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It is common for startups to raise early rounds of financing through convertible debt. Today’s post highlights valuation caps and discounts in convertible notes.

It is common for startups to raise early rounds of financing through convertible debt. Convertible debt, generally called a “convertible note,” typically converts into equity when the company raises another round of financing. In anticipation of the conversion, many investors will negotiate for valuation caps and discounts. In today’s post, I’ve highlighted the basics of valuation caps and discounts in convertible notes.

What is a Valuation Cap?

A valuation cap provides that the convertible note holders will convert their debt into equity at the lower of the valuation cap or the price in the subsequent round of financing. Without a valuation cap, the note holders would generally convert their debt into equity at the same price as the shares issued in the…

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Negotiating valuation cap

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In this post we use the recent news about a loophole in GoPro's lockup provision to discuss the importance of an often overlooked portion of the term sheet.

Here’s an example of a commonly overlooked provision in a term sheet coming into play. Recently, news broke that there was a “loophole” in GoPro’s lockup provision, and the company’s shares subsequently tumbled almost 13%.

What is a lockup provision?
A lockup provision is an agreement that the shareholders will not sell their shares for a specified period of time—often 180 days—following a company’s initial public offering. The point of the lockup provision is to keep existing shareholders from flooding the market and depressing prices in the company’s offering. There are two primary types of lockup agreements. The first is an agreement between the investors and the company during a private offering.

A standard industry term sheet has the following lockup provision:

Investors shall…

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Cage

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In today's post, we’ve extracted some of the highlights from Pitchbooks' report on valuations, financings, and terms for series seed financings.

Pitchbook recently released its VC Valuations and Trends Report, which analyzes a decade of data on VC valuations, financings, and series terms. We’ve extracted some of the highlights from the data on series seed financings below:

Series Seed Valuations at Ten Year High

Valuations in series seed rounds have increased year over year, with the median valuation for seed stage financings reaching $5.9 million in the first half of 2014. This represents a 23% increase over the 2013 median of $4.8 million. As many folks are now saying, series seed financings are now the new Series A!

Investors Take Larger Percentage in Seed Stage

Investors in software startups have taken a larger stake in companies than in prior years. In 2011, the median percentage…

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Series Seed Valuations Up

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Option pool size has considerable impact on valuation in startup financing, and ultimately it impacts the amount of dilution to founders’ shares.

Many startups ask us about reserving an option “pool.” The “option pool” is a reserve of authorized but unissued shares of stock that the founders intend to use to compensate future key employees and investors. There is no size of option pool that is right for every company, although you’ve probably read that a “standard” option pool is generally somewhere between 10-20%. Many founders aren’t terribly concerned with the exact size of the option pool, although we think they should be. The size of the option pool has a considerable impact on the valuation of a startup when it raises capital from investors and ultimately the amount of dilution to founders’ shares.

Pre-money Valuation and Option Pools

As we’ve discussed in our…

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Ruler

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In this blog post we discuss whether founders should be concerned about dilution, how it works, and what you can do to prevent dilution.

Successful Founders Get Diluted.

We often get asked by founders what they can do to protect against dilution. A few answers:

You can build a crap company nobody wants to invest in.
You can build a cool company that doesn’t need to scale.
You can pour your own money into the venture, if you have enough of it.
You can scale at a slow pace.
You might be able to get a loan instead of raising money through selling an interest in your company.

There are some small protections against dilution that your attorneys can fashion for you. But the reality of life for most founders of ventures designed to scale is that dilution is a normal part of success. Many founders are strongly opposed to dilution,…

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Coffee & Cream

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This post discusses business valuation, including the methods for valuing your business for a sale, merger, acquisition, divorce, or exit.

Entrepreneurs and business owners will generally need to value their business on many occasions during the course of a career. Whether part of a seed investment round, follow-on series investment round, merger or acquisition, partnership or owner dispute, or a partnership or ownership dissolution, you will likely need to fix a value to your business at least once.

Behavioral study indicates that people tend to value that which they are selling higher than they would value the same thing if they were buying. This means that most of the time, and especially when the valuation is forced, the number the buyer proposes and the number the seller will accept are far apart. So you often see business owners and entrepreneurs turning to…

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Business Valuation - Bean Counting

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This post discusses the "simple agreement for future equity," which is a new type of investment security unveiled by Y Combinator and referred to as a SAFE.

Y Combinator, a previous proponent of convertible debt, has unveiled a new type of investment security – the “simple agreement for future equity.” Or, as they’re abbreviating it, the SAFE. (I wouldn’t have advised calling it “SAFE,” as an investment in a startup is inherently risky. Despite the name, most investors should understand that just because it’s called SAFE does not make it a safe investment.)

Background

Security instruments are contracts by which companies exchange an interest in the company for consideration–usually cash used to finance the company. The SAFE is a contract that has some different features from traditional security instruments. To understand the SAFE, it’s helpful to have a grasp of the more traditional security instruments.

Common…

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Beginning on Monday, December 3, 2012, member firms of FINRA must file a copy of any offering document used in private placements.

Beginning on Monday, December 3, 2012, members of Financial Industry Regulatory Authority (FINRA) must file a copy of any private placement memorandum, term sheet, or other offering document used within 15 calendar days from the date the sale took place; the filer will have a continuing obligation to file any materially amended versions of the offering documents; if no offering documents are used, it must indicate that it did not do so; and filings must be made electronically with FINRA through the FINRA Firm Gateway.

FINRA has taken active steps to increase transparency and investor protection in private placements. In addition to the Rule 5123 filing requirements, Rule 5122 establishes standards on disclosure, use of proceeds, and a filing requirement for…

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Mergers and Acquisitions

Yahoo and Alibaba Close Deal
Yahoo has agreed to sell back half of its interest in the Chinese Internet company Alibaba. In 2005 Yahoo acquired a 40% interest in the company, but since then relations between the two companies have become strained, especially as Yahoo failed to meet investors’ expectations. As part of an agreement reached earlier this year, Yahoo will sell another 10% of its Alibaba holdings back to the company when the company files an IPO, and the rest of its Alibaba holdings after the IPO. Yahoo’s remaining interest in Alibaba is valued at just over $8 billion, which accounts for more than 40% of Yahoo’s market value.

IPOs

Fall IPO Calendar Filling Up
Take a look at iposcoop.com’s IPO…

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This is the final installment in our key term sheet provisions series. This post reviews rights of first refusal, restrictions on sales, voting rights, proprietary information and inventions agreements, co-sale agreements, founders activities, no shop agreements, and indemnification provisions.

Right of First Refusal
The right of first refusal provision grants investors a right to participate in subsequent stock offerings. This right is sometimes called a pro rata right, because it enables investors to participate pro-rata. Pro rata means proportional, and in this context means that an investor can purchase an amount of new stock proportionate to their holdings in the company immediately prior to the issuance of the new offering. In more simple terms, it means that if an investor has 5%…

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