Venture Finance Mid-Term

What are exceptions to limited liability for a Corporation or LLC?

"Piercing the corporate veil" - If certain procedures are not followed, it is possible for the entity to be ignored, resulting in personal liability. To make sure that the liability protections of the entity are respected, it is important to not intermingle funds between the entity and the shareholders, to adequately capitalize the company, to buy adequate insurance, to separate personal activities from activities of the company and to make clear the separate existence of the company in all business dealings. Taxes - The owners of the company can be personally liable for unpaid payroll and other types of taxes.

What is the post money valuation?

$8,000,000/.15 =$53,333,333

How many shares will the investors receive?

10,000,000 shares/.85 =1,764,706 shares

You are interviewing for a position at a start-up. You expect to receive options as part of your compensation package. If you receive options on 100 shares, how many of these shares would you expect to vest after one year based on the market standard vesting schedule.

25 shares

A VC says he'll invest $10 million for a 25% stake, but will need a 5% option pool. How much will the current investors own on a fully diluted basis after this investment based on these terms?

70%

What is a venture capital (VC) fund:

A VC fund is a private investment vehicle created to make investments in start-up companies. It is similar to a hedge fund or a private equity fund. It is "private" in that its shares are not issued to the public and there are no public disclosure requirements, unlike public funds like mutual funds. All of its owners must be Accredited Investors. The managers of the fund will typically be paid based on a percentage of assets plus a percentage of the returns. Like private equity funds, VC funds are designed to invest in illiquid investments that are not expected to have a liquidity event for five to ten years. VC funds will raise money in multiple series to make a set amount of investments. So, investors may buy Fund A, B, etc. Investors in the fund are typically called Limited Partners or LPs. The fund will be a separate entity from the management company.

What is a startup founder?

A founder is one of the people who receive shares in a startup company upon its creation. Founders typically take no or low salary until the fund is adequately capitalized. It is highly advisable for a potential single founder to find a co-founder, especially if the company is a technology company and the single founder is not a technologist.

What is a grant?

A grant is a form of funding that does not need to be repaid. This can also be in the form of a "forgivable loan," in which a loan is given that does not have to be repaid if certain activities occur, such as the hiring of a certain number of people. Governments and non-profits are sources of grant funding for start-ups.

Pay to Play:

A lead investor may want to require that all investors must continue to participate in future rounds or lose certain rights, such as their liquidation preference.

Protective provisions:

A provision that requires a special vote of one class of shares to approve a transaction.

What is a strategic investor?

A strategic investor is an actual operating company, as opposed to a company whose sole purpose is to make an investment (a "financial investor"), such as a VC fund. For example, Google might be a strategic investor for an advertising business or a business in which lead generation is a profit driver. A strategic investor will often times value a mature start-up at a higher amount than a financial investor because it can realize valuable synergies from the investment. Strategic investors traditionally wait until a start-up is in a growth stage before they invest, i.e., after the very early stage execution risks are proven out. However, operating companies are starting to invest more in pure start-ups now through "Corporate VC" groups or labs.

What are the benefits of an LLC?

An LLC can elect to be taxed as a partnership, which means there will be "flow through" taxation or no "double tax" as with a taxable corporation. This also means that members can use their share of the losses of the business for tax purposes in the year they are incurred.

What is an angel investor:

An angel is an individual investor, as opposed to an institutional investor like a VC. It is common that angels are the first investors in a start-up. It is important that angel investors qualify as Accredited Investors (see below). Angels can often be very valuable to the operations of a start-up. On the other hand, Angels can be unsophisticated and not experienced in standard start-up financing practices, so be careful.

EXTRA Explain why giving an investor a Right of First Refusal can become problematic when you try to raise more money.

Because it interferes with the negotiations with the new investor.

EXTRA Why would a VC not want to condition funding on meeting certain sales targets?

Because it may be a distraction form management and unproductive incentives.

Why would a founder invest in equity of his or her company?

Because she believes the company is worth more than others are willing to pay; to show future investors that she has "skin in the game" (investors will sometimes expect this); she wants to retain control.

Why would a founder not invest in equity of his or her company?

Because she doesn't want to risk too much of her personal capital on a very risky venture. (investors expect founders to be "all in" but do not expect that they would invest everything in a reckless manner)

What are the angel groups in Kentucky?

Bluegrass Angels (Lexington), Enterprise Angels (Louisville), Anchorage Angels (Louisville), Queen City Angel (Cinci, Northern KY), Kentucky Angel Investors (Statewide).

Name a few VC funds in the area:

Chrysalis Ventures in Louisville Drive Capital in Columbus, OH.

Vesting:

Equity Incentives Plans for employees are usually subject to Vesting. This means that the employee will only receive the grant if he or she continues to work at the Company. A common vesting schedule is 25% after one year with the remaining vesting monthly over the following three years. The grants usually vest upon a change of control of the company, for example, a sale.

What are common risks of a start-up? You should be able to identify risks based on a given fact pattern.

Execution; customer adoption; competition; regulatory; funding; personnel; liability

Investors always require audited financial statements for start-ups. True/False

False

Investors always require directors and officers insurance for start-ups. True/False.

False

It takes over one week to obtain a Federal taxpayer ID number. True/False

False

Start-ups are more liquid than public companies. True/False

False

VCs will usually sign non-disclosure agreements. True/False

False

Drag-Along Rights:

If one group of shareholders agrees to a sale, all of the other investors must agree as well.

Fully Diluted:

In a term sheet, per-share price is usually expressed on a Fully Diluted basis. This means that the number of outstanding shares includes shares that could be issued under a Warrant or an Equity Incentive Plan. For example, if there are 1,000,000 shares outstanding and 200,000 issued under a stock option program, then the Fully Diluted number of shares is 1,200,000. Note that there are times in which the relevant number of shares is not expressed on a Fully-Diluted basis, for example, for purposes of voting.

Why is an S-Corporation often not a viable form for a start-up?

In certain circumstances, a corporation can elect to be taxed as a flow through entity as an "S-Corporation." To meet these criteria, however, the corporation can only have one class of shares and there are restrictions on the number and type of investors. Since start-ups often issue both preferred and common equity and do not want to be restricted in relation to the types of investors, they have access to, S-Corporation status is inconsistent with most start-ups.

Equity Incentive Plan:

In start-ups, employee incentive plans are important because the Company doesn't have the cash to pay full salaries. These plans can be in the form of options, stock appreciate rights or profits interests (in the case of a partnership). In each case, the employee participates in the increase in the stock price above a fixed "strike price." For tax reasons, this strike price is usually at or above the price at grant.

What are the general income and net worth requirements for an Accredited Investor?

Income - $200,000 or $300,000 with spouse Net Worth - $1,000,000 (excluding home)

Study Guide

Intro & Formation

Study Guide

Investor Universe

Liquidation Preference:

Investors in a start-up almost always expect to receive at least the amount of their investment back before common shareholders. This is accomplished via the Liquidation Preference. The preference is normally the amount invested but could be a multiple of this amount. Note that the Liquidation Preference is payable on certain events - there is no uniformity around the definition of these events.

Right of First Refusal:

Investors may ask for the right to invest in the future at terms agreed to by the Company with another investor (beyond their pre-emptive right to participate pro-rata). This can make it more difficult to raise money as it introduces a third party into the negotiations.

Pre-emptive Rights:

Investors typically have the right to invest in future rounds to preserve their percentage ownership.

Anti-Dilution Protection:

Investors typically will want to be protected from dilution from shares being issued in the future for less than the amount that they pay, often called a "down round." This is generally accomplished by issuing the existing investors additional shares in such an event.

Information Rights:

Investors will likely require the periodic delivery of financial statements and timely tax information, such as a Schedule K-1 in the event of a partnership.

Conversion Discount:

It is common for a Company to issue a convertible instrument as a way to raise funding to "bridge" to future financing. This can be in the form of convertible debt or preferred stock. In either case, the investment converts into the investment that is issued in the future financing, usually at a discount of 10% - 20%. For example, if a $100,000 convertible note is issued with a 20% Conversion Discount and shares are issued in the future round at $12.50/share, the convertible note holder would receive 10,000 shares as $10/share (80% of $12.50). Note that convertible instruments used for bridge financing are often mandatorily convertible, meaning the holder must convert if the future financing is successful.

Participation:

It is common for start-up investors to receive a preferred security (with a Liquidation Preference) that either converts to common equity or participates in the equity upside with common equity following receipt of the Liquidation Preference. The participation rate is usually 1 to 1 with the common but could be a higher multiple with a cap.

Protective Provisions:

It is common that certain major corporate events, such as a sale, must be agreed to by a majority or super-majority of each class of shares. This allows a minority investor to be protected from the unilateral will of the majority. Note that there is always some degree of protection in the form of fiduciary duties owed by directors and officers to all shareholders.

What are the two most common company forms for a start-up?

LLC and Corporation. Owners of an LLC are called Members. Owners of a corporation are called Shareholders.

What are the benefits of a taxable corporation?

LLCs are complicated from an administrative and tax perspective. Many investors will not invest in an LLC for this reason. It is also difficult to construct tax efficient equity compensation grants using an LLC and LLCs are not suitable for IPOs or deferred tax reorganizations. For these reasons, many VCs who invest in high growth start-ups require corporate form.

What are the benefits to an investor of buying debt?

Less risk/" guaranteed return"

Reserve:

Money that a VC will set aside to make future investments in start-up companies that it invests in.

What makes a new venture different from a mature venture from a financial perspective?

New types of risks; no financial history; no hard assets; fewer investors in the market for this type of risk; fewer existing investors; no analysts to provide research; no downside cushion; potential for governmental grants; higher risk; higher expected return.

Does "de-risking" usually reduce valuation? Yes/no

No

Do all VC funds invest in the same types of investments?

No. VC's have unique investment profiles and constraints. VC's specialize based on industry type, stage of investment and geography. VCs compete with each other for investments and will often promote their ability to make connections or help with operational expertise.

Capital Call:

Often investors will not provide the full amount of the funding upfront. Rather than will wait until the VC finds suitable investments, at which point the VC will make a "capital call" to request the funding that has been committed.

Tag-Along/Co-Sale Rights:

One group of investors cannot sell shares unless all other investors have the opportunity to participate in the sale on a pro-rata basis.

What are the benefits to of an investor of buying equity?

Participate in profits; vote/control; tax benefits

EXTRA Sometimes investors in corporations may still be found liable for the actions of the company. What is it called when this happens ? Why might this happen ?

Piercing the corporate veil If the owners do not adequately separate the business activity of the entity from their personal activity, for example by co-mingling funds or not buying adequate insurance.

What are common ways of dealing with start-up risk?

Proof of concept with customer adoption ("proof points"), legal IP protection, partnering with founders who have proven execution experience, hiring well, putting in place quality first investors, hedging, insurance, diversification.

Why is "de-risking" important in the context of venture finance?

Reducing risk to increase valuation. This also increases the number of investors that will consider the investment.

What is the term for the money that a VC fund holds to make additional investments in start-ups following the first investment.

Reserve

Condition Precedent:

Something that must happen before the funding closes.

What is an angel group:

Sometimes angels will join together to review start-up opportunities as a group. This makes it much more efficient for both start-ups and angels. These groups will sometimes create a fund that looks a lot like a VC fund.

What factors determine whether an investor is a potential investor in a particular start-up?

Stage of the start-up (seed, Series A, growth); size of the raise; geography; type of business; valuation.

EXTRA What is the difference between a strategic investor and a financial investor?

Strategic investors consider synergies with another business

Warrant:

The Company may give an investor an option to purchase an interest in the Company in the future.

No Shop Provision or Exclusivity:

The Company will often be asked to refrain from trying to raise money from other potential investors for a fixed period of time.

What are examples of government funding for start-ups?

The Federal government has many grant programs for technology ventures. The Kentucky Science and Technology Corporation (www.kstc.com) helps start-up access these programs, including the Federal Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs. KSTC also provides its own grants of $30,000 as well as equity funding through the Kentucky Enterprise Fund. Commonwealth Seed Capital is another source of state funding. Additionally, Kentucky offers a state tax credit for angel investors in Kentucky start-up companies http://www.thinkkentucky.com/Entrepreneurship/KAITC.aspx. State-supported programs often require a presence in the state and funding from other sources.

Carried Interest:

The compensation to the VC manager in the form of a percentage of profits.

Contingency:

The investor may want to condition the investment on certain milestones being hit. This can introduce counterproductive incentives on management but may be necessary in certain situations.

Why might a Kentucky company may form a Delaware LLC or Corporation?

The laws of the state of incorporation will generally govern corporate conflicts. Many investors prefer to invest in Delaware companies because they are familiar and comfortable with the laws of that state.

Pay to play:

The obligation to either invest in a round or loss rights

Anti-Dilution Provision

The right to additional shares or other compensation in the event that the shares that you buy are later sold at a lower price.

Drag along rights:

The right to force other classes of shares to participate in a transaction that your class of shares wants to do

Preemptive rights:

The right to maintain your percentage ownership by buying in a future round.

Cap Table:

The table of equity capitalization or "Cap Table" is one of the first things that an interested investor will want to see before providing a term sheet. The Cap Table shows the number and type of shares outstanding. These can be detailed with each owners' name or grouped by share class. They often will be cumulative over time with columns for each raise. Debt is usually shown separately.

Why would a founder want to create a legal entity to own the business?

The two primary reasons are to limit personal liability and to facilitate fundraising. Limited Liability Companies and Corporations both limit personal liability to the amount of the investor's investment. The ability for these entities to issue securities such as stock or membership interests make it easier for the founders to raise money.

Pre-Money Valuation:

The value of the Company immediately before an investment. This is computed by subtracting the amount of the investment from the Post-Money Valuation. For example, if the Post-Money Valuation is $5,000,000 and the investment is $1,000,000, then the Pre-Money Valuation is $4,000,000.

Post-Money Valuation:

The value of the Company immediately following the investment. This is computed by dividing the amount of the investment by the percentage ownership held by the new investor. For example, if the investment is $1,000,000 and the percentage ownership is 20%, then the Post-Money Valuation is $5,000,000.

Name some famous VC funds:

There are many. Sequoia, Accel, Kleiner Perkins, Anderson Horowitz (relatively new); Union Square (Fred Wilson); General Atlantic, Bessemer Ventures; RRE .

Net Share Settlement: (Employee Options)

This is when an option is settled by delivery of the number of underlying shares that represents the value of the difference between the strike price and the total value of the underlying shares subject to the option. In such case the holder is not required invest cash. For example, if the share price is $10 and an employee has the option to buy 1,000 shares at $5, the "in the money" amount is $5,000 (1,000 * ($10 - $5)). Instead of the employee buying 1,000 shares for $5,000, the company divers 500 shares to the employee without any payment. These 500 shares are worth $5,000.

What is crowd funding?

This refers to a new phenomenon that has been made possible by the Jobs Act. https://www.sec.gov/spotlight/jobs-act.shtml. The Jobs Acts provides a new exemption to the SEC registration rules from small issuances. If certain criteria are met, start-ups are permitted to publicly offer securities to non-accredited investors. This makes it possible to sell small investments through online platforms. It is not a replacement for traditional fundraising channels for normal fast-growing start-ups.

What is an Accredited Investor:

This term is important because it defines what type of investors can be approached in a Private Placement. Generally, an angel is an Accredited Investor if he has a new worth of $1,000,000 (excluding his home) or income above $200,000 or $300,000 for a married couple.

EXTRA Why would an investor want to include a Pay-to-Play provision in a term sheet?

To Force other investors to invest more money if needed

EXTRA What does it mean for a FC to "lead" a round?

To negotiate the termsheet, conduct due diligence and likely take a board seat. Other more passive investors look to the lead investor for a stamp of approval.

Assignment:

Transfer of shares is usually highly restricted except to certain affiliated parties. Assignment in this context means transfer.

It is possible for a company to form a Delaware corporation without having an office in the state. True/False

True

It is possible for a shareholder in a corporation to be personally liable for the actions of a corporation. True/False

True

The expected return of public company stock is lower than that of a start-up. True/False

True

Name the person who manages the Von Allmen Center for Entrepreneurship at UK?

Warren Nash

Private Placement:

When raising money for a start-up, it is critical to be aware of laws that prohibit the public offering of securities without public registration. An offering includes any sort of promotion or announcement of the sale. A public registration is very expensive and not practical for a start-up, so fundraising for start-ups must qualify for a private placement exemption from the registration rules. https://www.sec.gov/oiea/investor-alerts-bulletins/ib_privateplacements.html. You should always engage a lawyer to help you navigate the securities laws if you are involved in raising money for any venture, since every situation is different. As a general matter, you should be careful about how many people you speak with about the investment offering and only offer the investment to Accredited Investors. Note that the Jobs Act provides additional exemptions to the registration requirements that make it possible to sell securities to non-accredited investors in certain limited circumstances - see below.

If you own 100% of a single member LLC, is it possible for this LLC to be disregarded for U.S. Federal income tax purposes? Yes or No

Yes

What do you call the compensation that a VC fund manager receives as a percentage of positive returns on the investments? a. Carried Interest b. Kicker Interest c. Bonus Interest d. Gravy Interest

a. Carried Interest

What is a market standard dividend rate on preferred stock? a. 2% b. 6% c. 15%

b. 6%

ABC Program is a competitive 12 week program that helps start-ups with mentorship and networking. At the end of the program there is a demo day with investors. What is the best way to describe the ABC Program? a. Starter b. Accelerator c. Catalyst

b. Accelerator

A public issuance of shares normally must be registered with the SEC. What is the common name for the type of securities offering that is exempt from registration requirements: a. Primary Placement b. Private Placement c. Privileged Placement d. Preemptive Placement

b. Private Placement

What is the term that requires an event to occur prior to funding? a. Conditional President b. Contractual Prefect c. Condition Precedent d. Confrontational Precept

c. Condition Precedent

Who usually delivers the first draft of a term sheet? a. Start up CEO b. Start up CFO c. Investor

c. Investor

What is the name of the legislation that made equity crowd funding possible? a. The START Act b. The SMART Act c. The JOBS Act d. The MOBS Acts

c. The JOBS Act

Name some resources for researching potential investors in a start-up:

cbinsights.com angel.com crunchbase.com gust.com ftpartners.com (fintech)