San Diego Angel Conference – Investor Education & Networking Series

Good evening everybody. I know most of you but not all of you. If I haven't met you, I'm Dan Moshavi, I'm the dean of the Balor College of Business and anyway delighted to see people coming back. That's always a good sign. And we have some new folks here as well. So we appreciate that this year Kathy and Jen have worked really hard to continue to product improve the experience. Last year we really as we were trying to have the knowledge download we basically did plug and play, largely not have to accelerator but we did our own version of just here's what's been done in the past, let's do that and then figure out what's going to work for us, what's going to work for you, more importantly in terms of the experience. So this whole notion of these monthly luncheon networking evening events are really designed to take this and make it more.

Of a year round programming.

A lot of you really appreciate the networking and the opportunities to learn from our speakers tonight and all nights. So thanks for being here and like you I'm excited to hear what's next.

All right, thanks Dan. All right, so like Dan said, these are investor knowledge and network events. We're gonna keep doing these monthly and we're really excited to be at Pillsbury tonight. Thank you so much for being our event host and a 25 and 26 sponsor for us. I also wanna thank all of these are all our committed sponsors already for 2026. So. So Sebastian from Mint, sorry, we've got C3 Bank, Pillsbury, ATS Ramon and Ross consulting on the on deck for this year so far. So if anybody else is interested in sponsorship you can talk to Kathy or I. So really what these are all about is trying to train and activate accredited early stage investors. We want this to be a collaborative environment, hence the networking. The more you get to know each other, the more you can trust each other when you're in that room making decisions. Right. We want to build this community and then learn through the process. So these monthly ones are really meant to just like be giving you some overview from people who are experts in the area and then we'll do some other just in time learning through the process. So, so as you get started, when you start Fund 8, we'll continue doing things that will help to train you. They may not look like because you'll be meeting weekly, they may not look like they look right now, but we'll be doing zooms or whatever and recording all those so that we have a whole pile of Information stored for you to go back and review any of the videos. The timeline, what that looks like is that now through March 26th we will be hosting these. And then starting in March is when the fund will kick off Fund 8 and that's again a member managed fund for accredited investors and that runs independent of sdsu. And you'll be having those weekly meetings and then the finale will happen at the end of May. And for information for the student startups, they will be. The application will open in February, so if you know startups that are looking to apply, the application will be open February through March 5th and then March 6th will be our Angel Academy and then we'll have a reception after. Again, it'll just be one day this year because we're doing a lot of the programming throughout the year instead of a two day boot camp. So October 28th we will be at Minsk and again November 20th we'll be at Mins. December 8th we're going to be at SDSU and change it up a little bit and do a luncheon. And then January and February are still tbd, but I'll keep you posted and we'll keep the website updated. It's going through some changes right now. I will send that out once it's kind of solidified and you can check back there for any updates. And and then March 6, like we mentioned will be that Angel Academy. Here is the information request form for investors. You fill these out every single year. If you haven't done it this year, please do one. It just keeps you on our list. It doesn't commit you to anything, but it'll keep you on our list. So you know when things are coming up and just lets us know that you are an accredited investor. And then if you have any questions, you can just reach out to me. So thanks and I'm going to go ahead and invite our speakers up. Thanks for having us.

You are very welcome. Well, we are happy to be here and happy to have you here. Hey kid, I don't know if you saw that there was a blank on there for January, February time frame. So, you know, I mean, I think it was, I think it was meant as a question to you. Really?

Oh, to me?

Yeah, I'm pretty sure wasn't it? Is that right, Jen?

Great.

So Ryan, Walter Scott, we're both attorneys in Pillsbury's emerging company Venture Capital Group. Startup attorneys I think we used to be called, but now it's ecvc, right?

Yep, that's right. Emerging company Venture Capital.

And so today I think we're going to focus on safes and convertible notes. Is that right?

Yeah. I know there's a lot of people here who might have some experience with angel investing. There's other people I talked to who have no experience whatsoever, and this is their first session. And so I think we're going to try to cover a few of the basics, like kind of corporations generally, what type of entities are, and then we'll talk about financing instruments and we'll go through a few other things, too. So.

So it could be pretty basic for some of you. It might be something you already know. If you're like me, you don't mind hearing that kind of stuff over and over again. But if you're not like me, just eat during those parts and perk up.

And also just jump in with questions, please. It's better if it's back and forth. We'd love that. So, yeah, just shout.

Yeah, that would be a lot better than waiting till the end, I think.

Yeah. Okay, so here's our actual agenda. We're going to start with key angel investing concepts, kind of like the. The life cycle of the angel investor. We'll go through some of the types of companies and what you might be investing in or. And which ones you might consider not investing in. The different types of financing instruments, which really are just broken down to three big buckets. Well, two big buckets, convertible instruments, and then actual equity rounds. But we're going to talk about safes, convertible notes, and preferred stock financings. We'll talk a little bit tax. Hopefully nobody gets bored because we're just going to be focusing on qualified small business stock. And then we'll go a few scenarios that might happen over the life cycle of your investment.

Sounds ominous.

Yeah. And then if we have time, we'll talk a little bit about some SEC rules, But even more ominous. All right, here we go.

Yeah. So where do you find good investments? I mean, just ask any of my clients. Right. They'll tell you right here. But actually, right here, this is where you find good investments. Right. This is one of the places.

Right. It's all about networking, finding people in your network to talk to and just getting out there. SDAC is obviously a really good opportunity or good resource to find those investments. New fund is another one. Just also Google and just doing some research, going on LinkedIn. But really it's all about communicating with people within your network.

I saw that you had a note on here about reading documents. Is that really that important to read your documents?

It depends which document it is. But no, no, it's definitely important to actually read the documents that you end up signing before you actually sign them. There's different implications for each different type of instrument that you use to actually invest in the company. And you should understand those. And we are going to go through those as well.

No one ever makes a mistake at Pillsbury or Mintz, of course, but aside from misspelling somebody's name or getting your address wrong, which seem to be the two places that investors look most for the mistakes, and they always find them there. So my advice would be go ahead and read the whole document.

The other thing we wanted to touch on for this slide is, you know, you're going to initially find a company, you're not just going to give him your money. Hopefully you're going to do a little bit of due diligence. That due diligence process, there's a lot of different steps to it. I know that SDAC goes into a lot of detail about that whole due diligence process. And so we're not going to do a deep dive. And it sounds like Mintz is also going to be doing that. But what we're going to focus on just from a high level is understanding kind of the vocabulary and the concepts of what a post money versus pre money means. And just having that conceptually, that conceptual understanding is really important, actually understand the terms. And if somebody says something that you don't understand, you should ask questions.

And like Kit said from the jump, feel free to interrupt and ask questions along the way, even on that slide.

Okay, so there's lots of different types of entities, structures out there. This lists almost all of them. There's, you know, the sole proprietorship, limited partnership, general partnership. I'm not gonna go down the list. But the ones that really need to focus on are the LLC and the C corporation. Now, a lot of people come to us and investors come to us and they say, is it okay to invest in a company that's an LLC? The question is, the answer is sometimes LLCs can be taxed as a flow through entity, which if you invested in the company directly, means that you're going to receive a K1 when you do your tax return. That means that income at the LLC level will flow through to you personally. And you're going to have to record that income on your tax return and pay taxes on it, regardless of whether you had a return on your investment or a distribution. Now there's ways to get around that you can invest through an entity rather than investing directly in the LLC itself. And investors are generally more comfortable investing in LLCs these days. But the industry standard still is investing in Delaware C corporations.

Especially if you're an early investor in a company that's later going to get investments from VC funds, they're going to become a C Corp. Probably at some point. So you're focused on C Corp. Yeah.

But a lot of times what I've seen is angel investors will just not even have a conversation with somebody if they're an llc. I certainly don't think that that is something that you need to do. You can have that conversation with them. We also represent a lot of companies. Right. Not just investors. And we do a lot of LLC conversions, you know, when they're about to get investment. And that happens all the time. So don't just shun them just because they're an llc. You can still have that conversation with them. They can fix it.

Yeah, there's plenty of folks out there that formed an LLC for perfectly good reasons when they. And it was. They didn't realize that they were going to be going after venture investment.

What do you mean by the LLC conversion?

That just simply means going from limited liability company to a different entity form corporation. I know you know that, Sebastian, but you asked for the benefit of the group and it's very simple to do, but it's not so simple to go back the other direction. Luckily, that's pretty rare.

Right.

So it really is an easy thing to do. And thanks for bringing that up. And so that's why, like Kit said, you don't need to shun folks just because they're an LLC today.

Yeah.

So I have a question.

So you said the income from LLC.

Passes through to your income as well that you're taxed on. What about the losses? Does it also apply to the losses?

That's true. It does also apply to the losses. And that's only that there. An LLC can be taxed in one of two ways. It can be taxed just like a C corporation is, which means that you're not going to record or receive any income on your tax return. It can, but it's more common for an LLC to be taxed as a partnership, which is. Which causes that result. So yeah, you do get the benefit of losses, which is why a lot of startups or founders want to start their initial business as an llc. So that. Because in the first couple of years they're inevitably going to have losses. I actually, when I formed, I formed an LLC when I was 18 because I wanted to be an entrepreneur. I did exactly that. I created an llc. I recorded the losses unfortunately, or I guess fortunately. And so that's definitely something that happens.

Please do you take a stem of.

You on an S C corp election or conversion as you do on llc?

Oh, now I've been saddled with taking a dim view on llc. I guess that's my own fault though, isn't it? Yeah. So the S corp election does not get you what you're. Yes, I'm as dim. Yes, my view is just as dim because it's not. It's not getting what you. Getting you what you want, which is a C corp, I say what you want. I mean what is. It's. What is ordinary in terms of this.

Group looking at an S corp they can convert is that.

Yeah.

An S corp is actually just a tax election.

Yeah. So the S corp tax election status will be blown by a certain number of any number of things that you can do along the way in the life cycle of the company anyway.

And so you can have that conversation. You can still have the conversations even if though they're an S corp. It does have the flow through tax issue though. And so that's just something for you guys to be aware of.

One more question. I've been reading about a lot of.

Companies considering corporating in Texas and Nevada. Is that something that one, you see?

Like is it.

Sure, nobody really have to think about. And two, is that.

Sorry. Absolutely, we see it and Wyoming as well. Some people even incorporate in California believe it or not, and it's all fine. Ordinarily though we see Delaware. Delaware has a much more mature set of corporate law. They have their own dedicated court of Chancery to deal with corporate law issues. I think the reasons that most people are heading toward Nevada and Wyoming, I'm not as sure about Texas, but Nevada and Wyoming, there's taxes, there's more privacy. I think Wyoming may be. They're a lot cheaper essentially. But also I think maybe Wyoming has some stuff about asset protection that folks go for. It's not, it's just. It's just not ordinary. That's the. If you want to kind of go down the well trod path and not do anything that is out of the ordinary for this part, if you want to keep all the oddness with the technology or all the innovation with the company itself and not with how you're going down this path, then it's Delaware. But those are not problems that folks have incorporated elsewhere.

I think it's Elon Musk's fault, honestly.

Oh the Fact that people want to go there.

Yeah, the fact that people are questioning Delaware.

Oh.

Okay. So there's different types of financing instruments and by financing instruments what we're talking about is the actual document or instrument that is going that the company issues to an investor in exchange for cash. The two main ones that angel investors really focus on are safes and convertible notes.

And what does, what does SDAC use? What has SDAC used?

I believe SDAC has used safes in the past.

Banana convertible notes. Limber was convertible note but has converted three years ago.

Limber was.

Yeah, convertible note that's converted into series C. Oh, okay.

That's a great result. Okay, that's cool. I didn't realize that.

Okay. Oh, so it's good that we're covering both then. Sounds like they have used both.

Yeah. And then there's also priced equity rounds. So for your priced equity round, the difference there is that actual equity from the company is going to be issued to you and that equity comes with different rights and preferences that you don't typically have with your convertible note or your safe. And just one other two more things on this is just your safe and your convertible note that's typically issued your early stage pre seed financings. So you might hear that term at your seed to series A and beyond. That's when you're going to have your priced round. That's when equity is actually going to be issued to you. Yep.

So when you get to the qsbs later, does the clock on that start when you sign? So if you haven't received the equity but you signed a safe, does the clock sign on the sign date or.

When you receive the equity and jumping ahead?

Yeah, we actually do have a slide on that. There's some investors are able to get side letters where the company will agree that everyone will take the position that the safest to have been treated as equity. I've never heard of anybody being able to make that argument with a convertible note since it really is truly debt. But yeah, people make the people do agree to say that the safe was equity such that the clock should start then.

It's a really good question though and I want to touch on it just a little bit more. And it really comes down to what you're wanting, how aggressive you want to be. The easy, the safest answer is that once the safe converts into equity, that's when your clock starts. That's what a lot of that's the vast majority of people will will push that. The risk comes down. The risk of making that Mistake is on the investor, though. It's not on the company. And so sometimes when we have investors who want to be aggressive about that holding period, we will. We have like a form side letter that we use that like Walter was saying, acknowledges, has the company acknowledged, all parties acknowledge that this is how the tax is going to be treated. That doesn't guarantee it. It's going to come down to how the irs, you know, pushes for that. But that's the best argument to say that the holding period starts, you know, today I think we had.

How do you view cap tables in this context and what are the red flags around.

How do you view cap table. Can you clarify your question?

Yeah.

In other words, if I'm. Whatever the financing structure is, often there's a downtable.

Yeah. Probably put it in.

But seems to me there are potential red flags from an investment standpoint. If I see a campaign with certain characteristics, I might be less likely to go with that.

Got it. I understand. Now, that's a good question. You know, one red flag is just having a ton of people on the. Or entities or investors on the cap table with very small investments. I mean, an ideal cap table, especially at the early stage, will have just the founding team, you know, 1, 2, 3, 4 people, whoever is like just initially coming onto the company, and then maybe like one or two investors who came in on a safe or convertible note. That's like an ideal cap table to kind of join in on. You really don't want a situation where there's hundreds of people who are on the cap table. I mean, it's not the end of the world, but it does create logistical and administrative issues in the future. I mean, we have a deal right now where we have to get 90% of the stockholders to approve the transaction. Yeah.

And there are a few dozen, I think a few dozen people on that one, you know. Yeah. So that's kind of hairy. Another thing would be if you had. If there are six or seven. Sorry, the sun's coming in right here. There are six or seven safes that are listed there. And then you dig down and you see that they've all got different terms. I mean, that's another. It's difficult to track, for one thing, but it also. It's just kind of a red flag, like what was happening there, all these changes that we needed to do a different deal for everyone.

Another red flag to think about, especially for the safe. And we were actually going to get into this a little bit later, but I think it's appropriate now is that the safe gets the benefit when it converts of all of the option pool that's currently available before the financing, when it converts. And so as an investor, you want there to be a large option pool that's available when you make that initial safe investment. A lot of people don't realize that, but that option pool gets included. But the increase to the option pool when there's the financing does not get included. And that actually will dilute you as the investor. I know that's kind of, that's a hard concept to kind of grasp just talking about it, but we'll get into a little bit more detail on that. But just remember, the key thing is when you make that safe investment, when you do your due diligence, when you review their cap table, you want there to be an option pool. If there is none, one thing that you could ask, depending on your size of your investment, because you have to be reasonable too, is you could ask them to implement or increase that option pool. The argument being that your money is being used to grow the business, which includes hiring new people to actually improve the business, improve technology, etc.

That's a good point.

So one of the things we were going to, we wanted to talk about about the safe. So first of all, it starts with simple agreement for future equity. The safe has several terms which include typically a valuation cap, it includes sometimes a discount rate. And then there's a third type of safe called a Most Favored nation safe. Those are the three different versions. Most Favored nation just means that if there's a future investor who gets a better deal, you will also get that better deal at the same time.

Remember we talked about maybe there's five or six safes on that cap table. Well, if one of them is better than yours, then you get those terms.

One of the terms that I just referred to, the value, the Post Money valuation, that's what this slide is all about. It's about how do you value the actual business. And you know that's what you're trying to set. That Post Money valuation at. That Post Money valuation is the value of the best. You should be thinking it's the value of the business at the time when they do their series A financing or whenever they do that price round, because that's when it's going to convert. You want at that value at that price round to be higher than your Post Money valuation cap.

So if you have, if you have a valuation cap, a Post Money safe, and you have a dollar amount that you've invested, you can actually look at your safe instrument and know exactly how much of that company you will get right before the Series A happens.

Right. I think that brings us actually to our next slide, too.

Do we actually have that arithmetic on a slide?

We don't have the arithmetic on the slide, but in just some quick math here, when you're thinking about how your investment is going to convert, let's say that you have a post money valuation cap of $10 million and you put in a million dollars into the company right before the financing occurs. You should own 10% of the company. That's how that math works. You will be diluted, though, by the increase to the option pool, which is a term that happens in these financings, which is really pushed by the venture capitalist or whoever it is that brings in the new money at that future round. And then you will also be diluted by the new money investor in that series A financing.

If you've been in this for 20 years or more, then you know that safes are fairly new. Convertible notes actually are kind of new. But safes are very new compared to convertible notes. And they used to have a safe that was characterized differently. It was a pre money safe. And investors would look at that and they wouldn't have any idea how much of the company they were going to own when, when the round happened. But so that's why they actually changed the safe. Y combinator now doesn't even have a pre money safe on their website. It's only post money safes. So, so that investors now can look at the safe, they can look at the, the valuation cap, and they know exactly how much of the company they own right before the Series A. And I think, I think folks just like that a whole lot better.

Yeah. And it's also designed to be a simpler instrument. It's designed to avoid negotiation between the parties, just so that people can say, hey, I know exactly what this document does. I know the risk profile for it, so I'm just going to sign it, give the money, and we're going to be done. As opposed to the convertible note, which we'll talk about in a little bit, that's a little bit more heavily negotiated. I say heavily, but it's just more negotiated in general than your typical safe. Now, investors still will push for advanced or better terms than what was typically given in your cookie cutter safe, and we'll talk about that in a little bit. But the whole benefit here is really for the company and not necessarily for the investor. So that's just something to like, consider when you're deciding between the SAFE and the convertible note, it's designed to be company favorable rather than investor favorable. We talked about this a little bit. This slide just says kind of the different key economic terms for the safe. We talked a little bit about pre Money versus Post Money.

Yeah, we did the valuation cap. Right. But not the conversion discount.

Right. So let's talk about that just for a second. So the alternative way that you can convert your SAFE is at a discount rate, which just means that it's a percent off of what the future equity investor pays at that round. We always argue when we're company counsel that the discount rate is a. I mean, it's certainly better for the company to give just a discount rate than it is a Post Money valuation cap. So when you guys are reviewing, when somebody comes to you, who is the company that you're looking at and they propose, hey, I just want to give you a 20% discount rate, you should know right off of the top of your head that's not the best case scenario for me. Typically. And just some quick math here. If you had a 10 million post money valuation cap and the company at their future financing is valued at 12.5 million or higher, then you would have been better off choosing the valuation cap over a 20% discount rate. All else being equal. That's super quick math. But in your mind, you should just remember discount rate is not as good as the Post Money valuation gap.

Just to say a little more about that, keeping it simple and keeping it somewhat company friendly, Y Combinator has gotten rid of the safe form that offers both valuation cap and discount rate. They used to have that. It was actually kind of confusing. We have a worksheet that we would share with people so that they could understand the scenarios, but some investors will still actually push for that. And so, I mean, I don't know how often you end up using it, but I actually have to go pull that thing out more than any other safe.

I honestly think it's almost become the market standard to include both, despite the.

Fact that it's not on Y Combinator's website anymore, right?

Yeah, because, I mean, the angel investors are taking significant risk investing this early stage in the company, and the company typically needs the money. And so they're able to drive the terms of that. And so you might as well include both of them. But I just wanted to make sure that everybody knew the differences between the two. And we're, we won't even touch between Pre Money versus Post money because it can get really complicated. You should Just always want a post money cap as opposed to pre money cap.

Yeah. And if the company's pushing for a discount instead, then why not both?

Actually, both is coming up and we always ask for both and we explain because then we're aligned as investors with the company no matter what. Like, do they need financing? Are they going to convert early or late? You know, and then like, well, we don't care. Like, we either get a discount or we get it, but otherwise, no, no, don't do equity round now because we're going to get. We don't get anything. So anyway, I explained it to the company that way.

It's like, we're aligned.

You get your financing when you need to get your financing and we'll take our cut, we'll get our bonus either way.

Right. But from the company's perspective, at that early stage, it's so difficult to value them. I mean, people just throw out 4, 5, 6 million when they're first doing that and that's like inevitably what it ends up being. But yeah, I take your point though.

Yeah. And it's also true that it's just, it comes up. That's what everybody's using, despite the fact. So maybe why Combinator will put it back on the website at some point, I don't know. But it's off for now. Question.

On my understanding from nasdaq, the pooling in general between angel investors, is it typical that every angel investor has their own safe or do people generally pull together?

It varies. Do you want to speak to how or. I'm not the person to speak to.

Oh, yeah, I know how the SDAC does this because I did invest in the fund. And so SDAC will pull all of the money together from its angel investors into a single entity. That entity will enter into the safe directly with the company that it's investing in using the angel investor dollars. Now, there's other scenarios where some of the angels probably invested directly with some of the companies that SDAC also did. They will get their separate safe, but they're outside of the technical fund. Does that answer your question?

Okay, so they're LPs and SDAC is.

Yeah. Okay.

Members are LPs. Okay.

Are there any limitations to what a company can do after they issued a safety, like the number or the amount or the like? Are there any limitations to how they can continue to raise after that? Is there a point where they have to convert or how does that.

There's practical limitations and real dangers. The devil of a post money safe is you can give away 10% to this person and 30% to this person. And before you know it, you've given away an awful lot of that company. But in terms of a rule, I think it's just practical considerations, right?

Yeah, that's right. So, I mean, one thing that we're always advising our clients about on the company side is that you can't be in a situation where at the time when you do your future financing, you've given up like more than 30% of your company because it will stack. This is just the first initial financing. Because if you give up. So let's say you did a $20 million valuation, that's what you got for your future round and you raised 4 million bucks, that means that you. Or 5 million bucks, that means you just gave up 25%. If you had somebody else on the cap table that came in at that million dollar, million dollar investment, 10 million cap, you just gave up 35% of your company. And then that's not including the options that you have outstanding. So your individual, as the founder, your individual ownership will just completely get diluted quickly if you're not careful about it. And honestly, as an investor, you should care about that too, because you don't want to be in a situation where you just invested in a company and now the founders have no economic interest to 100x your you know the company and sell. Right.

And then of course, there are, there are, you could end up with a financing that is large enough to trigger the conversion of a, say for convertible note. That's probably not what you were asking about though. But that too is another place where you would just simply run up against. You couldn't go any. If you had a financing larger than whatever the qualified number is, then everything would convert.

So this slide, we're just talking about a few of the advantages versus disadvantages of the safe. Some of the advantages we talked about, they're quick, they're simple, company friendly. You're able to get in and out of them, not out of them, but you're able to enter into them very quickly. One thing that you should be aware of about the SAFE is that they will convert into what's called shadow preferred. So there's something called a liquidation preference that's given to preferred stock at that future financing. This is one of those rights and preferences I was alluding to earlier. What a liquidation preference means is that you're going to get your money back. Typically, if it's a 1x before anybody else gets paid anything, any of the common stock, any of the option holders, anybody else, the preferred will get paid back that money. First, the convertible note, which we'll talk about in a little bit. Before the safe came around, they would convert right into the exact same type of preferred stock that's given in the equity financing, which basically means, because they're converting at a better rate, that they get a higher effective liquidation preference than they would if they had just invested in that initial round.

So they're getting the same liquidation preference that all the preferred investors say they paid a dollar a share, they're going to get a dollar a share back as a liquidation preference. And even though the convertible note holders only paid 85 cents a share, they're still going to get $1 a share back as their liquidation preference. And so this became. That was just an advantage of coming in early for many years. And then the safe came along.

Yeah. And now the safe holders, when you convert, you don't get that benefit. You convert and you get liquidation preference based off the amount of money that you paid and you don't get that incremental benefit that typically the convertible note holders do get.

So again, company friendly.

And then some of the different disadvantages of the safes, this is really kind of company side. So the disadvantages are if there's multiple safes on the cap table, they will only dilute the current cap table, meaning like the founding team. And as an investor, you should be aware of that. And so if there's, I mean, that doesn't necessarily impact your equity ownership because your equity ownership will be protected from the other safe investors. But that means that we're diluting the founding team, just like we were talking about before. And so you should just be aware, are these guys doing successive safe investments? How much are they raising? Are they getting better terms? Are they getting worse terms?

This is one of those red flags that was asked about on the cap table.

The next one is about zombie safes. So zombie safes, that term, you might have heard of it, you might have not. Basically, if the company never goes through an equity financing, it just sits there and does nothing. And so there's a huge risk for angel investors because you can be in a scenario where you just put in five, $10,000, whatever, in this, in this startup, and then they just keep going on. Let's say they're, they're revenue positive and they're actually doing really well and they're able to grow without having to do a financing. They can just let that safe sit there on the cap table. You don't accrue interest. And so you're not getting a return on your investment. And so you could wait years before seeing any benefit, really. But that's true. Even if of the convertible note, other than a few things, if you had.

A convertible note, at least you have a maturity date.

Right.

You get your money back at some point. Maybe it's not the return you wanted, but if you have a safe just sitting there forever, that's no good.

Is there any projection? I'm sorry?

Oh, sorry. Probably the same question. Is there any move toward people doing safes with time limitations or entities? Well, the whole per. That goes away from the purpose of the safe. The intent is that there's no maturity date. It's more like equity, less like debt. And so those are key terms that are within the convertible note that are not within the safe that you should consider when deciding what type of instrument to choose for your investment.

Way to dodge the question. Not that we've seen, but it might be coming.

You can write anything.

So we did one, we did one recently that gave us a veto over another state or a different fund.

Oh, you had a side letter?

Yeah, we did a side letter and that gave us a veto rights.

That's not even one of the things you listed, is it? As a side letter.

I know they were like, oh, don't worry, we're converting in six months, you know, but we didn't have to exercise it, but they gave us a few. It was a big enough investment.

Nice. Okay. Yeah. I mean, because you typically when you're coming in on a safe, you're not putting in enough capital to justify getting these advanced, like heightened terms like that. But in our next slide, we're actually going to go through all of the different like side letter rights that we've seen.

But that's not on there because that's, I mean, that's pretty aggressive.

That's pretty rare. I did want to touch on one last thing though. On the safe, like just generally what happens if the company sells before their equity financing. And the way that the liquidation waterfall will work at that future sale is that the preferred stock and the safe will be on equal footing. That means they will get paid out before any of the common stock, which is great for you guys because. Because that's what you want. You want to be paid back your money before anybody else's, but you're below debt and the convertible notes are higher up on that liquidation stack and so they'll get paid back before you do. And so in a horrible situation where not everybody's getting their money back. The convertible note is superior.

Yeah, you know, I'm glad you mentioned that because that's also one of the ways that a zombie safe might not be as. Might not turn out to be a zombie, because eventually, unless you're both revenue positive and you decided that you never wanted to have an exit, the stakeholders will eventually get their money back, but it's still not what you're hoping for.

Right. Okay, so these are some of the terms that we see that are actually protecting investors future or their investments in their safes.

These are not in the safe themselves. These are only in a side letter if, if it's negotiated.

So we'll just go through them really quick because I think they're important. And these are things, honestly you should be asked. Not all of them, but a lot of them you should just be asking for every single time because some of them are just really not controversial. So first of all, pro rata rights, also known as pro rata participation rights, this is your right to invest in the future financing. So without this right, there's no reason why they have to go and call you and say, hey, we're doing a future round. Are you interested in putting in some money? This preserves that. It also effectively allows you to preserve your ownership interest in the company. Because at that future round, the amount of money you're entitled to invest is your pro rata ownership. And so you can put in another. If you put in $5,000, that gives you 1% or whatever the percentage is, you can put in another. It might not be 5,000, but you can buy up to 1% of the company just to preserve that ownership. The next one here is information rights. Information rights is basically just the right to receive quarterly, monthly, yearly reports. I really like these. As an angel investor, I always ask this when I invest in companies. Not that I'm going to actually necessarily get them, but I just want like a touch point and them to have an obligation to keep me up to date to show me the difference between their budgeted financials and their actual. Because I care about that stuff. I'm not gonna do anything necessarily with that information. But that allows me to keep tabs on the company and also just understand generally how they're doing over the next couple years after I've made that investment.

What kind of preferential terms in future financings are you seeing?

Well, if there's better terms, the future financing, then an MFN provision is going to provide you with those preferred terms as well.

Okay. All right, so then There are protective provisions and consent requirements. The veto is almost like a consent requirement, but that's not really what we had in mind there necessarily. And those are going to be. Is it really. It's not the full panoply probably of what preferred investors are going to get?

No, like if there's, like if you invested enough money, then you could get things like if they're going to go through a change of control, you get to approve that. It's basically just the same type of protective provisions that you might see in a preferred financing, but baked into a safe financing depending on how much money that you put in.

And then we have optional conversion there, which. That's the way. Avoid being a zombie. Maybe the repurchase, right, you want to say a little bit about that?

Yeah. So the repurchase, right. This is basically the right to force the company to buy back your safe. Very rare to see this one, but we have added it in. Even rarer to see it exercised. Even investors in future financings, when you're a VC or institutional investor, I always encourage our investor clients to ask for that because then it's something kind of hanging over the person's head. Hanging over the company's head. And it also sets a timeline because usually it's like five years in the future is when they have the right to force the repurchase.

It's like a maturity date in a convertible note, typically not forced, but you have it out there.

The next two are kind of under the same bucket. Board, observer rights, board election rights, your observer rights. This is basically the right to sit in on the meetings that the board attends. No right to actually vote on anything, but you actually get all of the information that they do, all the materials that they receive, unless there's like some serious confidentiality issues. And so it's actually something that depending on how much you invest, it's something that would be worth asking for, especially if you want to be operationally involved with the company moving forward. But it really depends on your investment thesis. If you're a sit back and see what happens kind of investor, then that's not something you want to ask for. The election rights is actually the right to vote somebody on the board, probably yourself or somebody else, doesn't matter. But that's different from your observer rights. And that's also something that's less common than asking for an observer. Right.

You keep talking about like a dollar amount. So just out of curiosity and like what would a dollar amount look like? You keep saying like how much you invest, like if you invest a small amount, it's ridiculous to ask for some of these things. Like is there a number where it's like, okay, we've invested X amount of dollars now that since we've given you this much, these are reasonable to expect.

It's less about a dollar and it's more about a percentage. So if you have a, I don't know, 4, $4 million valuation cap and you put in a million bucks, you're getting 20% of the company, effectively, you can start asking for some of these rights.

Or if you know you're the only, you're going to be the only investor for who knows how long. Or like it was saying, if you intend to really be involved with this investment.

Yeah, it's about the value as an investor that you're putting in. And so it can be even significantly less. It could be $100,000 if the company really needs that money. Depends on your leverage and the company's leverage. But I would say percentage is a really easy way to think about it. If you're only put in taking 1% of the company, you probably shouldn't ask for a board seat.

And really maybe not even the observer or observer rights either because there is some hassle to having to send out materials to every single person and get their. Because when you send out materials, you get, you get feedback back.

Okay, so now we're talking about convertible notes. We've touched on this a lot. But just really quickly, the high level items to consider with the convertible, because it acts just like a safe, something that you get in exchange for putting in money, it converts it a future financing. The differences are that it has an interest rate typically 5 to 8%. Just depends. So it accrues interest during the life of the convertible note. It has a maturity date. We typically see 18 to 24 months. That means at the end of the maturity date, the note becomes due and payable. Now, depending on the scenario, you can have a situation where a lot of people are coming into the round. Right. It's not just you that's purchasing this convertible note. Typically, then if it's a majority of all of the outstanding principal and interest of the note, that's required to call the note after maturity.

Otherwise, even though it's already gotten to the maturity date.

Right, even though it's got to the maturity date. And then there's just the standard discount rate valuation cap that works exactly the same way mechanically as the safe. The only nuance I'll say here is that typically what we see is that the convertible notes will be on a pre money basis rather than a post money basis. Although when we advise our investor clients, we always say post money. There's no real market reason for that. That's just historically. I think what happened is historically they were always pre money and that has just lived on.

And the safes were pre money. As I said before, the safes were pre money. Safes at the beginning, too. This is evolving as well. Should we hurry through our slides to give some time for questions? I'm noticing that we're 15 minutes till 7.

Fair point. Let's move on. I guess one last thing on this slide, because I think it's important we did touch on it. There is a change of control premium because they convert at a lower rate and so they get that higher liquidation preference as opposed to the safes that are shadow preferred. But we already touched on that, so we can.

Is there anything as an investor that is being signaled by a company that's using a safe or a convertible note?

Like.

I mean, maybe they know what they're doing, maybe they don't know what they're doing. But, like, is there any. Is there anything that we infer?

It's an interesting question, actually. I would say I wouldn't have thought of this necessarily, but if I was looking at a company that was going out with a convertible note offering that I think that probably would communicate to me that they had sophisticated counsel. It wouldn't necessarily communicate to me that they had unsophisticated counsel if they were going out with a safe. But I think anybody can grab a safe and everyone does grab them. But convertible notes are still a little more complicated. And so that would probably say to me that they. Yeah, for whatever reason, they either have the money to spend or they're cautious or they have connections. But that would tell me they had more sophisticated counsel, probably. Or sophisticated counsel. Not more sophisticated counsel. Is the fact that the timeline is.

Fairly narrow suggests that they've got a little bit more faith there.

Optimism in their ability to convert.

Well, yeah, no, it's an interesting point. It puts pressure on them. Right. And so that's another benefit from the investor side is there's pressure on them. They have this looming convertible note maturity date. Oh, no, we could go bankrupt. They could call it. They could force us to pay it back. Honestly, the practical reality is that investors don't typically call them because you're literally bankrupting the company in that typically.

It's just such a funny question to raise because before safes, convertible notes, these were the urgent instrument. And now we're kind of talking about them as though they're the instrument of folks that aren't in a hurry. But I guess there is kind of that sense. Yeah, so maybe there would be that sense.

Yeah. This next slide is a comparison table between the two. I think this slide deck is going to be shared. We're not going to go through these because we've gone through it at length here. I just want to say the vast majority of our pre seed financings are on safes. They're not on convertible notes. We see it sometimes, but as an investor you should honestly consider doing a convertible note. You get an interest rate, you can set a maturity date and you are higher up the liquidation stack. Now, on qsbs though, which I think we're going to talk about in one or two slides, it's going to be, I would say it's really, really difficult to try to claim that your holding period starts when the safe is or when the convertible note is received. So that's something that you lose.

And they're more expensive, as you point out, obviously.

So we touched, we talked a lot about these priced rounds and we, we told you a little bit that it's, you know, where the company has a, there's an investor comes in, they value the company, they issue preferred stock. And we just wanted to go a little bit deeper into that like what kind of dollar values it means. And so typically what we see is that when a company's ready to do a price round, it's, they're receiving checks like 5 million or above and they're doing valuations at 20 million or higher. Now that's not always true. It's definitely not always true. But that's usually the point where you can start to do that because like I was talking about before, that's where the founders are not going to be as diluted as they would be below those type of numbers. Now, just to touch on the difference between preferred stock and common stock. Common stock is the equity that's given to just the new founding team. Anybody that exercises options. It's just vanilla. There's no specific rights or preferences. Nothing comes with it other than at the time when there's an exit, you'll receive some cash, hopefully depending on how much money that the company is selling for. The preferred stock, however, has lots of different bells and whistles that come with it. There are voting rights. So typically it takes a majority of a particular class of preferred in order to do things like a majority approval to do things like sell your business, raise a future round, change anything in the charter, take on debt over a certain dollar amount. The idea being that the investors want to have some sort of control over their future fate. Because if you're bringing in more debt, if you're doing future rounds, you're diluting the investors and you're reducing how much money they could potentially earn.

So for rights like that, and then.

Maybe going back earlier for like information.

Rights, what is the difference between explicitly rights that have to be explicitly defined versus are sort of implicit with the vehicle itself?

Well, just to be clear, though, the preferred stock will have explicit information rights. There will be a document that will contain a laundry list of these rights explicitly. So I guess I'm not.

There actually are none. There are no rights that are implicit other than the common. Your basic right as a common stockholder. All the rights the preferred have are. They're all by contract, they're all contractual rights. They may need to be. They may need to be in the charter, put in the charter. But it's all explicit.

There are some implicit rights, like the right to have access to the books and records. But that one's a really light right.

But just to be clear, that's a common stockholder right. It's not a preferred right.

There's rights to vote on certain things depending on the structure of your acquisition. All equity holders have the right to vote in that to prove the deal, depending on how you structure it. There's other things like that. Those are statutory rights, implicit rights.

But just. Sorry, the question was the difference between common and. Was it. Oh, oh, sorry. Okay. Yeah. Thank you.

Sorry.

You understood the question. I didn't.

So. Qualified small business stock. This one's really important. I wanted to make sure we touched on it. Qualified small business stock is a tax exemption that is up to $15 million or 10 times your adjusted basis that you get federally to reduce your taxable gain on your. On the sale of your stock. So basically that means if, if the com. If you bought in on the company, if you're a founder and you just started a company, your basis is zero, you sell the company for $15 million. Five years later, all of that, you're not going to pay any federal income tax. Unfortunately, we're in California and California does not follow the federal rules. So you will pay state income tax that, probably 13%, whatever. And so. But there are states, some states that follow it, and there's also some states that have no income tax. So if you're in, like Texas, good thing for you. There are.

What if I buy my stock from somebody else?

Oh, yes. So there. If you buy your stock from somebody else, a secondary transaction, you will not receive qualified small business stock. It has to be issued directly from the company. That's really important because a lot of angel investors will do will participate in these secondaries or these recapitalizations for the company and they're not going to get qualified small business stock. The other nuance here is that it has to be a small company. And by small business they mean $75 million of gross assets or less. Sounds like a pretty big business to me. And then there's a holding period requirement. In July, it was the first week of July, they just changed the rules on qualified small business stock to your benefit. So now you only have to hold the stock for three years and then you get 50% of the tax exemption. Four years you get 75%. Five years, you get the full 15 million.

We focus on 15 million because of course 10x is way low. You know, you guys are on 100x, right?

Is there a carve out for a fund holding it on behalf of a group of direct owners? Well, that's a good question. I don't know the answer to that. You individually will not get the benefit of that. The fund might. So you paying tax on the gain. Right. So if a fund buys the round and distributes the ultimate proceeds, you're not going to get this.

That should be a pass, right to. If you're an lp.

Yeah, I think that's right. You won't get that. That benefit. But I don't know with 100% certainty about to answer that question.

VCs want QSBs, right.

Is it because of the.

Yeah. If VCs want QSBs, then it must be faster.

Yeah. Okay.

They must get the benefit.

Yeah, that makes sense. It's something that we need to look into. It's a good question.

But the other thing that your question brings up is if you're in a, if you're in a safe, if you're in a safe as a group, maybe you would prefer to get the stock. If it turns out that it's not correct, then you might actually want your stock individually to be issued later because then you would actually get the. Even though the holding period wouldn't start until the issuance.

Yeah, it's a good question. Yeah. And then we talked. The last bullet here is just about the side letter for your safe. You want that to you ideal. In an ideal situation, you get that so you can Try to make a better argument with the IRS that your holding period starts earlier. That's less of an issue now because of the three year, four year benefit from the new tax change in july. Second. So there's a lot of different scenarios that might happen. Companies go through different financing. So that's a scenario where you would convert if you held a safe. They can go into a down round, which creates a significant issue for existing investors. They can obviously exit and they can exit at a premium that's high enough where you can, you will convert into common and you will get more than what you actually put in for your initial investment. Or there can be a scenario where they're not paid out enough and you just get your investment back. There's also bridge rounds. So there's scenarios where. Let's say you've converted. I think we had a company that converted to a series C financing. There's a scenario there where they actually do a safe financing in between that series C and their series D financing. Oh, okay. Yeah, I don't that. Right, yeah, but good point. There's recapitalizations. So a recap is basically where some of the existing investors will sell their equity either in a secondary or part of a future round. You know, that's a scenario where you might want to get in on the round at that point. That's also a scenario where you might want to sell. Sell your safe or your equity at a premium, hopefully. And one of the rights we were talking about earlier with our side letters included the right to participate in a recapitalization. So another thing that you can include in your side letter, I know that we're kind of running out of time here. We wanted to.

So what's a masked down round?

A masked down round is where instead of setting the pre money valuation at lower than the prior round, which would be a definite down round, they issue warrants to the other preferred stockholders. Warrants are just effectively the right to purchase equity in the future at an exercise price.

But that might be a penny, right?

It might be a penny warrant. And so in that scenario they're masking the fact that the effective purchase price is significantly lower for them because they're receiving these additional, like an additional benefit to receive those warrants.

Should we leave that for the deck since we're at 7 o'? Clock?

Yeah. Are there any questions?

I know. What does this slide mean? Is that the question? I'm sorry. Next time.

Okay, well, I guess just some key takeaways and then we'll I guess open up for questions. I didn't realize we're on the key takeaway slide. The one thing, the first thing was structure matters. C Corporation versus llc pass through versus double taxation. With that C Corp. Second is just angel investing is a journey. You want to, you know, you're starting off with negotiating, you're looking into the company, you're doing your due diligence, and then you're making your investment. And remember, read your documents. Know your instruments, just like reading your documents, deciding whether you do the safe versus the convertible. Note whether you participate in an equity round. There's all different rights and preferences that come with all of those different three scenarios. There's the tax planning side, qualified small business stock. We talked about that, what that means. And when your holding period starts, something to think about. And then we have a question we're.

Going to answer for you.

And then we have the rights shape outcomes. This is talking about the different side letters that you can have and asking for those rights. The right to participate in a future round, information rights, those things are key. It helps you be informed and have a right to participate in the future.

Unfortunately, we didn't talk about compliance, so maybe it doesn't matter. It matters.

All right.

Are you sure? No questions. Oh, I'll take it.

Cool.

But thank you so much, you guys. Really appreciate it.

All right, thanks, everybody. It.