Venture Term Sheet

Venture Capital Financing David A. Neal Term Sheets from the Entrepreneur’s Perspective The Term Sheet is the roadmap to definitive agreements that will control the investment an entrepreneur’s company receives from a venture capitalist. A Term Sheet expresses basic understanding of the key points of a deal, with the understanding that there is much more to be discussed once a Term Sheet is signed. There are usually only three parts of a Term Sheet that are legally binding: • Fees. • Standstill or No Shop. • Confidentiality. None of these provisions make the deal binding on the investors and are generally protective of investors’ interests. Fees A venture capital Term Sheet provides that all legal fees and due diligence expenses will be paid by the company. In practical terms, this means that the payment of these fees comes off the top of the proceeds of the financing. Entrepreneurs sometimes question why the company should bear all the fees of the transaction, however, attempts to oppose this provision have virtually no chance of success and will tip off the opposition that a player is inexperienced in the money-raising game. The best approach is to work with opposing counsel to © David A. Neal 2002 set a limit on fees. Such a limit provides a useful incentive to investor’s counsel to be efficient and accommodating in the deal-making process. Standstill or No-Shop The “standstill” or “no-shop” provision provides that once the company has accepted the Term Sheet, it is barred from continuing negotiations regarding financing with any third party. In the venture investment environment of the last two years this provision had little impact. Any company that could negotiate a Term Sheet felt a powerful motivation to complete that deal. Any discussions with third parties would have jeopardized the existing deal and would be considered reckless. In more competitive times, if an entrepreneur is fortunate enough to have multiple investment groups interested in funding his or her company, the negotiations for the best terms and conditions must be carried out before choosing a preferred investor and ; a Term Sheet is signed. Aside from legal ramifications, any entrepreneur or company that engages in discussions with other investors after a Term Sheet has been signed runs the risk of sabotaging the current deal as well as making it much more difficult to raise money in the venture market again. At the same time, it is unwise to permit an unlimited No Shop Clause for the investors. Because the entrepreneur/company is tied up and has little recourse if the investor begins to drive the deal away from the agreement, the logical © David A. Neal 2002 approach is to limit the No Shop Clause to 60 to 90 days from the execution of the Term Sheet,. This limit provides investors with an incentive to close the deal in a timely fashion. Confidentiality Venture capital firms are hesitant to sign non-disclosure agreements because their constant contact with so many entrepreneurs leaves them particularly vulnerable to charges that they had transmitted confidential information to portfolio firms. This requires a balancing act by the entrepreneur seeking capital. The entrepreneur must disclose sufficient, compelling information to demonstrate why the product or company is unique without giving away the farm.. If the entrepreneur makes it to the Term Sheet stage with a venture capitalist, there is some relief from the VC’s refusal to sign a confidentiality agreement. The VC has an interest in maintaining the confidentiality of the specific terms offered to the entrepreneur. In exchange for the entrepreneur’s promise to keep the terms of the offered deal confidential, the VC should agree to maintain the confidentiality of information provided by the entrepreneur in the due diligence process associated with closing of the Term Sheet. This provides protection of information during a time when the company is required to provide increasingly sensitive information. Venture capital firms that are known to (a rare occurrence) share confidential information outside the context of discussions with a potential © David A. Neal 2002 investment are unlikely to gain future access to intriguing investment opportunities. Closing The Term Sheet offers a specific amount of capital to the entrepreneur, although it may not be made available immediately. Many venture capital firms prefer to stage or tranch the investment based on achievement milestones that the parties agree to during negotiations. This technique minimizes risk for venture capitalists by creating an opportunity for them to decline future installments if specific milestones are missed. This type of payment structure motivates the entrepreneur to focus resources on specific mutually agreed upon goals. The milestones of the closing terms are often labeled, “to be agreed upon later.” If possible, the entrepreneur should seek identification of these milestones before the final documents are completed. Capitalization The Capitalization section of the Term Sheet clarifies the pre-money valuation of the company by stating number of shares of stock in the respective classes that are outstanding (and will be outstanding as of closing) as of the date of the Term Sheet. As important, this section specifies the number of shares to be set aside for an option pool to be divided between management and other employees. © David A. Neal 2002 In most companies, the option pool will be calculated at 15-20% of the shares outstanding on an “as converted” basis. “As converted” indicates the total number of shares outstanding, plus all shares allocated to the stock option pool plus all other equity instruments (options, warrants, etc.) that could be converted to shares of stock in the company. To a founder, the size of the option pool is a double-edged sword. The option pool will typically be created before the proposed financing is completed. This will have theffect of diluting the founders (and any current shareholders), while not diluting the investors participating in this round. Conversely, the founders are often unable to increase the value of their shares without additional management talent and therefore should be willing to allocate shares to an option plan. Dividends Cash dividends are rarely paid out to investors of start-up technology firms. This does not mean that dividends do not affect the distribution of proceeds in sale of the company or its shares. Investors who get preferred stock usually demand a provision calling for cumulative dividends. Cumulative indicates that even if dividends are not paid in a prior year, the dividends are still due to the preferred shareholders. Non-cumulative dividend provisions indicate that if the Board of Directors declines to authorize dividends for a year, the company would not be required to retroactively authorize dividends for that year. © David A. Neal 2002 Given the limited cash resources of most start-up companies, venture capitalists recognize that cash dividends are extremely unlikely and therefore insist on cumulative dividends. These dividends will continue to accrue every year with the result of increasing the venture capitalists’ claim to the proceeds of any sale of the company, its stock or its assets. This is accomplished by making the accrued dividends part of the liquidation preference to be received by the preferred investors. For example, if a $4 million Series A investment is accepted with a cumulative dividend of 8% and the company is sold in two years, Series A Preferred shareholders will receive $4,665,600 in liquidation preference, assuming there is no multiple liquidation preference. Liquidation Preference In the event of a sale of the company or any other winding up of the affairs of the company, a venture capitalist will seek a liquidation preference. The liquidation preference will be paid to preferred shareholders in preference to holders of other classes of stock. In practice there may be one or more levels of preferred stock, each with liquidation preferences. Liquidation preferences typically range from 1x the amount invested to a multiple of the amount invested. In the down times for venture investing, the multiple requested might be 3x-6x the amount invested. For example, with a Series A investment of $4 million and a liquidation preference of 3x, preferred investors would be entitled to receive the first $12 million (plus accrued dividends) of proceeds from a liquidation event. Once the liquidation preference is paid out, the preferred and common stockholders share © David A. Neal 2002 the remaining proceeds according to their respective converted ownership positions. Preferences create dilemmas for the entrepreneur. In difficult times, it is nearly impossible to conclude a transaction without agreeing to a multiple liquidation preference. These preferences confirm the primacy of capital sources during such times, however, they can create compensation problems for the founders, management and employees of the company. Consider a company that was created in the late 1990’s, raised large amounts of money and found a way to survive through the recent difficult economic and investment conditions. Because investment conditions and expectations were different during the early stages of that company, many such survivor companies have relatively large amounts of invested capital. Even with only a 1x liquidation preference, only an outstanding liquidity result will create value for the founders as common shareholders. If multiple preferences exist on the entire amount of capital invested to date, the chances of an outcome that creates significant wealth for common shareholders become even more remote. Investors recognize that this situation (little prospect of significant gain for management) works against overall success. When the amount of preference dollars becomes sufficiently imposing, investors are usually willing to share with the management team to make sure that the incentives are strong enough to © David A. Neal 2002 encourage the desired result. This can be accomplished contractually via agreements that provide a pool of money to be shared among key players at the company or by the creation of special classes of stock that reward key managers and employees. Conversion/Automatic Conversion The conversion rights permit the holder of preferred shares to convert them (plus accrued dividends) to common shares at the option of the preferred shareholder. Under normal circumstances, an elective conversion is almost never considered. Automatic conversion becomes important in the event of an initial public offering. Because investors in public companies will not tolerate classes of stock with more rights than the public shareholders (especially when the superior classes of stock have paid substantially less per share), it is necessary for all preferred shares to be converted to common shares before an IPO is completed. The issue at this point is how large an offering must be to constitute a valid public offering of shares. Investors’ counsel will set requirements for the minimum amount of capital to be raised and a minimum price per share (at some multiple of the price of the current round of preferred). The entrepreneur’s task is to make sure that the numbers used in this provision are reasonable with regard to expected financial performance of the company. Price Protection Provisions © David A. Neal 2002 Price protection provisions protect venture capitalists in the event shares of the company are sold at a price below the per-share price they paid. In theory, if shares are sold at a lower price than originally paid by the preferred investors, a mistake was made in the valuation process. All shares purchased at higher prices will be adjusted down to the lower sale price. As a result, previous investors will gain more shares and holders of common shares or preferred shares without price protection will be diluted. There are two main types of ratchet provisions found in price protection provisions. The weighted average ratchet, which is more reasonable from the entrepreneur’s viewpoint, takes into account the amount of securities sold at a lower price in determining the number of new shares to be issued. Suppose a company that raised $4 million in a Series A round then raised $40,000 to cover a payroll before a new financing is complete. The weighted average ratchet would take into account the fact that raising $40,000 represents only a 1% dilution of the Series A investors, resulting in only proportional price protection for the preferred investors. The full ratchet has a more profound effect on the founders and other shareholders. The full ratchet is worth resisting because it is easy to argue that it is inherently unfair. Regardless of how few shares of stock are sold at the lower price, every share of preferred stock subject to price protection will be adjusted to the lower per share © David A. Neal 2002 price. A small sale of stock can have a huge impact on the capital structure of the company. Whether a Term Sheet will contain a weighted average or a full ratchet is usually reflective of overall market conditions.. Voting Rights and Protective Provisions Most Term Sheets provide the preferred investors with equal voting rights on an as converted basis. Any holder of preferred stock can vote on any matter that common stock would be entitled to vote. In reality, the holders of preferred shares enjoy the benefit of a number of “protective” provisions that affect the way the shareholders can direct the company to operate. These protective provisions typically require approval of a majority (or a supermajority) of the affected preferred class to: • Sell the assets or stock of the company. • Merge with another company. • Purchase or redeem certain shares of the company. • Authorize a class of securities with equal or superior rights to the preferred class. • Alter or change the powers, preferences or rights of the preferred class. • Change the charter in a way that adversely affects the preferred class of shares. • Liquidate or wind up the business. • Permit an IPO. © David A. Neal 2002 It is hard to deny that the investor has a legitimate interest in making sure that none of these actions occur without their advice and consent. It may be reasonable to request that a minimum percentage of the original shares of the affected class of preferred still be outstanding or that the preferred class maintain a minimum ownership threshold. Redemption The redemption clause is the investor’s insurance policy against the company becoming a comfortable paycheck for management. Venture capital firms are organized as partnerships with finite lives. Accordingly, they rely on the expectation of an exit event within a few years of an investment. Should a company become a profitable enterprise but lack opportunities for a sale or IPO, the VC needs a way to force the company to create a return on its investment. Most redemption provisions take affect five or six years from the date of investment. While it is difficult to argue against the redemption clause in principle, it is reasonable to negotiate the timing, the amount required for redemption and the methodology to be used in any redemption. Registration Rights The registration rights language provides rights to preferred investors to force an IPO or to include their shares in the IPO or subsequent registration. This section of the Term Sheet is among the most complicated and seldom becomes © David A. Neal 2002 important in actual transactions. In addition, the underwriters of a public offering often require wholesale changes to the registration rights granted to preferred investors. There are three types of registration rights that are usually covered in these provisions: • Demand rights permit the investor to require the company to register portions of the investor’s stock of threshold size or dollar amount (for example, owners of at least 50% of the preferred must ask to register stock worth at least $15 million). Demand rights usually come into force after three or four years. Because most companies and their management want the option to become public (and because piggyback rights exist and would be available if a demand is plausible), these demand rights are seldom invoked. • Piggyback rights let the investor obligate the company to include some portion of the investor's shares in any registration that the company undertakes. Because of the broad right created, piggyback rights are used frequently by investors. • S-3 rights are similar to demand rights and are favored in theory because the registration expenses are low. Because an S-3 is generally a relatively inexpensive document to prepare and file, investors often get the right to © David A. Neal 2002 use one or two S-3 registrations per year and have smaller minimum amounts that need to be registered. As with other provisions such as redemption rights, these provisions are driven by venture capitalists’ requirement for liquidity events. It is advisable to negotiate some of the terms that control these rights including: • The percentage of shareholders from the preferred class necessary to force registration ― the company prefers a higher required percentage. • The minimum dollar size of the public offering in connection with demand rights ― the company prefers a larger number (at least $20-$30 million) because the costs and requirements of being public are not justified for small public offerings. • The number of demand rights to be granted in a specified period. • Whether piggyback rights will apply to a company’s IPO. It is customary that the company be required to bear the underwriting costs, legal fees, accounting fees and other costs associated with these offerings. Right of First Refusal/Co-Sale First refusal rights ensure that if a founder, common shareholder (or preferred shareholder) wishes to sell their shares, they must offer them first to the company or the preferred shareholders. These provisions are useful to insure that the company’s shares are not transferred to persons that the company © David A. Neal 2002 prefers to exclude from its shareholder group and to allow the company or its shareholders to capture economic value in the event of a distress sale. Co-sale rights are directed at the company founders. These provisions provide that if any sale of the founders’ ownership position occurs, each investor will have a right to include some of their shares in that sale. Investors are betting on management, so it is best not to contest these provisions. Make sure that certain small transactions, especially pertaining to tax planning or estate planning, are permitted. Vesting of Founders’ Shares This is often a tough pill to swallow for founders that have poured their lives into the creation of a company. They own common stock positions by virtue of their status as founders. The venture capitalist usually asks that the founders give up that established right and agree to have their ownership vest over a period of years. From the VC’s point of view, this is reasonable because many founders do not remain with the company throughout its life cycle. Without a strong bargaining position founders are unlikely to avoid a vesting schedule. Accordingly, attempt to negotiate to have some of the shares remain vested and to limit the vesting period. Founders can make stronger arguments for protecting shares from the vesting process or shortening the vesting time by demonstrating: © David A. Neal 2002 • A long period of time working to create the company. • Contribution of personal intellectual property to the company. • Investment of personal funds in the company. Pay-to-Play Provisions Pay-to-play provisions are intended to provide an incentive for all key investors to participate in each subsequent round of financing provided to the company. They do this by creating stiff penalties for investors who do not invest their full pro rata share in subsequent financings. This is most likely to create problems where the members of the investor syndicate have disparate abilities to reserve and contribute capital to later rounds. The practical effect of these provisions is to dilute the investor that does not participate at a pro rata share level in an investment. The dilution is often severe; causing significant concerns for the company because investors who have been “crammed down” sometimes look for ways to recover their dilution losses through litigation. Board of Directors Balance is the key to a helpful Board of Directors. Balance in this context means representation from investors, industry experts and other entrepreneurs. A board of five directors eases some logistical pressures. If the investors agree to a five person board an ideal mix might be: • Two VC’s representing the preferred shareholders. • CEO of the company. © David A. Neal 2002 • Two industry experts, at least one with entrepreneurial expertise, that can open doors for and provide advice to the company. © David A. Neal 2002