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Capitalization Overview Video

Convertible Securities Terms

Investment instruments such as the YCombinator SAFE and the 500 Startups KISS are widely used among startup companies in Silicon Valley.

However, many of the terms found in convertible debt and convertible equity instruments can have a significant impact on the success of future financing rounds. As a result, it is crucial to understand both the short- and long-term effects of each provision within these agreements, particularly from the perspective of future investors as they engage in the due diligence process when evaluating a potential deal.

Maturity Date

The due date of the loan, typically set between 12-18 months after the effective date of the convertible note. Generally, investors who make investments in early stage startup companies are not interested in receiving a 7% return on their investment, and are understanding if the startup is unable to raise a venture financing round before the maturity date. If the startup needs more time to raise VC funding, the startup should enter into a side agreement with the investor, extending the maturity date another 6-12 months. In exchange, the startup can offer the investor terms such as an increased discount rate or a lower valuation cap.

Interest Rate

Typically between 3-7%. The default SAFE does not include any interest rate, on the assumption that early stage investors would prefer to not even bother negotiating the interest rate.

Discount Rate

The discount given to the investor that will be used when converting the loan into equity in the company. For example, if the Company raises a financing round where the Company was valued at $5 per share, a discount rate of 20% would allow an investor to convert their loan as if the Company was worth only $4 per share. In this case, if the investor held a $200,000 convertible note in the Company, the investor would be able to convert the note into 50,000 shares of stock ($200,000 divided by $4), rather than 40,000, if there were no discount.

Valuation Cap

Places a ceiling on the valuation amount used to calculate the number of shares the investor will receive if a conversion event occurs. The valuation cap (1) protects the investor from being diluted beyond a certain point and (2) serves as an incentive to the investor to support the highest possible valuation during the next equity financing round, since they will get the benefit of more equity for a lower dollar amount invested. For example, if the investor invested $500,000 with a $4,500,000 valuation cap and, during the next equity financing round, the company were valued at $10,000,000, the investor would convert as if the company were worth only $4,500,000 (excluding the value of the investor's note), as the cap amount is the highest valuation that would apply to the company for purposes of converting that investor’s convertible security. In this case, the investor would be able to convert the amount of their convertible security ($500,000) into 10% of the company ($500,000 divided by $5,000,000). If the convertible security includes both a valuation cap and a discount rate, whichever method results in a lower per-share price for the investor is the one used in the calculation for converting the note.

Most Favored Nation Clause

Enables the investor to receive the best terms given to any other investor. In the event that the Company issues convertible securities to other investors, this clause allows the current investor to amend their convertible security to have the same terms as the subsequent investors’ convertible securities. After securing subsequent investments, the Company must disclose the terms of the investment to those investors with a Most Favored Nation agreement, so that they may assess whether they wish to gain the same terms.

Conversion Shares (KISS)

Conversion Shares represent the mechanism used to convert the loan provided from the KISS investor into equity in the Company. Conversion Shares will convert the money loaned to the Company into Preferred Stock if any of the following occur: (1) the company raises a round of equity financing of at least one million dollars; (2) the company is sold; or (3) the maturity date of this agreement is reached. The reason the Agreement refers to these shares as conversion shares and not “Preferred Stock,” is because the conversion formula differs based on which event triggers the conversion.

Corporate Transaction (KISS)

Is a sale, transfer, merger, or similar transaction after which the Company no longer owns any substantial assets. This triggers a conversion of the loan into Preferred Stock or the “Corporate Transaction Payment,” which cashes the current KISS investor out at two times the amount they loaned to the Company. In the SAFE, a Corporate Transaction falls under the definition of a Dissolution Event.

Information Rights

The right to access certain records held by the Company, specifically financial statements, and information surrounding the financial condition, business, or corporate affairs of the Company.

Right of First Offer

Requires the Company to extend to prior investors the opportunity to match any proposed subsequent investments. The company may not take a future investment unless the prior investors reject the opportunity to match the offer on the table.

Right to Assign or Transfer (KISS)

Allows the investor to sell or transfer the KISS to a third party. Afterward, the Company would be obligated to that third party. For example, if the Company is sold in the future, the proceeds of the investment would go to the third party, not the original investor.

Accredited Investor

In the case of an individual, the requirements are that either (1) the investor have a net worth of >$1,000,000 excluding the value of the their primary residence; or (2) they made >$200,000 (or >$300,000 jointly if married) in income during each of the last two years with the reasonable expectation of doing the same this year. In order to legally sell any of its shares, the Company must either register with the SEC or find an exemption from registration for each prospective buyer. Many exemptions are only viable if each buyer qualifies as an “Accredited Investor.”

Major Investor (KISS)

An investor whose investment exceeds a certain threshold amount of money as defined in the investment terms. In the KISS, the investor must invest at least $50,000 dollars to be considered a “major investor.” This designation gives the investor certain perks, like information rights and participation rights (e.g., right of first offer).

Information Rights

The right to access certain records held by the Company, specifically financial statements, and information surrounding the financial condition, business, or corporate affairs of the Company.

Venture Capital Due Diligence and Negotiation

During the due diligence and negotiation process for a Series A financing round, the investor’s legal advisors will review and address a number of areas to assess potential risks involved in the investment.

IP Issues

The Company should be able to demonstrate that it owns all of the intellectual property that make up the core of the business. This means showing: (1) the written Invention Assignment Agreements between the Company and its founders, employees, and independent contractors; and (2) any licenses that apply to third-party content that the Company uses, such as open-source code or photographs/video. Additionally, if any current or former founders/employees/independent contractors were employed elsewhere while working for the Company, then the legal team would assess whether their contributions may, in fact, be owned by the other employer. If so, the founder/employee/independent contractor may need to enter into a waiver/release agreement with the other employer to clear up ownership rights in the IP.

Previous Investor Rights

Incoming investors are wary of terms that give previous investors extensive control or economic benefit. For example, if the valuation cap on a convertible security were set too low, the convertible security investors may convert at a price far lower than the purchase price of the Series A Preferred Stock. As a result, the prospective Series A investors may refuse to invest unless the previous investors agree to amend the cap.

Contractual Commitments

Any key contracts involving the Company will be analyzed for indemnification obligations, limitations of liabilities, disclaimers of warranties, and the presence of non-compete/exclusivity terms in order to assess risks and potential limits on market growth.

Co-founder Disputes

In-fighting between current co-founders, or between co-founders and former co-founders, is one of the largest risk factors for a venture capital investment. The main concerns involve IP ownership and minimum wage/overtime compliance.

Securities Issues

Any securities (convertible notes, stock, warrants, options, etc.) sold, or even offered for sale, without an applicable securities exemption will raise flags for prospective investors (See Securities Exemptions below). Violations of securities regulations may bring enforcement proceedings from the Securities and Exchange Commission (SEC), with civil and criminal penalties. Additionally, any investor to whom securities were sold without an applicable exemption would have the right to demand a refund of the purchase price plus interest, increasing the Company’s exposure to potential lawsuits.

Board of Directors

Typically, Series A investors will insist on a 3-person Board: 1 chosen by the Common Stockholders (the founders), 1 chosen by the Preferred Stockholders (the Series A investors), and 1 “independent” Board member chosen by mutual agreement between the founders and the investors. Be aware that independent Board members suggested by the investors likely have a history of working with those investors, and therefore, may feel more loyalty toward the investors than the founders. This situation may be avoided if the Company can preemptively secure an industry expert (outside of the founding team and unaffiliated with the investors) to serve as the independent Board member.

Fully Diluted Capitalization

A representation of how ownership of the Company is split. This representation includes all Common Stock and Preferred Stock on an as-converted basis. For example, if certain shares of Preferred Stock have anti-dilution protections associated with them, then those shares of Preferred Stock could convert into Common Stock at a ratio greater than 1:1. The Fully Diluted Capitalization of the Company would account for this adjustment, if applicable. Additionally, in the context of a venture financing transaction, the unissued stock reserved for the option pool is included in the Fully Diluted Capitalization, whereas in a merger or acquisition, the unissued stock reserved for the option pool is not included. See below for more details.

Option Pool Sizing

Shares for the option pool are carved out from the authorized pool of stock and set aside for use as incentive compensation. For future financing rounds, the stock reserved for the option pool is considered to be part of the Company’s fully diluted capitalization. However, this is not the case if the Company were to be acquired. When calculating the proceeds during an acquisition, only the issued stock would be included in the Company’s fully diluted capitalization. As a result, the investors would receive a greater proportion of the acquisition proceeds than what might have been expected.

For example, let’s assume that the Company’s equity were split as follows:

  • Founders: 6,000,000 Common Stock;
  • Investors: 2,000,000 Series A Preferred Stock; and
  • Option Pool: 2,000,000 Common Stock, of which only 500,000 shares have been issued.

For venture capital financing purposes, the entire option pool (both issued and unissued stock) is included in the fully diluted capitalization of the Company. This means that the Investors own 20% of the fully diluted capitalization (2,000,000 out of 10,000,000).

However, for acquisition purposes, the remaining 1,500,000 unissued shares reserved for the option pool are not included in the fully diluted capitalization. As a result, if the Company were acquired, 8,500,000 would be the figure used as the denominator when calculating Company ownership to split the proceeds of the sale. Therefore, the Founders would receive ~70% (6,000,000 divided by 8,500,000) of the acquisition proceeds, the Holders of Issued Options would receive ~6% (500,000 divided by 8,500,000), and the Investors would receive ~24% (2,000,000 divided by 8,500,000)—even though for VC financing purposes, they only had a 20% stake in the Company. But these are a lot of numbers. Let's take a look at a visualization:

Fully Diluted Capitalization: 10,000,000

As shown in the above hypothetical, because unissued shares have the effect of increasing the Investors’ relative ownership in the Company, it is in the Investors’ best interests to negotiate for an option pool that is larger than necessary. As a result, the Founders should aim to set the option pool as low as necessary during the negotiation process. This typically requires drafting a reasonable hiring plan showing that a smaller option pool would suffice.

Option pool sizes usually range from 10% - 20% of the Company’s total authorized stock. If the Company needs to hire several C-level executives or senior VPs, the Company will likely need to set a larger option pool. If, however, the Company has fewer hiring needs, this would justify a smaller option pool.

Participating Preferred Stock vs. Non-Participating Preferred Stock

Preferred Stock is better than Common Stock in every way. Let's recap some of the key advantages. Holders of Preferred Stock (the investors):

  • Get paid before the holders of Common Stock (the founders);
  • Get veto rights over various company actions; and
  • Get to convert their Preferred Stock into Common Stock at their discretion.

It's that last bullet point where we need to consider the impact of Participating vs. Non-Participating Preferred Stock.

But first, let's take a step back. If it's so superior, why would an investor ever convert their Preferred Stock into Common Stock? The answer is that if they want to cash out their investment, Preferred Stock only allows the investor to receive their liquidation preference back. For example, if an investor invested $1 million in a company with a 2X liquidation preference, and the company is acquired, the investor would be entitled to a payout of $2 million with their Preferred Stock.

However, holders of Common Stock get to receive a proportion of the payout according to their ownership stake in the company. For example, let's say the company was acquired for $20 million and the investor's Preferred Stock, if converted into Common Stock, would amount to a 20% ownership stake in the company. In that case, the investor would certainly convert their shares into Common Stock, as a $4 million (20% of $20 million) payout is better than a $2 million one.

Now here's the rub. An investor who has Participating Preferred Stock doesn't even need to make a choice between getting their liquidation preference back or converting their shares into Common Stock. If an investor has Participating Preferred Stock, the investor first receives their liquidation preference back, and THEN converts into Common Stock to share in the sale proceeds. Going back to our example, the investor with Participating Preferred Stock would receive a $4 million payout (their liquidation preference), and then convert their Preferred Stock into Common Stock to receive 20% of the remaining proceeds—in this case, $3.2 million (20% of $16 million).

Securities Exemptions

As mentioned above, securities are highly regulated in the US. Additionally, they are subject to both federal and state securities laws. As a result, whenever a private company sells, or even offers to sell a security, it needs to make sure that a security exemption applies to the transaction. See here for a summary chart of exemptions available.

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