Month: December 2017

What’s new in California Employment Law for 2018?

It was another busy year in the California Legislature with regard to employment and labor issues. Of particular note for California employers, including many startups, are the new laws related to employee hiring practices with the prohibitions on requesting an employment applicant’s salary history information, limitations on the use of an employment applicant’s criminal conviction history, and the New Parent Leave Act, which provides 12 weeks of unpaid parental leave for employees of small employers (20 or more). Discussed in detail below are the most significant new laws pertaining to private employers in California that are effective January 1, 2018, unless otherwise noted. California employers should review their policies and procedures, especially those related to employee hiring, to ensure compliance with these new laws in 2018.

Read about these new California employment laws.

Convertible Note Conversion Caps

Historically, one of the main advantages of funding a startup through convertible notes has been the ability to avoid setting—or even discussing—a valuation for the company. Investors received a discount (often between 10% – 30%) off the price per share paid in the next “qualified” financing round by future investors (i.e., a financing where at least a specified amount is raised triggering an automatic conversion of the notes into equity). This structure kicks the valuation discussion down the road and leaves it to future investors. The pre-money valuation for the next round determines the conversion price for the notes, rather than the company and investors setting that price now. The rationale for this structure is generally that valuing a new startup with little or no track record is extremely challenging and future institutional investors will be better positioned to accurately value the company.

The Rise of Valuation Caps

In recent years, round sizes for early-stage convertible note rounds have increased, companies have more frequently raised multiple nonpreferred stock (e.g., convertible note or SAFE) rounds, and startups—particularly tech companies—have found ways to stretch the dollars raised in these rounds. These factors have resulted in greater potential for significant valuation increases between a note round and the equity financing in which the notes convert. As a result, investors have grown concerned that a discount alone will not fairly compensate them for investing at a riskier stage in the company’s development.  In addition, as round sizes have increased, larger investors with greater experience in setting valuations are participating more frequently in note rounds.

These factors have led investors—particularly institutional, corporate, and sophisticated angel investors—to increasingly demand a valuation “cap” in notes. The purpose of the cap is typically to protect investors against valuation increases significantly in excess of the parties’ expectations. The conversion price in this structure is generally set at the lower of the price resulting from (1) the discount described above or (2) a predetermined, pre-money valuation (the “cap”).  Investors receive upside protection from the cap and downside protection from the discount in the event the next round is priced below or only slightly above the cap.

Potential for Unexpected Results

While the cap makes sense to investors, it can lead to results that founders may not anticipate. If the cap is significantly below the pre-money valuation for the next round, an investor will receive far more shares and a much greater liquidation preference than with a discount alone. This can lead to greater dilution than founders expected, and an increased likelihood that new investors in that round will require that all or a portion of the note shares be included in the pre-money capitalization (reducing the price per share and increasing dilution).

To illustrate, the table below compares the results in a Series A financing of an investor (1) making a new money investment (2) with a 20% discount and (3) with a $3 million cap, assuming in each case a $7.5 million pre-money valuation, a $1.00 Series A price per share, a 1x liquidation preference, and $1 million worth of notes converting/dollars invested.

 

Type New Investors 20% Discount $3 Million Cap
Conversion/Purchase Price Per Share $1.00 $0.80 $0.40
Effective Conversion Discount 0% 20% 60%
Shares Received 1,000,000 1,250,000 2,500,000
Liquidation Preference $1,000,000 $1,250,000 $2,500,000
Effective Liquidation Preference Multiple 1.00x 1.25x 2.50x

Options for Founders

If you are a founder and believe that the above results are unfair, what can you do?  Obviously, you can first try to negotiate away the cap. However, if your investors insist on a cap, you have options, including those listed below. Your counsel and other advisors can help guide you regarding which is most appropriate, given your circumstances.

  1. Ensuring the cap is set at an appropriate level.

Assuming the cap is effectively serving as insurance against a skyrocketing valuation, the cap should reflect a reasonable expectation of the anticipated pre-money valuation for the next round. Founders can consult a trusted advisor to get a sense of median pre-money valuations for that round, taking into account factors such as industry, stage, and amount raised. If instead the cap is serving as a proxy for the company’s current valuation, the cap is likely to be much lower. This approach is much less common as it effectively turns the note round into an equity round—typically based on the justification that a note round saves costs/time versus an equity round.

  1. Changing the type of shares issued.

You can reduce the negative effects of the cap by either:

  • Issuing shares in excess of the debt amount in common stock rather than Series A.
  • Issuing a shadow series of preferred stock (e.g., Series A-1) that has an issue price and liquidation preference per share equal to the conversion price, but is otherwise identical to the Series A.

While each of these alternatives still results in the investor receiving the same number of shares (i.e., $2.5 million in our example), they reduce the investor’s liquidation preference to equal the amount of the debt converting (i.e., $1 million in our example rather than $2.5 million).

 Flipping to an equity round.

If an investor is insisting on a cap that approximates current valuation, consider simply doing a Series Seed equity round. While there still typically is a cost/time savings in a note round versus a Seed round, that gap has narrowed. Further, Seed investors typically receive fairly limited control/economic rights. However, one disadvantage of an equity round is that the issued shares will always be counted in the pre-money valuation for the next round, increasing dilution. In contrast, the company may be successful in having all or a portion of the note shares excluded from the pre-money capitalization.

Bottom Line

Founders need to be familiar with caps in light of their increased use and the material consequences they can have on post-financing ownership. Before agreeing to a cap, founders should model out and understand the cap’s effects on various scenarios, and discuss potential strategies and alternatives with counsel to prevent an unexpected result.

Startup Diligence is more than ‘Basic IP Diligence’

This article explains that intellectual property is an important indicator of a company’s enterprise value for potential investors. When considering a technology-based startup, it is particularly important to perform a robust assessment to ascertain the possible hidden risks that could emerge as the company matures. The piece outlines how to identify issues around prior employment, contractors and consultants, and existing market participants, in addition to basic IP diligence factors.

Read the full article.

10 Steps to Increase the Odds of a Successful Angel or Seed Fundraising Round

Starting a business is incredibly hard. You need a great idea—ideally one that is disruptive and will scale and that you care about passionately. You need to recruit an amazing team, and ideally, have co-founders you trust and respect. And for those not blessed with inherited wealth, you need money.

Many entrepreneurs confide that raising capital is their hardest task. They delay and delay any approach to the capital markets for as long as possible. We understand. Most investors reject the opportunity to invest and being told “no” hurts.

However, if you want to increase the chance that you will successfully close a round in late 2017, try the following 10 step approach.

What Does a “Down Round” Mean?

When a startup raises a new round of capital at a lower price per share as a prior round, it is referred to as a “down round.” In this video, MoFo partner Tim Harris details why this might occur and explains the antidilution adjustments needed for previous investors.