InContext Solutions - Structuring Friends and Family Investments

An Approach to Structuring Family and Friends Investments

July 16, 2012

Presented by:

Bob Gillespie

Co-Founder of InContext Solutions

Bob@TheG.ws

773.844.2329

Bob Gillespie

Education

BA from Knox College in Computer Science and English

MBA University of Chicago Booth School of Business in Entrepreneurship and Finance

Work Experience

Software and Consulting – CNA, Navigant, Fair Isaac, Keane

Startup – VP, Director of Operations at Credit Interlink

Took from $1.7M to $10M in Revenue in 3 years

Loss of $750K to Profit of $2M

Co-Founder of InContext Solutions in January 2009

Awards and Recognition

• Lead411 Recognized as the 9th fastest growing technology company in America.

• 2012 Moulder Student Entrepreneur Award Presented by Polsky Center for Entrepreneurship at the University of Chicago Booth School of Business

• 2011 Cool Vendor “InContext Solutions provides innovative cost-saving research capabilities for the CG industry.”

• 2010 Up-and-Comer Award “InContext Solutions’ unique, online 3-D virtual store experience is eerily close to reality.”

• 2009 America’s Most Promising Companies “In Context Solutions wants to revolutionize how …companies test their marketing strategies.”

Let’s Start a Company

Seed Funding Needs

• Assumption: we have our Articles of Incorporation, Operating Agreement, NDA’s, FEIN number, Chicago Business License, Employee Agreements, etc already taken care of.*

• We have decided that we need $250,000 in seed funding to get started and meet some milestones.*

• We believe that we can raise this through our Friends and Family network and do not anticipate seriously pursuing professional investors (Angel, Venture, Private Equity, Debt/Equity).

• Our friends and family are looking for us to create a fair and professional structure for their investment.

*This would be an entire presentation on it’s own

Some Quick Assumptions

• Minimum individual investment of $5,000

• Investments in increments of $5,000

• Our total raise will be the $250,000 we need

• We have looked into Accredited/Non-Accredited investor rules, Blue Sky laws, SEC stuff*

• We are structured as an LLC, so we’ll issue Units instead of Shares. For our purposes they are the same*

*This would be an entire presentation on it’s own

OK….So. Uh. Yeah. What?

• What does an investor “get” for putting in their money?

• What is the company “worth”?

• Is this a loan? If so, what is the interest rate?

• What kind of protections or guarantees do they get?

• When can get their money out?

• How much money will they make?

• What happens if the company fails?

SOME DEFINITIONS

Valuation Types

• Pre-Money: What the company is worth BEFORE any additional capital is invested. “We had a pre-money valuation of $3M”.

• Post-Money: What the company is worth AFTER additional capital is invested. “We had a pre-money of $3M, raised a $1M, our post-money valuation is $4M”.

Options and Dilution

• Option Pool: A pool of Units/Shares in the company to be used to attract and incentivize employees. If they are never issued, they just disappear.

• Fully Diluted Ownership Share: Percentage of Ownership if ALL options were issued.

• Undiluted Ownership Share: Percentage of Ownership not counting unissued shares. If the company sold today, this is the current ownership amount.

• Example Units Fully Diluted Undiluted

– Investor A 50,000 5% 5.6% – All Other Units 800,000 80% 88.9% – Issued Options 50,000 5% 5.6% – Unissued Options 100,000 10% -- Total 1,000,000

Important Takeaway – Create an Option Pool

• It’s a cheap way to conserve cash

• You can use it to attract talent and incentivize employees (annual option grants)

• If you don’t grant them, they go away and it’s like they never existed (well, kinda….we’ll get to the painful part later)

• Any institutional investor is going to make you issue an option pool pre-money anyway, so you should just get over that emotional hurdle now

• Try to create a big enough pool to get you to the next round

• 20% of the total amount of units/shares is a decent number and should last for 2-3 years

More Definitions – Equity Types

• Convertible Preferred – Ownership in company in Preferred Units. On a liquidity event, they have a “liquidation preference” and can either take their initial money back plus their dividend, or they can CONVERT into common units and take their pro-rata share of proceeds. Provides Investor with downside protection.

• Participating Preferred – Ownership in company in Preferred Units. On a liquidity event, they have a “liquidation preference” and take their initial money back plus their dividend, then they ALSO convert into common units and PARTICIPATE in their pro-rata share of proceeds. (This is also referred to as “double dipping” and I would probably never agree to this, or at minimum, cap it at 3-5X).

• Remember - Convertible Preferred equity works out better for the Entrepreneur.

One Option – Put a Value on the Company

Valuation Approach

• Issue $250,000 worth of Convertible Preferred units with a post-money valuation of $2.5M with 2.5M total units ($1 per unit).

• Your F&F investors would own 10% of the company post-money (undiluted) and have an annual 8% cumulative non-compounding dividend for the Convertible Preferred Units.

• Post-close, create an option pool of 20% of the total units.

• Our Capitalization Table: Units Fully Diluted Undiluted

– Preferred Units 250,000 8% 10% – Common Units 2,250,000 72% 90% – Unissued Options 625,000 20% -- Total 3,125,000

Valuation Approach – Pluses and Minuses

• Pluses

– Pretty easy to understand

– Quick and clean

– Provides reasonable downside protection (Preferred Units, Dividend)

• Minuses

– More expensive legal costs

– Valuation is very, very arbitrary

• Why not $1M? $250K would be 25% undiluted

• Why not $3M? $250K would be 8.3% undiluted

– Dilution in a possible future down round could be brutal

• A future investor wants to put $250,000 in with a pre-money valuation of $1M. New Investor would have 20% of the company and your Original Investors would only own 6.67% fully diluted and they put in the same amount of money and took a bigger risk

Another Option – Convertible Debt

Defining Convertible Debt

• Convertible Debt – Essentially, it is a unsecured bond that the company will covert into equity at some future date. It has an interest rate that will accrue and can either be paid at a future date or be converted along with the principal. For our purposes, we will convert the interest as well.

• It will be carried as a liability on the balance sheet, along with the accruing interest, until it converts.

Convertible Debt

• Raise $250,000 in Convertible Debt and defer the valuation until the market can provide better information about the companies value.

• Provide annual 8% non-compounding interest that will converted with the principal.

• Let the future valuation -- either by a professional investor or professional valuation firm -- be set by the market.

• Provides very good downside protection for our initial investors if our future valuation is low.

• We can build in terms that will protect them if our future valuation is huge.

Example Using Convertible Debt

• As founders, we create a company with 2M Units and an additional 20% in unallocated options.

• We then take the $250,000 in Convertible Debt from our Friends and Family

• Our Capitalization Table and Balance Sheet Liability would look like this:

Units Fully Diluted Undiluted

– Common Units 2,000,000 80% 100% – Unissued Options 500,000 20% --- Total 2,500,000

Convertible Debt $250,000

Convertible Debt – Typical Questions

• Our initial investors will convert at a later time when we take a round of funding from a professional investor. But they took the risk NOW. Shouldn’t they get a premium over and above the 8% interest?

– Yes. When we convert them, we will give them a 15-25% discount on the future valuation and convert them at that discounted value.

• Our investors have some downside protection, but can’t they end up with a miniscule ownership stake if we are wildly successful and the future valuation is huge?

– Yes. So when we convert them, we will put a cap on the valuation that they would be converted at, say a maximum of $5M. (Do NOT make this too low as to interfere with the free market setting the valuation of the next round).

Great Article on this: http://martin.kleppmann.com/2010/05/05/valuation-caps-on-convertible-notes-explained-with-graphs.html

Convertible Debt – Additional Questions

• What if we don’t take a future round of funding, how does this convert?

– A few possibilities:

• It could stay as debt and just pay it back with the interest

• After a set period of time (say 2-3 years), get a third party to value the company and then convert at that valuation

• The decision could be the companies, the investor or mutual, but spell all the above our as part of the convertible debt agreement

• Is the Conversion Mandatory?

– Yes, that is what I recommend. Protects both Investor and Company (IMPORTANT

TAKEAWAY)

• Investor doesn’t risk simply having the loan repaid to them if company is wildly successful. They get to participate in the upside

• Company doesn’t have exposure to the loan being “called” by the investor when cash flow is very important

Providing Downside Protection

IMPORTANT TAKEAWAY

• In my opinion, you owe your investors as much downside protection that you can reasonably provide. Your investors will appreciate it and you can drive a harder bargain on the upside

• How does Convertible Debt provide downside protection?

– Senior to any common ownership

– Generating reasonable interest rate

– When it converts, it converts into a Preferred security senior to common

– Discount of the conversion price provides risk premium for being earlier than the new money

• It also provides upside protection by putting a maximum amount on conversion valuation

Let’s Look at Some Examples

Additional Points

• The Convertible Debt is already included in the Pre-Money Valuation (we already have that money). Therefore, the Post-Money Valuation only includes the New Money from the Angel.

• In our example, I didn’t allocate additional options. A new investor will want some pool of unissued options available. Remember: any options that you allocate will be Pre-Money, lower your price per unit (therefore selling more shares) and any unissued options at a liquidation event will go away, essentially giving your new investors an additional pro-rated share of ownership.

• On Conversion, the initial investors would normally have the same equity type as the New Money (including Preferred Dividend, Anti-dilution protection and a bunch of other stuff)*

*This would be an entire presentation on it’s own

Summary

• Create an Option Pool now. It will be easier emotionally later on when you already have that dilution “built in”

• Mandatory Conversion provides protection to both the investor and the company

• You can avoid a lot of problems (and ask for better upside terms) by providing good downside protection for your investors

• A Convertible Debt structure creates greater alignment between founder and debt holder interests

• Point of Caution: Convertible Debt provides for very nice structure, but be careful not to take on so much debt that a low valuation in the future would provide massive “overhang” (If you have $750K in convertible debt and later have a pre-money valuation of $1M, it doesn’t leave much equity for founders)

Questions/Discussion

Bob Gillespie Co-Founder of InContext Solutions Bob@TheG.ws 773.844.2329