1. 12 Term Sheet Issues (8 that matter and 4 you should understand…
12 Term Sheet Issues (8 that matter and 4 you should understand….) SLP | Startup Leadership Program

2. Issues Valuation & Cap Table Dividends Liquidation Preferences
Board Seats
Option Pool
Anti-dilution Protection
Drag Along
Founder Restricted Stock
Pay-to-play
Right of First Refusal and Co-Sale
Redemption
Pre-emptive Rights
Source: Richard Kimball, EAPD

3. 1. Valuation: Jargon “3 on 3” means $3M pre-money with $3M round
With a $6M post-money ($3+$3) VCs will own 50% of the company
Lets also assume that the options are 15%
Source: Shari Loessberg, MIT Sloan, Fall 2003

4. This is what the cap table will look like
Series A Preferred
Investors
50%
Founders
35%
Option Pool
15%
Source: Shari Loessberg, MIT Sloan, Fall 2003

5. 2. Dividends & its Impact on Vesting
Straight versus Cumulative
Interest rate (dividends) are 4% to 8%. Never higher ! (In China they can approach 15%)
If Dividends are “Cumulative”…
It is usually in the form of cash
Sometimes in the form of common stock
Very rarely in the form of preferred stock (called PIK)
Cumulative dividends transfers small ownership increments (4-6%) of investment every year that the company isn’t sold. Its bad news.
High cumulative dividends esp when Preferreds own a big chunk of the company are bad news. Avoid them.
Dividends that need to be declared every year are best. They’re never declared! (Straight) But you’ll see “Participating Preferred” or liquidation preferences >1x
Source: SLP, EAPD

6. 3. Liquidation Preferences
Straight versus Participating Preferred
1.5x participation with straight dividends common
Whatever you start with will tend to stay till the end
If >1.5x participation, negotiate against cumulative dividends
How to negotiate away very high liquidation preference. Just remember a step-ladder approach
2.0x if sold for $50MM
1.5x if sold for $75MM
1.0x if sold for $100MM
Danger of this step-ladder approach!
Complicates the cap table
Strange incentives (VCs sell for $99MM instead of $100)
Still a good tactic to bridge a valuation gap
Source: SLP

7. 4. Board Seats
“AOL almost sold to Compuserve in 1991 for $60M. The VCs wanted to sell. [Steve] Case won by 1 vote. 10 years later, [AOL was] worth $100 billion.”
- Mark Pincus/Blogger from Steve Case Talk
Tough to negotiate away
All important decisions must be approved by the Board
Odd numbers are preferred to avoid deadlocks
VCs secure rights to 1-2 Board Seats (also observers) in a 5 member board
Even if the VCs don’t have a majority of the seats or ownership, they still can use legal means and veto financing and company sale – watch this carefully in the legal docs
Source: Venture Hacks, SLP

8. 4. Board Seats (cont’d)
A VC can sometimes ask for two votes with 1 seat
Expect the Independent or the Biggest Investor will be Chair(man) of the Board
Typical Series A Board is a 5-member board
2 Investors
1 CEO (sometimes hired later; which Founders seat will he/she get ?)
1-2 Founder (can this be two. Who will stay, who will go? )
1 Independent
Don’t let the future CEO step into a “common” seat that is currently held by Founders.
Create a new seat but remember Founders may need to choose someone at some point
Source: Richard Kimball, EAPD, SLP

9. 5. Option Pool
Counted as part of the pre-money (sometimes, rarely negotiable)
Option Pool typically 10-25%
Term: 3-4 years (4 more common)
1/4th Cliff vesting of 1 year. Then monthly or quarterly
“Accelerated vesting schedule”
If you leave (unless its mutually agreed, usually nothing)
If you are fired without cause (negotiable or in contract)
If the company gets bought (in the contract)
Buying your options if you leave: Cashless or Exercise price. Usually days
“Double trigger” vesting is common – you get accelerated only if buyer fires you. Ask for single trigger!

10. You own 2% of the company. VCs invest $4MM on $6MM premoney and company sells for $20MM
$000
2010
2011
2012
2013
No Acceleration
$118
$222
$316
$400
50% Acceleration
$294
$333
$368
100% Acceleration
$471
$444
$421
Source: SLP

11. 6. Anti-dilution Example Effects of Wtd. Avg. v
6. Anti-dilution Example Effects of Wtd. Avg. v. Ratchet Company sells 1,000,000 shares of Series B at $.05 per share
All shares on As converted basis
Shares Before Series B
% Owned Before Series B
Shares After if Wtd. Avg.
Shares After if Ratchet
% After if Wtd. Avg.
% After if Full Ratchet
Founders
6,000,000
35%
32.3%
8.6%
Pool
2,571,429
15%
13.8%
3.7%
Series A
8,571429
50%
8,996,458
60,000,000
48.5%
86.2%
Series B
1,000,000
5.4%
1.4%

12. 7. Drag-Along
Majority shareholders (or even minority investors) can “drag” minority shareholders to sell when they do. This is a drag-along right
Remember “management team” runs the company. Buyer usually wants the management team. So investors need you to cooperate
But this scenario is possible:
$10MM invested in your company (for 50% stake)
2x liquidation preference
Drag-along right to investors
Offer to buy company for $20MM, 6 months after investing
Investors sell, drag along everyone ! Make 2x their money (HAPPENS! REAL CASE)
Management gets nothing
Solutions
Can be solved with a “carve-out” – e.g. give mgmt a few million
Negotiate drag-along when majority of common agrees OR
Negotiate a threshold/floor value below which Founders cannot be dragged (recent Delaware case; VCs voted to sell the company)
Source: SLP, EAPD

13. 8. Founders Restrictive Stock
You thought you owned 100% of the company
VCs may ask you to vest it (over say 48 months)
If you leave before the time, you will lose what you did not “earn”; your remaining stock may be cost
Typical term: Founder pays $0.001 per share; vests his stock over 48 months with monthly vesting
When do you lose it ? : Fired, Died, You quit
Negotiate it (its possible!)
Can a Founders’ cancelled shares be reissued to remaining founders ? (maybe)
Source: SLP

14. And Some That Aren’t (but you should what they mean)

15. 9. Pay-to-play
In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated above under “Right of First Refusal” below will be converted into Common Stock.
Don’t see it often
Good for the company (usually) unless you lose a strategic investor (bad messaging to the market)
Matters investors, not for Founders/Employees
Can be a BIG issue between preferred shareholders
“Pay-to-play” can wipe out clutter of investors
Source: Legal extract from learnvc.com, Advice from SLP

16. 10. Redemption Rights
Investors can make the company purchase their shares after a certain date if there is no exit
Done so that Founders don’t create a lifestyle business
Usually investors want 5 years plus accrued dividends; might be cumulative
Tough to exercise ! Where’s the money ?
Source: SLP

17. Few more curveballs you may see from Investors
Take our bridge loan since you have no money (they’ll really own you during the negotiations then)
Here’s my no-shop termsheet without doing any DD (now you’re locked without the investor being “vested”)
I’m really rich (READ = Billionaire). Take my money and we’ll ride this all the way to IPO (be careful; allow no vetos. This person doesn’t need the returns)
As an investor, I can sell my shares to anyone after 3 years, but you can’t
Who are the other VCs interested in your company (don’t tell them till you accept their termsheet)
Tier 1 VC firm gave you a $5MM valuation. we’ll give you $9MM (says Tier 3)
We’re a VC firm but we do $250K seeds. Take our money (if they don’t invest later you’re tainted)
We want 40% warrant coverage with our high pre-money valuation (same as a low pre-money valuation)
Source: SLP

18. More Perspectives on termsheets

19. Opening Remarks: “Don’t be paranoid”
Home
The day you take money, assume you’ve given up control
You don’t control how much money is raised, who it is obtained from and who acquires your company
But VCs don’t want to run your company, or
VCs are not your friends. They are your business partners. Their incentive is only monetary: grow fast x grow big or protect their investment
This is not a bad thing. VCs are Insurance Policies
Don’t negotiate alone. Get a lawyer who does this every day. Trust them. But know what questions to ask
Talking to a lawyer is $500 per hour. Its expensive so don’t get paranoid.
Source: SLP

20. More perspectives VC Partners see 400 deals. Angels see 200 deals
Home
VC Partners see 400 deals. Angels see 200 deals
They’ll end up signing 4 termsheets, closing 2 deals
VCs don’t like to negotiate pre-money valuation. Step back and the whole picture
I know a VC that fired a closing. He negotiated too hard. Working with these VCs later means its a fine balancing act
“Let the dream live”….Pravin Chaturvedi. They’re funding your dream. Keep that perspective.
In downrounds, VCs get “killed” far more than managers. You’ll get options to incent you to stay if you’re needed. Someone has to run the company
If the company gets sold for very little, you’ll also get money to stay (from the VCs and the buyers). Someone has to run the company
Source: SLP

21. Basics of a Term Sheet Not legally binding until you sign it
2 legally binding items when you sign; nothing else Confidentiality & Expiration (latter, not really !)
5-8 pages. Short and readable
Signed with a lead investor; sometimes (less often) two investors
After signing, it ain’t over ! You now need to “complete” the syndicate and close the round
Use the SLP Termsheet Worksheet (Cheatsheet) to make sure you have mapped out and understand every term
Source: Leo Parker, UW Business School

22. Syndicate
When you get a Lead Investor, you’re not there yet ! You may have $5MM of a $10MM round. But its easier after the lead has signed the termsheet
We’ve seen big deals collapse because management could not find the last $2-3MM of the syndicate.
Good VCs attract good syndicates. Weak VCs as leads are problematic because others may not want to play with them.
Finalizing a syndicate takes 3-4 weeks (all those who said “keep us informed, we’re interested” so keep them warm
Hurry up to closing so no one changes their mind (happens)
A growing trend for Series A to not be syndicated
Lead VCs like to build their own syndicate
Source: SLP

23. Appendix

24. Valuation Deep Dive

25. Valuation Deep Dive
What you need to know to calculate number of shares to be issued to Investors and the price per share?
Pre-money valuation
Number of Shares outstanding pre-money
Post-money option pool set aside required
Amount of Investment
Source: EAPD

26. Valuation Calculation Example
Term sheet provides that Investors will invest $3M at a $3M pre-money valuation and require a 15% post-money option pool
There are 5M shares outstanding
Warrants to purchase 1M shares
What do we need to calculate?
Number of shares to be issued to investors
Number of shares to be in option pool
Price per share to sell shares to investors
Source: EAPD

27. Valuation Calculation Example
What do we know?
We know the investors are going to own 50% of the fully diluted post closing shares
$3M pre-money investment + $3M investment = Post money valuation of $6M
Investors % = Investment/Post-money valuation
$3M/$6M = 50%
What else do we know?
We know the option pool is going to be 15% of the fully diluted post closing share amount
Source: EAPD

28. Valuation Calculation Example
So... if the investors will own 50% and the option pool will be 15%, then the 6M shares outstanding on a fully diluted basis (5M shares and warrants for 1M shares) will equal 35% of the post closing fully diluted shares.
Now we can calculate the total fully diluted share amount outstanding post-closing (6M/.35)
Source: EAPD

29. Valuation: Post Closing Cap Table
Holders
Number of Shares
Percentage
Pre-money (Founders)
6,000,000
35%
Investors
8,571,429
50%
Option Pool
2,571,429
15%
Totals
17,142,858
100%
Source: EAPD

30. Valuation Recap
Step 1-- Calculate what % of post closing FDS that pre-money FDS equals
Step 2 – Calculate total post closing FDS by dividing pre-closing FDS by the post closing % they represent
Step 3 – Calculate Option pool and shares issued to investors by multiplying post close FDS time % represented by each
Step 4 – Calculate price per share by dividing total investment by shares to be issued
Source: EAPD

31. 3. Illustrating Participating Preferreds: VCs invest $10M: Take 50%
Source: SLP

32. Payouts @ different Preferreds

33. 3. Liquidation Preference: 1x
The amount of the liquidation preference is set in the term sheet. Sometimes it’s just the amount invested. Sometimes it’s double the investment, and sometimes it’s triple. This is a key term to pay attention to.
Source: Leo Parker, UW Business School 33

34. 3. Liquidation Preference: 2x
The amount of the liquidation preference is set in the term sheet. Sometimes it’s just the amount invested. Sometimes it’s double the investment, and sometimes it’s triple. This is a key term to pay attention to.
Source: Leo Parker, UW Business School 34

35. 3. Liquidation Preference: 3x
The amount of the liquidation preference is set in the term sheet. Sometimes it’s just the amount invested. Sometimes it’s double the investment, and sometimes it’s triple. This is a key term to pay attention to.
Source: Leo Parker, UW Business School 35