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12 Term Sheet Issues (8 that matter and 4 you should understand…

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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, 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

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