking right, even though they do not even control the
Preferred
iv. In either case, is this appropriate protection or is it a means to inappropriately hold up a transaction?
1. Depends on which side you’re on

VII. Redemption rights (Inherent)


a. Right of Preferred stockholder to compel Company to repurchase their shares (a “put”)
i. Usually at cost, plus some modest increase, such as accrued dividends
b. Supposedly means for Investors to get their money back in Company that is going nowhere (gives the VC a
means to exit if none is likely)
i. But will they actually be able to?
ii. Statutory limitations on distributions to stockholders to avoid “impairment of capital”
iii. How likely is it that Company will have enough cash to redeem Preferred, either for legal reasons
or practical reasons
c. Real reason, in theory, may be to enable Investors to force successful but reluctant Company to go public
d. When would this come into play?
i. Company is successful, but not enough for IPO or sale, and management is content working for a
small private company but there is no real exit for investors
e. Entrepreneurs want the redemption clause to start being effective as far into the future as possible—
typically, 5 to 7 years
i. Sooner terms can jeopardize the company b/c during the early years the company won’t have the
cash to pay back and investors, and a redemption call would force a sale of the company
VIII. Information Rights (Contractual)
a. Investors have right to receive financial and other information about the Company periodically
i. Financial statements
ii. Annual audited financials
iii. Quarterly unaudited financials
iv. Monthly informal financials
v. Annual budget
vi. Right to visit Company facility and inspect books and records
b. Investors on Board of Directors will get all this already
i. Companies generally “forget” to send these to smaller investors
ii. To the extent they aren’t excluded as non-”Major Investors”
c. Company should resist or limit these to only those investors with very large stakes
i. They can be disruptive of company operations and conflict with the board’s performance
IX. Registration Rights (Contractual)
a. There will be a fair amount of negotiation on this
b. Right to require Company to register Investors’ shares under the Securities Act of 1933 so that they can be
sold in public market
i. Even if a company does go public, it is not always easy for VCs to sell shares
ii. Because VCs usually have more than 10% of the company, they are deemed affiliates and are
subject to Rule 144 even if the company has gone public (if company not public, this won’t even
help)
1. Rule 144 imposes a holding period, volume limitations, information requirements, and
manner of sale requirements on affiliates when they try to sell restricted unregistered
stock
2. This is why the VC wants the company to register the stock, so it can be freely resold
c. Three types

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i. Demand Rights 🡪 right to force Company to undertake a public offering just so Investors can sell
some of their shares
ii. Piggyback Rights 🡪 right to have Company include Investors’ shares among shares being sold in
Company public offering
iii. S-3 Rights 🡪 same as Demand Rights once Company qualifies to use simpler Form S-3 Registration
Statement form
d. There are usually about 20 pages of terms dealing with these rights
i. But a lot of these details don’t matter very much
ii. If Company is able to go public, people are surprisingly willing to waive rights and make
accommodations
e. Things that do matter:
i. Ensuring that none of these rights can mess up Company IPO
1. Investors’ shares can be excluded completely from IPO merely if Underwriters “request” it
(UWs usually unwilling to permit existing SHs to sell in IPO b/c it could affect the market
of the stock)
ii. As quid pro quo for receiving these rights, Investors agree they will not sell any of their Company
stock for 180 days (in most cases) after Company’s IPO
1. “Market Stand-off” or “Lock-up”
2. Assists Underwriters in maintaining orderly trading market shortly after IPO

X. Pre-Emptive Rights (Contractual)


a. Right of first refusal on future Company issuances of securities
i. If Company issues additional securities in the future to a 3rd party, VC has right to participate
1. Generally, right to buy pro rata share of issuance to maintain % ownership in Company
2. Rarely, right to purchase entire issuance to maintain control
ii. Generally same issuances excluded as are excluded from Anti-Dilution Protection
iii. Rarely, if ever, used
1. If existing Investors are willing to invest more, why would you turn them down 🡪 Take the
money
b. Right of first refusal and right of co-sale on sales of stock by Founders
i. If a Founder wants to sell some of her shares prior to IPO, Investors have right either to buy those
shares or sell their own shares along with her on the terms offered
1. If Founder is selling at a low price, Investors get to take advance of that low price to buy
more shares
2. If Founder is selling at a high price, Investors get to take advance of that high price to sell
some of their shares
ii. Generally some exclusions for small sales, gifts and estate planning
iii. This allows the VC to make sure that the founder doesn’t transfer control of the company
iv. Rarely, if ever, used

XI. Founder stock matters (Contractual)


a. Investors will impose vesting on Founders’ equity
i. If not there already, Investors will specify terms
ii. If something there already, Investors will review and require changes if too Founder-favorable
b. Investor Objective 🡪 Ability to reclaim Founder’s stock upon termination/departure
i. Source of shares to incentive successor
ii. Reduces Founder’s ability to exert post-termination control
iii. Reduces Founder’s share in post-termination Company success
c. Founders’ Objectives 🡪 Avoid losing everything when VC decide time for a change
d. Usual result:
i. Upfront vesting of a portion of Founders’ shares 🡪 6-12 months vesting credit (12.5%-25%);
Notionally tied to time served, so long as not too long
ii. Remainder may vest monthly over 3 or 4 years

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iii. Acceleration of vesting upon termination without “cause” or resignation for “good reason”
(“Constructive Termination”)
1. 6 to 12 months acceleration (12.5% to 25%)
2. Longer end for Founder CEO; shorter end for others
iv. Acceleration of vesting upon similar termination or resignation within 12 months after an
acquisition
1. More generosity here, on assumption that acquisition is a good outcome and Founder has
high risk of being fired by new owner
2. 50% to 100% of unvested shares/options

XII. Other Terms


a. Expenses of transaction
i. Company pays all its own expenses
ii. Company pays all Investors’ expenses
1. Up to a cap
2. Unless transaction doesn’t go through
b. Exclusivity/confidentiality
i. Investors don’t want you shopping the deal to try to get better price from another Investor
ii. OK for a while (~30 days), but not too long

Mechanics and Documents

I. Basic Documents
a. Stock Purchase Agreement
i. Representations and warranties
ii. Conditions to closing
b. Amended Certificate of Incorporation
i. Rights inherent in the Preferred
c. Voting Agreement
i. Agreement to vote for Board designees
d. Investor Rights Agreement
i. Information rights
ii. Registration rights
iii. Right of first refusal over future Company issuances
e. Right of First Refusal and Co-sale Agreement
f. Legal opinion of Company counsel

II. Legal Due diligence


a. VCs’ lawyers will ask for and go through all documents on:
i. Corporate organization
ii. Stock and option records
iii. Material contracts
b. Stock Purchase Agreement will require similar disclosures
i. So no point in hiding warts and defects
ii. Also illegal 🡪 If you think disclosing something might cause Investors not to invest, that
exactly a thing that has to be disclosed
c. Some types of ugliness will kill the deal outright
i. Defects or merely lack of clarity in IP ownership
ii. Issues with previous employers
iii. Unresolved relations with ex-founders or previous investors

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iv. Wrong team members

III. Corporate Approval Process


a. Board of Directors
i. All aspects of transaction
1. Sale of stock
2. Terms of stock
3. Granting of contractual rights
4. Solicitation of Stockholder approval
ii. Majority vote at Board meeting or unanimous approval in writing
1. In-person meeting with deliberations may be better record
b. Stockholders
i. Amendment of Certificate of Incorporation to create stock
ii. Any additional votes called for by Certificate or contract
c. Third Party consents
i. Any approvals required by contract (rare)

IV. Legal Opinion


a. Basics
i. Company Counsel gives its highest level of professional assurance to the Investors
1. Somewhat a substitute for due diligence where Company Counsel is in a much better
position to know the answers
2. But generally these specific matters covered are things where some legal judgments
and analysis is needed
a. Factual matters are better covered by representations from the Company itself
ii. Sometimes an Opinion is requested; sometimes not
1. If one is requested, it can be heavily negotiated
2. But usually not in Venture Financings
iii. Counsel can and does get sued for mistakes
b. Matters always covered
i. Is the Company really a company?
1. Due incorporation of Company
2. Corporate power to conduct its business
ii. Does the Company have the ability and authority to do the financing?
1. Corporate power to enter into financing
2. Whether all necessary corporate authorizations have been obtained
3. Whether the transaction violates any laws (usually limited to laws generally applicable to
transactions of this type)
4. Whether any approvals from the government or third parties are needed

iii. Are the financing agreements enforceable contracts?


1. Are there any provisions that aren’t enforceable under the law?
2. Are there any defects in the Company or the approval process that would allow the
Company to get out of them?
c. Matters usually covered in opinions for Venture Financings
i. Whether the Company has any conflicting obligations in any of its contracts that will cause a
material problem
ii. Capitalization of the Company
1. Types and numbers of Authorized Shares
2. Types and numbers of Outstanding Shares
3. Existence of Option Plan, but not Options actually outstanding
4. Usually only given if Counsel has really good records
iii. Compliance with Securities Laws

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1. Although this can be easily blown by actions Counsel may not know about, so usually
based on some assumptions
iv. Presence/absence of any litigation
1. Not really a legal judgment
d. Matters that should never be covered
i. Whether the Company is in compliance with all laws generally
ii. Whether the Company is in compliance with all it contracts
iii. What the likely outcome will be in any litigation
iv. Whether provisions of the financing documents not normally in financing documents are actually
enforceable

VCS BEHAVING BADLY AND FIDUCIARY DUTIES

I. Overview
a. Four different cases demonstrate the conflict between different groups in VC backed companies
b. Silicon Graphics – Founders vs. Management
c. Alantec – Founders vs. VCs
i. Fiduciary duties
ii. Down-Round financings (three main issues)
d. Benchmark and Watchmark – New Investors vs. Old Investors
i. Pay-to-Plays
e. Trados – Preferred vs. Common

II. Case 1: Silicon Graphics 🡪 Conflict between founders and “professional” management
a. Conflict b/w founder with strong views and professional management
b. Jim Clark - built the geometry engine -- does intense calculations for computer graphics
i. Clark was not a good manager, went to Mayfield VC fund
ii. Took a lot more money than Clark thought to build a hardware company
iii. Glenn Mueller was the VC that invested, didn't get along with Clark
c. When Mayfield invested, one of its conditions was bringing in professional management
d. When company got off the ground, Clark disappeared, and all the grad students did the work
e. Clark went on to found Netscape with Marc Andreessen

III. Case 2: Alantec 🡪 relationships b/w entrepreneurs / founders and investors / VCs
a. This case involves a down round and fiduciary duties
b. What do you do when a company needs more money and the only people willing to invest are the existing
investors?
i. Investors who control the company at the time and thus sit on both sides of the table in any further
investment?
c. Putting in more money is fraught with peril
i. How do you ensure that the inside down round is really the only alternative?
ii. Even if it is, how do you ensure that the terms of the inside down round, especially price, are
market terms that are fair to those stockholders who don’t or can’t participate?
iii. How do you demonstrate all this years later in court when the company has become a wild success?
d. Fallout from a Down-Round Financing
i. Capital structure is often a mess

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1. Massive dilution of existing shareholders, both Preferred and Common
2. Hugely bloated number of shares
3. Extremely low per share value
4. Most existing employee options now deeply underwater
5. Messy, semi-neutered series of Preferred held by investors who didn’t invest
ii. So the financing is often followed by:
1. Reverse stock split to shrink the capital structure
2. Option replenishment program for management/employees
3. An outright recapitalization, with all old Preferred converted into Common
iii. It’s amazing the company can survive to be successful
e. Legal issues in a down round
i. Massive dilution to existing shareholders
1. Management/employees get brought back up
2. Existing investors can participate to offset dilution
3. So impact falls mainly on former Founders, ex-employees and investors who do
not/cannot participate
ii. Possible additional loss of rights by failing to participate (“Pay-to-Play”)
1. Pay to play 🡪 a solution to incentivize investors to participate in a down financing
a. Basically, investors that do not participate to their full pro-rata percentage of the
financing are punished by losing certain rights.
b. Pay to play provisions tied to dilutive financings provide that only investors that
participate in the dilutive financing are entitled to the benefit of the anti-
dilution formula in effect.
c. Investors that do not participate do not receive any anti-dilution protection.
2. Might in fact be more fair -- and thus better from legal point of view -- to convert all
existing Preferred to Common regardless of participation
iii. Investors are on both sides of transaction
1. Who is looking to see if terms are fair?
2. Why an inside-led financing rather than one led by someone independent?
3. Why this terms and not others?
4. Why this price and not a different one?
5. So, due to the conflict, VCs will not get business judgment rule protection but will instead
have to prove entire fairness (fair price + fair dealing)
f. Methods to reduce legal risk 🡪 because this is an interested transaction (VCs on both sides), the VCs need to
prove that the transaction was fair to the minority stockholders
i. Extensive search for alternative sources of financing
ii. Disinterested director approval
1. Committee of disinterested directors is even better
iii. Open disclosure to all shareholders in advance
iv. Shareholder approval
1. Disinterested shareholder approval is better
v. Invitation to all shareholders to participate – “Rights Offering”
1. Benefits only those who have the cash and are Accredited
vi. Price determined by third party valuation expert
1. No one likely to give up this control (or pay the expense)
vii. Fairness opinion from Investment Bank
1. Even larger expense that valuation expert so no one does this
viii. Clear Board record of distress and lack of choice

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IV. Case 3: Benchmark and Watchmark 🡪 New investors v. old investors
a. Benchmark
i. Preferred stock rights are “contractual in nature,” and all rights must be “expressly and clearly
stated” and will not be “presumed or implied”
1. Even though the merger was extremely dilutive to Series A and B, it was routine within the
corporate group and did not trigger consent requirements of A and B preferred
2. No amendment was made to the Company’s Certificate of Incorporation; changes were
made through a merger
3. “Other financing or economic rights” was not specific enough to be enforced
ii. Why not a breach of fiduciary duty?
1. The board doesn’t owe a separate fiduciary duty to the preferred holders
2. Board owes a duty to the stockholders as a whole and to the common shareholders as
residual owners
b. Pay to Play Financings
i. In order to create additional “incentive” for Existing Investors to participate in the financing,
Company imposes punitive terms on Existing Investors who do not invest
ii. Pay-to-Play”
iii. Investors that don’t invest or invest less than their pro rata share suffer some diminution of their
Preferred rights
1. Loss the rights such as Liquidation Preference or Anti-Dilution Protection, or
2. Complete conversion of their Preferred Common
iv. Investment required to avoid consequences may be all or nothing or proportional
v. Implementation requires amendment of terms of existing Preferred in Certificate of
Incorporation
1. So majority of Preferred must be willing to go along
c. Look for intra-group mergers as a means to get around the consent requirement of early rounds of preferred
stock

V. Case 4: Trados 🡪 Investors/VC and management v. Former founders and Ex Employees


a. How do you determine damages if the company is sold after a long and tough sales process, if one common
shareholder claims the deal wasn’t fair?
b. Experts and litigation 🡪 really long and really expensive
c. Issues that arise when a Company is sold for proceeds below or barely above the aggregate Liquidation
Preference of thee Preferred Stock
i. Does the Board’s duty to Common requiring it to override what’s in Certificate of Incorporation
(outlining the preferred stock rights)?
1. Running Company into ground if non-zero chance of success

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2. Throwing a nickel to the Common
ii. What about when Company value is less than aggregate Liquidation Preference?
1. Debt obligations are generally contractual in nature
2. But when Company is insolvent, Board must take into account what’s best for creditors in
a fiduciary-like manner
3. Why isn’t Preferred treated the same way, when its Liquidation Preference is endangered?
iii. How can you protect the company?
1. Independent Director approval
2. Form an Independent Director Committee
3. Throw a nickel to the Common
4. Majority vote of Common (mandatory in California)
5. Drag Along Rights
6. Waiver of Dissenters’ Rights
7. Force the Sale provision? Serendipitous Redemption rights?
Fiduciary Duties

Directors owe duties of care and loyalty to the corporation and its stockholders

I. Duty of Care
a. When making decisions or acting on behalf of the corporation, the duty of care requires directors to act with
the care that a person in a like position would reasonably believe appropriate under similar circumstances
i. CA Corp. Code § 309 🡪 Directors must act on an informed basis after due consideration of relevant
materials and reasonable deliberation
b. Analysis of process not substance 🡪 Courts focus on the process used in making the decision rather than
the substance of the decision (employing the BJR)
i. Did the Board review all information reasonably available?
1. Was there appropriate input from management and qualified advisors?
2. Directors may rely on such input, but it can’t substitute for their independent judgment
ii. What were the nature and extent of deliberations?
1. Time spent
2. Director participation
3. Meeting environment
iii. Was there consideration of alternatives?
c. Liability standard is “gross negligence”
d. But generally Directors are completely insulated from actual monetary damages for breach of Duty of Care
due to Van Gorkem and § 102(b)(7) of the DGCL
i. Exculpation clause in Certificate of Incorporation
ii. Mandatory indemnification in Bylaws “to the maximum extent permitted by law”
iii. Mandatory advancement of legal and other expenses of litigation also in Bylaws
1. Subject to repayment if later found by Court to not be indemnifiable
iv. Directors and Officers liability insurance
1. May be available to cover things that aren’t indemnifiable
2. Very important if Company has no cash or is no longer around

II. Duty of Loyalty


a. Directors owe undivided loyalty to the Company and its stockholders
i. Actions must be taken with a good faith belief that they are in the best interests of the Company and
its stockholders
ii. No standing on both sides of a transaction
1. Conflicting interests can be direct or indirect, past or present, through financial, familial or
other close business or personal ties.
iii. No “self-dealing”
1. No deriving improper personal benefit

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2. No usurping corporate opportunities
iv. Interests of Company and its stockholders come first
b. No exculpation in Certificate of Incorporation for breach of Duty of Loyalty
i. Directors can be held personally liable for monetary damages
ii. Indemnification likely to not be permitted
iii. Advanced expenses have to be repaid
iv. Even insurance may or may not cover
c. We are more concerned with this duty, since VC sits on both sides of table
d. Once VCs have control of the board, and they will invest in future rounds, they have an inherent
conflict 🡪 directors owe a duty to the stockholders as a whole, not just a certain group
i. Conflict situations can be dealt with through:
1. Full and accurate disclosure of interest, and
2. Either:
a. Approval by disinterested directors, or
b. Approval by stockholders
i. Do they have to be disinterested too?
3. OR, Board bears burden of proving actions were entirely fair
ii. If none of the above can be shown, the transaction is automatically voidable

III. Standards of Review for Board Actions


a. Normal Board actions 🡪 Business Judgment Rule
i. Courts should not second guess the business decisions of Directors made in the heat of battle
ii. BJR 🡪 Court will not inquire into fairness of transaction or wisdom of Board’s decision, if made:
1. In good faith
2. On an informed basis
3. In honest belief that transaction is in the best interests of the Company and shareholders
4. Attributable to a rational business purpose
iii. Challenging shareholder can overcome Rule’s presumption by showing:
1. Board did not follow a reasonable and informed process
2. Directors had interests different from those of shareholders
b. Sale of Control matters 🡪 Enhanced Scrutiny
i. Generally in just two situations:
1. Board has made decision to sell the Company for cash
a. Board’s duty is to realize short-term value (highest value reasonably available to
stockholders)
b. Fear that Board will choose another deal for improper reasons
2. Adoption of anti-takeover defenses
a. Measures cannot be coercive of shareholder vote nor preclusive of alternative
deals
b. Fear of Board seeking to entrench itself
c. Interested director transactions 🡪 Entire Fairness

d. Interested director transactions 🡪 Entire Fairness


i. Where presumption of Business Judgment Rule is overcome
ii. Board must show transaction was “entirely fair”
1. Fair as to process
2. Fair as to result
iii. Difficult standard to meet
1. Especially since Board bears burden of proof
2. Challenging shareholder will get benefit of presumption of validity of any colorable claims
in all pre-trial proceedings

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a. As a result, it is difficult to get litigation dismissed before massive expense of
extensive discovery and full trial

IV. Private Company Governance in Reality


a. This is tough b/c these rules were built for public companies, and they are being applied to private
companies
i. But the law isn’t different for VC backed companies
ii. Duties run to the common stock holders, the VCs do not have duties to the preferred stock
holders
b. The reality of governance of a VC-backed Company is completely different from the public company ideal
c. VC Directors are very different from non-management directors on public company boards
i. They generally control thee Company
ii. They have strong financial interests in Company performance
1. Success determines whether they keep their jobs
iii. They are the designees of powerful, large controlling shareholders
d. VC Directors are active and engaged with frequent input on Company affairs and interactions with
Founders/CEO
i. At best, they are mentors and confidants, providing contacts, assistance and advice
ii. At worst, they are highly focused on protecting their economic interests
1. They will be active in making changes to attempt to fix performance problems, including
replacing management, RIFs, changing business plan\
e. But the law isn’t different for VC-backed companies
i. The Company is not a republic, the Board is not a legislature, and the Directors aren’t
representatives of their constituencies, especially not the Preferred shareholders
ii. VC Directors tend not to know this or at least act this way
f. To whom is the duty owed?
i. Board’s duty is to do what’s best for the Common
1. A board of directors is not a legislature, and directors are not representatives of the Class
that elected them
ii. Preferred gets only what in the Certificate of Incorporation
1. Preferred rights are “contractual in nature” as opposed to fiduciary
2. Board has no duty to go beyond strict reading of Preferred’s rights
3. In particular, no duty to protect potential return of Preferred’s Liquidation Preference

INITIAL PUBLIC OFFERING PROCESS

Introduction
I. Pros and Cons of Going Public

Benefits Drawbacks
● Large amount of new capital ● Disclosure obligations
o Burden
● Liquidity for investors/employees

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o Loss of confidentiality
● Future access to capital markets
● Increased legal exposures
● Currency for acquisitions
o Disclosure claims
● New types of equity o Fiduciary duty claims
compensation (more flexible) ● Expense, effort and staff
● Prestige (of being on NYSE) o Preparation and offering ($2M in
legal fees, 7% to UWs)
● Fulfillment of IPO dream o Long-term
● Tyranny of quarterly results

● End of IPO dream

II. Prerequisites to Going Public


a. Business requirements:
i. Scale (Pre-money Value of at least $200M)
ii. Appropriate business and financial outlook 🡪 Growth, Profitability, Predictability
1. Except in biotech (for now)
b. Adequacy of internal financial reporting structures and accounting controls
c. Maturity of Company’s governance structures
d. Nasdaq/NYSE listing requirements
i. Various mixes of minimum assets, revenues, profits, investment

III. The year before going public


a. Position business for market and long-term performance
b. Build public company team
i. Fill key management team positions
ii. Add new outside directors to create public company Board of Directors and committees
c. Complete/resolve all open messiness
i. Corporate clean-up 🡪 Need a clean capital structure
1. Clean-up (creation?) of pedigree for all stock and option holdings
2. Ratifications of missed Board and approvals
3. Securities law compliance
4. Other legal compliance
ii. Settle any pending litigation
iii. Complete any pending acquisitions
d. Establish public company finance function
i. Hire additional staffing
ii. Develop public company financial reporting systems
1. Ability to produce Financial Statements on time
2. Solid systems of accounting and disclosure controls
3. Focus on forecasting reliably and predictability of earnings
4. Timely, accurate and as-expected

e. Adopt new compensation plans


i. Executive cash incentive bonus plan
ii. Executive change-in-control agreements
iii. Director compensation terms
iv. New Option Plan with much more than just options

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v. Employee Stock Purchase Plan
f. Implement public company corporate governance
i. Public company Board of Directors and committee structures
1. Majority of Board must be “independent”
2. Committees generally must be entirely “independent” (under various different definitions)
a. Audit Committee
b. Compensation Committee
c. Nominating and Corporate Governance Committee
ii. Public company corporate policies
1. Conflict of Interest Policy
2. Insider Trading Policy
3. Code of Conduct
4. Board Governance Guidelines
iii. Many Sarbanes-Oxley, SEC and NYSE/Nasdaq requirements

IV. Players in the IPO Process


Main players Secondary Players • Tertiary Players
– Company’s Board and Management – Financial Printer – Financial Statement Consultant
– Investment Bankers or UWs – Transfer Agent – Compensation Consultant
– Company Counsel – Sarbanes-Oxley Consultant
– Underwriters’ Counsel
– Accountants

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***Remember, with JOBS Act, you can submit doc with the SEC confidentially first (as opposed to filing it on Edgar)

V. Overlapping Timelines

● Selling ● Preparing – governance


o Creating the story o Board and stockholder approvals
o Price discovery o Public company charter documents
o Locating buyers o Corporate governance structures and policies
o Roadshow o Public company compensation plans and programs
o Negotiating deal terms in Underwriting Agreement o Defensive measures
o Listing for trading on NYSE or Nasdaq Stock
● Preparing – financial
Market
o Financial organization
● Drafting o Financial processes and systems
o Drafting Registration Statement
● Verifying
o Preparing Financial Statements
o Filing with SEC o Business due diligence (internal and external)
o Responding to SEC comments o Financial due diligence
o Legal due diligence

VI. Organizational Meeting


a. All the main players in one place
b. Outline of proposed offering
i. Amount to be raised
ii. Distribution objectives
iii. Selling Stockholders participation
iv. Timeline
c. Summary of offering-related legal issues
i. Minimum price for conversion of Preferred
ii. Registration rights obligations
iii. Lock-ups

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VII. Pre Filing Period Overlapping Efforts of Key Parties
a. Selling
i. Stopping all selling and anything that looks like selling
1. SEC-mandated strict limits on Company publicity in general and prohibition of mentioning
offering specifically
ii. Positioning business for long-term performance
1. Dynamic and rapidly growing market
2. Problem/opportunity/inadequacy/pain not being addressed
3. Solution offered by Company
iii. Developing mid-term strategies to achieve long-term goals in next few years
iv. Creating the Story
1. Explanation of the foregoing
2. Investment thesis for buyers in offering and against which Company will be judged in first
4-12 quarters after IPO
v. Determining appropriate timing for IPO
1. Highly dependent on Company’s market
2. But also on quarterly financial cycle, seasonality and SEC review process
vi. Locking up all outstanding shares and options
1. Assists Underwriters in making an orderly trading market post-IPO
2. No sales, hedges, pledges of any Company stock by current SHs for 180 days after IPO
b. Drafting the Registration Statement
i. Purpose:
1. Explain Company and its business to investors and convince them to buy Company’s stock
2. Protect Company, Board, Management, Underwriters and Accountants from liability for
failure to disclose all material information about Company completely and accurately
3. Protect investing public from buying stock without adequate information about the
Company and understanding of the risks involved
ii. Requires significant amount of management time and participating 🡪 but best results come when the
lawyers draft it
iii. Consists of two parts
1. Prospectus 🡪 Actually selling document
2. Part II 🡪 SEC procedural stuff, exhibits and signatures
iv. Multiple versions of the Prospectus
1. Draft Prospectus
2. SEC-compliant Prospectus
3. Red Herring Prospectus
4. Time of Sale Prospectus
5. Final Prospectus
v. Main sections of the prospectus
1. Summary
a. Responsible parties:
b. Bankers, Entire Group
2. Contents:
a. Main investment thesis
b. Short versions of rest of document
3. Business Section
a. Responsible parties: Company, Bankers, Company Counsel
b. Contents:
• Longer version of main investment thesis
• Market → Problem → Solution → Strategy

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• Details of Company’s products, technology, R&D process, sales and
marketing process
c. Details of intellectual property, litigation, competition, employees
4. Financial Statements
a. Responsible parties:
• Written by Company, Financial Statement Consultant
• Audited by Accountants
b. Content:
• Annual results for past 3 years
• Quarterly results for past 2 years and since last year-end
5. Management’s Discussion and Analysis of Financial Condition and Results of Operation
(“MD&A”)
a. Responsible parties: Company, Company Counsel, Accountants, Financial
Statement Consultant
b. Content: Explanations of what’s going on in the Financial Statements
c. Main place to get sued
6. Risk Factors
a. Responsible parties: Company Counsel, Company
b. Content: Everything that can go wrong, no matter how remote
c. Main defense if sued
7. Management
a. Responsible parties: Company Counsel, Company, Compensation Consultant
b. Content: Biographies of Officers and Directors, Board governance matters and
structures, Compensation, Compensation Disclosure and Analysis (“CD&A”),
Related party transactions
8. Stock matters
a. Description of rights of capital stock
b. Principal stockholders
9. Offering Matters
a. Underwriting terms
b. Selling stockholders, if any
c. Pro forma effects of IPO on Financial Statements and Capitalization
c. Verifying / Due Diligence
i. Why due diligence?
1. All material facts about Company must be disclosed in Registration Statement accurately
and completely
2. Company is strictly liable for any misstatements or omissions
3. Directors, Officers and Underwriters can be personally liable unless they were duly diligent
in investigating accuracy and completeness of disclosures in Reg. St.
ii. Business due diligence
1. Company’s business, customer relationships, etc.
a. Internal – Does Company actual do what it says it does?
b. External – What do customers say about Company’s products
2. Parallel purpose of weekly drafting sessions
iii. Financial due diligence
1. Underwriters build financial models mirroring Company’s
2. Underwriters and Underwriters’ Counsel interview Company’s Accountants re their views
of financial operations, processes and controls
iv. Legal/document due diligence
1. Company sets up data room of all material documents plus a some others
2. Junior corporate attorneys discover the reason for their existence
3. Underwriter Counsel interviews attorneys handling litigation, IP matters, regulatory
compliance

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VIII. SEC Review Period / Waiting Period Overlapping Efforts of Key Parties
a. Selling rules during SEC Review portion of Waiting Period
i. Oral offers can now be made
ii. But no written offers unless accompanied by a § 10(b) prospectus
1. No handouts, no emails
iii. “Testing the Waters” meetings can be held
1. But no actual commitments can be made
2. Presentation must be consistent with what is in Registration Statement
3. SEC will ask to see presentation and check
b. Selling
i. Negotiating the Underwriting Agreement
1. UWs will buy stock from Company at a discount and then resell to the public at full IPO
price
a. Firm Commitment vs. Best Efforts offerings
b. Over-allotment option or “Green Shoe”
2. Key Sections
a. Representations by the Company
b. Indemnification for misstatements and omissions
c. Opinion of Company Counsel
d. Closing conditions and expenses
3. Participation by Selling Stockholders (if any)
a. Representations
b. Indemnification
c. Inability to back out
ii. Stock exchange matters
1. Nasdaq or NYSE?
2. Both have elaborate listing application processes
3. Both have minimum standards of qualification relating to assets, revenues, profits,
shareholders and market makers
iii. FINRA matters
1. Review of underwriter compensation
iv. Blue Sky compliance
1. Federal preemption if listed on NYSE or Nasdaq, so generally not necessary
v. Near end of SEC Review Period:
1. Underwriters and Company prepare Roadshow presentation
a. Presentation must flow out of and not go beyond disclosures in Registration
Statement
2. Underwriters provide anticipated price range for offering
a. Need to analyze effects of range
b. Is a stock split needed? 🡪 Underwriters will want to sell stock in IPO at $10 to $15
per share regardless of actual value of Company or stock pre-offering
c. Is bottom of range high enough to ensure Preferred Stock will convert
automatically? 🡪 If not, stockholder vote to force conversion may be needed
d. “Cheap Stock” issues
• SEC compares recent option exercise pricing to anticipated offering
price
• If too big a discrepancy, SEC will force Company to revalue options on
its Financial Statements
c. Drafting

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d. Drafting
i. Every sale of a security in the US must be registered with the SEC
1. SEC doesn’t judge whether investment is good or bad
2. SEC does require full and fair disclosure so Investors can make their own decision
3. “Disclosure-based,” rather than “merit-based” system
ii. SEC review process
1. Draft Registration Statement filed with SEC electronically through EDGAR system
2. Confidential initially (so not officially “filed” at this stage)
3. Pricing information and share numbers left out, until price range determined
4. SEC provides comments roughly within 30 days
a. “Justify claims of performance or uniqueness.”
b. “Balance positive statements with additional risk factors.”
c. “Provide missing required disclosures.”
d. “Explain how the Company’s accounting practices comply with accounting rules.”
e. “Rewrite bad writing in ‘plain English.’”
• No technical jargon
• No defined or capitalized terms
• Use • and – rather than (i), (ii) . . .
• Use “we” instead of “the Company”
5. Company Counsel and Accountants prepare responses to comments along with proposed
revisions to language in Registration Statement
a. Amendment to Reg. St. then refiled with SEC along with comment response letter
6. Multiple rounds of back-and-forth comments and responses with SEC, progressively
clearing comments
a. May take 30-60 days
b. Sometimes long enough that Financial Statements must be updated to next quarter
c. Amendment filings, SEC comment letter and Company’s response letters still
confidential at this stage
e. Preparing and Governance
i. Board and shareholder approvals
1. Revise Certificate of Incorporation and Bylaws to public company forms
2. New Equity Plans
ii. Corporate governance
1. Complete implementation of corporate governance structures and policies
2. Complete establishment of independent Board and committees
3. Adopt any desired “defensive” measures
a. Classified board
b. Limits on calling stockholder meetings and actions in writing
f. Verifying
i. Due diligence continues
ii. Complete anything not done before first filing
1. Should be mostly confirmatory at this stage
2. Changing text in the Registration Statement is possible, but:
a. May draw SEC questions and comments
b. After public filing, may draw comments, even ridicule, in press
c. Looks sloppy
3. But incorrect or incomplete things must be fixed regardless
iii. Negotiate Comfort Letter
1. Accountants provide written confirmation to Underwriters of accuracy of all financial
numbers in Reg. St. 🡪 But not to the level of an audit or “expertization”

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iv. Must be sensitive to new events or changing circumstances
1. Accuracy and completeness are measured at the time of the offering, do diligence
never stops through end of process

IX. Roadshow Period / Waiting Period Overlapping Efforts of Key Parties


a. Selling
i. When SEC review process close to complete, Company files Registration Statement with SEC
publically
1. Public now knows of IPO, and Reg. St. is available for competitors, customers, employees,
etc. to see
2. Must be at least 21 days before start of Roadshow
ii. Once Underwriters have given Company anticipated price range, Company can files Reg. St. with
SEC-Compliant Prospectus inside
1. Price range and share numbers now filled in
2. Prospectus can now be used to make written offers
a. Generally no other written materials can be used
b. Except “Free Writing Prospectuses” – rarely used in IPOs
3. Shortly before Roadshow, Company files and prints “Red Herring” Prospectus
b. The Roadshow
i. Ten-day whirlwind tour of 10 to 20 cities in US and sometimes Europe where major investment
groups/mutual funds located
ii. Purposes:
1. Articulate Company story and sell investment thesis
2. Demonstrate management credibility
3. Begin to set investor expectations
4. Focus sales on long-term holders
5. Begin to determine price based upon interest
iii. Presentation must come out of and not go beyond material information in Registration
Statement
c. The last day
i. Roadshow:
1. Last meetings in New York and Philadelphia
2. Offering order book should be filled to multiple times number of available shares
ii. SEC review process:
1. All comments cleared
2. Company asks SEC to declare Registration Statement “effective”
iii. Pricing:
1. Underwriters provide Company with “recommended” price
2. Usually ~15% below actual value so first public buyers avoid immediately losing money
3. Also less 7% for the Underwriters’ discount/commission
4. “It’s always 7% -- it’s a cartel.”
iv. Underwriting Agreement is signed
1. Only now is Underwriter bound to do the IPO
2. And only now is Company committed to pay them
v. Trading begins next morning
1. Shares are first sold from Company to Underwriters at IPO price less Underwriters’
discount/commission
2. UWs immediately sell shares to investors in order book from Roadshow at IPO price
3. Investors can hold shares or turn around and sell them at whatever market bears
vi. Company actually gets proceeds from IPO 3-5 days later

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X. Post Effective Period
a. Now the company is publicly traded
i. Company now evaluated based on performance in eyes of new set of shareholders and Wall Street
expectations
ii. Execution of business plan critically important
iii. Missing projected numbers – even if not from Company itself – will punish stock
iv. Company now has public shareholders as new constituents in its business decisions and governance
b. SEC Matters
i. Prospectus must be updated for material events for 25 days following IPO
ii. Company usually files additional registration statements for employee equity plans
iii. Insider trading rules, restrictions and filings now come into play
c. Communications
i. Company under continued restrictions for 25 days
d. Public company status
i. Company must ensure corporate governance structures and disclosure controls and procedures are
in fact effective for proper governance and timely and accurate reporting
ii. Time to start prepare for first periodic SEC filing under the Securities Exchange Act of 1934

Securities Laws

I. Securities Laws in Three Slides


a. Every Sale of a Security in the U.S. must be approved by both Federal and State governmental authorities or
must come under Exemptions under both entities’ laws
i. Relevant Laws
1. Section 5 of the Securities Act of 1933
2. SEC regulations and rules
3. Blue Sky Laws of individual states
ii. Registration and Exemption Rationale:
1. Exempt sales only to:
a. People rich enough to protect themselves (in theory)
b. Family and friends whose relationships are close enough to get key information (in
theory)
c. Employees and other service providers, with whom the Company should be OK
with sharing some information (in theory)
d. Officers and directors, who should know everything since they are running the
Company
e. People who invest a small enough amount that they won’t be hurt (much) when
they lose it all
2. Registration 🡪 sell to everyone else
b. Any Omission or Misstatement of a Material Fact in connection with the Purchase or Sale of a Security is a
violation of the law
i. Relevant Kaws
1. Section 11 and 12 of the Securities Act of 1933
2. SEC Rule 10b-5 and other regulations and rules
3. Blue Sky Laws of individual states
ii. Disclosure rule
1. How do you force a Company to provide to an average person considering purchasing its
stock information about its business and the risks of investing in it that is accurate and
complete?
2. Make it strictly liable: for anything it says or doesn’t say that is “material.”

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II. Securities Act of 1933 Overview
a. Disclosure-based, not merit-based, regulation
i. Investors judge merits of investment themselves, based upon full, fair and accurate disclosure from
the Company
b. Section 5 makes it illegal to:
i. Offer to sell a security orally unless a Registration Statement is on file with the SEC
ii. Offer to sell a security in writing other than by means of an SEC-compliant Prospectus
iii. Actually sell a security unless preceded or accompanied by delivery of a Prospectus contained in a
Reg. St. declared effective by the SEC
c. Section 12(a)(1):
i. Violating Section 5 entitles investors to rescind the transaction and get their money back

III. Overview of Registration Process


a. Company files Registration Statement with SEC
i. Reg. St. contains a draft Prospectus
b. SEC comments on Reg. St. to force accuracy and completeness
i. Company revises Prospectus in response and files amendment to Reg. St.
c. When major comments cleared, Company separates out Prospectus and distributes it to prospective investors
i. Preliminary or “Red Herring” Prospectus
d. When SEC is satisfied and Company is ready for offering, SEC declares Reg. St. “effective”
i. But SEC takes no responsibility for actual accuracy or completeness

IV. What is an Offer


a. Two broad areas of focus
i. Formal Offers
ii. Inadvertent Offers
b. “Offer” is broadly defined
i. Any communication (press release, e-mail, Company website, news articles) may be seen as an
offer
ii. Publicity in general that has the effect of arousing public interest in the Company may be seen as
“hyping the stock” or “conditioning the market”
iii. The SEC’s technical term is “gun-jumping”

V. Three Major Timelines for Pre-IPO Publicity


a. Pre-Filing Period: prior to filing Registration Statement
i. Safe Harbor Period 🡪 prior to 30 days before first filing of Reg. St.
ii. Quiet Period 🡪 30 days ending on date of first filing with SEC
b. Waiting Period: between first filing and Effectiveness
i. SEC Review Period 🡪 prior to filing an amendment to the Reg. St. that includes a price range for
the offering
ii. Roadshow 🡪 marketing period after price range has been disclosed
c. Free-Writing Period: after Effectiveness for 25 days

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V. Guidelines for Publicity
a. Avoid content, manner, timing, or targeted audiences that would suggest a stock selling effort is underway
i. Stick to factual matters and avoid “puffing”
ii. Avoid off-limits topics
iii. Is this communications really crucial?
b. Stick to the trade press and avoid the financial press
c. Be consistent with existing practices in ordinary course timing and form
i. Avoid starting new practices
d. In everything, there should be just one story, and that story should be the one in the Prospectus
e. Press releases:
i. Product focus for trade press consistent with past practice
ii. No offering matters
f. Articles and interviews:
i. Careful on content and timing 🡪Early interviews can come out at crucial times much later
1. Can’t prevent quotes being taken out of context
2. Simple fact-checking may be OK
ii. Company shouldn’t be seen as participating or initiating
iii. Social media
g. General advertising and marketing activities
i. Not the time to start a new campaign
h. Presentations and speeches.
i. General industry/technology maybe
ii. No Company- or market-specific materials
i. Conferences and trade shows.
i. Probably OK, if really trade and not investor focused
ii. Careful about marketing collateral

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j. Company website:
i. No puffery, projections and anything inconsistent with or beyond Prospectus.
ii. SEC will review
k. Social media 🡪 be careful, lawyer’s nightmare
l. Employee communications
i. IPO is Company confidential information, and employees should not discuss it with outsiders,
including through: Social media; Emails, web postings and chat rooms; Conversations with friends
ii. Random inquiries should be directed to the CFO or GC
m. Off limit topics
i. Financial information
1. Revenues, profitability, margins, and anything else relating directly or indirectly to
historical or projected financial performance, growth or valuation
ii. Corporate strategy and tactics
iii. Any discussion or comparison with competitors
1. Other than possibly unadorned, concrete, factual comparisons of the Company’s
products/services with competing products/services
iv. Market opportunities, market dynamics, and forecasts or projections on market growth
v. Any expectations about the future for any of these matters

VI. Risks and penalties of “gun-jumping”:


a. “Cooling off” period of up to 6 months
b. Embarrassing disavowals and risk factor disclosures in prospectus
c. Fines and sanctions
d. If violation by an Underwriter, expulsion of that Underwriter from the deal
e. Termination of offering
f. Rescission of IPO and return of proceeds to investors

VII. Liability Overview


a. Sections 11 and 12(a)(2):
i. Company is strictly liable for any material misstatement or omission in the Registration
Statement/Prospectus
1. Untrue statement of a material fact
2. Omission of a material fact required to be in Registration Statement
3. Omission of a material fact necessary to make the other statements in Reg. St. not
misleading
b. If there is a misstatement or omission:
i. No defense of inadvertence, good faith, best efforts, lack of causation or non-reliance by the
purchasers
c. Remedy:
i. Purchasers in the IPO can get their money back
ii. Buyers in the aftermarket can recover losses they suffer
d. But it’s not just the Company who can be liable 🡪 OTHERS HAVE PERSONAL LIABILITY unless they
can prove due diligence defense
i. Officers signing Registration Statement
ii. All Directors, including anyone about to become a director
iii. Accountants and other experts who certify the accuracy of portions of the Reg. St.
iv. Underwriters

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VIII. Material Fact
a. Positive or negative info that an investor would consider important in deciding whether to buy or sell
i. Anything that might affect an investor’s decision to buy the stock is exactly what must be
disclosed
b. Examples:
i. Market size, characteristics and opportunities
ii. Product capabilities and competitive position
iii. Significant research and development activities and results to date
iv. Future development plans
v. Relationships and agreements with licensees, customers, suppliers and partners
vi. Financial results
vii. Known trends in the business
viii. Litigation and threats of litigation
ix. Experience and background of members of management
x. All risks that the Company may not achieve its objectives, succeed or even survive

IX. Due Diligence


a. For “non-expertized” portions of the Registration Statement (generally, everything other than the audited
Financial Statements), must show:
i. After reasonable investigation, . . .
1. See § 11(c) and Rule 176
ii. Individual had reasonable grounds to believe, . . .
iii. And did in fact believe, that
iv. All disclosures of material facts were true and complete.
b. For “expertized” portions (e.g., the audited Financial Statements), must show:
i. Individual had no reasonable ground to believe, . . .
ii. And did not in fact believe, that . . .
iii. Any disclosures of material facts were untrue or incomplete

X. What are Reasonable Grounds / Invesigation?


a. Section 11(c) 🡪 “That required of a prudent man in the management of his own property”
b. Rule 176 🡪 What is reasonable depends on the circumstances:
i. Type of issuer
ii. Type of security being offered
iii. The relationship of the individual to the Company or offering:
1. If an Officer, what office did he/she hold?
2. If a Director, was he/she also a member of management?
3. If an Underwriter, what role did it played in the offering?
iv. Did the person rely on others and was that reliance reasonable?
c. Case law as to what is reasonable:
i. In general 🡪 reasonableness of investigation efforts is determined in light of surrounding facts and
circumstance
ii. Failure to follow common industry practice is highly likely not to be reasonable
iii. In particular:
1. Independent verification of Company representations from sources both insider and outside
Company is required
2. Taking Management’s word on faith, particularly with respect to important information, is
not reasonable
3. Underwriter must act as a “devil’s advocate” and drill down on any red flags
4. Reliance on experts, such as auditors, for expertise is OK, but only if no red flags
d. Due diligence must continue all the way through to the closing

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XI. Reasonable Investigation Cases
a. Barchris 🡪 You are going to be responsible for whatever documents you signing
i. So you better read those documents
ii. And check on things that don’t seem right
iii. And make sure the junior associates do their jobs
b. In re Software Toolworks 🡪 diligence done right
i. Underwriters are not held to same accounting knowledge as auditing Accountants and do not have
to second-guess them, unless brought face to face with obvious evidence of potential wrongdoing
by Company or Accountants
1. Underwriters uncover memo indicating Company was backdating contracts to recognize
revenue improperly; UWs properly launched an investigation – demanded info from
auditors, required other firm to attest that the practices were acceptable
2. Absurd for plaintiff to suggest that Underwriters, who are not accountants, possibly could
have known of any mistakes by auditors.”
a. “No defendant other than auditors could be liable on this basis.”
c. In re Worldcom 🡪 diligence done wrong
i. Underwriters’ due diligence for a shelf registration offering consisted of: One phone call with CFO
memorialized in memo by legal counsel; Review of minutes and public filings; Comfort letter from
Arthur Andersen, independent accountants
ii. Did the underwriters conduct a reasonable investigation?
1. BarChris: Underwriters must make some reasonable attempt to verify the information
submitted to them
2. Underwriters cannot merely listen to management’s explanations
iii. OK to rely on Financial Statements certified by Accountants but only if:
1. Financial Statements are included in Registration Statement
2. Financial Statements are actually audited with Accountants’ opinion; and
3. Accountants consent to inclusion of their opinion in Reg. St.
4. Comfort Letters though useful, do not meet this requirement
iv. UWs must follow up on “Red Flags” rather than just relying on audited Financial Statements
1. Any information that “strips [an offering participant] of his confidence in the accuracy of
information premised on the audited Financial Statements, whether or not it relates to
accounting fraud or audit failure” requires further investigation
2. Here, specific “Red Flags” were:
a. Divergence of WorldCom's communications line cost ratio to those of its
competitors
b. Asset write-downs taken by Sprint and ATT, but not WorldCom
v. Very different standard from In re Software Toolworks
1. “Red Flags” here were not in Financial Statements themselves
a. They weren’t even within Company itself
b. They were facts in industry that were absent at Company
2. Underwriters should have applied outside knowledge to second-guess Company’s and
Accountants’ accounting decisions in Financial Statements even though they were
audited

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XII. Who does Diligence on What?

• Lawyers
● Underwriters ● Accountants
o Factual statements
o Industry environment o Financial statements o Corporate organization and authority
and projections o Accounting issues o Capitalization
o Customers, suppliers o Accounting systems o Ownership of assets and properties,
and competitors and financial especially IP
o Financial projections controls o Management-related information
and business model o Comfort letter o Litigation and regulatory matters
o Capital expenditure o Contracts (All material contracts must
plans be filed as Exhibits to Registration
o Sources of other capital, Statement)
such as credit facilities

a. Business due diligence


i. Industry and Company background
1. Analyst reports and trade publications on industry sector in general and on Company in
particular
2. SEC filings of competitors
3. Company’s own marketing materials, website, press releases, etc.
ii. Business description
1. Management presentations
2. Customer, supplier and business-partner calls
3. Site tours of principal facilities
4. Background checks of management
5. Review of Risk Factors
iii. Financial
1. Comparison to Underwriter analysts’ business models
b. Accounting due diligence
i. Audited annual Financial Statements are “expertized”
1. But quarterly financial statements and most other financial data are not
ii. Underwriters and both Counsels review in detail:
1. Critical accounting policies
a. Places were accounting is based upon Management judgments and estimates
2. Any differences of opinion or disagreements with Accountants
3. Accountant’s “Management Letters” regarding reportable contingencies, material
weakness, significant deficiencies, going-concern issues, etc.
4. Upcoming changes in accounting rules that might affect Company
iii. The “Comfort Letter”
1. Accountants provide Underwriters with “comfort” regarding accuracy of almost every
financial number in the Registration Statement
2. Hierarchy of strength of “comfort,” in declining order:
3. Audited Financial Statements for most recently completed fiscal year
4. Financial Statements for quarters since last fiscal year end
5. Numbers taken from the above Financial Statements
6. Numbers derived from the above Financial Statements
7. Numbers taken from Company accounting records
8. Confirmation of math calculations
c. Legal due diligence

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d. Legal due diligence
i. Docs to review
1. Charter and bylaws
a. Capital structure
b. Rights of outstanding stock that can affect the offering
2. Board and shareholder minutes and other actions for Company and principal subsidiaries
3. Matters and documents relating to Company financings and other issuances of all
outstanding securities
a. Warrants and other rights
b. Securities law compliance in previous issuances
c. Registration rights agreements (any waiver necessary?)
4. Agreements with and/or among shareholders
5. Customer, supplier, business partner contracts
a. Any consents needed to be disclosed or filed?
b. Anything triggered by an IPO?
6. Loan agreements, lines of credit, indentures
7. Acquisition agreements
8. Compensation documents
a. Employment agreements
b. Severance agreements
c. Employee equity plans
9. Litigation and investigation files
10. Other government filings and matters
a. Environmental
b. Regulations particular to business (e.g., FDA)
ii. Beyond docs to review
1. Statements disprovable with one example or not at all
a. “Unique”
b. “State of the art”
c. “Next generation”
d. “The leading”
2. Belief” statements
3. Projections
a. Quantitative
b. Qualitative
XIII. Typical diligence issues
a. Customers and suppliers
i. Who’s a “customer”? Is there a binding contract in the document review?
ii. Cherry-picked customer list
1. How recently did they buy?
2. How much did they buy?
3. Are they a distributor or an actual end-user?
4. Do we need their consent to being named?
iii. Does Company have any sole source suppliers?
1. No guaranteed supply
2. Have their been past interruptions?
3. How stable is the supplier’s business?
4. Does Company have contingency plans?
iv. Product claims
1. Do products actually perform as claimed?
2. Are comparisons with competitors’ products accurate and objective?

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3. Is there independent third-party verification for both of the above, rather than just internal
marketing hype?
v. Contracts
1. Do any contain conflicts with doing an IPO?
a. Confidentiality clauses
b. Change in control clauses
c. Consents required to issue stock
2. Do any raise business issues?
a. Unusual commitments
b. Unusual exposures
b. Intellectual Property
i. Ownership of patents, trademarks, copyrights
1. Did all founders properly assign all their rights to Company
2. Any consultants who did not explicitly assign their rights?
3. What is the scope and duration of any IP licensed into Company?
4. What is the scope and duration of any IP licensed out by Company?
5. Are things claimed as “proprietary” really proprietary?
ii. Infringement claims, threats and/or vulnerabilities
1. What products are covered?
2. Did Company get a non-infringement opinion?
3. Can a license be obtained and at reasonable cost?
4. likelihood of litigation and monetary and injunctive exposure in a negative outcome?
c. Litigation
i. Financial impact of current litigation
1. Has Company set aside adequate reserves for loss?
2. What is impact of ongoing expenses even if win?
ii. Non-financial impact
1. What are the possible effects on business and/or sales?
2. What is the effect of the distraction of management time and attention?
d. Capitalization
i. Were all stock and options issued with proper corporate actions and approvals?
ii. Is stock really owned by whom Company thinks it is?
iii. Is description of stock being sold accurate?
iv. When can existing shareholders sell their stock after the IPO?
e. Securities laws
i. Have there been any Gun-jumping violations
ii. Website content
1. Is it consistent with the Registration Statement
2. Is there anything material there that isn’t in the Reg. St.?
3. Is there anything there that couldn’t go in the Reg. St.?
iii. Employee equity issues
1. Did Company properly comply with Rule 701?
2. Maximum amount of stock that can be issues
3. Proper delivery of Financial Statements and Risk Factors if over certain threshold
iv. Foreign securities law
1. Any large issuance of securities in foreign jurisdictions?
f. Employees and consultants
i. Stock/option matters
1. Were all Section 83(b) tax filings done on time?
2. Does anyone’s vesting accelerate because of the IPO?
ii. Prior employment matters for key employees
1. Is any of them subject to an enforceable non-compete agreement

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2. Is any of them covered by any non-solicitation or non-hire obligations that could implicate
Company
3. Is Company improperly using any trade secrets from their prior employers
g. Management
i. Backgrounds
1. Any involvement with bankrupt companies?
2. Any involvement with questionable securities law practices?
3. Any involvement in other questionable activities?
ii. Executive compensation
1. Is all historical compensation disclosed?
2. What are future compensation arrangements/commitments?
3. Are there any benefits triggered by a change-in-control or termination without cause?
iii. Stock ownership
1. Are all holdings completely and properly described?
iv. Related-party transactions
1. Does anyone have any interest on the opposite side of any Company transaction?
h. Regulatory compliance
i. Sales practices
1. Any issues of bribery on foreign countries or other Foreign Corrupt Practices Act issues?
2. Does Company have all necessary export licenses?
3. Are Company’s products such that Department of Defense clearance is needed for certain
exports?
ii. Environmental/occupational safety matters
1. Does Company use any hazardous materials?
2. Do employees engage in any hazardous activities?
iii. FDA matters (for MedTech)
1. What is the timing of FDA action?
2. What indications have been approved for use?
3. Are claims being made supportable?
i. Past Company public statements
i. Historic
1. Any discussions of historical financial performance, especially if inconsistent with that in
Registration Statement?
ii. Future
1. Any discussions/predictions of future financial performance?
2. Any mention of IPO plans?
3. Any predictions of stock performance post-IPO?

Registration Statement

I. Form S-1
a. Used for:
i. IPOs
ii. Original issuances by companies who can’t use Form S-3
iii. Any offering for which there isn’t another specific Form
b. Contents
i. Business
ii. Properties
iii. Financial Statements
iv. Management
v. Stockholders

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II. Registration Statement Contents
a. Cover Page
i. Name of company
ii. Amount and title of securities
iii. UWs and counsel
b. Prospectus
i. Summary
1. Description of business, statement of problem, how issuer solves it
2. Size of offering
3. Use of proceeds
ii. Business Section
1. Description of business
2. Market sizing
3. Market → Problem → Solution → Strategy
a. Business section of every registration statement uses this format
b. Market 🡪 overview of market for type of products that the Company makes
c. Problem 🡪 Problem that this type of product is intended to solve
d. Existing alternatives 🡪 Short general discussion of ways people have tried to
address this Problem, but without mentioning specific competitors
e. Inadequacies 🡪 Why all of the existing alternatives don’t really solve the Problem
f. Needs 🡪 What characteristics would be required for a true solution to the Problem
g. Solution 🡪 What the Company offers customers that uniquely (and miraculously)
solves the Problem and has every one of the required characteristics mentioned in
Background
h. Strategy 🡪 How the Company is getting (or will in next few years get) its Solution
out to customers
i. Strategy for selling to customers
ii. Strategy for expanding markets
iii. Strategy for developing new products that embody Solution
4. Rest of business section
a. Technology behind our solution
b. Details of what we sell
c. Who we sell it to
d. How we sell it
e. How we make it
f. Who we sell against
g. A lot of facts and risk-factory type stuff
5. Goals
a. Craft a tight convincing story for Company with a clear business strategy and
investment thesis
b. Provide general business information and financial disclosures
c. Prepare sales force to create demand
d. Secure sophisticated, high-quality, long-term investors
iii. Financial Statements
iv. MD&A (Management’s Discussion and Analysis of Financial Condition and Results of Operations)

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v. MD&A (Management’s Discussion and Analysis of Financial Condition and Results of Operations)
1. Provide investors information to help them understand Company’s financial condition,
changes in financial condition and results of operations
2. Discussion of key indicators of financial condition and operating results
a. “Financial condition” = Balance Sheet
b. “Results of operation” = Income Statement
c. “Changes in financial condition” = Cashflow Statement
3. Areas of focus:
a. What are the main drivers of Company’s revenues, expenditures and cash
generation?
b. What caused increases or decreases in numbers?
c. What are one-time events vs. ongoing conditions?
i. Effects of seasonality
ii. Offsetting factors and “Masking”
d. Material trends and uncertainties
i. Most valuable disclosure and crux of litigation, for good or ill
4. Principal objectives:
a. Enable investors to see Company and its financial operations through eyes of
mgmt
b. Enhance overall financial disclosure and provide context within which numerical
financial results should be analyzed
c. Provide information about quality – and potential variability – of revenues, profits
and cashflows, so that investors can ascertain to what extent future performance
can be projected from past performance
vi. Risk Factors
1. Identify and prioritize key factors affecting business, operating results, and financial
condition
c. Part II
i. SEC-only disclosures
ii. Acknowledgements of SEC policies
iii. Exhibits
iv. Signatures

After the IPO

I. Public Company Reporting and Disclosure


a. How does the public marketplace get full and accurate information about a Public Company after the IPO is
over?
b. Mandatory disclosure
i. SEC-required periodic report filings 🡪 Forms 10K and 10Q and annual Proxy Statement
1. Annual Report on Form 10-K – 75/60 days after year end
a. Contents: Business, Financials and MD&A, Risk Factors
2. Proxy Statement – generally within 120 days after year end
a. Contents: Management, Executive compensation, Stockholdings, Related party
transactions
3. Quarterly Report on Form 10-Q – 40 days after quarter end
a. Contents: Financials and MD&A only, Risk Factor updates
ii. SEC-mandated “Real-time Disclosure” 🡪 Form 8-K

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iii. SEC-mandated “Real-time Disclosure” 🡪 Form 8-K
1. Company generally must file a Current Report on Form 8-K describing triggering event
within four business days
2. Typical events triggering filing:
a. Material changes in financial condition or operations generally
b. Entry into/termination or amendment of material agreement not in ordinary course
c. Material financial obligation created, default on or accelerated
d. Material write-offs, restructuring charges or impairments of assets
e. De-listing of Company’s securities or non-compliance with listing standards
f. Unregistered sales of equity securities by Company
g. Changes in management or management compensation
3. Implications of failing to file Form 8-K on time
a. Inability of insiders to sell Company securities until filing is made
b. Loss of ability to use short-form Registration Statement on Form S-3 for offerings
for next 12 months
c. Quasi-mandatory disclosure
i. Quarterly financial results press release and earnings call
1. Press release generally within 20 to 30 days after quarter end
2. Conference call or web-cast for securities analysts and public to discuss results, provide
more details and answer questions
3. Release of previously unreleased material information regarding historical financial results
triggers SEC requirement to “furnish,” not “file,” copy of press release on Form 8-K
a. “Furnished” information technically has lower level of liability than “filed”
information
b. Rule 10b-5 liability rather than overt liability for misstatements in SEC filings
4. Company will also generally post press release and recording or transcript of conference
call on Company web-site
ii. Press releases for major events
1. “The Duty to Disclose”
a. Silence, absent a duty to speak, is not misleading
b. When does a Duty to Disclose arise?
i. Periodic Reports / Registration Statements
1. Past events
2. Known trends and uncertainties in MD&A
ii. Nasdaq/NYSE requirements
iii. Stock sales by Company or Insiders
iv. To correct past incorrect statements (“Duty to Correct”)
1. But not to update correct statements that are no longer true
2. No “Duty to Update”
2. Materiality” revisited
a. Are some events so material that they have to be disclosed?
i. Duty to Disclose says no
ii. But general practice is to do so
b. Magnitude of materiality also heightens likelihood of leaks
c. How does one determine the magnitude of materiality?
i. “Price and Structure” Test
1. Have the parties actually reached an agreement on the basic
business terms?
ii. Basic v. Levinson Test

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1. Multiplicative analysis: (Impact of Event) X (Likelihood of
Occurrence)
2. New customer win – modest impact, so likelihood must be high
3. Acquisition of Company – huge impact, so likelihood doesn’t
have to be much
iii. Reasonable Investor Test”
1. Would a reasonable shareholder consider it important in deciding
to trade in stock or vote shares?
d. Discretionary disclosure
i. Presentations to investors and Wall Street Analysts
ii. Forward-looking information – “Guidance”
1. Regulation FD
iii. If Company chooses to speak, it must speak completely and not misleadingly
iv. So why would you do it, if you don’t have to?
1. For Wall Street Analysts
a. Key information intermediaries
b. Providing interpretations and glosses on Company disclosures
c. Providing their own models and forecasts of Company performance
2. Analyst coverage is vital for new public companies
a. Avoiding the Land of the Living Dead
b. Importance in choice of Underwriters
v. Issues in dealing Wall Street Analysts’ reports and forecasts
1. No duty to correct their mistakes
2. In fact, once Company starts doing so
a. It may be seen as endorsing accuracy and completeness of report and thus become
liable for contents
b. It may create expectations that it will correct mistakes in future reports
3. But Company may nonetheless choose to do so:
a. To maintain credibility – and thus goodwill – with Analysts
i. Surprising the Analysts is not a good idea
b. To avoid divergences of Analysts forecasts from reality that can lead to
precipitous drop in stock price
i. Surprising the market is a very bad idea
4. Selective disclosure and tipping
a. Now prohibited by Regulation F-D (in addition to Rule 10b-5)
vi. Forward-looking information – “Guidance”
1. No duty to provide Guidance
2. But realities of relationships with Wall Street Analysts may force Company to provide it
a. Goodwill
b. Dangers of divergence
3. MD&A requires disclosure of “Material Known Trends and Uncertainties” in Registration
Statements and Periodic Reports
4. SEC provides safe harbor for “Forward-Looking Statements”
a. Must identify the forward-looking statements
b. Must discuss risks why such statements may not come to pass
c. Doesn’t apply to IPOs
vii. Regulation FD
1. Whenever:
a. A public Company or person acting on its behalf . . .
b. discloses previously unreleased material information . . .
c. to certain enumerated persons . . .
i. In general, securities market professionals and holders of Company’s
securities who may trade on basis of the information

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2. Then Company must make a public disclosure of that same information:
a. Promptly, for unintentional disclosures
b. Simultaneously, for intentional disclosures
3. Impact:
a. Serious liability for failing to comply
b. Lowering of quantity/ quality of publicly available information?

II. Modern Application of 1933 Act


a. Application of rules to webcasts, electronic roadshows, websites, chatrooms, bulletin boards, blogs, etc.
b. Websites
i. Does posting information on Company’s website make it “public”?
ii. Does posting satisfy broad disclosure requirement of Reg. FD?
iii. Does posting constitute a “public announcement” generally?
iv. Possibly OK so long as:
1. Company website is a generally recognized channel of Company communication, such that
posting information on it can be assumed to adequately disseminate it to general public
2. Nature of information such that it can be communicated effectively – and would be
expected to be communicated – on a website
v. Rule 10b-5 anti-fraud rules apply to website information
1. Must be careful to delineate investor disclosures from general marketing puffery found on
most of websites
c. Chatrooms and bulletin boards
i. Rule 10b-5 anti-fraud rules apply for all Company statements
ii. No liability for content of third party postings 🡪 No duty to correct
iii. But what about statements by employees?
1. Companies should prohibit employees from commenting about Company
2. But no way to control anonymous postings
iv. Blogs by senior executives
1. Violations of Regulation FD, Rule 10b-5 or, more likely, both just waiting to happen

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