Helsinki School of Economics, Biotechnology Concentration
Introduction to VC term-sheets and protection mechanisms
Jari Lauriala, Partner Replicon Corporate Finance Oy February 2004
Content
• • • • • • • • • • • Fundamentals of Venture Capital VC as a shareholder of the company Stages of Investments Due Diligence of VC Term-sheet Shareholders’ Agreement Antidilution provisions Liquidation Preference Example of Liquidation Preferences Discussion Appendix I Replicon Corporate Finance Oy
Who is this guy ?
• Jari Lauriala, LLM, Licenciate of Law, Partner in Replicon • Mr. Lauriala has specialized in equity capital markets, with particular expertise in venture capital and private equity transactions. Mr. Lauriala has acted as a lawyer for several high-tech entrepreneurs and innovation oriented growth companies in their private fundraisings. • Prior joining to Replicon he was a Legal Counsel at PCA Corporate Finance Oy, member of LBKiel Group, where he was responsible for several issues concerning financial, securities and corporate laws in domestic and cross-border equity and equity-related issues, stock option and convertible debt issues. • Mr. Lauriala is also a certified management consultant (registered by Ministry of Trade and Industry) with corporate governance, venture financing and private equity -spelicialist profile. He has written several publications on the legal aspects of Venture Capital and Private Equity Investments, which are used as text-books at the Faculty of Law. • Mr. Lauriala holds Master of Law and Licentiate of Law degrees and has completed Biotechnology Management program in Helsinki School of Business Administration.
Fundamentals of Venture Capital Investing
• • • Venture capitalists’ (“VC”) approach is to invest in quality science, commercial strategies and management which it believes are key elements in building successful technology businesses. The focus will be on investments in undervalued companies who meet venture capitalists’ investment criteria. The entry valuation of investor will depend on factors such as investors return expectations, the proportion of the company that the management will give up to attract the investment and the investors view of the opportunity for new concept, product or service. The intention is to invest within 4-5 years and to liquidate the shareholding in early phase companies after 4-8 years and in companies with follow-on funding after 1-3 years. The VC will need to consider his or her own risk/return expectations, and the management will need to consider the proportion of the company it is willing to sell to an investor. Capital structure is divided in to series of shares: i) preferred shares (VC’s); and ii) common shares (founders). VC’s exit could be anything between liquidation and IPO.
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VC as a shareholder of the company
• • In addition to money, professional VC as a shareholder bring strong industry, operational, financial and investment banking skills to the partnership with the target company. Through the VC’s expertise and network the portfolio companies could gain access to:
• • • • • a) follow-on capital through venture capital ties; b) knowledge of partnership opportunities in multiple markets c) in-depth operational and management experience; d) access to high quality management teams; e) ties to the investment banking community.
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VC adds the most value by assisting in the creation of the best possible team to manage and supervise the target company. Management asessment is one of the major tasks to be carried out by the venture capitalist before deciding to invest.
Stages of Investments
• • The stage of development of the company will determine how much factual information is available to base an analysis of potential investment. The stage will also initially determine the risk-reward rate of the company.
• • Early stage companies may have proprietary technology or intellectual property that has the potential to be exploited on a global scale. The technology or lead product is usually beyond proof of principle stage. Mid-stage companies may have strong pipeline of technologies and products, which have been developed by research and management teams with scientific and commercial credibility. The lead product is usually approaching clinical trials at this stage. Late stage companies have operational and corporate finance skills ideally positioned and company may need investments to precipitate consololidations. Companies at this stage are within 12 to 18 months of an IPO and have their lead products well advanced in clinical trials.
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Stages of Biotech Investments
private equity
Value
venture capital seed finance
Proof of Principle Phase I Pre-clinical
Time
Due Diligence of VC
• • Subsequent to initial assessment, due diligence is performed. Based on this information, the business concept is subjected to further analysis and validation by investor by study of the literature and relevant databases, interviews with customers or potential customers, competitors, consultants and relevant experts from network connections. The due diligence undertaken by the bio-tech investor typically includes several phases:
• In scientific and clinical investigations the investor will look at the validity of the scientific proposition, the practicalities of its scientific strategy, the credibility of the research planning and the feasibility of delivering against milestones. In particular, investor have to look at existing property held by the company, its origins and ownership and the prospects for securing a sound intellectual property estate downstream, given prior art and competitive positions. Deals in place and the likely ability to secure significant partnerships are another feature of biotech investor’s due diligence.
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Term-sheet
• The term-sheet is analogous to a letter of intent, a non-binding outline of the principal points which Shareholders’ Agreement and related agreements will cover in detail. The main purpose of the term-sheet is to guide discussions and drafting of final documents Term-sheet covers all relevant parts of VC investment:
• • • • • • • Valuation; Conversion features; Antidilution provisions; Liquidation Preference features; Control rights; Protective provisions; Conditions of closing etc.
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Some portions of term-sheets are ment to be binding. That is usually confidentiality of the disclosures made in the negotiations.
Shareholders’ Agreement
• Once the division of the equity has been achieved, number of other important matters require attention. These include corporate governance issues, investor rights (particularly if the investor holds a minority of the voting shares) and control over the exit process. Terms and conditions in the shareholders’ agreement will limit the target company's management ability to behave opportunistically In the shareholders agreement the parties agree to have the aim of operating and developing the company’s business along the lines set out in it’s business plan so as to generate the maximum maintainable profits and to enable a trade sale or an IPO within reasonable time from the date of signing the agreement. The agreement also specify the terms of the parties’ governance and ownership in the company. Each shareholder undertakes to exercise all voting rights and powers available to it at meetings of shareholders in the company so as to give full effect to the provisions of the agreement.
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Antidilution provisions
• • • In many (usually all) cases antidilution provisions are also implemented to the VC term-sheets and shareholder’s agreement. The main categories of antidilution provisions are full ratchet antidilution protection and weighted average antidilution protection Antidilution provisions mean that in the event that the company issues or sells shares, preferred shares or warrants, options, convertible securities or other rights to purchase shares at a price per share less than the price of the shares subscribed by investor, the price of those shares shall be adjusted to a price equal to the price paid per share for such new shares or share equivalents. The purpose is to protect investors against dilution in down rounds by making adjustments to conversion price (preferred -> common) or straight to amount of shares held by VC. When used, antidilution protection always actually re-prices VC’s preferred shares and therefore dilute holders of common !
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Liquidation Preference 1/2
• Liquidation preference is important harvest mechanism for VC’s, since it can enable investors to have at least some portion of their investment in liquidation event. Liquidation event means merger, reorganization, acquisition or other type of transaction in which control of the company’s shares or votes, or all or substantially all of its assets are transferred, or bankruptcy or any kind of insolvency of the company. Liquidation preferences specify the order in which holders of different classes of securities get paid and how much proceeds they can collect before other investors are repaid. VC’s will typically receive a specifically stated amount on liquidation, before any of the proceeds are distributed to the holders of common stock (entrepreneurs, management team and employees)
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Liquidation Preference 2/2
• • • • • The liquidation preference amount is usually equal to the original purchase price of the preferred stock plus any accrued, but unpaid dividends. Liquidation preference structures divides in two categories:
• Straight liquidation preferences (above); and • Participating liquidation preferences
When participation rights are attached to preferred stock, that stock is generally referred as to “participating” preferred stock. Participating preferred stock has become common in VC transactions also in Finland. Under full participation rights, VC’s are first paid their specified liquidation preference amount and then both preferred and common stockholders share all remaining proceeds on a pro rata basis.
Example of liquidation preferences
• • • Newly formed company in which the VC invests €5 million for 50% of stock and the founders invest €1 million for the other half. The company will be acquired by the acquiror valuing the business at €10 million. Under straight liquidation preference, the VC would receive €5 million (it’s money back) and common holders €5 million (five times their original investment). Under participating liquidation preference, the VC would first receive €5 million (it’s money back) and then the residual €5 million would be shared between VC’s and common holders reflecting their shareholding. VC’s get €7,5 million and common holders €2,5. The difference between these simple clauses in term-sheet is €2,5 million !
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Discussion
• • The rationale behind participation rights is the same as that for straight liquidation preferences: Venture capitalists should be entitled to additional returns because they incur substantial financial risk, but do not receive salaries and bonuses, which the founders, managers and employees (the common holders) do receive. Straight liquidation preferences can be unfair to VC’s, as it permits common holders to realize significant gains while while depriving preferred holders of any gain whatsoever. However, the most attractive deals may utilize the simple preference, with no participation, while the company struggling for funding will often have to concede to the most extreme form of participation…
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Appendix I Replicon Corporate Finance Oy
• • Replicon group is independent Finnish corporate finance and consulting house based in Helsinki. Replicon Corporate Finance Ltd. provides highly specialized and quality-oriented corporate finance and consulting services for growth companies and their potential partners as well as venture capital and private equity funds. Our core services include: • Project Valuations • Financial Arrangements • Financial Instruments • Legal Counselling • Partnering Solutions Replicon’s special focus area is Life-Science -sector including: Biotechnology, Medical Technology, Pharmaceuticals / Biopharmaceuticals, Diagnostics, Bioinformatics as well as IT-Solutions. www.replicon.fi jari.lauriala@replicon.fi Tel. +358 9 677 464; Gsm +358 400 918 855
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