STARTUP ESSENTIALS: Part 2 of 4 Financing Your Startup

1. STARTUPESSENTIALS: Part 2 of 4Financing Your Startup Adam Yormack | Partner Escalante Yormack Law, PLLC

2. Topics • Part 2: • Startup Financing • Overview • Typical characteristics • Types ofinvestors • Types ofinstruments • Seed financing mistakes • Part 3: • Advanced Level Financing • Beyond the Seed rounds • VC • Institutional Investors Part 1: Startup Formation • Choosing an entity • Founder issues • IPissues • Operating Agreement/Shareholder Agreement • Membership distribution • Partnership • Membership Incentive Agreements • Other formationissues • Formationmistakes

3. Seed Financing Overview • Seed Stage of Development • The first stage of venture capital financing. Seed Stage financings are often comparatively modest amounts of capital provided to inventors or entrepreneurs to finance the early development of a new product or service. • Development • Market Research • Building a management team • A genuine seed-stage company has usually not yet established commercial operations - a cash infusion is essential. • Seed-stage VC funds will typically participate in later investment rounds with other equity players to finance business expansion costs such as sales and distribution, parts and inventory, hiring, training and marketing. 

4. Seed Financing Overview • Typical Amounts Raised • An initial seed investment round made by a professional VC firm typically ranges from $250,000 to $1 million.  • Angels are anywhere from a few thousand to $250,000. • Types of Investors • Friends, Family and Fools • Angels, Super-angels • Seed-stage VC funds

5. Seed Financing: Following the Rules Reg 506(b) • Number of Investors Restriction • 506 (b) Rules • Unlimited Accredited Investors and Unlimited Amount • 35 other purchases. All non-accredited investors, must be “sophisticated” – they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluation the merits and risks. • Companies have to make the determination, what needs to be provided to the investors, “do no harm”, no false or misleading statements. • Companies must give non-accredited investors disclosure documents, similar to Reg A – financial statements, potentially audited.

6. Seed Financing: Following the Rules Reg 506(c) • 506 (c) Rules • Broad solicitation and generally advertise. • Investors all have to be accredited investors. • The company takes reasonable steps (questionnaire) to verify that the investors are accredited investors, which include reviewing documentation, such as W-2’s, tax returns, bank and brokerage statements, credit reports and the like. • PPM (Business Plan), Subscription Agreement, Operating Agreement, Investor Questionnaire,

7. Other Great Funding Tools, Convertible Note • Convertible Notes • The convertible note is a form of short-term debt that converts to equity, typically in conjunction with a financing round. • The investor is loaning money to the startup and instead of a return in the form of principle plus interest, the investor would receive equity in the company • Debt that converts to equity, at a discount, but still gets the investor “in the deal”. • Stock provided at a discount, less per share. Yeah! • Pros – Allows for a round of capital w/o giving away a % of the company. • Con – Convertible notes can effect the decision making of the next round of capital. New investors may not like the terms, ect. • Angels are actually preferring to invest more simply.

8. Other Great Funding Tools, SAFE • A SAFE is a (simple agreement for future equity). • Simpler alternatives to convertible notes, created in 2013 by Y combinator. • Allows startups to structure seed investments without interest rates or maturity dates. • Not debt and do not accrue interest.

9. Biggest Financing Mistakes • Excessively low valuation cap in notes or SAFEs • Excessively high pre-money valuation in Series Seed preferred stock financing • Overly aggressive preferred stock terms • Participating preferred • Multiple liquidation preference • Cumulative dividends Giving seed investors too much control over the company’s operations or future financings/exits

10. Types of Financing

11. Crowdfunding? What’s that? • Involves the use of the internet and social media to raise capital, typically from a large number of individuals, in relatively small amounts. • By using the internet and social media with limitless reach, crowdfunding also raises complex federal, state and even non-US securities liability questions. • Enables small and early staged businesses that may not have easy access to traditional methods of capital formation and fundraising. • Raising capital for a business from investors with a financial interest in business' success brings crowdfunding under the jurisdiction of federal and state securities laws. • Such a type of crowdfunding is illegal without registering the offering with the SEC or fitting within an exemption from registration. • Traditional registration exemptions are often unavailable or difficult to take advantage of in the crowdfunding context.

12. Rewards Funding Simplified • Examples: Kickstarter &Indiegogo • Inventors, artists and entrepreneurs seek funds to finance their projects, products orbusinesses • Typically used to finance consumer products andartistic projects • Generally no restrictions on who canparticipate • Contributors DO NOT get equity interests, but mayreceive • Small gifts or rewards (such as branded T-shirts, tickets,etc.) • Initial products (pre-paymentmodel)

13. Accredited Investor Simplified • Examples: AngelList, CircleUp, & SeedInvest • Startups raise seed capital from large groups of angels Outgrowth of formal angel investing networks • Only open to “accredited investors” (AIs) Net worth > $1MM (excluding value of primary residence) OR • Annual income > $200K for last 2 years + reasonable expectation of earning at least that much this year • Investors receive equity in the companies

14. Federal Funding Simplified • Federal equity crowdfunding for non-accredited investors • Congress created framework in Title III of the Jumpstart Our Business Startups (JOBS) Act enacted in 2012 • SEC proposed rules to implement Title III in Oct. 2013 • Final SEC rules (called Regulation Crowdfunding) adopted in Oct. 2015 became effective on May 16, 2016 • SEC has approved 9 “funding portals” so far

15. “Blue Sky” Crowdfunding • After Congress passed the JOBS Act, many states did not wait for SEC rulemaking process • States created their own crowdfunding regulatory regimes for intrastate offerings exempt from federal registration • Over half the U.S. states have adopted some form of “blue sky” crowdfunding regulation • The JOBS Act also provides that a state may only enforce state laws, rules or regulations against a registered funding portal with respect to its business as a funding portal if: • The portal's principal place of business is in that state. • The state's laws, rules and regulations are not in addition to or different from the requirements for registered funding portals established by the SEC.

16. Public Offering (Starting Small) • Examples: StartEngine & SeedInvest • Early Stage/Startup companies use a “mini” public offering framework under amended Regulation A (or Reg. “A+”) to sell equity to the general public • Old Regulation A was seldomly used because of $5 million limit and lack of “blue sky” preemption • Congress ordered SEC to overhaul old Regulation A in Title IV of the JOBS Act

17. Peer to Peer Lending (“P2P”) • Examples: Lending Club & Prosper Marketplace • Not advertised as “crowdfunding” but very similar: • Online borrowing platforms • Large number of lenders • Each lender individually commits relatively small amounts to the principal of each borrower’s loan • Not limited to accredited investors • Investors receive debt, not equity

18. Adam YormackPartner Escalante Yormack Law, PLLC5201 Blue Lagoon Dr., 200 | Miami, FL 33126305.514.0046 | adam@eylawyers.com | eylawyers.com