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Structuring the Deal: The Key Terms for Most Seed Investments

Adapted from "Seed Investing as a Team Sport", by National Association of Seed and Venture Funds (NASVF), 2001; "High Tech Start Up", by Nesheim, J.L., 2000, and "Angel Investing", by Osnabrugge, M.V. and Robinson, R.J., 2000

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"