Negotiating Term Sheets

Negotiating Term Sheets Oregon Graduate Institute Real World Entrepreneurship Ted Bernhard July 26, 2005 Ted Bernhard • • Corporate and securities attorney in Stoel Rives’ technology venture group Law practice focused on representing: – Venture Capital and Private Equity Investors – Startup and Rapid Growth Technology Companies Prior life: – Partner with a seed stage venture capital fund called Cascadia Partners focused on seed stage technology investing in the Northwest. – Strategic Consultant with Booz Allen Hamilton in NYC. • • Negotiated, drafted, or been directly involved with well over 150 term sheets over the past 16 years. 2 Overview of the Discussion • Go through the term sheet in the order usually prepared – Definition – Underlying Goal of the Provision – Alternatives – Recent Market Trends – Typical Mistakes made in Negotiating • Negotiating Tips – Overview of the terms in rough order of importance – Specific Tips 3 Understand the Stage of Your Company • • • Pricewaterhousecoopers MoneyTree definitions: Seed/Start-Up Stage - The initial stage. The company has a concept or product under development, but is probably not fully operational. Usually in existence less than 18 months. Early Stage - The company has a product or service in testing or pilot production. In some cases, the product may be commercially available. May or may not be generating revenues. Usually in business less than three years. Expansion Stage - Product or service is in production and commercially available. The company demonstrates significant revenue growth, but may or may not be showing a profit. Usually in business more than three years. Later Stage - Product or service is widely available. Company is generating on-going revenue; probably positive cash flow. More likely to be, but not necessarily profitable. May include spin-outs of operating divisions of existing private companies and established private companies • • • Match your investors to the stage of your business – – – – – – Self Friends and Family Angels Venture Capital Strategic Investor Public Markets 4 Understand the motivations of your investor(s) • Venture Capitalist: – A professional fund organized for maximizing IRR or ROI for it’s limited partners money by working as hands on investors – Want highest reward (even if it means high risk) – 45-55% IRR on each deal – Expect a large exit via IPO or Acquisition – Long term investment horizon (funds last 10 years) Angel: – Investing their own money – Have a passion or strategic interest they are pursuing – Want to minimize risk, even if it means lower reward – Different liquidity horizons • 5 What is a Term sheet? • • An indication of two parties wanting to try to come to an agreement sometime in the future Goals: – Articulate the basic provisions and terms of a potential deal that can be used to draft the actual definitive agreement – Sometimes lock down the negotiations between the Company and Investors for a period of time Risks: – Company relies on a term sheet before it should. (Expression of intent – not a deal until the money is the bank!) – VC’s risk getting sued by a disgruntled entrepreneur if deal doesn’t come together Can be really dangerous because of the often mistaken perceptions that surround them • • 6 Term Sheet Overview C A T E G O R Y IN S H E E T • • • • • • • • • • • • • • • • • • • • • • T E R M T a r g e t c lo s in g d a t e ( e x p ir a t io n o f t e r m sh e e t) E x c lu s iv it y C o n f id e n t ia lit y d u r in g n e g o t ia t io n s T y p e o f S e c u r it y G e n e ra l T e rm s ( N u m b e r , P r ic e ) R e p s a n d W a r r a n t ie s a b o u t C o m p a n y A tto rn e y ’s F e e s D iv id e n d s L iq u id a t io n P r e fe r e n c e R e d e m p t io n C o n v e r s io n A n t i- d ilu t io n V o t in g S u p e r m a jo r it y o r C la s s V o t in g P r o v is io n s B o a rd S tru c tu re a n d M e m b e rs P r e - e m p t iv e r ig h t s R ig h t o f F ir s t R e fu s a l C o - S a le R e g is t r a t io n R ig h t s F in a n c ia l a n d I n f o r m a t io n C o v e n a n ts D r a g A lo n g E m p lo y m e n t R e la t e d A g re e m e n ts fo r K e y E m p lo y e e s W H E R E IT S H F IN A L L D O C U M E N In te rm sh e e t o n O W S U P E G A L T A T IO N ly IN P u rc h a se A g re e m e n t o r S u b s c r ip t io n A g r e e m e n t C o rp o ra te C h a rte r: A r t ic le s o f I n c o r p o r a t io n (O re g o n ) C e r t if ic a t e o f I n c o r p o r a t io n ( D e la w a r e ) S h a r e h o ld e r s A g r e e m e n t ( V o t in g A g r e e m e n t ) N o t e : F ir s t R e f u s a l a n d C o s a le m a y b e in s e p a r a t e a g re e m e n t I n v e s t o r s R ig h t s A g r e e m e n t D r a g A lo n g R ig h t s A g re e m e n t E m p lo y m e n t • A g re e m e n t S t o c k O p t io n s o r • R e s t r ic t e d S t o c k P u rc h a se A g re e m e n t C o n f id e n t ia lit y a n d • T e c h n o lo g y 7 Who issues a term sheet? • Like everything else, it’s a function of relative negotiating power • Varies by type of financing: – Venture Capital Financing – the VC’s will deliver it to Company – Angel Financing – Often Company will prepare standard terms and circulate an offering document and invite people to participate. 8 Things to be careful of between Term Sheet Signing and Closing • Expiration Date (may have to negotiate and decide very rapidly) • “No Shop” Provisions • Confidentiality • Due Diligence (likely to become more intense) • It’s not a deal yet! 9 Choice of Security – Convertible Debt • Convertible Debt + Warrants: – When used: bridge financing or by angels – Watch out for: • bridge to somewhere? • You do have to repay at a fixed time or lose your company • Warrants that accumulate over time – Advantages: • Additional Security for Investors with upside equity participation • You don’t have to set a price for your shares and can maintain flexibility with stock incentive plan and future investment Interesting to note that PWC Moneytree doesn’t even include debt financings as “rounds.” Angels seem to love these types of deals. Common warrant coverage ratio is 25% up to 50% in extreme circumstances • • 10 Choice of Security – Convertible Preferred Stock • • When used: The “standard” venture capital financing security Advantages: – Equity investment not debt – Voting rights for investors – Preferences to investors – Allows for maintaining low pricing for options – Familiarity by Investors and their LPs – Set’s Value for Company Disadvantages: – For investors, they have less ability to pull the plug – Company can be structured in a way that puts investor shareholders interests at conflict with founders and employees who hold common. • 11 Choice of Security – Common Stock • • When used: seed and very early stage rounds Advantages: – All for one and one for all (everyone treated equally) – Simplicity (keep those legal costs down!) – Low barrier to educate people about them Disadvantages: – VC’s probably have to justify why they are violating common expectations of Preferred to their LPs – Can seriously mess up your stock option pricing (FMV or greater) – Likely to be unfair upon liquidation in the near term • 12 Choice of Security • Typical Negotiating Mistakes: – Trying to convince a VC to take an angelstyle deal or vice versa – Treating the advice from any single person as “the” way to do it – Making yourself an LLC or a Partnership. VC’s do not like and are often prohibited from investing in an LLC because of the attributes passed through to their own LPs. 13 General Terms (Price, Shares, Valuation) Recent Market Trends: Price Change Q1 2005 Price Change Down Flat Up Q1 ‘05 31% 10% 59% Q4 ‘04 28% 12% 60% Q3 ‘04 32% 15% 53% Q2 ‘04 21% 12% 67% Q1 ‘04 30% 19% 51% Q4 ‘03 45% 13% 42% Q3 ‘03 53% 12% 35% Q2 ‘033 56% 4% 40% Most common Negotiating Mistakes: • Getting too hung up on valuation – it’s just supply and demand • Failing to take into account who bears the dilution from the option pool • Failure to contemplate long term fundraising plan 14 Reps and Warranties • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • Usually term sheet just says “standard reps and warranties” Which means: Section 3. 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 3.15 3.16 3.17 3.18 3.19 3.20 3.21 3.22 3.23 3.24 3.25 3.26 3.27 Representations and Warranties of the Company Organization and Qualification Capitalization Subsidiaries Authorization Valid Issuance of Preferred and Common Stock Consents Litigation Intellectual Property Confidentiality and Proprietary Rights Agreement Compliance with Other Instruments Agreements; Actions Registration Rights Title to Property and Assets Employee Benefit Plans Taxes Labor Agreements and Actions Employees Related-Party Transactions Permits Financial Condition Insurance Minute Books Section 83(b) Elections Qualified Small Business Stock Brokers Environmental and Safety Laws Disclosure • 15 Be Prepared – Get your corporate clean-up done BEFORE HAND. Dividends • • • Definition: The rights to receive dividends (i.e. cash distributions) from out of the profits or cash flow of the Company. Underlying Philosophy: Investor’s have to get their cash back somehow. The Reality: Except for tax reasons or because the company has failed, Investors look for a return through a single time liquidity event (IPO or acquisition) rather than siphoning off a recurring revenue stream. Things to pay attention to: – Mandatory or discretionary (almost always discretionary) – Cumulative or non-cumulative (very few cumulative these days) – Ability to make “in-kind” dividends 16 • Liquidation Preference • • • Definition: The priority scheme of how money that gets paid upon liquidation to certain groups of shareholders Liquidation includes a Merger or acquisition! Underlying Philosophy: – 1. He who puts up real cash gets cash back before others who didn’t. – 2. LIFO – he who puts in real cash most recently gets his money back first. Variations: – Single or Multiple Preferences – Participation or non-participation – Capped or non-capped • 17 Liquidation Preferences Recent Market Trends: Liquidation Preferences Q1 ‘05 • Percentage of Deals having a liquidation preference: 50% • Percentage of Deals having multiple liquidation preferences: 12% • Percentage of Deals with a particular multiple: 1-2X – 100%; 2x-3x – 0%; 3x – 0% • Percentage of Deals having participating preferred: 73% • Percentage of Deals with uncapped participation: 51% Source: Fenwick and West Typical Mistakes made in Negotiating: – – – – 18 Failure to contemplate the “sideways” exit scenario Failure to contemplate the cumulative affect of adding the preferences on top of each other. Structuring the deal in a way that in encourages reckless behavior on founders and executives part Remember that while “double dipping” may be the norm now, it is still double dipping. Redemption • Definition: The repurchase of stock by the company at some time in the future at a predetermined price. • Common confusion: put (investor favorable) or a call (company favorable) • Underlying Rationale: – Put: if company doesn’t succeed at generating a liquidity event within a finite period, investors should have the right to demand to be bought out – Call: if investor/shareholder is causing harm to the company, the Company for its long term sake should be allowed to buy out and get rid of investor 19 Redemption Provisions • • Recent Market Trends – Q1 ’05 30% of deals; Q2 ’03 40% Source: Fenwick and West Typical Negotiation Mistakes: – Not making reciprocal – Investor mistake: capping its upside – Company mistake: effectively handing over control of Company if short of cash when comes due. Generally avoided these days in VC deals because: – It puts incredible pressure on cash strapped companies – Investors (call) don’t want to have upside limited – Why if it is in there at all should not it be reciprocal? – Larger dollar amounts involved lead make one time “buyouts” more difficult • 20 Conversion • • • • • Almost all debt financings are convertible into common or preferred stock Almost all preferred financings are convertible to common stock Conversion is usually 1:1 (unless adjusted) Voting is on as if converted basis Other things to watch: – Is interest convertible? – Can you be converted against your will by a group vote? – Mandatory vs. Optional Conversion 21 Anti-Dilution • • • Definition: Provisions designed to compensate current investors in the event of a future “down” round of financing Underlying Goal: Protect Investor from the economic dilution resulting from future down rounds of financing Different Alternatives: – Full Ratchet – Weighted Average – None – Very unusual: Lock in a particular investor at a fixed percentage Mechanically this can be done by altering the conversion ratio or by granting additional shares • 22 Anti-Dilution Provisions • Recent Market Trends: – Anti-dilution provisions Q1 ’05: • Full Ratchet: 9% • Weighted Average: 87% • None: 4% Source: Fenwick & West • Typical Negotiating Mistakes: – Spending too much time and effort on this – Failure to take into account additional complexity these provisions add – Accepting a full ratchet for any reason 23 Voting Rights • Shareholders have right to elect directors and approve all major transactions • Shareholder’s agreement contractually obligates people to vote a certain way • Majority of all shares on an as converted basis is generally required • Exception: Special Voting Approval – Supermajority percentages – Separate Class Voting 24 Voting Rights • Recent Market Trends: – In almost all preferred stock deals these days – fairly standard list of items requiring supermajority(see attached) – Shareholders agreement is typical in all but the earliest stage rounds Typical Negotiating Mistakes: – Treating this laundry list as “boilerplate” and just signing off on it – Effectively signing away right to influence on future transactions – Locking in veto power to specific voting blocks • 25 Typical Items requiring special consent • Protective Provisions: Without the approval of the holders of at least a majority of the Series A, the Company will not take any action that (i) effects a sale of all or substantially all of the Company’s assets or which results in the holders of the Company’s capital stock prior to the transaction owning less than 50% of the voting power of the Company’s capital stock after the transaction, (ii) alters or changes the rights, preferences or privileges of the Series A Preferred so as to materially and adversely affect such shares, (iii) increases or decreases the number of authorized shares of Preferred Stock or increases the number of shares reserved under the company’s option or stock plans, (iv) authorizes the issuance of securities having a preference over or on a par with the Series A Preferred, (v) redeems shares (excluding Common Stock repurchased at the lower of fair market value or cost upon termination of an officer, employee or director or consultant pursuant to a restricted stock purchase agreement), (vi) changes the number of directors, (vii) amends the Articles of Incorporation or Bylaws of the Company so as to materially and adversely affect the rights of the holders of the Series A Preferred or, (viii) authorizes payment of any dividends, distributions or similar action, or (ix) authorizes any secured borrowing or any borrowing or guarantee by the Company of an amount or obligation in excess of $500,000 on a cumulative basis. 26 Board Structure and Members • Definition: Board of Directors oversees and directs all actions of the corporation, subject only to 1.shareholder votes on major transactions and 2. Authority they specifically delegate to executive officers or others. • Elected by the shareholders annual, unless staggered terms • Complete flexibility in terms of number as long as there is one or more 27 Board Structure and Members • Most Recent Trends: – Increasing Number of Independent Board Members, independent chair – Smaller, less cumbersome boards (5 members or less until the later stages) – More active participation and oversight being demanded Typical Negotiation Mistakes – Trying to keep all founders on the board – Allowing VC’s to stack the board just because they are writing checks – Adding too many board members, too soon. • 28 Pre-emptive Rights • • Definition: The right to participate in future offerings by the Company. Underlying Philosophy or Goal: Allow all investors willing to make new investments to participate on the same terms in order to avoid dilution. Alternatives: – Some countries or states included these as a default provision – Most do not, so need to be put into documentation Whether or not the rights get hardwired into the agreements: – Company will almost always want to take the money – It’s good practice to offer participation to everyone to avoid future claims of self dealing • • 29 Right of First Refusal • • • Definition: The right of either the company or the other shareholders to purchase that are proposed to be sold by a founder (or other current shareholder) Underlying Goal: Unlike Pre-emptive rights, this is about maintaining control and avoiding undesirable shareholders. Alternatives: – Have the provision or not (almost always put in) – Order of the rights (company first or investors first) Drawbacks: – Delays the potential sale; could risk losing buyer because of the delay – Makes it more difficult to raise cash quickly when needed • 30 Co-sale Rights • Definition: The rights of investors to participate in the sale of a founder or other shareholders shares to a third party buyer. • Underlying Goal: To prevent a founder from profiting at the expense of the remaining shareholders by selling his shares at a very high price to a third party. • Kicks in usually after parties elect not to participate in the right of first refusal because: – Don’t have cash – Purchase price is inflate and don’t want to pay 31 Co-sale Rights • Most Recent Trends: Virtually ubiquitous. • Typical Negotiating Mistakes – Too long of a combined time frame between ROFR and Co-sale – Granting the right to others beyond just the new investors 32 Registration Rights • • General Definition: Lock in ahead of time specific contractual rights that will allow the investors to sell their shares once the company gets to IPO and beyond Typical Rights granted to investors: – – – – – – – Demand Registration: Piggyback Rights S-3 Short Form Registration Expenses of Registration Limits on Future Registration Rights Market Standoff (Lock Up Period) Termination of Rights • 33 Can be useful, but more often then not the I-Bankers will do whatever they want. Registration Rights • • Most Recent Trends: Fairly standard these days, driven by very specific securities laws (Rule 144, 1933 Act) Typical Negotiating Mistake – Getting fed up with the 17 pages of registration rights language and throwing them out completely • You probably won’t get the opportunity to get them later • They really do matter when you try to sell your shares on the open market and cash out – Spending too much time haggling with this -- investment bankers fight hard to keep the selling volume to a minimum and they control the purse strings at IPO time and therefore who gets what rights – Failure to get the company to covenant to keep its SEC reports current 34 Financial and Information Covenants • Most recent trends (fairly standardized) – Audited annual financials as soon as Company can afford, maybe sooner. – Quarterly P&L, Balance Sheet, and Cash Flow, plus quantitative description of business operations – Monthly unaudited financial statements – Reasonable access to information for investors 35 Drag Along Provisions • Definition: Require minority shareholders to voluntarily cast their vote in favor of that which is approved by the majority, regardless of how they would like to vote. • Goal: Prevent obstructionist minority shareholders from killing an acquisition or merger. • Remember to distinguish from “Tag Along Rights” (slang for Co-Sale Rights) 36 Drag Along Provisions • Recent Market Trends: – They exist now and are put in separate agreements – Probably more common than not – 5 years ago, they didn’t exist at all – Result of a VC market evolving to where acquisition is the preferred exist, not IPO. • Typical Negotiating Mistake – Underestimating the significance of them with a substantial preferred investor – signing away the decision to merger or not to the investor without recourse. 37 Employment-Related Agreements • • In a technology company or a start-up usually, the people are the most significant asset. Common Employment Agreements: – Employment Agreement – Options vs. Restricted Stock – Vesting Provisions – Intellectual Property Assignment – Confidentiality – Non-solicitation – Non-Compete Board Seats for Founders • 38 Employment-Related Agreements • Most Recent Trends – 15-20% of Outstanding Equity Set aside for option pool – 3-4 year vesting – Deferred compensation and option accounting rules impact structure of compensation Typical Negotiation Mistakes – Making IP related documentation (I.e. non-competes) so oppressive that you can’t attract quality employees – Failure to adequately motivate employees • Number of shares • Vesting – Failure to articulate who bears the dilution of the Incentive Pool – Not setting up your capitalization table to make the options look attractive • 39 A Subjective Prioritization Target Closing date Exclusivity Confidentiality during negotiations Attorneys Fees Type of Security General Terms (Number, Price, Valuation) Reps and Warranties Dividends Liquidation Preference Redemption Conversion Anti-dilution Supermajority or Class Voting Provisions Board Structure and Members Pre-emptive Rights Right of First Refusal Co-Sale (Tag Along) Registration Rights Financial Information and Information Covenants Drag Along Emloyment Related Agrements 40 Importance to Company/Founders Medium High Medium Medium High Medium Medium Low High Medium Low Medium High High Low Low Low Medium Low Medium High Frequently Disputed? No No No No Yes Yes No No Yes Yes No Yes Yes Yes No No No No No No Yes Conclusions and Things to Remember as You Negotiate • • It’s a gigantic balancing act between all of the moving parts and -prioritize what you care most about Intellect doesn’t carry the day -- It’s a free market (this is capitalism in it’s purest form!). – Market forces governs (once you are educated) – Get multiple term sheets Don’t get fixated on valuation. It really is not zero sum – the moment the deal is done, you all have should have very interests in making the company succeed (or else the term sheet is structured wrong). Don’t get emotional Don’t get intimidated – the fact that you got a term sheet at all from a VC is something to be happy about Get advice from others who have been through it before If you like the people who are going to be investors, just “get the deal done.” • • • • • • 41 Final Thoughts… • The “Adversarial” Conference Panel Story First words out of the entrepreneur’s mouth: “me and X (Venture Capitalist, the other panelist) have done this three times before and, by now we could literally hammer out the term sheet for our next company on a napkin in a bar in15 minutes over a beer. The term sheet negotiation should not be painful! Behavior is during this process is a really good indicator of what is to come in the “partnership.” As a VC, I and my partner walked away from deals where we had “agreed” on the terms just because of the way the entrepreneur behaved towards the negotiation and us and what it made us envision what our “marriage” to the entrepreneur for the next 10 years would be like. • • 42