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1.    CHOICE OF SECURITY

• Common Stock

• Convertible Preferred Stock

• Convertible Notes and Warrants - Debt Security

Investor's money goes in as preferred stock and comes out as a common stock at the time of the initial public offering (IPO) or sale of the company to a larger corporation. If the company is unsuccessful, its assets go on the auction block, including the technology; the preferred shareholders would have then certain rights in priority to the ordinary shareholders, especially as regards entitlement to dividends and entitlement to repayment of capital.

Pros and Cons

Common Stock

Convertible Preferred Stock

Convertible Notes and Warrants

• Easiest and simplest

• Same risk as founders
• Little structural flexibility

• Valuation set for future

• Structural flexibility
• Can manipulate internal rate of return
• Upside guarantees

• Downside protection

• Protection of principal
• Interest as current return
• Warrants as sweetener

• Limited upside

2.    PRINCIPAL OBJECTIVES OF THE INVESTMENT DOCUMENTS

3.    DUE DILIGENCE ITEMS

• Guidepost for behavior & expectations

• Fleshes out due diligence issues

• Identifies:

  • Downside protective strategies

  • Liquidity opportunities

  • Management issues

  • Investor/founder issues

  • "Early in" issues

Representations and warranties of the company:

• Use of proceeds

• Organization and authority

• Ownership of property and assets

• Ownership of intellectual property

• Employment of key personnel

• Government approvals

• Absence of litigation

• Compliance with other agreements

4.     DOWNSIDE PROTECTIVE STRATEGIES

5.     LIQUIDITY OPPORTUNITIES

• Liquidation preference

  • straight

  • participating - rare in seed context

• Antidilution protection (if later rounds dilutive as to price, re-price at the lower valuation)

  • weighted average

  • full ratchet - draconian

• Dividends

• Initial Public Offering (IPO)

  • registration rights

  • conversion

• Acquisition

  • liquidation preference

  • conversion

• Redemption

  • lackluster performers

6.     CLASS VOTING RIGHTS

7.     AFFIRMATIVE COVENANTS OF THE COMPANY

• Investor can block 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

• Should disappear if preferred holds less than certain equity percentage of company

• Accounts and reports

• Approvals of budgets

• Board of directors

• independent public accountants

• Financial statements

8.     INVESTOR / FOUNDER ISSUES

9.     "EARLY IN" ISSUES

• Sweat equity vs. financial investor

• Vesting / buy back at cost

• For cause vs. "No Fault Divorce"

• "Tag Along Rights"

• Rights of First Refusal / First Offer

• Baskets for management shares

• Non-competition / non-solicitation agreements

• Employment / severance agreements

• Preemptive rights

• All vs. Pro Rata

• "Pay to Play"