Understanding VC Term Sheets

© 2013 Foley Hoag LLP. All Rights Reserved.

Understanding VC Term Sheets

Presentation to TiE Challenge January 9, 2013

Mark A. Haddad Partner

617-832-1724 [email protected]

Understanding VC Term Sheets | 2 © 2013 Foley Hoag LLP. All Rights Reserved.

These materials have been prepared solely for educational purposes. The presentation of these materials does not establish any form of attorney-client relationship with the author or Foley Hoag LLP. Specific legal issues should be addressed through consultation with your own counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. © Foley Hoag LLP 2013.

United States Treasury Regulations require us to disclose the following: Any tax advice included in this document and its attachments was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.


What is a term sheet?

aka- “Letter of Intent,” “Memorandum of Understanding,” “Agreement in Principle” Basic agreement on the material terms of the

transaction –Road map, marching orders

More detail is generally better (especially for the company) Legally binding? For the most part, no, but….. If you really want to mess up your transaction,

this is the place to do it


Non Binding

A term sheet is not a binding agreement to fund – Subject to actual documents – Subject to due diligence – Subject to other closing conditions (legal opinion, etc.)

Confidentiality – Term sheets typically have a binding confidentiality provision

prohibiting disclosure of the terms and the existence of the term sheet

Exclusivity – Term sheets typically give the investor some period of

exclusivity (30 to 60 days)


Types of Early Stage Financing Deals

Seed Financing: –Convertible Notes –“Series Seed” or “Series AA” (i.e. Series A light)

Series A Series B and later rounds


Series A

Takes the form of “Convertible Preferred Stock” with lots of contractual protections and benefits Control issues:

– Voting control, board seats, veto powers, forced sale – “CEO” and the three envelopes

Economic issues: – Make sure you understand how the economics work and are not

comparing apples to oranges


Convertible Preferred Stock

Why Convertible Preferred Stock? –“Preferred” - Preference over common stock on

dividends, distributions, liquidation, redemption –“Convertible” - All of the upside of common stock


Pre-Money Valuation

“Pre-Money Valuation” is the value given to the company before the transaction. It allows for the calculation of the share price, which is equal to the pre-money valuation divided by the number of shares “outstanding” before the transaction:

Share Price = Pre-money Valuation / Pre-money Shares Outstanding

Critical Issue –What shares are being counted in the “Shares

Outstanding” number? (All outstanding options? Options reserved under the option pool? What is the size of the option pool?). The higher the number of shares deemed “outstanding,” the higher the number of shares (and “actual” percentage of the company) that the investors receive for the same dollar amount of investment.


Post-Money Valuation

Post-money valuation is the sum of the pre-money valuation plus the amount invested.


Math Geek Part 1

Offer 1: Pre-Money Value of $10 million, $5 million investment, 10% Post-Money Option Pool Offer 2: Pre-Money Value of $11 million, $5

million investment, 20% Post-Money Option Pool Which is the better offer?


Math Geek Part 1 Answer

Offer 1, even though it’s a lower “pre-money valuation.” It values the outstanding common stock higher because it includes a smaller post-money option pool. Here’s the math: Offer 1 Values: O/S % FD %

– Preferred Stock $ 5,000,000 37% 33% – Option Pool 1,500,000 NA 10% – Common Stock 8,500,000 63% 57% – Total Post-money $15,000,000

Offer 2 Values: – Preferred Stock $ 5,000,000 39% 31% – Option Pool 3,200,000 NA 20% – Common Stock 7,800,000 61% 49% – Total Post-money $16,000,000


CAUTION! Valuation is only one of many economic terms. As the saying goes, a VC will gladly let you pick the

valuation if they get to pick all the other terms. You can construct the other economics in many ways, the easiest of which is the liquidation preference…


Liquidation Preference

Liquidation preference = the right of the holders of preferred stock to get their money back (and perhaps more) before the common stock when a “liquidation event” occurs (generally, an M&A transaction). Sometimes “multiples” are used (1x, 2x, 3x). Sometimes accruing dividends are included (essentially like adding

an interest rate component to the preference– range of 4% to 9% in Q3). “Preference overhang” refers to the total amount of liquidation

proceeds that go to the holders of preferred stock before the holders of the common stock begin to share in the liquidation proceeds. Three main flavors:

– No participation – Participating preferred (aka “Piggy Preferred”) – Capped participation


Math Geek Part 2 Assume we took Offer 1 ($10m pre and $15m post) and a year later we sold the

company for $30 million (with the option pool fully issued/vested for simplicity). Here are how different preferences and participation rights would play out:

1x preference, no participation: – Preferred Stock: $10 million (33% of proceeds) – Common Stock: $20 million

1x preference, full participation: – Preferred Stock: $13.3 million (44% of proceeds) – Common Stock: $17.7 million

1x preference, participation capped at 2x: – Preferred Stock: $10 million (33% of proceeds) – Common Stock: $20 million

1x preference, participation capped at 3x: – Preferred Stock: $13.3 million (44% of proceeds) – Common Stock: $17.7 million

3x preference, full participation: – Preferred Stock: $20 million (67% of proceeds) – Common Stock: $10 million


Math Geek Part 2

Now assume it was only one week later and for $15 million: 1x preference, no participation:

– Preferred Stock: $5 million (33% of proceeds) – Common Stock: $10 million

1x preference, full participation: – Preferred Stock: $8.3 million (55% of proceeds) – Common Stock: $7.7 million



3x preference, full participation: – Preferred Stock: $15 million (100% of proceeds) – Common Stock: $0


Math Geek Part 2

Source: www.wikipedia.org


Liquidation Preference- Take Aways

Having a preference is standard, but focus on trying to minimize participation and accruing dividends. Understand how the preferences interplay so that everyone’s

incentives are aligned. It can get very complicated when multiple rounds are stacked up. In some cases you can have flat spots or even drastic jumps that create divergent incentives. The early rounds set a precedent for later rounds, so early

investors that are too greedy on terms may live to regret it (use this argument to your advantage in negotiating favorable terms in the early rounds). Sometimes preference can be used to bridge a valuation gap, but

again, worry about the precedent in that case. Generally not applicable in IPO


Uncommon but BIG Traps

Dividends paid in equity –Example: Series A priced at $1 per share. 8%

accruing dividend, can convert to common at $1 per share.

Liquidation preference that converts into equity –Example: Upon conversion, in addition to the

preferred stock converting to equity (initially one for one) the liquidation preference is paid out in the form of common stock at current fair market value. In the upside scenario this is simply extra juice in an IPO (that the VC would have gotten in a sale at the same value) but in a downside this is essentially full ratchet antidilution and then some.


Antidilution Protection

Addresses Investors’ concern re: valuation Changes the conversion price used to calculate the

number of shares of common stock issued when a share of preferred stock converts Helps protect investors in the case of a “down round,”

when new money comes in at a total pre-money valuation (or price per share) that is lower than the previous round’s post-money valuation. Two main flavors:

– Full ratchet – Weighted average (broad-based and narrow based)


Weighted Average

Weighted average anti-dilution adjustment takes into account the proportional relevance (or weight) of each component in the calculation rather than treating each component similarly. In a down round, the conversion price of the Series A is lowered to

a price that is an average of the price at which the company sold the new stock, valuing the common stock outstanding at the pre-adjusted conversion price. Sometimes formulated as “broad-based” and sometimes as

“narrowly-based.” (“narrowly-based” is more favorable to the protected preferred stock.) More common than full ratchet, and much less onerous to un-

protected stockholders. Formula: New price= (P1)(Q1) + (P2)(Q2) (Q1) + (Q2)


Full Ratchet

The conversion ratio of the protected preferred stock is “ratcheted down” to the lowest price at which securities are sold in the down-round (where stock is sold at a price lower than the earlier protected round). This applies even if only one share is sold. It treats all subsequent down-round stock issuances similarly, resulting in an adjustment to the conversion ratio regardless of the number of shares issued. Very onerous, and increasingly less common (although

makes a comeback at times, like in 2008-2009 decline).


Math Geek Part 3

Assume again Offer 1 is closed on ($10m pre and $15m post). Subsequently, the company has to raise an additional $2.5 million in a Series B at a $7.5 million pre-money valuation (a 50% decline from the $15 million post-money).

If the Series A had no antidilution, the resulting cap table would be: – Series B: 25% ($2.5 million) – Series A: 25% ($2.5 million) – Common: 50% ($5.0 million)

If the Series A had “full ratchet” antidilution, the resulting cap table would be: – Series B: 25% ($2.5 million) – Series A: 50% ($5 million) – Common: 25% ($2.5 million)

If the Series A had “weighted average” antidilution, the resulting cap table would be: – Series B: 25% ($2.5 million) – Series A: 27.5% ($2.75 million) – Common: 47.5% ($4.75 million)


Math Geek Part 3

Weighted Average Math: New price= (P1)(Q1) + (P2)(Q2) (Q1) + (Q2) = ($1)(15,000,000) + ($0.475)(5,263,158) (15,000,000) + (5,263,158) = $0.86363… Fully diluted A = (5,000,000)/($0.86363…) = 5,789,474 Common: 10,000,000 42.5% Series A: 5,789,474 27.5% Series B: 5,263,158 25% Total: 21,052,632 100%


Board Seats

Usually investors require one or more board seats Challenge: What is the proper balance between

founders, investors (both existing and new), and outside directors? Keep board size manageable – bigger is not always

better Sometimes a “board observer” rather than board seat Think carefully about “CEO board seat” and consider

“Founder board seats”


Protective Provisions

aka “Negative covenants,” “Veto rights” or “blocking rights” Essentially a list of things you can’t do without

investors’ prior consent - Consent at either the Board or Stockholder level Usually hotly negotiated This is a foot on the break, not on the accelerator Gets complicated in later rounds; interests of investors

can diverge The relevant thresholds are very important depending

on the dynamics of your investor base


Other Key Terms

Co-sale (“tag along”) rights – Ability to sell along side founders/management (and sometimes

also other investors)

Right of first refusal – Ability to purchase shares for sale by founders/management

(and sometimes also other investors)

Founder vesting – Will often get renegotiated. Focus on what is vested up front

and what happens on change of control.

Drag along rights – Ability to force all stockholders to go along with a sale that

meets certain conditions. Focus on appropriate thresholds for founders/common stock.


Other Key Terms (cont’d)

Pre-emptive rights – Right to participate in future financings – Make sure it is based on fully diluted ownership, not % of

preferred

Pay to Play – Ability for investors to force each other to invest in future rounds.

Information rights – Make sure appropriate restrictions on use and not sent to

competitors

Registration rights (IPO) – Standard and not worth negotiating as long as reasonable


Series B and later

Series B and later will usually piggy back off of the Series A terms – Realize you will have to live with the Series A, generally terms

can only get worse, not better – Further dilution and control issues

Growth equity – Could be similar terms or could be opportunity to recap and

cash out prior investors (and some portion of founder equity)

IPO – The big homerun, but liquidity for the founders is still not

necessarily immediate


What is a Convertible Note

First and foremost, it is debt, so it sits above any equity (stock) in the capital stack However, it also has an equity feature in that it

converts upon specified events into stock of the company The most common conversion is upon a

“qualified financing” (generally an equity financing of a certain size), but notes can also provide for conversion on other events


Key Features

Conversion rate: – Fixed discount or increasing discount over time – Can have caps and collars (maximum and/or minimum

conversion price) – If using caps, try to set a fixed price based on today’s cap table

Automatic conversion on qualified financing – e.g. upon an equity financing of $1m

Optional conversion (sometimes included) – By investor to common at cap price or other negotiated price – By company to common at floor price or other negotiated price

upon maturity Interest

– Converts along with principal – Interest rate is generally modest (for example, 5%), unless that

is being used with a smaller discount


Example

$100k convertible note, 5% interest, 25% discount upon qualified financing Company raises qualifying Series A at $1.00

per share one year after issuing the note Note converts into shares of Series A:

–Principal + interest = $105k –Note converts at 25% discount, so at a price of $0.75

per share –$105k / $0.75 = 140,000 shares of Series A (instead

of 100,000 shares that a “new money” $100k investment would purchase)


Key Features (cont’d)

Payment on acquisition: – Can be based on the discount, can convert at pre-determined

price or can be a formula (e.g. 2x return)

Maturity date – Later the better – Give yourself enough runway to get to the next milestone and

have at least a 6 month cushion beyond that

Collateral (secured or not) Amendment of notes

– Use a single note purchase agreement that lets a majority of the principal amount of all notes amend the terms


When to use Convertible Notes

In most cases, will be simpler, faster and cheaper than doing a preferred stock financing, but not always Generally speaking

– $500k or less, use convertible notes – $1m or more, use preferred stock (even if “seed preferred”) – But there are exceptions to both of these

Consider your future financing needs: – If you may never need to raise more money, do a stock deal or

build in an automatic (or optional) conversion of the notes at maturity

Consider if you are able to value the stock: – Often convertible notes are a way to treat friends and family

money fairly by deferring a valuation until “sophisticated investors” can negotiate with the company


Company Pros and Cons

Faster and cheaper to execute More control over your company (notes do not vote,

and generally you don’t give board seats or significant protective provisions to note holders) Delays dilution until you can increase the valuation Risk of getting to maturity date without resources to

repay or a “plan B” Quickly “insolvent” on paper as the money is spent

(although this helps with valuation position with respect to employee options and equity)


Investor Pros and Cons

Faster and cheaper to execute Discount can be small compared to the relative risk of

the investment (misalignment of interests) – Valuation is too high in “homeruns” (can be mitigated by the use

of caps) Having “debt” in an insolvent entity is not much

protection Less control over the investment (delaying typical

investor protections until conversion, but can negotiate for some, like pre-emptive rights or info rights) Capital gains treatment does not start until conversion

happens


Seed Preferred Alternative

Increasingly, a number of “Series A Lite” or “Seed Preferred” deals are being done as an alternative to convertible notes Provides for equity without all of the usual bells and whistles of a

full Series A deal Usually has at least a liquidation preference and pre-emptive

rights, but may not have many more investor protections than that A few sets of standardized documents that are open source and

available for use to keep transaction costs down: – Series Seed (seriesseed.com) – YCombinator (ycombinator.com/seriesaa.html) – TechStars (techstars.com/docs)


What is Market? (Series A)


What is Market? (B and later)


Final Thoughts

Generate scarcity and interest: – best terms will come from competition – try to land multiple term sheets in a short window to increase

your leverage and options

Choose your investors wisely: – like a marriage, you will be with them for a long time – think about how it positions you for the next round, including

issues like signaling and available dry powder – all money is not created equal – do reference checks on your investors with others they have

funded


Final Thoughts (cont’d)

Choose your fights wisely: – make sure you know what really matters to you, and understand

the market dynamics. – don’t be afraid to ask “why do you need that?”

Choose your legal advisors wisely. This stuff gets complicated fast. And do it early (before negotiating the term sheet!)


Other Resources

Foley Hoag Venture Perspectives (our quarterly publication tracking terms of New England VC deals) NVCA Model Venture Capital Financing

Documents (including model term sheet): –www.nvca.org (click “Resources” then “Model Legal

Documents”) or use http://bit.ly/bj7Pn –Forms are intended as starting point only

Understanding VC Term Sheets

Documents

Transcript of Understanding VC Term Sheets