Let's talk about investments securities since that's a big topic that comes up with startups. Investment securities are used to attract talent, it's used to attract investors and it becomes a big part of the equation when you think about how you're going to fund your startup. In this lesson, we'll talk about various ways of raising capital and then the types of securities that may be available to you in terms of investment securities. We'll spend a few minutes talking about the term sheet and then give you some things to keep in mind when you're dealing with transactions involving investment securities. There are multiple ways for you to raise capital for your business. You can seek venture capital funding, you can partner with other businesses through joint ventures or strategic alliances, you can engage in seed money from angel investors or family and friends, you can sell finance the business, or you can look at federal grants or federal loans as a means for obtaining capital for your business. Now if you're engaging in venture capital funding or angel investing or even with family and friends, you're likely to have some type of security involved in that transaction. That's what we're going to try to delve into here today, the different types of securities. Primarily, the individual investor will dictate the type of security that you end up issuing as part of the transaction. Some investors may want white stock, others may want other convertible debt. Some investors want warrants. Your employees for example may want stock options. Then what's the difference between warrants and stock options? They're very similar. Warrants and stock options both allows the holder of the option or the holder of the warrant to purchase, gives them the right to purchase stock at a given price. We call that the strike price and that strike price is usually set at a fair market value of the stock at the time the warrant or the stock option was granted. Then the holder of that option or the holder of the warrant benefits from any increase in value from the time the warrant or stock option was granted, and the time the option is exercised. Warrants though are used for outside investors. Stock options are used for company insiders in exchange for their service to the company. This would be your employees, your officers, your directors, any consultants that are providing service to your company, you provide them with stock options whereas completely disinterested outside investors would be afforded warrants. There are multiple different types of stock. If your company has just one class of stock, everyone has the same rights under that stock, it's called common stock. Oftentimes, investors like angel investors or venture capitalists, they will require preferred stock because they want additional rights. They want to have the right to appoint directors to the board, they want to have the right to make major decisions for the company or to have the right to convert their stock to common stock at a later time. This is a different class of stock typically call it preferred stock, and it includes the right to convert the preferred stock to common stock at a later time. It's convertible preferred stock. Now in your incorporation papers, so when you create your cooperation, as part of your articles of incorporation, you must include the type of stock that's issued and the number of shares in each class of stock. To the extent you started off with just common stock, everyone had the same rights, and you later need to issue preferred stock or convertible preferred stock for investors and later funding grounds that will require a change in your charter documents. You have to go back to that article of incorporation and clarify that you now have more than one class of stock. Let's talk about some of the rights that preferred stockholders have and I have loaded to a few of them. Both holders of preferred stock want to be able to appoint members to the board. They want to have an active role in the control and management of the corporation. In addition to these, there are few other rights that preferred stockholders also insist upon. The first is a liquidation preference. What this does is allow the owner of preferred stock the ability to liquidate their interests. Usually this preference allows them to liquidate their interests at or above their original investment. Also, the dividend preference. Dividend preference essentially says that the holder of the preferred stock will have preference on dividends that the company decides to pay up meaning if a company decides to pay out dividends, they would pay dividends to the preferred stockholders first before paying dividends to the holders of common stock. Now, a company is not required to pay dividends, so what this dividend preference essentially says is if the company decides to pay dividends, preferred stockholders get preference. The other is a conversion right. We talked about convertible preferred stock and that's essentially what this conversion right is. It's the right of a preferred stockholder to at some point convert their preferred stock into common stock. Now before we move from this point, let's talk about put and call rights. These are essentially the same time thing, one coming from the investor perspective and one coming from the company perspective. But the idea here is if a company decides to buy back it's own shares, that either the company can demand that an investor sell at a certain price, or an investor can demand that a company that's engaging in repurchasing it's shares, the investor can demand that the company purchase the shares at a certain price. These put and call rights can be spelled out as part of the rights for preferred stockholders. Other issues that typically come up with the transfer of securities or anti-dilution. Investors whenever they make a commitment to equity ownership in your company Oftentimes they want to ensure that, that equity interest is not diluted when other investors buy into the pool. There are measures that you can put in place to ensure that if there's a stock split, that the investor's interest changes to match the new number of shares that exist. Voting rights. Investors what to ensure that depending on the number of shares that they own, they get a requisite number of votes in the decisions that are happening with your business. They finally charter amendment. We alluded to this issue earlier, but securities are major part of your cooperation. In fact, even in the initial documents that you file to create your corporation, it's acquired that you list both the classes of shares that you have, common stock, preferred stock, and the number of shares for each class. To the extent that you're business is developing and you're deciding, hey you want to issue more preferred stock and you want to issue more common stock, all of these require a change in those incorporating documents. If you're engaging in the transfer of securities whether it's what a family and friend, investor or [inaudible] investor or you're talking to a VC fund about raising capital, once you have a general agreement on the terms of that transfer, that agreement is reduced to what we call a term sheet. A term sheet essentially outlines the principal terms of the agreement for the transfer of securities. This term sheet is then used by attorneys to draft what we call a stock purchase agreement. That's the formal agreement for the sale or transfer of stock or the securities. You will have the term sheet in place before you go when a man, your charter, to talk about the changes and the number of shares or that the changes in the classes of shares. I often get this question, what's the legal effect of a term sheet? Because it's only being used to then go draft a real agreement. The term sheet typically and I say typically because the law on this is still evolving and it's an area that can go different ways depending on the specific facts of the case. But typically, a term sheet is undermining. Is essentially is a guide, that the parties are using to flesh out the full agreement, which would be binding one sign and executed by both parties. However, there is a requirement in the law that once you have a term sheet and you're in the process of drafting up the formal agreement, that you must act in good faith. You must negotiate with the other side in good faith. There's case law that suggests that if you don't act in good faith or if you don't negotiate in good faith, that the court could actually hold the term sheet and the terms in the term sheet binding upon the parties. Things may change when you're negotiating after the term sheet and before you settle on a stock purchase agreement. But your obligation is to ensure that you are engaging in those negotiations in good faith. You can't walk away from the table in bad faith. You must negotiate in good faith. Otherwise, you may be held accountable for the terms of the agreement that have been outlined in the term sheet. Keep in mind, as you're thinking about negotiating the terms for a term sheet with the other side, think about what it means for your control in the company because you're giving up equity ownership. Often times investors also what that to accompany some level of control of the company. Think about control. Think about equity dilution. Your own equity interest in the company, will be diluted wherever new people come into the pool and gain equity ownership in the company. Then also think about your relative bargaining power. You are the founder of the company, oftentimes you're starting with little to no money and you're seeking funding from a third party in exchange for giving them equity ownership or giving them stock or giving them other securities related to the company. There may be some bargaining power issues there that will impact your ability to negotiate, keep that in mind. Just to wrap up, the different types of securities: there are stock options, there are warrants, there's other convertible debt. All of these are viable ways of using securities to help fund your business. Now, there are certain investors who will insist on a menu of rights alongside their security interests. The ability to appoint board members, the ability to have some control, a liquidation preference, a dividend preference. These are putting a knowable and so don't be alarmed if you're getting asked for these types of preferences when negotiating a stock purchase agreement. You want to negotiate the key terms, keep in mind that there are relative bargaining power, but negotiate and negotiate in good faith. Because once you've reduced your general agreement down to a term sheet, that term sheet could be binding if you fail to continue negotiating in good faith towards a stock purchase agreement. Whenever you get into the space where you're thinking about the transfer of securities, you're thinking about issuing equity ownership in your company, use a very complicated issues that are governed by very highly technical securities laws and securities regulations. If you add that point in your business where securities equity transfers or what you need to move your business to the next level, it is highly recommended that you seek advice from an experienced securities counsel to help you navigate these issues.
