Standby Equity Purchase Agreement (SEPA) And Equity Line Funding

I recently discovered an innovative financing arrangement for young companies called the Standby Equity Distribution Agreement, sometimes also called the Standby Equity Purchase Agreement (SEPA).  Please don't confuse this acronym with the Single Euro Payments Area, Solar Electric Power Association, Science Education Partnership Award, or Southeastern Power Administration.  None of those things have anything to do with a SEPA financing agreement.  I only mention them to keep my readers away from distractions.

The company must first register with the SEC by filing the appropriate forms.  Companies that execute a SEPA sign a term sheet with a private investor that allows said investor to buy shares in predetermined dollar amounts.  The term sheet defines the funding formula under which the company will sell shares to the investor to net its desired amount of capital.  That's why this type of deal is also called an "equity line," because it resembles a credit line that draws predefined amounts of capital in tranches.

My concern with this type of arrangement is that it may resemble a floorless convertible debenture that becomes toxic.  The term sheet must define a floor price that prevents an investor from bidding down the public trading price of the company.  This protects the company from an unscrupulous investor who shorts the stock into a death spiral and prevents it from raising further rounds outside the SEPA.  The investor can then buy a controlling interest for very little money and the pre-SEPA investors are diluted into irrelevance.

The SEC knows that convertibles pose risks of dilution.  I won't let this death spiral happen to any company in which I hold an early-stage equity stake.  I want to see covenants in the term sheet that prevent it from becoming a toxic convertible.  The company must define the price floor using a convention like the volume-weighted average price (VWAP) that will enable it to cancel a draw down if the price moves adversely during the funding window.  The term sheet should limit the SEPA to the growth period of the company, say two or three years.  Beyond that time the company should have sufficient cash flow that it won't need to return to private investors to seek more capital.  I also want a covenant that prevents the outside investor from short-selling the stock once they purchase it under a SEPA.  The threat of legal action for violating this covenant should be sufficient to scare away SEPA investors who secretly covet total control after cramming down the stock.

Term sheets for equity line SEPAs limit the funding window to a number of days after the company issues the private investor a draw down notice.  I am agnostic as to how long this window should be open.  It would seem that a company with a very volatile stock should keep the number of days the window is open in the single digits.  Less volatile stocks allow the company a longer period during which the VWAP is not expected to deteriorate.  Volatility is difficult to anticipate during the pre-registration phase when the term sheet is being drafted and the stock is not trading publicly.  The length of this window comes down to trust between the company and investor.  I typically don't trust anyone, so my incubated company had better get a longer window for more flexibility.  Investors who want to negotiate anything shorter should be prepared to give up something favorable, like fewer shares for the dollar amount invested in each tranche of the equity line.

I can do only so much as an angel investor who does not own a majority stake in a startup.  The entrepreneurs need the services of a good securities attorney to help draft the term sheet for a SEPA.  I could probably find a few here in the SF Bay Area.  I'm not an attorney and my blog articles do not constitute legal advice.  The SEPA is useful if its term sheet protects companies from exploitation by predatory investors.  

Enabling Early Startup Investors' Skin In The Game While Saving Money

Last night's TiE Silicon Valley event on sources of funding for startups yielded a treasure trove of wisdom on exhausting every avenue available before seeking VC money.  I'll plug their affiliated Startup Leadership Program because the program alumni who presented at TiE impressed me.  If the startup bug has bitten you, get your fill of accelerators and conferences at F6S.

The founder of Micello regaled us with stories from the trenches about how he raised money for his startup without significantly diluting equity.  I was amazed to learn that major prospective customers are willing to subsidize up to 50% of their estimate of a tech startup's product development costs if the beta version is something they really want to use.  Putting IP in escrow is no worry as long as you execute and crowdfunding is an excellent way to discover demand.  Early stage startups can skimp on non-core functions by getting free or cheap services, bartering for services, getting loaner hardware from excited business development reps at big partners, holding meetings at free WiFi hot spots, and volunteering at events just to get access to big shots.  These are all IMHO examples of effective Toilet Paper Entrepreneur tactics for success.

I noticed that serendipity played a major role in the lives of many of the entrepreneurs at TiE who have shared their stories.  Getting outside your comfort zone increases the numbers of people you meet who may help you with free services or product development subsidies.  Attending conferences and winning startup contests is integral to amassing a "collection of small wins" that will keep a startup team motivated through the ups and downs of its early years.

The best lessons were about parceling out equity in exchange for services.  The Micello co-founders had to buy their way in if they wanted significant equity; other employees and advisors who aren't being paid in cash would be smart to have options agreements that grant them more equity later as they keep performing their roles.  I did not know that some law firms will accept a deferred payment for their services in lieu of equity, so long as the startup successfully raises capital later.

Convertible notes are useful in Silicon Valley.  Micello granted a convertible note to an early partner that funded their product development.  Convertible notes can be "fixed discount" or "capped convertible."  The very first angel investment I made in 2007 was under the terms of a convertible note called a bridge loan.  It granted me shares upon the company's completion of a subsequent fundraising round and had a warrant attached that allowed additional shares to accrue.  I've read a few VC blogs on the subject and capped notes seem be falling out of favor because they offer little flexibility in subsequent fundraising rounds.  Convertible notes increasingly come with liquidation preferences nowadays so earlier investors have some options in later rounds.  Speaking of options, sweat-equity contributors need to know how their equity options accrue and entrepreneurs need to know how their attorney accounts for their vesting schedules in the cap table.

I have much more appreciation for the nuances of early stage investing after reading up on the controversies around some ways to structure convertible notes.  I'm not the kind of investor who holds entrepreneurs over a barrel and I won't structure my own investment in a way that hurts a company's future growth.