1. CHOICE OF SECURITY

Common Stock

Convertible Preferred Stock

Convertible Notes and Warrants ─ Debt Security

Investor's money goes in as preferred stock and comes out as a common stock at the time of the initial public offering (IPO) or sale of the company to a larger corporation. If the company is unsuccessful, its assets go on the auction block, including the technology; the preferred shareholders would have then certain rights in priority to the ordinary shareholders, especially as regards entitlement to dividends and entitlement to repayment of capital.

Pros and Cons

Common Stock

Convertible Preferred Stock

Convertible Notes and Warrants

  • Easiest and simplest

  • Same risk as founders

  • Little structural flexibility

  • Valuation set for future

  • Structural flexibility

  • Can manipulate internal rate of return

  • Upside guarantees

  • Downside protection

  • Protection of principal

  • Interest as current return

  • Warrants as sweetener

  • Limited upside

   

2. PRINCIPAL OBJECTIVES OF THE INVESTMENT DOCUMENTS

Guidepost for behavior & expectations

Fleshes out due diligence issues

Identifies:

  • Downside protective strategies

  • Liquidity opportunities

  • Management issues

  • Investor/founder issues

  • "Early in" issues

 

3. DUE DILIGENCE ITEMS

Representations and warranties of the company:

Use of proceeds

Organization and authority

Ownership of property and assets

Ownership of intellectual property

Employment of key personnel

Government approvals

Absence of litigation

Compliance with other agreements

4. DOWNSIDE PROTECTIVE STRATEGIES

Liquidation preference

straight

participating ─ rare in seed context

Antidilution protection (if later rounds dilutive as to price, re-price at the lower valuation)

weighted average

full ratchet - draconian

Dividends

 

 

5. LIQUIDITY OPPORTUNITIES

Initial Public Offering (IPO)

registration rights

conversion

Acquisition

liquidation preference

conversion

Redemption

lackluster performers

6. CLASS VOTING RIGHTS

Investor can block important corporate transactions

mergers, sales of stock or assets

issuances of additional preferred

grant of excessive options to employees

incurrence of debt

sales or transfers of technology

Should disappear if preferred holds less than certain equity percentage of company

    

 

7. AFFIRMATIVE COVENANTS OF THE COMPANY

Accounts and reports

Approvals of budgets

Board of directors

independent public accountants

Financial statements

8. INVESTOR / FOUNDER ISSUES

Sweat equity vs. financial investor

Vesting / buy back at cost

For cause vs. "No Fault Divorce"

"Tag Along Rights"

Rights of First Refusal / First Offer

Baskets for management shares

Non-competition / non-solicitation agreements

Employment / severance agreements

 

9. "EARLY IN" ISSUES

Preemptive rights

All vs. Pro Rata

"Pay to Play"

 

References

1.    "Seed Investing as a Team Sport", by National Association of Seed and Venture Funds (NASVF)

2.    "High Tech Start Up", by Nesheim, J.L.

3.    "Angel Investing", by Osnabrugge, M.V. and Robinson, R.J.,

Equity Investor's Compensation

Ways of Realization of Financial Returns for Investors

Private Placements

Private Placement of Convertible Stock: Sample Term Sheet

Terms and Conditions for Securities Offerings

Typical Terms of Preferred Stock Issued to Venture Capitalists