Edward Lopez and John Stevens - Universal Mobileapps

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Universal MobileApps

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Edward Lopez and John Stevens are two brilliant entrepreneurs with expertise in both the technical and the investment-banking field and are looking to secure their first round of funding with one of the two elite venture capital firms. The two entrepreneurs estimated that they would need $3 million in this round of funding to support the company and for further product development. Top Gun Venture is a premier venture capital firm that is known for its successful investments in the past and that have recently raised a large new fund. Red Baron is a smaller, more recently established venture capital firm with less of a track record. In receiving the VC funds, they should consider to work with venture capitalists who can offer financial support and valuable resources such as professional advices and business connections in the field. They should also ensure that their interests are maximized through examining and focusing the terms in details specifically listed below.

Valuation: Valuation of the company or the price per share is an important issue that entrepreneurs need to carefully focus on. It is commonly known that a high company valuation (pre-money and post-money) is always substantially better than a lower valuation as it grants higher assets for the founders. However, there are some cases where the entrepreneurs should accept a lower price in exchange for more flexible terms. They also need to consider whether the option pool for future employees is included in the pre-money valuation or the post-money valuation of the firm. If the pre-money valuation includes an option pool, it will be more dilutive to the founders as they will bear 100% of the dilutive cost of the option pool. On the other hand, both entrepreneurs and new investors will share the dilutive cost if the option pool is established “post-money.” Moreover, entrepreneurs need to consider how the pricing of this round will affect their next capital raise. If a valuation is very high in the current round, it might be problematic when they rise funding for the next round since their valuation is ahead of their business fundamentals. Thus, they might have to re-set the company valuation. In this case, the entrepreneurs might bear the cost since they are not being protected, whereas, earlier investors are protected by the anti-dilution provisions.

Liquidation Preference: Liquidation preference is one of the terms that could have the greatest impact on an entrepreneur. It defines how the money is shared once the firm is liquidated. Liquidation preference helps to protect venture capitalists from losing money by making sure that they receive back their initial investments back in full value prior to any common shareholders in any events of a sale of the company or bankruptcy. In such cases, the entrepreneurs get nothing before the liquidation preferences are met and the preferred stockholders are paid fully.  The lower the liquidation preference or even no liquidation preference, the better it is for the entrepreneurs. In cases where the entrepreneurs feel confident and have a strong belief that the company will perform better in the future, they might offer higher liquidation preference to their investors as an attractive clause in the negotiation. By giving a high liquidation preference, the investors are more willing to accept a higher valuation of the firm, benefiting the initial founders. Generally, when the company is in good state, valuation of the company increases and investment will also increase; thus, the liquidation preferences fall, and vice versa.

Employee Stock Pools: These are shares set aside as incentive compensations for employees. The most common type of stock pool is call options on common stocks. Having available stock for this purpose is invaluable as it plays a key in attractive new and innovative employees to the company. As mentioned before, entrepreneurs need to understand the concept of an option pool as the creation of it can dilute pre-money shares in the company because investors often insist on it. Many factors affect option allocations such as the quality of the existing team, the size of the opportunity, and the experience of the new talented employees. A reasonable range of a start-up company would be 5% to 10%.

Types of Shares Offered: Entrepreneurs need to understand the type of shares they are offering in order to know how to manage them in an appropriate manner. Common shares have voting rights while preferred shares, which usually have the option to be converted to common shares, usually do not have voting rights.

Vesting: Vesting ultimately gives the employees the rights to certain employer assets over time, with a specified vesting period where the employees partial stocks get forfeited if the employee decides to leave within the vesting period. Attention should be given on examining whether the shares are issued immediately and the length of the vesting period. The right vesting period would effectively accelerate the vesting section based on the change of control and give the employees and the founders the right incentive to work for the company and strive for high profile performance.

Anti-Dilution Protection: Anti-dilution provision protects Series A Preferred Stockholders in the down round when the current round of financing is at a lower price than the previous round’s post-money valuation. There are two common alternatives for anti-dilution provisions: Full-ratchet protection and weighted-average anti-dilution protection.

Corporate Governance and Ownership: The entrepreneurs should also pay reasonably attention on the ownership percentage, as it is an indication of control.  However, the management team and the board of directors actually take true control of the company. The members on the Board, the list of strict criteria for board approval with regards to financing and operating decisions, and the voting rights will all have a huge impact on control of the company. Notice that a small board is often better than a larger board as it gives more efficiency in the decision making process and overall management. Entrepreneurs need to consider whether multiple investors or directors would add balance or complexity to the company. They should also make sure that they would have at least certain power as representatives of the Board to develop and maintain the vision and goal that they are fond of.

Impact of the Terms if the Company Runs in Good State [Appendix A]:

Facing the upside scenario, the venture capitalist will choose to convert their participating preferred shares to common shares to fully explore the upside profits. If they do not convert, given their liquidation preference, the payoff for the venture capitalists from the redemption will only be 4M*2=8 million for Top Gun and 4M*2.5=10 million for red baron. If converted, given their ownership share exhibited in the cap table, Top gun will exploit 44.44% of the total exit payoff while Red Baron can gain 40% of the total exit payoff. Hence, the conversion point in terms of total exit payoff will be 18M for Top Gun and 25M for Red Baron.

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