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 Americas Most Promising Companies

In Context Solutions wants to revolutionize how companies test their marketing strategies.

Lets Start a Company

Seed Funding Needs

Assumption: we have our Articles of Incorporation, Operating Agreement, NDAs, 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 its 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 well issue Units instead of Shares. For our purposes they are the same*

*This would be an entire presentation on its 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 All Other Units 800,000 Issued Options 50,000 Unissued Options 100,000 Total 1,000,000

5% 80% 5% 10%

5.6% 88.9% 5.6% --

Important Takeaway Create an Option Pool

Its a cheap way to conserve cash You can use it to attract talent and incentivize employees (annual option grants) If you dont grant them, they go away and its like they never existed (well, kinda.well 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 prorata 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 postmoney 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 Common Units 2,250,000 Unissued Options 625,000 Total 3,125,000

8% 72% 20%

10% 90% --

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 Unissued Options 500,000 Total 2,500,000 $250,000

80% 20%

100% ---

Convertible Debt

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. Shouldnt 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 cant 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 dont 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 doesnt risk simply having the loan repaid to them if company is wildly successful. They get to participate in the upside Company doesnt 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

Lets Look at Some Examples

Additional Points

The Convertible Debt is already included in the Pre-Money Valuation (we already have that money). Therefore, the PostMoney Valuation only includes the New Money from the Angel. In our example, I didnt 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 its 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 doesnt leave much equity for founders)

Questions/Discussion

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