Understanding Stock Ownership and Valuation · •Pre-money valuation is fixed so conversion price...

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March 28, 2020

Understanding Stock Ownership and Valuation

Mysty Rusk | [email protected] | 619.260.4657

SDAngelConfTheSDAngels.com

StockCommon• AKA Founders Stock• Divided into equal pieces• Paid out last

Preferred

Common 100100%

• Paid first• Only what’s paid in +

dividends

Common 10083%

Preferred 2017%


Preferred - Cash Out

Sell for $1,000Investor gets $200Founder gets $800

Sell for $500Investor get $200Founder gets $300

Investor $200 Founder $800 = $1,000 Valuation

Sell for $2,000Investor get $200Founder gets $1,800


Preferred vs CONVERTIBLE Preferred

Sell for $1,000Investor gets $200Founder gets $800

Sell for $500Investor gets $200Founder gets $300

Investor $200 Founder $800 = $1,000 Valuation

Sell for $2,000Investor’s stock CONVERTS to common stockInvestor gets $200

$900$1,100

Founder gets $900


OwnershipF&F % Seed % Series A %

Initial SharesFounders (Common) 100 100%




Seed RoundFounders (Common) 100 83%Angel (Preferred) 20 17%




Seed RoundFounders (Common) 100 83%Angel (Preferred) 20 17%

Series AFounders (Common) 100 42%Angels (Preferred) 20 8%Venture Cap 120 50%


Ownership

Founder 100

Founder 83

Founder 42

Angel 17Angel, 8

VC 50

0

20

40

60

80

100

120

F&F Seed Series A


ValuationF&F Seed Series A

Initial Valuation $500,000After Seed $3,000,000After Series A $10,000,000

$500,000

$2,490,000

$4,200,000

$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

F&F Seed Series A

Founder Angel VC Linear (Founder)


Seed Financings: Choosing an Instrument

• Equity vs. Non-Equityo When and why should a company issue

Preferred Stock? • Convertible Notes vs. SAFEs

o What is the difference?o Are there any drawbacks to using SAFEs?


1% of a lot is more than 100% of nothing


Seed Financings: Types of Instruments

• EquityoCommon Stocko [Series Seed] Convertible Preferred Stock

• DebtoPromissory Notes (Term Loans, Bank Loans, A/R

Loans)oConvertible Promissory Notes

• DerivativesoSimple Agreements for Future Equity (SAFE)


SAFES

§ Essentially a form of a Promissory Note without interest and without maturity

§ Benefits: • Simplicity• Low transaction costs

§ Concerns regarding (i) possible difficult valuation calculations; (ii) lack of oversight and knowledge by founders issuing this instrument; and (iii) lack of protection for investors (very entrepreneurial friendly).


Convertible Notes (A closer look)

§ Convertible Notes are Debt• Term loan (with interest) that is to be repaid in cash or equity• Intent is to have loan convert into next round of financing,

rather than repaying the loan with cash

§ Convertible Notes are “Securities”• Shares issuable upon conversion are also subject to securities

laws.§ Why issue?

• Simpler, cheaper, and faster than an equity investment• No formal valuation given to company at time• Can “bridge” the company to some event or milestone


Key Terms of Convertible Notes (Debt Terms)

§ Principal - Original Loan Amount§ Interest – Interest on the loan§ Term – Duration of the loan§ Security Interest(s) –

• Secured or Unsecured?• If secured, what is the collateral?

§ Prepayment – The debt may be paid before maturity§ Amendments – What is required to alter the terms§ Default – Company cannot repay. Now what?!


Key Terms (Principal & Interest)

§ Principal – Amount of the loan§ Interest Rate - Market rate is between 5% and 10%§ Methods of Calculating Interest

• Compounding vs. Non-Compounding (Simple Interest)• If compounding: annual, quarterly or monthly?• Counting days for interest calculations (365 v. 360)

• Market is Simple Interest, based upon 365 day period§ Repayment Mechanics – First costs, then interest, then

principal


Key Terms of Convertible Notes (Conversion)

§ Conversion – What shares will notes convert into?§ Automatic Conversion -

Notes convert automatically upon “Qualified” Financing§ Qualified Financing – Dollar Amount or Milestone§ Voluntary Conversion – If no “Qualified” financing§ Conversion Price –

Price per share that Notes convert into stock§ Valuation Cap – Minimum % of Company holders will

own


Key Terms of Convertible Notes (Conversion)§ Company and Investors expect Notes to convert into

securities

§ Automatic Conversion• Automatic conversion if Qualified Financing prior to maturity• Qualified Financing sets limits (usually minimum investment)

for Notes to convert

§ Voluntary Conversion• Typically after maturity• Liquidity event (IPO) prior to Qualified Financing


Conversion Mechanics

§ Conversion Price• Automatic Conversion: Based upon Qualified Financing• Voluntary Conversion: FMV or Pre-Negotiated valuation

§ Discount Rate • Most important incentivize for Investors to participate• Price is discount vs. subsequent equity investors • Typical range is 10-30%.

§ Valuation Cap• Highest valuation of Company at which the notes will

convert • Meaning investors will own no less this % of Company


Conversion Mechanics(Valuation Cap)§ Valuation Cap

• If a subsequent equity financing occurs at a valuation above the valuation cap, the note holder may be able to convert the note at a discounted price relative to that paid by investors in the equity financing.

• Will typically bear some relation to an estimated current valuation of the company and valuation at time of conversion.

• A valuation cap on the conversion price per share will typically be expressed as (x) a valuation amount divided by (y) the Company’s “fully diluted” capitalization prior to the qualified financing


Conversion Mechanics(Valuation Cap)

§ Valuation Cap Table Example 1• 2 Convertible Notes with Valuation Caps of $8M

• 1 Convertible Note was issued at principal and interest that equals $1M in aggregate

• 1 Convertible Note was issued at principal and interest that equals $700k in aggregate

• Company raises $3M new money with a pre-money valuation of $10M {i.e.., for 23% of company)

• Available Option Pool (post-financing) equals 10%

• This comes in pre-money


Conversion Mechanics(Cap Table)§ Step 1: Finalize Pre-Money Valuation ($10M) + New Cash

($3M)

§ Step 2: Option Pool (post-financing) equals 10% (pre-financing)

§ Step 3: Work with Promissory Notes and/or SAFEs

§ Step 4: Determine Total Shares Outstanding = 129,904,306

§ Step 5: Determine Series A Price Per Share = $0.077


Example 1 (Value at Financing Above Valuation Cap)

NameCommon

StockOptions Issued

Fully Diluted Stock

Percent Fully-

Diluted Series A Series A-2Total

PreferredPercent of Preferred

Total Fully-Diluted Stock

Percent Fully-

Diluted

Founder A 45,000,000 45,000,000 45.00% - 0.00% 45,000,000 26.65% 53.29%

Founder B 45,000,000 45,000,000 45.00% - 0.00% 45,000,000 26.65%

Optionee 1 500,000 500,000 0.50% - 0.00% 500,000 0.30%

Note I - 0.00% 13,423,445 13,423,445 21.83% 13,423,445 7.95% 13.33%

Note II - 0.00% 9,093,301 9,093,301 14.79% 9,093,301 5.38%

Investor I - 0.00% 29,228,469 29,228,469 47.54% 29,228,469 17.31% 23.08%

Investor II - 0.00% 9,742,823 9,742,823 15.85% 9,742,823 5.77%

Options Available 9,500,000 9.50% - 0.00% 9,500,000 5.63% 10.00%

Pool Top-Up 0.00% - 0.00% 7,387,560 4.37%

Totals: 90,000,000 500,000 100,000,000 100% 38,971,292 22,516,746 61,488,038 100% 168,875,598 100%


Conversion Mechanics(Valuation Cap)

§ Valuation Cap Table Example 2• 2 Convertible Notes with Valuation Caps of $8M

• 1 Convertible Note was issued at principal and interest that equals $1M in aggregate

• 1 Convertible Note was issued at principal and interest that equals $700k in aggregate

• Company raises $3M new money with a pre-money valuation of $7M {i.e.., for 23% of company)

• Available Option Pool (post-financing) equals 10%

• This comes in pre-money


Conversion Mechanics(Cap Table)§ Step 1: Finalize Pre-Money Valuation ($7M) + New

Cash ($3M)

§ Step 2: Option Pool (post-financing) equals 10% (pre-financing)

§ Step 3: Work with SAFEs and/or Promissory Notes

§ Step 4: Determine Total Shares Outstanding = 147,325,581

§ Step 5: Determine Price Per Share = $0.0475


Example 2 (Below Valuation Cap)

NameCommon

StockOptions Issued

Fully Diluted Stock

Percent Fully-

Diluted Series A Series A-2Total

PreferredPercent of Preferred

Total Fully-Diluted Stock

Percent Fully-

Diluted

Founder A 45,000,000 45,000,000 45.00% - 0.00% 45,000,000 21.38% 42.76%

Founder B 45,000,000 45,000,000 45.00% - 0.00% 45,000,000 21.38%

Optionee 1 500,000 500,000 0.50% - 0.00% 500,000 0.24%

Note I - 0.00% 21,046,512 21,046,512 21.28% 21,046,512 10.00% 17.00%

Note II - 0.00% 14,732,558 14,732,558 14.89% 14,732,558 7.00%

Investor I - 0.00% 47,354,651 47,354,651 47.87% 47,354,651 22.50% 30.00%

Investor II - 0.00% 15,784,884 15,784,884 15.96% 15,784,884 7.50%

Options Available 9,500,000 9.50% - 0.00% 9,500,000 4.51% 10.00%

Pool Top-Up 0.00% - 0.00% 11,546,512 5.49%

Totals: 90,000,000 500,000 100,000,000 100% 63,139,535 35,779,070 98,918,605 100% 210,465,116 100%


Conversion Mechanics and Considerations§ Timing

• Note included in pre-money or post?• Pre-Money Valuation Method

• Pre-money valuation is fixed so conversion price for the notes fluctuates

• Percentage Ownership [Or Post-Money] Method• % of company that investor is purchasing is fixed and

the other variables are computed is determined • Dollars-Invested Method

• Post-money valuation equals agreed-upon pre-money valuation plus the cash invested by investors plus principal and accrued interest on converting notes


Conversion Mechanics and Considerations§ Timing

Pre-Money Valuation Method is the most common• Investors in next round of financing do not want to be diluted

from conversion of notes• Price per share of Qualified Financing is calculated assuming

conversion of all notes (prior to the new investment) and top-up in option pool

• Example:• For $1M, equity investors expect 20% of Company (all-in)• $4M pre-money valuation & $5M post-money valuation• If Series A sold at $1 per share and Notes convert at 20%

discount -> straight conversion of $1,000 loan means $1,000/($1.00*(1 – 20%)) = 1,250 shares Series A


Conversion Nuances (Let’s Get Creative)

§ Sometimes: Accounting for Discount• Notes convert into preferred stock + common stock• Notes convert into shadow preferred class (Series A-1)• Example: $1,000 loan, Series A sold at $1 per share,

Note holder converts at 20% discount• Straight conversion: $1,000/($1.00*(1 – 20%)) =

1,250 shares Series A• Discount rate to common:

1,000 Shares of Series A, 250 Shares of Common• Separate class: Note holders get 1,250 shares of

Series A-1 with an $0.80 liquidation preference


Treatment at Maturity & Default

§ Maturity? • What happens if no qualified financing prior to maturity date• Holders (individually or as a group) may demand repayment

• It is a loan after all!• Convert into capital stock according to pre-negotiated

valuation

§ Default?• Typically: (i) failure to make payments in accordance with

Notes; (ii) bankruptcy; or (iii) pre-negotiated covenants (as appropriate)

• If Default: (i) default rate of interest; and/or (ii) holders (individually or as a group), may declare Notes due and payable


Amendments/Prepayments/Fees

§ Amendments• Purchase Agreement and Notes may be amended,

or any term waived, upon consent of Company and holders of a majority in interest of the Notes

§ Pre-Payments• Typically need consent of majority in interest• Normally no pre-payment penalty

§ Fees and Expenses• Either (i) Company covers fees and expenses of

lead investor (up to a cap) or (ii) each party pays its owns fees


Sale of Company at a Premium

§ If Company Sells Prior to Maturity Date• Company to pay Note holders cash payment

based upon principal and interest outstanding in satisfaction of obligations

• Typically range of multipliers from 1.5X – 3X• Used instead of conversion at sale

• Gives investors equity-like “upside” in a sale of Company


March 28, 2020

Financial Primer for Entrepreneurs

The Brink

6 November, 2019


Agenda

• Know Your Investors 10%• Business Plan Assumptions 50%• Creation of the ProForma Financials 10%• Presentation and Discussion 15%• SME Review and Advice 10%• Continuous Improvement 5%


Investors• Yourselves - Pre Seed up to $150K

• All subsequent investors will want to know that you have personal $ committed to this• Convertible Note

• Friends, Family and Faithful – Pre Seed up to $500K• Less sophisticated, less formal, but require legal documentation nonetheless• Convertible Note

• Angels – Seed Round $500K to $1.5M• More sophisticated, higher expectations, investment is a business, not a hobby, Board

role with business accountability• Formal Equity

• Venture Capital – Some VC Funds focus on Early Stage Cos - $250K to $2M• More investment specialization – not all firms are candidate investors• Usually a Board role, high degree of business accountability• Expect management/leadership changes to accelerate progress


Business Plan Assumptions• Are you a Feature, a Product (Service) or a Business?

• Feature• A component of a larger Product• Tangible enhancement of a Product• Can be licensed to the owner of the product

• Example: Its Deductible was a single Product Business that was acquired by Intuit and enrolled as a Feature inside of TurboTax

• Product (Service)• Difficult for any business with a single Product to survive

• Business• Multiple Products or Services• Think in terms of a Product Platform

• Good / Better / Best• Core / Complimentary – vertical or horizontal integration


Defining your Product/Service• What, exactly, specifically, is it?

• How is it different/better than current solutions?

• Is your difference defensible (i.e. sustinable)?

• Who, specifically, will consume your product/service? Why will they buy it?• Consumers and Payors are not always the same• Consider changing costs

• What does it cost to manufacture your product or deliver your service?

• How will you price your product/service?• Transaction• Subscription


Go To Market Strategy• Who will buy your product/service?

• Do you have a local, regional, national or global business approach?

• How do you reach your customers?• Direct Sales• Wholesale• eCommerce• WoM

• What is your Warranty?


Supply Chain Strategy

• How will you deliver or ship product to your customers?

• How much inventory do you need to carry?

• Who will manufacture your products?


Operating Expenses 1 of 2• What staff will you need and when?

• How much will you pay them?• What benefits will you provide?• Don’t forget about payroll taxes @ 12% of compensation• How will your Equity be shared/assigned?• What subcontractors will play key roles?• What is Product Development going to cost you before

anything is sold?• Any consumables that the Product Development

team will require to develop products?• What facilities will be required for your team?


Operating Expenses 2 of 2• What IT capabilities will you need?

• Computers• Ofc365 licenses• Quickbooks / ERP and CRM software, Payroll provider• Network• Website hosting• VOIP Phones• WIFI

• Travel and Conference Expenses

• Insurance

• Legal, Tax and 3rd party Specialty services


Banking and Insurance

• Not all Banks are entrepreneur-friendly

• Insurance – Commercial Package, Work Comp, EPLI, D&O (Errors and Omissions, Cyber coverage later)


ProForma Development 1 of 3• Multi-tab excel spreadsheet• Accrual based accounting• Illustrate Cash consumption as well

• One tab for each “section”

• Revenue Projections• Revenue Recognition isn’t the same as Sales or Cash• Units to be sold by month

• Cost of Sales Projections• Based on manufacturer quotes• Units to be sold, by month (assume inventory > sold)

• Inventory balance is Built minus Sold

• Don’t forget about Other Income• Grants• Sublease Proceeds


ProForma Development 2 of 3

• Staff and Subcontractor Expenses inclBenefits and PR Taxes

• Consumables Expenses

• Facilities Expenses


ProForma Development 3 of 3• Each Tab should be organized by month, over a 5 year horizon,

with Quarterly and Annual totals

• One Master Tab should pull “inputs” from the source tabs in the form of a P&L by month, over a 5 year horizon

• Edits/updates should be identified in a single tab, and each change should be dated, described, and checked for projected impact, one at a time to maintain version control

• For Accrual ProForma Balance Sheets• You will need to build assumptions for A/R collections and A/P payments,

Accrued Bonuses and Commissions, prepaids, and Amortization of TI and multi year Lease provisions

• You will need to account for cash invested in inventory


Presentation and Discussion• Need to align with Key Business Milestones• Conservative for Revenues / Aggressive for Expenses• Understand Investor Perspective: Lifestyle Business vs.

Investable Business• Should be Quarterly for Y1, Annual summaries for Y2-5• High Level Illustration ONLY

• Revenue• Gross Margin• Operating Expenses*• EBITDA• Cash Consumed YTD and Inception to Date

• Graphical and Tabular• Know Your Numbers


SME Advice• Are you an Investable CEO?

• Not All Founders are investable CEOs

• Source of referrals for Leadership/Board• Product Family Philosophy• Pricing for Value• Ramp Rates• Conservative Sales / Revenues• Aggressive Expenses


Continuous Improvement

• Persistent Tuning and Updates to the Business ProForma

• Version Controlled Plan

• Limited Access


For Each Raise of Capital

• 409a is required to value the Common Stock

• The hope is that over successive rounds (Seed to A to B), the value of the Common Stock rises to protect those who placed the earliest bets.


March 28, 2020


-2) The Comfort Zone


-1) Importance vs Urgency


1) The Big and Small Economic Picture


2) How to Read a P&L Statement and Other Financial Documents


3) Cash Flow:What It Is and How to Improve Yours


4) The Regulatory and Legal Framework Within You Work

• Business structure LLC or C-Corp (Delaware)• Articles of Incorporation• Business name - Trade Mark• Employee Handbook & Posters• Tax IDs (federal and state)• Permits and licenses (including business

licenses)• Insurance


5) Marketing 101 (and MBA, etc.)

• Tactical • Communications• Graphic Design• Web Strategy• Short Term

• Strategic• Product Strategy• Branding• Market Segmentation• Competition• Long Term


6) Business Model

• Technology has no inherent value – The Business Model creates the value and different business models will create different levels of value

• The Business Model Canvas

1. Target Customer / Segment2. Value Proposition3. Sales Channel4. Customer Relationships5. Revenue Streams

6. Key Activities7. Key Resources8. Partner Relationships9. Cost Structure

Understanding Stock Ownership and Valuation · •Pre-money valuation is fixed so conversion price...

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