1. © 2012 Foley Hoag LLP. All Rights Reserved. Legal Issues for Start-ups: Seed Financing Presentation to Boston ENET December 4, 2012 Matt Eckert 617-832-3057 meckert@foleyhoag.com www.emergingenterprisecenter.com

2. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 2 These materials have been prepared solely for educational purposes. The presentation of these materials does not establish any form of attorney-client relationship with the author or Foley Hoag LLP. Specific legal issues should be addressed through consultation with your own counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. © Foley Hoag LLP 2012.

3. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 3 Remember…  Investors are looking for teams, not terms  If you are having productive talks with potential investors, the terms can be worked out  The best way to get “market” terms is to have a market for your deal  Form of financing (debt-equity vs. equity) should take a back seat to substance: What do you need to raise; What will you do with it?  When you raise, you pay for it in dilution, regardless of form. What should it cost you?

4. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 4 Convertible Debt vs. Seed Equity

5. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 5 What is Convertible Debt?  It is debt, and as such is senior to equity  It carries an equity feature in that it converts into equity upon specified events into stock of the company  The most common conversion is upon a “qualified financing”

6. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 6 Key Features of Convertible Debt  Conversion rate: –Fixed discount or increasing discount over time –Can have caps and floors (maximum and/or minimum conversion price) (almost always caps, and almost always no floors…sorry  ) –Caps are a means by which seed investors can participate in the upside associated with equity (sort of like an option) –Caps are generally expressed as a fixed pre-money valuation in the next round. The devil is often in the details with this kind of cap  Automatic conversion on qualified financing; sometimes optional conversion  Interest –Converts with principal –Interest rate is generally modest. Sophisticated seed investors don’t care about interest per se, but when coupled with the conversion feature interest can be significant

7. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 7 Key Features of Convertible Debt (cont’d)  Payment on acquisition –Can be based on the discount, can convert at pre-determined price (e.g., cap) or can be a formula (e.g. 2x return) (or a combination of the two)  Maturity date –Does not usually come into play (there generally won’t be proceeds available for payment at maturity anyway), but –Better to have enough runway to get to the next milestone and a cushion beyond that  Amendment of notes –Use a single note purchase agreement that lets a majority of the principal amount of all notes amend the terms and demand payment upon maturity

8. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 8 What is Seed Equity?  Capital stock or other equity interest issued in exchange for seed capital  Can be common stock, although investors seldom invest in common stock  Usually a simplified variant of venture preferred (e.g., “Series Seed Preferred”)

9. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 9 Key Features of Seed Preferred  Liquidation Preference –If the company is sold, proceeds will go first to the seed preferred, then to the common –Generally seed preferred is non-participating; in the event of a sale of the company, holder of seed preferred gets the greater of liquidation preference or conversion value  Convertibility –Seed preferred is convertible into common stock, initially at a rate of 1:1 –Often, but not always, seed preferred has anti-dilution protection –Mandatory conversion under certain circumstances  Dividends –Generally only a common-equivalent dividend (not accruing), and therefore not relevant

10. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 10 Key Features of Seed Preferred (cont’d)  Protective provisions –Protective provisions are common, but generally narrower in scope than in a Series A  Other transaction documents: –Purchase Agreement Representations and warranties usually more limited than in a Series A, but still relatively comprehensive –Investors’ Rights Agreement Drag-along, right of first refusal (on founder transfers), participation rate (for company issuances), –Voting Agreement (sometimes – depends on whether investor is getting a board seat)

11. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 11 Convertible Notes vs. Seed Equity  In most cases, convertible notes will be simpler, faster and cheaper than seed preferred, but not always (but almost always)  You generally cede less control over your company with convertible debt  Convertible debt delays dilution until you can increase the valuation (although caps can be very dilutive)  Convertible debt carries risk of getting to maturity date without resources to repay or a “plan B”  With convertible debt, the company is quickly “insolvent” on paper as the money is spent

12. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 12 Convertible Notes vs. Seed Equity, cont’d  If you have a start-up with some maturity (customers, revenue) then it is easier to value and a priced deal (i.e., seed equity) will likely be less dilutive  Usually, the smaller the raise the more likely it will be in the form of convertible debt, but no fixed rule  Convertible debt is premised on the need to raise an equity round

13. © 2012 Foley Hoag LLP. All Rights Reserved.Legal Issues in Seed Financings 13 Key Takeaways  Substance over Form. You can give up a lot in either a convertible debt or equity structure. Understand the economics of your deal  In all cases, keep it simple. Documentation for both convertible notes and seed equity have become fairly standardized; try to keep it that way  Do not make decisions based on a slide show. Talk to your trusted advisors before you sign anything, including a term sheet (and get them involved early in the term sheet stage as well)