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MassMEDIC

MassMEDIC. Creating Deal Velocity: Deal Terms that Really Matter John Hession, Partner McDermott Will & Emery LLP jhession@mwe.com. Building Successful MedTech Companies: Financing Strategies for Entrepreneurs. So . . who is McDermott?.

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MassMEDIC

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  1. MassMEDIC Creating Deal Velocity: Deal Terms that Really Matter John Hession, Partner McDermott Will & Emery LLP jhession@mwe.com Building Successful MedTech Companies: Financing Strategies for Entrepreneurs

  2. So . . who is McDermott? • International Law Firm: 10th in US, specializing in Corporate Transactions, Intellectual Property, Financings, Acquisitions, Health Care, Life Sciences, Government Affairs & Regulatory Matters, Labor, Litigation, Trusts & Estates • 14 Offices spanning the Globe: Boston, NYC, DC, Chicago, Miami, Los Angeles, Orange County, Palo Alto, San Diego, London, Munich, Düsseldorf, Rome, Brussels

  3. Yeah, so …who is Johnny Hession? • Former High School Teacher, Former Sales Rep for Burroughs, Office Products Division (Legion of Honor in Sales – top 10% in first two years) • Now: Advisor & Attorney for emerging-growth, technology companies from cradle, through financings, through strategic alliances, through culmination

  4. Representative Experiences • 125 Acquisitions: representing Buyers & Sellers: Silknet Software ($4.2B merger with Kana); Excel Switching ($1.2B sale to Lucent); i-Prospect.com ($50M, bought by Aegis plc); Eigner ($22M, bought by Agile); Netlink ($185M, by Cabletron); Mainspring (bought by IBM); Feanix ($50M earn out to Axon plc); Apama UK (bought by Progress) • 175 VC & Angel Financings: representing either companies or VC investors: Turbine ($15m, Highland & Polaris); Polaris ($16M investment in Meridio, Northern Ireland); TD Capital ($5m investment in Contour Semiconductor); Powerspan ($30m, Rockport, Beacon Energy, First Energy Corp.); Highland ($20M in AMP Resources) • 100+ Strategic Alliances: representing ALWAYS the small tech company against IBM, Microsoft, AOL, Tandem, Compaq, HP, Apple, Samsung, EMC, Allied Signal, Pratt & Whitney, GE, Lucent, Alcatel • 25+ Public Offerings: Silknet, Excel Switching, CVC Products, Mainspring, Integrated Genetics, Focus Enhancements, Netegrity, Tecogen, Astea International, Alloy Systems, DynaGen, Mortgage.com

  5. The Venture Industry, 2007 • More dollars raised in 2003-2005, despite economic downturn in technology • Fewer firms, but with more $$$ per firm • Larger deal sizes, and higher minimum investment per company • Liquidity Horizonback to 5-8 years • 5 years for IT 7/8 years for biotech • EXTREMELY tough market for start-ups

  6. The Venture Industry, 2007 • Return expectations are aggressive: 50+% IRR for early-stage, 35-45% IRR for first institutional round, 18-25% IRR for mezzanine round • The Market is crowded with early-stage companies seeking financing – but professional and institutional money has moved up market to later stage deals • Angels eclipse the Venture Capital investment in seed and early-stage sectors by 10x order of magnitude -- --

  7. The Future = The Past Venture Capital Median Amount Raised By Round Type Source: E&Y / VentureOne

  8. Current Market Conditions • Technology financing markets rebounded in last two years • Financings have heated up in last year • Competition for first institutional financing rounds becoming fevered • Anecdotal evidence that valuation & term skirmishes waged for perceived “good deals”: complete team & product with customers, early revenues

  9. Current Market Conditions • Improvement in underlying technology markets: IT spending is returning, projected to increase in 2007 • Pre-$$ Valuations back to 1997 Pre-Bubble levels – approximately: • $2.5-$3.0m Seed; $5.5m First; $13.0m Second Round • Deals are moving faster to completion • 2 to 4 months now typical, cycles compressing

  10. The Valuation Game • Deal Valuation is a function of: • Amount raising now and ultimate cost of capital, rounds of financing • Valuations on alternative deals, comparable investments (find it on Venture One) • Number of other interested VC funds calling – “The Lemming Phenomenon” and “Nothing Beats a Good Deal like Competition” • Transaction structure and deal terms improving valuation: participating preferred, Board composition, control mechanisms

  11. The Valuation Game • Deal Terms Can Improve Valuation: • Board Compositionand # of seats for VCs • Cumulative Dividends:compounding, accruing dividend • Liquidation Preference: 2x-3x return of capital, plus Participating Preferred • Anti-Dilution Adjustments: “ratchet” anti-dilution versus weighted-average • Option Poolfor future hires: maybe 15-18% of fully-diluted capitalization • Organic Change-Covenant Control: veto rights on sales or other acquisitions, new financings, incurrence of debt, stock or options above a permitted threshold

  12. Current Market Conditions • Median pre-money valuations improved over last few years • Bay Area median pre-money valuations slightly higher than East Coast • Note: Data corrupted by size & cost of capital required for each industry, average round size, number of rounds required

  13. Current Market Conditions • More recent anecdotal evidence indicates median valuations increasing as competition for “good deals” heating feverishly • Life science valuations may have stabilized, perhaps due to poor IPO after-market performance recently of some entrants • VC funds aggressively putting money to work($60 Billion overhang in VC capital!) • 2008 Forecast: more funds coming to market, more capital to invest, maybe more overhang? • Still Extremely Tough for early stage

  14. Current Market Conditions • Median % ownership by investors increased in 2006-07: received more company for less $$$ invested • Median Investor Equity Ownership %: • First Round = 50% • Second Round = 39% • Later Round = 28%

  15. Deal Terms & Structuring • Common Stock • Same Risk as Founders • Little Structural Flexibility • Preferred Stock • Structural Flexibility • Different Valuation for Management’s Shares • Manipulate IRR • Upside Guarantees, Downside Protection • Convertible Note & Warrants • Protection of Principal • Interest as Current Return, Deduction for Interest • Warrants as Sweetener

  16. Preferred Stock Deal Terms • Liquidation Preferences • Participating Preferred • Cumulative Dividends • Cash-Out Election on Sale • Anti-Dilution Protection • Class Voting/Veto Rights • Board Composition

  17. More Deal Terms • “Play or Pay” - “Play or Lose” Provisions • Mandatory Redemption • Registration Rights • Piggy-Back • Demand • Short-Form S-3 Rights • Preemptive Rights, Rights of First Offer, Rights of First Refusal

  18. Preferred Stock Deal Terms • Basket (the “Pool”) for Management Shares • Noncompetition, Nonsolicitation Agreements • Employment/Severance Agreements for Founders and Management • Vesting, Buy-Back of Founders’ Stock • Co-Sale & Rights of First Refusal on Management, Founders’ Shares

  19. Liquidation Preference • Recoup Principal • Investor Receives Priority over Management • Option to Recoup Principal Amount or Choose to Convert Preferred • Economic Effect in Event of Acquisition or Sale of Company • Issue: Do Founders Get Liquidation Preferences Too?

  20. Liquidation Preference • All later-stage rounds now have senior liquidation preferences • Multiple liquidation preferences are abating, except for recapitalizations, or perceived “high valuation” for early-stage financing • most = 2x preference; but some as high as 3x-5x! • argue for vanishing preference as a multiple of capital rather than IRR hurdle: multiple of capital is flat over time; IRR hurdle increases over time with compounding effect

  21. Cumulative Dividends • Built-In Return; Rates Vary from 8%--12% • Dividend Accumulates Until Paid on an Acquisition, Redemption, Liquidation or Cash-Out Election Event, Public Offering? • PIK Dividends: Payment-in-Kind, Tax Issues abound for Foreign LPs • Issue: Dividend Should be Forfeited on Voluntary Conversion or Public Offering Event - Investor Loses the Built-In Return if Company Achieves IRR Better Than the Dividend

  22. Participating Preferred • Investor Gets $$$ Back & Then Participates in All Residual Amounts on an “As-Converted” Basis!!! So-called “PIG Preferred”! THIS IS THE BIG KAHUNA! • Potentially Disastrous Impact on Founders’ equity if Sale or Acquisition Does Not Yield a Decent Return • Investor Recovers the Investment (including dividends) & Then Plays Again in Upside Gain • Issue: Resist It! Get an “IRR Hurdle”/ Multiple of Capital Threshold Such that Investor Forfeits This Right

  23. Participating Preference • Participating preferences are the “receding norm” • many are uncapped (always receive return of capital), some are capped at 2x-3x or receive as-converted participation • evidence of liquidation preference also paid on IPO • participation features among series can create conflicts and lead to anomalous results • Resetting or washing out old preferences is the biggest challenge • Participating Preferred is disappearing for “hot” deals

  24. Anti-Dilution Protection If Subsequent Rounds of Financing are Dilutive as to Price, Investor Gets to Reprice the Old Money at Today’s Dilutive Valuation • Ratchet Formula: If Company Issues 1 Share at Lower Price, Conversion Rate of Preferred is Reduced to Lower Price !!!! • Weighted-Average Formula: Factors in Overall Impact of Total Shares Issued in New Dilutive Round and Adjusts Old Conversion Rate Based on Impact on Total Capitalization

  25. Anti-Dilution Provisions • “Weighted-Average” is still market standard • Full Ratchets appear in later rounds, below minimal levels or within specified time frames • Full ratchet may appear in early rounds as quid pro quo for higher pre-money valuation • Full Ratchets in early rounds may haunt investors when later round investors demand the same deal terms • Cold Weather Syndrome: East Coast VCs used anti-dilution and ratchet more frequently than Bay Area VCs!

  26. “Play or Lose” Provisions • Investor Does NOT Receive Benefit of Price Anti-Dilution Protection if Investor Does Not Play for Full Pro-Rata Share in any New Dilutive Financing • Incentive for Investors to Play in Dilutive Financings and Support the Company • Ensures that Investment Syndicates will Remain United in Support

  27. Play-or-Lose Provisions • Most deals still do not have “Pay-to-Play” or “Play-or-Lose” provisions • doubled-edged sword nature is an issue • When used, typical provision calls for conversion to common, not just loss of anti-dilution protection • Trigger is no longer pro rata participation; now set at share of insider investor allocation to apply to inside rounds

  28. Class Voting Rights • Investor has Ability to Block\Veto Important Corporate Transactions • Mergers, Sales of Stock or Assets • Issuances of Additional Preferred • Grant of Excessive Options to Employees • Incurrence of Debt • Sales or Transfers of Technology • Issue: Separate Class Voting Rights Should Disappear if Preferred Holds Less than Certain % of Equity

  29. “Drag Along” Rights • “Merger Extortion Device”: Investor has Ability to compel a Liquidity event: i.e., sale or merger • Stated percentage of Investors (maybe 67% of a round or all preferred) determine that Company should be sold • Board determines that Company should be sold • Result: Minority stockholders are “dragged along” in the sale process, a “Forced March to the Merger Alter” -- with waiver of appraisal

  30. Mandatory Redemption • Investor Wants Money Back After Time (5-7 years) • Depends on Stage of Company and Venture Fund Investing, Business Plan and Profitability Model, Expectations of Liquidity Events • Redemption for Dollars Invested, Dollars Plus Cumulative Dividends, Stated Return, or Fair Market or Appraised Value • Delinquent Redemptions??? Increase in Conversion Rate for “Blown Redemption” – potentially ruinous to management

  31. Mandatory Redemption • Mandatory redemption seems to be an peculiar East Coast phenomenon • Begins in years 5-6, in annual install-ments (2-3 increments) • Redemption typically greater of liquidation preference plus dividends or Fair Market Value (without liquidity discount – i.e., deemed sale of company) • Redemption = Forced sale of company rather than payout of redemption price

  32. Failed Redemption • Penalties for failed redemption: • “Board Takeover” right • Conversion of unredeemed portion to promissory note • Increase in conversion rate on preferred • Complexity of timing of redemption with multiple series of preferred

  33. Basket For Management Pool • Get Agreement From Investors: Certain % of Capitalization Set Aside as Option Pool for Future Employees or to Reward Existing Talent • Share Equally Dilution Presented by “Basket” or Option Pool -- On Pro Rata Basis -- by Investors & Founders • Pool or Basket Typically Represents15%-18%-18%-20% of Total Fully-Diluted Capitalization, Post-Financing – but comes out of pre-money !

  34. Non-Competition Agreements • Investors are Backing People & Ideas -- Want Assurances Key Employees Will Not Leave to Form Competitive Venture • Time Periods for Post-Employment Non-Competition: 1 Year – 18 months (beyond that = unenforceability risk) • Consideration Needs to Support a Covenant Not To Compete • Issues: Should NonCompete expire if Person is Terminated Without Cause, or Downsizing?

  35. Vesting & Buy-Out Of Founder • Investors Require Founders or Managers with Cheap Equity To Give Back Some Shares and Be On aVesting Schedule-- If Person Leaves Before Stock is Fully Vested, Portion of Equity Can be Repurchased at Original Cost • Issues: How Much Vested at Time of Investment? What Happens to Shares if Terminated w/o Cause or Voluntarily, Death/Disability? Vesting Period: Annual/Quarterly/Monthly? Buy-Out Price?

  36. Board Composition • Investor Representation Often Tracks $$ • Management Needs Representation too • Importance of Outside Directors critical • 5 Directors Is Often the Magic Number • Follow the “Martini Rule” for VCs on Board • Ask me about the “Martini Rule”

  37. Fourth Edition VentureOne: Deal Terms Survey

  38. Participating Preferred • Companies raising first institutional round of financing were more likely to experience participating preferred • Series A: 73%of survey had Participating Preferred in first round of financing • Second Round: 54.5%had Participating Preferred (last year Second Round = 79.3%) • Third Round: 65.4%= Participating Preferred

  39. Cap on Participating Preferred • 41%of Survey respondents had a cap on the multiple of investment return;59% did not • 47.4% reported a “participation cap” when the round was at an enhanced valuation • Caps of2xwere most common (55.9% = 2x Cap; 31% = 3x Cap; 13%>4x Cap))

  40. Cumulative Dividends • 48%of Survey respondents reported Cumulative Dividend structures • 8%was the median dividend rate • Companies closing second roundswereleast likelyto report a Cumulative Dividend structure • East Coast dealsreported higher percentage of Cumulative Dividend structures

  41. Cumulative Dividends • 49.5%of First Round respondents reported Cumulative Dividend • 42.2%of Second Round respondents reported Cumulative Dividend • 50.0%of Third/Later Round respondents reported Cumulative Dividend

  42. Staged Financings • 26%of First Round respondents reported Staged Financing fund raisings • Key Triggers: • Product Development:30.4% • Set Passage of Time:21.4% • Specific Customers Landed:12.5% • Key Managers Hired:12.5% • Revenue Targets Achieved:14.3%

  43. Company Control • Median Amount of Company Sold: • First Round: 40% (previously 50%), with median amount raised at $5M (from $5.3M) • Second Round: 33% • Third/Later Round: 26%

  44. Company Control: Founders • Median Founders Ownership After Round: • First Round: 31.5% • Second Round: 15% • Third/Later Round: 10%

  45. Anti-Dilution Protection • 64.3%ofFirst Roundrespondents reported Weighted-Average Anti-Dilution (vs 13.3% = Full Ratchet) • 64.6%of Second Round respondents reported Weighted-Average Anti-Dilution (vs 15.4% = Full Ratchet) • 66.7%ofThird/Later Roundrespondents reported Weighted-Average Anti-Dilution (vs 20.5% = Full Ratchet)

  46. Size of Option Pool • Median Ownership Percentage allocated to Option Pool = 15% • First Round =15% • Second Round =15% !!! • Third/Later Round =15% !!! • Mean = 14.6% -- Median = 15% • Ranges reported from 11% to 18.8%

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