[wilmerding, 2001] term sheets & valuations

Term

S h eets&

Val uationsAn Inside Look at

the Intricacies

ofTerm Sheets &Valuations

The All-Time Best ^Selling Book onTerm Sheets'Information gatheredfrom bookstore chains,independent booksellersand online booksellers, i

VISIT US ATWWW.ASPATORE.COM

By AlexWilmerding

J&'&AASPATORE

^v^

ASPATORE(Executive ^Business QnteCCigence

A _^

^#

ASPATORE(Executive (Business QnteCCigencewww.Aspatore.com

Aspatore publishes only the biggest names in the business world,including C-level leaders (CEO, CTO, CFO, COO, CMO, Partner) fromover half the world's 500 largest companies and other leadingexecutives. Aspatore publishes the Inside the Minds, Bigwig Briefs,Focusbook and Aspatore Business Review imprints in addition to otherbest selling business books, journals and briefs. By focusing onpublishing only the biggest name executives, Aspatore provides readerswith proven business intelligence from industry insiders, rather thanrelying on the knowledge of unknown authors and analysts. Aspatorefocuses on publishing traditional print books and journals withindividuals, while our portfolio company, Corporate Publishing Group(CPG), works with leading companies to help them generate a newrevenue stream from publishing. Aspatore is committed to providing ourreaders, authors, bookstores, distributors, publishing partners andcustomers with the highest quality books, book related services, andpublishing execution available anywhere in the world.

CORPORATE PUBLISHING GROUP (CPG)Establish a Corporate Publishing ProgramTurn Your Corporate Information, Research and Analysis

Into a New Revenue Stream For Your Company

www.CorporatePublishinqGroup.comCorporate Publishing Group (CPG), the B2B publisher owned byAspatore, works with leading companies to establish corporatepublishing programs, specifically designed to generate a new revenuestream from publishing, build their brand, and reward specificemployees with the opportunity to get published. Types of publicationspublished include books, Annual Intelligence Reports, Behind theBusiness, white papers, newsletters, briefings and journals. Learn howCPG's award winning editors, publicists, marketers and writers can helpyour business establish a corporate publishing program that can be putin place very quickly, using everyone's time in the most efficient mannerpossible and help create a new revenue stream from publishing. Formore information please e-mail [email protected].

Term Sheets &Valuations

An Inside Look at the Intricacies ofTerm Sheets & Valuations

By,Alex Wilmerding

^_ A

Wm

ASPATORE(Executive (Business QnteCCigence

Published by Aspatore Books, Inc.For information on bulk orders, classroom use, sponsorship opportunities orany other questions please email [email protected]. For review information,comments, speaking inquiries or any other information regarding this book,please email [email protected].

First Printing, September 200110 98765432-

Copyright 2001 by Aspatore Books, Inc. All rights reserved. Printed in theUnited States of America. No part of this publication may be reproduced ordistributed in any form or by any means, or stored in a database or retrievalsystem, except as permitted under Sections 107 or 108 of the United StatesCopyright Act, without priorwritten permission of the publisher.

ISBN 1-58762-068-5

Library ofCongress Card Number: 2001093288

Bigwig Briefs Editor, Ginger Conlon

Cover design by Rachel Kashon, Kara Yates

Material in this book is for educational purposes only. This book is sold withthe understanding that neither the author nor the publisher is engaged inrenderinglegal, accounting, investment, or any other professional service.

This book is printed on acid free paper.

Special thanks also to: Ted Juliano, Tracy Carbone, and Rinad Beidas

Term Sheets &Valuations

Contents

Chapter OneTerm Sheet Basics

Chapter TwoHow to Examine a Term Sheet 19

Chapter ThreeA Section-by-Section View of a Term Sheet 31

Chapter FourValuations and the Term Sheet 82

Chapter FiveWhat Every Entrepreneur Needs to Know AboutTerm Sheets 94

About the Author 135

Chapter 1Term Sheet Basics

Term Sheets & Valuations 7

What Is a Term Sheet?In the venture capital community, a term sheet outlines theterms for a deal; it serves as a letter of intent given to acompany seeking investment by a venture firm in order tooutline the proposed terms for an investment transactionbetween the two parties. A term sheet has two importantfunctions: it summarizes all the important financial andlegal terms related to a contemplated transaction; and itquantifies, both in numbers and qualified terms, the valueof the transaction or the venture capital financing. If theterms for a financing as captured in the term sheet areagreed to by the entrepreneur and the investor who presentsit, the document then serves the basis by which to draft thelegal documents surrounding the class of the securitiescontemplated by the financing and to make modificationsto the articles of incorporation of the company wherenecessary.

Typically, term sheets are used by venture capital investorsas well as institutional investors or syndicates of angelinvestors in their discussions and negotiations withprospective investees. Outside of the venture capitalcontext, term sheets can be used for any businessdevelopment or financing deal. For example, a companycontemplating a contract with a potential business partnercan capture the terms of a proposed relationship in a termsheet. The value of a term sheet is its ability to focus partiesin a deal on the essence of the deal prior to initiating costlylegal drafting and to move them to close the transaction.

8 Term Sheets & Valuations

Term sheets are most often produced by the venture firmthat is making its initial investment in a private company.The firm or individual investor who puts out the term sheetis usually the lead investor in a venture investment round.Take, for example, a company that has been founded bymanagement and has only common stock. The founder orcore of executive management of that company willapproach prospective angel and venture investors in thehope that those investors will be interested enough inmaking an investment that they will draft a term sheet andpresent that to the company.

Once drafted, the term sheet becomes an expression of agroup of investors' interest in investing in a company aswell as an outline of the terms by which they are interestedin investing. It is typically presented to that prospectiveinvestee's CEO. As part of the process of agreeing on theterms of a term sheet, the two parties (the investors and theCEO or core executive team of the firm seeking funding)participate in a series of discussions, with the expectationfrom the investors that the company will accept theirproposed terms. In situations in which companies are hotlysought after by venture investors, term sheets can besubject to negotiation.

Magnified ImportanceIn the venture capital community, the importance of a termsheet is magnified when a round requires an amount ofcapital greater than that which one investor alone is willingto provide. In these instances, the term sheet allows anentrepreneur, CEO, or management team to gain acommitment from one investor and use that investor as areference point to bring aboard other investors as part of a


syndicate that commits to invest the required amount ofcapital. This is particularly important in the later stages of acompany's life in those instances when a term sheet isinitiated by investors who had participated in prior roundsof a company's financing. For example, in weak markets,companies may be unsuccessful in attracting new capitaland a new investor at a time when additional capital isrequired by the company. In order to do so, it may benecessary for an existing investor or group of investors tocome up with a term sheet and float it to the company.

Typically, investors from prior rounds of financings areprepared to invest in subsequent rounds because they bothbelieve in the company's prospects and want to ensure thata new round of financing does not dilute their originalinterest in the company. Unless of course a company isfabulously successful, the amount that an investor or groupof investors will commit to investing in rounds subsequentto their initial round of investment will typically be only aportion of the contemplated subsequent round. In the eventthat a company is struggling to raise that round, existinginvestors who float a term sheet will do so under terms thatare attractive when compared to prior rounds, called adown round, or represent a round at the same price as theprior round, called a flat round.

Written in Stone?A term sheet is not technically a binding legal document.As a matter of contract law, both parties have an impliedduty to negotiate in good faith. Yet while a term sheet isnot legally binding, to the extent that a person's word is hishonor, it reflects an agreement between two parties toproceed to a financing subject to the terms incorporated in


the term sheet. The more reputable the venture firm and themore ethical the entrepreneur the more likely the essence ofthe term sheet will be preserved and remain binding upuntil the closing ofa financing.

Term sheets often include an exclusivity clause. Thisrequires the company, once it has accepted the term sheet,not to solicit competing term sheets from other venturefirms or syndicates. Nevertheless, an entrepreneur retainsan "out" in effect, because there is little legal recourse forthe prospective investor if he does so.

The tenor and nature of the relationship that is establishedbetween prospective investors and a company is critical tothe strength of the term sheet and the extent to which itremains binding through to a financing. From a reputableventure firms perspective, the assumption is that once aterm sheet has been agreed upon and due diligencecommences, the deal is going to be consummated on anagreed timetable (in many cases it can take two to fourweeks of legal drafting for a round to be finalized). In therare situation in which investors or the company moves torevisit and diverge from the terms after the term sheet hasbeen agreed upon, the bedrock of the relationship betweeninvestors and a company is challenged, sometimesirreparably.

The Only Thing Constant is ChangeEven so, a term sheet is not a living, breathing documentthat lasts beyond a financing. A term sheet accepted by theentrepreneur and the investor who is proposing it works asa summary or outline that is used to draft the legaldocuments surrounding the new class of securities that are


contemplated in a round of financing and to makemodifications to the articles of incorporation of thecompany, also known as the company's charter. Whilecommon stock may be owned by the founders and angelinvestors, venture investors will typically call for a newclass of stock, called preferred stock, to be issued whenthey invest. A new class of stock can be issued during eachround of investment; the terms will vary depending uponthe strength and state of the company. The terms of eachround of financing may affect previous classes of stock andthe legal language that dictates the powers related to thoseprevious classes of shares. As a result, powers that weregranted to existing shareholders may need to be changed ormodified as a result of the terms proposed by a new roundof investors before a round of financing can beconsummated.

For example, a new investor may want to receive a class ofsecurities that have liquidation preference, the right to bepaid back before other investors. The corporate charter willdictate whether investors holding previous classes ofsecurities have to agree to allow a new class of shares tohave terms or powers superior to theirs. The new investormay propose that he wants those powers only for his classof securities, but the entrepreneurs and previous investorsmay say that the a new class of shares can't have themunless prior classes are allowed them as well. So, it iscritical that the term sheet reflect a clear understanding of acompany's capital structure and the expectations andunderstanding of the business by existing shareholders.

After the term sheet is agreed to, the lawyers have to redraftand make amendments to the company's articles of


incorporation in order to reflect any changes required bythe new class of shares created by a round of financing andto make any changes to the powers of existing classes ofshares. To the extent that they are empowered to, investorsholding prior classes of stock whose powers are amendedas a result of a new financing will need to agree withproposed changes. During the drafting process, the termsheet gives the lawyers the framework to draft a Purchaseand Sale Agreement, the document that the investors in thenew round will sign, and to make amendments to thecompany's charter or articles of incorporation. Anyamendment to the articles of incorporation thatcompromises the powers of existing classes of shareholdersrequires a vote by all the shareholders and directors beforethe amendment to the article of incorporation can be madeand the financing proceeds.

Once the documents surrounding a financing, typically thePurchase and Sales Agreement and revised Certificate ofIncorporation, have been prepared and signed off, thecompany gets back to its usual course of business and theterm sheet is no longer relevant to the life of the company.It is just a part of the history of the company's financing.

Finding a Term Sheet That FitsAs is the case in any investment, terms and conditions willvary widely. So much, in fact, that one could compare aninitial template (see Chapter Three) with a final term sheetand see few similarities. The reason that term sheets varyso much is that the context in which each company findsitself is different. The competitive profile of everycompany is different; its management team and list ofcustomers, for example, will have different values or merits


depending upon the bias of each group of investors. Theinvestment climate at the time of each contemplatedfinancing will also vary.

So context is really what dictates the contents of a termsheet. It is the context in which an investment finds itself oris placed that will determine the profile of a term sheet andthe extent to which terms appear fair or more favorable tothe investors or to the company.

There are, however, five basic forms and styles of termsheets. These are typically attributable to the leadingventure legal firms: Cooley; Hale and Dorr; Mintz-Levin;Testa, Hurwitz and Thibeault; and Wilson-Sonsini. Termsheets created by these firms don't vary significantly ingeneral format but do vary in style. The fact that aprospective investor does not use one of these firms shouldnot be a red flag for an entrepreneur; countless other firmshave developed reputable venture practices and haveadopted term sheet styles that follow the format and stylesof the term sheets of these five firms.

Because a term sheet is basically an outline for atransaction and reflects the style of the legal firm used bythe investor, there can be anywhere from eight to 15sections. There are many variables within each of thesesections in terms of legal language, which can be changedand substituted so that there is an exponential number ofterm sheets that one could devise. So the structure of termsheets will be similar in nature, but the language andeffective result can vary significantly.


Investors: Institutional Versus Angel Term SheetsTerm sheets written by institutional investors, whichincludes venture capital firms and large corporations, arelikely to vary from those offered by angel investors, whooften do not offer term sheets at all. Angel investorstypically invest during the very early stages of a company,use their own private capital, and may invest in chunks of$10,000 or $50,000 or $100,000 or $250,0000. Angels aretypically buying common stock, the same class of stockowned by founders. That sort of individual may be fluent inthe terms and conditions that venture and corporateinvestors use but is not likely to dwell on legal parlance in aterm sheet to the extent that later stage venture investorswill. Angels are classed as such because they are willing toassume greater risk at a time when the future of acompany's business is more uncertain. It is therefore lesslikely that they will be able to secure from entrepreneursterms that require a company to meet very specific andexact hurdles in terms of financial performance.

Angel networks and angel investors themselves havehowever become more sophisticated. It is entirely plausiblethat one angel or several could work together to provide anentrepreneur a pool of capital and in so doing require thattheir capital be treated differently from that of theentrepreneur who would hold common stock. In thisinstance, the angel investor or investors would probablyprovide a term sheet but given the early stage of thecompany, the framework of the term sheet would likely bequite simple.

The process of working with angel investors who purchasecommon stock on an individual basis is likely to be more

Term Sheets & Valuations IS

informal, because angels who are experienced will typicallyassume that the rights of common stockholders will be asubject for negotiation when the company entertains a laterround of venture investing. Having said this, it serves thecompany well to incorporate in its charters a host of rightsto common stockholders; while they can always benegotiated out at a later stage, it is easier to do so than totry to negotiate them at that stage.

Angel money typically assumes a subsequent round offinancing and enormous potential for change in the profileof a company; it is therefore less practical for angels whotypically invest in smaller amounts and not as syndicates tonegotiate preferential terms and to slow the work of acompany down by requiring companies to issue newclasses of preferred stock at a stage when growth and timeto market are critical. At the time of an investment by aventure investor, however, term sheets take on an importantrole for the venture investor who is looking to captureexpectations in terms of the company's revenueperformance and profitability and the way in whichliquidation or exit will be handled by the company.

Corporate ResponsibilityThe objective for financial return for an institutionalinvestor (corporate or venture) is similar to that of the angelinvestor, but an institutional investor's primary concern isthe investor's own fiduciary responsibility to its owninvestors. A key issue for an institutional investor is howthe terms of its participation, dictated in the term sheet, willenable the investment firm to work within the guidelines ofits own investment mandate. This is why a time frame


spelled out clearly on a term sheet is so important to aninstitutional investor.

Entrepreneurs seeking funding must understand thatventure and corporate investors have limited partners orshareholders to speak to. In the case of the venture investor,which primarilywork as limited partnerships, their partnersdictate that they will only operate as a partnership for arestricted number of years. In some cases it is as limited asfive years with a two year extension; in other cases its aslong as 10 years with the ability to extend for one or twoyears. These limited partners, whether they be pensionfunds or wealthy individuals, will expect to contribute theircapital over a relativelyshort number ofyears (one to four),and they will expect to see returns within three to sevenyears.

As venture capitalists (VCs) propose a term sheet to acompany they are naturally going to try to include termsthat will encourage the way the companyoperates to reflectthe time frame to liquidity that the venture investor islooking to receive. In otherwords, the company is expectedto meet its financial responsibility to the venture firm in theinvestor's necessary time frame. This can be managed orexpressed in certain clauses within a term sheet. The mostobvious one is called a milestone section, in which aventure investor will set strict milestones in terms of whena company should have performed or achieved certainlevels of revenues or numbers of contracts that are assumedto be each yielding certain revenue, and at what time. Thisstages the infusion of capital. For example, an investor canmilestone a $10 million syndication of capital so that thecapital is contributed to the company in two or three lump


sums based on the company achieving certain levels ofrevenue and sales.

In the Driver's SeatWhen entrepreneurs receive their first term sheet, theyshould consult their lawyer and decide whether theeconomics of the deal are close to what they expected themto be. If so, they should ask the lawyer or the lawyer of theventure investor to draft the necessary securities documentsrelated to the new class of shares.

If the economics of the deal is not up to the entrepreneursexpectations, the term sheet enables the entrepreneurs topotentially seek other investors; in other words, acceleratethe process of getting the right financing. But entrepreneursmay go about this the wrong way. Assuming there is noexclusivity clause in the term sheet, which is intended toprevent them from continuing to shop a deal, some maymeet with a prospective investor and say, "We have acommitment at a pre-money valuation of X, but we reallywant Y; we don't think they will give us that amount.You're firm is a better fit for us; it has strengths the otherfirm doesn't." This is not the best approach. The venturecapital community is small and tight-knit. Many deals aredone together, so turning your back on one firm meanspotentially turning your back on everybody. Even if anentrepreneur considers a term sheet non-binding, whetheror not it has an exclusivity clause, shopping the deal has therisk of undermining his credibility and reputation with thefirm that has already submitted a term sheet to him. It'sbetter to look for a firm that brings a host of positives andmeet at some reasonable middle ground on valuation,because the nature of the relationship that evolves during a


term sheet negotiation will be carried forward throughoutthe life of a company should an investor agree toconsummate a deal, and should a term sheet result infinancing.

On the other hand, it's possible to shop for financing theway one might shop for a car: You are trying to find thedealer with the best price, and they all have Audi's. That'snormal. In a financing, the entrepreneur may approach twofirms simultaneously and work with the one that commitsto the dollar amount that solves all his financial goals.

The smartest entrepreneur is working several venture firmssimultaneously, looking either to have one of them financethe deal in entirety or to bring them together to finance thedeal as a group. This is likely to happen when anentrepreneur is looking for financing and either can't find afirm that will provide the entire amount or doesn't want afirm to provide the entire amount. The entrepreneur mayreceive a term sheet from an investor willing to give 25percent of the round, then he can use that term sheet to helpattract investors willing to partner with the lead investmentfirm and cover the remaining 75 percent.


Chapter 2How to Examine a Term Sheet

Under the Looking GlassIt is critical to consult experienced counsel prior toagreeing to a term sheet. But while a lawyer is examiningthe economics of the deal spelled out in the term sheet, theentrepreneur should be conducting his own examination ofthe terms. If the term sheet is balanced and fairly aligns theinterests of investors and the company, it will typically nothave substantive effects on the companyif the companyperforms to or exceeds expectations and meets milestonesthat have been agreed upon or represented in thecompany's business plan. Nevertheless, there are a fewterms and sections to which the entrepreneur should giveextra attention. For the purposes of discussion, the sectionnames to which I will refer correspond to the term sheetframework and style provided by the Boston offices ofKirkpatrick and Lockhart.

The most obvious section that requires extra attention is theprice per share. Price per share is important because itembodies the economic value of where the company istoday. It is possible to do a simple equation to determinewhat the price per share converts to in terms of pre-moneyor post-money valuation for the company.

The Current Securities Section (which describes all sharesand the number of shares in each class of stock that haveexisted before the round that is being contemplated) givesthe investor's summary of the company's capital structureand will typically include not only existing shares but a


summary of any warrants and options issued. Thecalculation of pre-money value should be the result ofmultiplying the total number of shares outstanding,including warrants and issued options, by the price pershare that is offered in the term sheet. The post-moneyvaluation is determined by adding the total amount to beraised in equity in the round of financing contemplated bythe term sheet to the pre-money valuation. The post-moneyvalue placed on a company at the time of the term sheetdiscussions embeds some expectations for performance ofthe company over time. So one can look quickly to thevalue placed on the company, examine the company'sexpectations as to how it's going to perform in terms ofrevenue numbers and profitability over subsequent one tothree years, and consider what values the company maycommand at future periods of time either in a sale or in afuture financing. Then one can calculate what that means interms of a multiple or rate of return over a period of yearson the investment. If a venture investor is looking toachieve a gross return of 50 percent and a net return afterfees in the 35 percent range, the relationship between thepost-money valuation and the value of the company at timeof exit are critical in the VC's calculation of expectedreturn.

Corporate GovernanceIt's also vital to inspect the terms in the Board Compositionand Meetings as well as Special Board Approval Itemssections that concern corporate governance and the way inwhich the company's executive team and board of directorswill be expected to interact. These terms help investors,who are close enough to the company and have doneenough due diligence, immediately see the way in which


certain types of actions and powers, if held by certainmembers of the board, could be useful in affecting how thecompany is managed in certain critical circumstances.

When examining these sections, it is important to reviewwho the directors are and which classes of stock will berepresented by which seats or individuals. It is alsonecessary to consider how many executives, members ofmanagement teams, and founders are represented on theboard, and the total number of board members. Thisinformation is critical, because as classes of shares areissued subsequent to each financing, each class willtypically require one or several board seats and the right toinfluence certain actions of the company. Additionally, aboard that has a majority influence by founders andindividuals who are related to founders may be lessattractive to a sophisticated institutional investor at anystage of investment unless the majority of individuals onthe board alongside the VC are clearly established industrynames with a depth of experience and are respectedindependent thinkers. The degree of influence that a boardcan have over the direction of a company is diluted unless aboard has a balance of management, independent industryexperts, and financial investors.

In later-stage investments, the board composition andmeetings section gets more complex, because a companythat initially offered only common stock and possibly oneclass of preferred stock may experience one or moresubsequent rounds of preferred financings. This will affectthe board composition, because as more investors becomeinvolved, their expectations will need to be represented.


The degree to which management is executing becomesincreasingly under greater scrutiny by the investors.

For all of these reasons, it is necessary to inspect theSpecial Board Approval Items section for any powers thatexisting board members hold. Often board membersrepresenting preferred stock or a majority of theshareholders of a class of preferred stock (the shares thatventure investors typically purchase) will expect to giveapproval in the event that the company contemplates suchactions as taking on debt above certain modest levels, say$250,000; making significant management hires; orengaging in a merger or acquisition. Entrepreneurs arenaturally loathe to give up the freedom to make certainoperating decisions, however VCs expect their level ofinfluence to be high, particularly over areas that couldsignificantly affect the company's capital structure orprofitability.

Don't Get Held UpAnother sticking point in a term sheet is options and theway in which they are treated and valued in a pre- or post-money valuation. There can be extreme differences inopinion as to how many options should be issued in orderto accommodate future growth.

Companies can have great plans for doubling the size of itsworkforce within a 12-month period. But after financing,say they have 10,000 shares outstanding, only 5 percent ofwhich are options, all of which are granted, they may needto create another 15 percent of options for new employees.Or, founding management who have founders shares mayask to be treated as employees. Those who do so are


effectively double dipping. They want to keep theirfounders shares but also want to be awarded as employees,so they ask for a percentage in terms of options. Suddenlythe contemplated valuation of the company can change by10 to 20 percent, depending on the future expectations forthe company.

Essentially, founders see themselves getting diluted duringeach subsequent financing. Although dilution is a typicalpart of each subsequent round of financing, they sometimeswant to be awarded options for their role as employees. Ifthey do, the founders should be prepared to raise the barand tie additional options awards to improved performanceand shareholder value.

Red FlagsPrice per share, corporate governance, options, andvaluation. These are all key areas of a term sheet thatentrepreneurs need to inspect thoroughly. But they are notthe only areas to watch. Entrepreneurs must look out for themany possible red flags any term sheet may have. The threebiggest are as follows:

1) Underfinancing One red flag is if an amount ofmoney offered by an investor is lower than the dollaramount the entrepreneur feels he or she reasonably needs toget through the next phase of growth and to a subsequentfinancing at a reasonable subsequent valuation.

This strategy may benefit the company seeking financing,but it has drawbacks and attendant risks unless it is acarefully crafted part of a long-term financing strategy. Itmay also benefit the VC. The VC can ensure that the value


of the company will rise if, by requiring an entrepreneur toaccept a lower dollar amount in a round, the entrepreneur isthen able to bring in a strategic investor later on to secureadditional financing for the company and do so at a highervaluation. The downside comes about if the strategydoesn't work out and the company fails to attract capital ina later round for any number of reasons. Should the marketchange, investors might, in a competitive financing market,conclude that one of the reasons a prior round was smallwas because the company's business model had not beencompelling enough to attract sufficient numbers ofinvestors. Similarly, a sector can lose its luster or suffer ageneral re-evaluation by the VC and corporate strategicinvestment community. Under such circumstances when acompany cannot attract new investors on better terms, itsexisting round of investors may seek to protect themselvesby investing money at preferential terms.

Encouraging companies to pursue business plans whichassume subsequent rounds of financing within relativeshort periods of time can be an effective way for VCs tomotivate companies and to ensure that their funding isprovided at intervals rather than up front. But it is wiser forentrepreneurs to seek funding which will last them 12 to 18months in competitive financing environments. This doesnot mean that financing for this period of time neednecessarily be secured in one payment up front. Asyndicate of investors with the capability of investing fundsin several trenches can enable the entrepreneur a 12- to 18-month period of funding; the challenge for the entrepreneuris to assemble a syndicate with this capability, but under aninitial valuation that leaves room for future fUnding.


2) Limitations to the Scope of a Syndicate Anotherred flag is investors who try to dissuade an entrepreneurfrom opening a round or increasing it in size in order toaccommodate other interested VCs. Some investors may doso only to maximize influence and control by that VC firmor to take as much of a good thing as they can get. Theremay, however, be legitimate reasons for a VC to do so: Notall VCs work well together; certain round sizes may alsobecome too small to justify the overhead that may berequired to administer an investment.

The other practical downside in not opening a syndicatethat includes several venture firms is that a company maylimit its options when it looks for follow-on rounds offinancing. Presumably, the more diverse the profile of asyndicate the higher the likelihood of more introductions toother VC firms in a future round of financing.

One simple rule in any financing for entrepreneurs is this: Itis often wise to take funding from interested investors whenyou are offered it. The fundraising process is distractingand eats up precious time.

3) Milestones Milestones can be a reasonable approachto constructing a term sheet; they can also be a serious redflag. For some entrepreneurs any milestone set by aninvestor in a term sheet is a red flag. Investors typicallymilestone a deal by writing into a term sheet thecommitment to fund, but only in allotments and based uponspecific financial performance prior to subsequent roundsof funding. Investors might provide $10 million incommitments in four quarterly payments, for example,enabling the investors to revisit the performance of the


company at the time of each quarter's funding payment.From the view of an entrepreneur, everybody participatingin an early stage company typically should accept that it isa highly risky venture. Opportunities as perceived todaycan change quickly, and companies may need to retrenchand revisit assumptions.

What's more, management is taking additional risks bycommitting to a highly risky venture. Not surprisingly,management will want to have the flexibility to be able tochange course as necessary, rather than to find out that intwo or three months, should the company not be meetingtheir plan for unanticipated and understandable reasons, aninstitutional or venture investor who has prescribed thispower can basically take over control of the company, bootmanagement and bring in new management, or curtail theinvestment entirely.

Even so, goals that require a company to meet at aminimum 50 percent or 75 percent of plan should beachievableparticularly in expansion and later stagedealsbarring enormous cyclical shifts in the economy orin a sector. At the end of the day, if a company can't meet amajority of its plan, particularly when due to factors withinthe company's control, the company is not performing.

Clearly, a key reason investors like to use milestones is thatit can provide downside protection for them. In the eventthe firm doesn't reach certain targets there can be aconversion ratio that will allow the preferred investors tohave an adjustment in their stock value. With a downsideprotection clause investors will set a date by which certaintargets are expected to have been met. For example, if


actual revenues for a period are below 75 percent of atarget, a conversion ratio could kick in to adjust the valueof shares issued in the most recent round of financingproportionately. A second hurdle could require the shareprice to be adjusted further under a more demandingformula in the event the company fails to reach revenuetargets of 50 percent of plan. An entrepreneur can becomfortable with these conversion ratios if a company'splan is eminently achievable, and there is little perceivedrisk associated with doing so. However, the entrepreneurhas to be careful to ensure that the manner and way inwhich revenue will be recognized is stipulated. Somethingas simple as a change in the way Globally AcceptedAccounting Practice (GAAP) regulations recognizerevenues could trigger an adjustment to share pricing,unless language stipulating the contrary has beenincorporated into documentation. It's vital to ensure thatthe term sheet articulates the standards, or referencesstandards given elsewhere, and shows an example. Ifstandards change and an investor wants to take advantageof such a clause, the entrepreneur may be setting himselfupfor a legal challenge.

Although milestones are a red flag, they are alsonegotiable. But depending upon a company'scircumstances and the funding environment, other issuesmay be more important negotiation points for theentrepreneur.

Red Flags for InvestorsAs much as milestones are a source of discomfort forentrepreneurs, strong resistance by a company to accept arevaluation of investors shares in the event a company does


not meet milestones or to accept funding in trenches can bea red flag for an investor. If the stage of the investment isso early that a revenue plan is clearly unpredictable, itmight be unreasonable for an investor to expect anentrepreneur to accept tight milestones. But if a company isa relatively later or expansion stage opportunitywith a highdegree of predictable revenues and a sufficiently rich pre-money valuation it is understandable that an investor mayconsider an entrepreneur's intransigence on this issuedisconcerting at best or a no-go at worst.

The category of Special Board Approval Items that aredefined by venture investors in term sheets is another areaabout which VCs will be somewhat stubborn. Fiduciaryresponsibility to ensuring a modicum of influence over thecourse of an investment, particularly when an investment isnot going to plan, makes these issues particularly importantto an investor and a source of significant concern when anentrepreneur looks to remove them from a proposed termsheet.

Board composition is likewise as significant an issue forinvestors as it is for entrepreneurs. When a venture investoris in the business of trying to predict to some high degree ofprobability a successful financial outcome, he wants toknow that the future course of the company is relativelyclear and that as many tools as possible are provided to himto influence that future when necessary. If a board iscomposed of a majority of advisors and friends of the firmwho do not have close alignment with the interests ofshareholders in maximizing value, the VC is going to wantto see a change that creates some sort of balance that moreclosely aligns the board with the goals of a majority of


shareholders. To a VC, a board requires a balance ofmanagement, independent industry experts, and financialinvestors.

A variety of other areas can also cause VCs to seriouslyreconsider an investment. Protection in the event ofliquidation, found in the Liquidation Preference section of aterm sheet, is a critical area for investors. Entrepreneursneed to remember that if pricing is fair or aggressive,downside risk will be the one area which VCs will focuson.

Limitations in the Information Rights section will also be ared flag for investors. Entrepreneurs rightfully do not wantto spend a majority of their time reporting to VCs.Nevertheless, entrepreneurs who are too controlling andresist providing an investor with the right to a full audit ofthe company's operations or even a reasonable level ofaccess by VCs to company information risk turning offinvestors completely. The way this section is handled andrenegotiated could signal to the investor that theentrepreneur may want to try to hide something in thefuture or may be difficult to work with.

To avoid creating a red flag for investors, entrepreneursmust look for balance and flexibility when negotiatingterms.

Beware of Strategic Partners, That BecomeInvestorsA final red flag, for both investors and entrepreneurs, iswhen a firm's strategic partner is interested in becoming aninvestor in that company. A strategic partner that is also an


investor can put a company in a compromising position fortwo primary reasons. First, the strategic partner can requireup front certain rights or powers to influence or blockfuture partnerships or a sale or acquisition of a company,whether or not its investment is staged. These red flagswould typically show up in the Special Board ApprovalItems section. The amount and nature of an equityinvestment from a strategic partner can put off futurepotential partners and acquirers. The term sheet is theentrepreneur's first opportunity to see what the trueintentions of a strategic partner may be.

Second, if the partner's investment is staged and thecompany's business model is too dependent upon thestrategic partner, the company can unknowingly limit itschoices and independence down the road. Certainly, astrategic partner can offer a host of distribution channels aswell as product collaboration opportunities. But it is criticalthat a company's business plan is not so dependent on astrategic partner that a staged investment by that partnercould allow the partner to renegotiate terms unfairly when alater stage of the investment comes due. So the core goalsof one's business plan need to be considered carefullywhen analyzing the terms and conditions incorporated intoa term sheet by a strategic investor.


Chapter 3A Section-by-Section View of a Term Sheet

What is a Term Sheet?In the venture capital community, a term sheet is basicallya letter of intent prepared by a venture capital firm tosummarize all the important financial and legal termsrelated to a transaction and to quantify the value of thetransaction or the venture capital financing. A term sheetserves as an outline of a transaction, so there are usuallyeight to 15 sections. (There are 16 sections in the sampleterm sheet presented in Figures 1 to 18 in this chapter.)There are many variables within each section, in terms oflegal language, so that there is an exponential number ofterm sheets that one could draw up. Many of these sectionscan be written either to favor the investor, to favor theentrepreneur, or in a balanced manner so as to benefit bothparties as fairly as possible.

Every entrepreneur contemplating venture financing needsto understand the degrees to which sections of a term sheetare either Company or Investor Favorable. This section hasbeen designed to provide a range of examples of how manysections of a term sheet can be either Company Favorable,Investor Favorable, or Middle of the Road. Whereappropriate, examples are labeled Investor Favorable,Middle of the Road, and Company Favorable. A term sheetwould only have one clause, not all three, but the formatused here is intended to provide entrepreneurs with a clearpicture as to how any one of the three types of clauses canvary the economic and qualitative effect of the investor'soffering.


The PreambleIn a preamble to a term sheet there can be certainexclusions or assumptions as to the length of time that aterm sheet will remain in place, and provisions as to theentrepreneur's ability to shop a deal to other investors.

There may be a paragraph that states that during a periodcommencing on a given date, the company's directors,employees, and representatives may not contact, solicit,engage in any discussions, enter in any agreement, orfurnish any information to anyone other than the investorsor representative of investors, without prior writtenconsent. This type of language effects a quiet period orlock-up period during which the term sheet should not bediscussed with third parties or other term sheets solicited.

Opening InformationThe first paragraph of a term sheet is fairly standard (seeFigure 1). In fact, quite often that first paragraph doesn'teven exist. Instead the term sheet might simply have a titlethat gives the name of the company being funded, a subtitlethat reads "A Summary of Terms for Proposed PrivatePlacement of (name of stockSeries A Preferred Stock,for example), and the name of the stock issuer, whichwould be the name of the company that would be receivingthe investment from the venture capitalist or syndicate ofinvestors. But the first paragraph is a good way ofsummarizing what is in the document and of providing anoverview of the nature of the transaction contemplated. Ifthe term sheet is going to be read by people who aren'tclose to the transaction, the opening paragraph clarifies thenature of the situation.


In the example below, [ ] Ventures, L.P. would referto the typical name of a venture capital firm's fund, each ofwhich typically are limited partnerships, here abbreviatedas L.P. The bracket referring to the "Investors" couldinclude the name of individuals or corporate investors whomay be investing as a syndicate alongside the venture fund.

FIGURE 1

[Company Name][Term Sheet Date]

MEMORANDUM OF TERMS FOR PRIVATEPLACEMENT OF EQUITY SECURITIES

General[ ] Ventures, L.P., and [ ] (the "Investors") are preparedto invest $ [ ] million in [ ] (the "Company") under theterms contained in this term sheet. With the exception of the section ofthis agreement relating to expenses, this term sheet is a non-bindingdocument prepared for discussion purposes only, and the proposedinvestment is specifically subject to customary stock purchaseagreements, legal due diligence, and other conditions precedentcontained herein, all satisfactory to the Investors in their solediscretion.

[Other Company or deal specific terms.]

New Securities OfferedThe New Securities Offered section, which appears at thetop of Figure 2, at first appears to be self-explanatory. It iscritical, however, that an entrepreneur understand thedifferences between different classes of securities and whatthe implications are of the type of security contemplated bya proposed offering. Figure 2 assumes that Series APreferred will be offered.


In order of priority, common stock usually holds no specialpowers, it's just ordinary stock with one vote exercisableper share in the event a shareholder vote is called. Preferredstock takes a more senior position in the company's capitalstructure, which means it usually has some rights attachedto it that give it preference over common stock and usuallyhas powers that common stock do not hold. There can bemultiple series of preferred stock. As each subsequentfinancing transpires, it is often appropriate to issue a newseries of preferred stock at the time of each transaction inorder to provide that series with the rights and pricing thatis appropriate at that point in the life of the company.Assuming the life and value of a company is not static,Purchase Price Per Share for each new class of stock willtypically differ at each subsequent offering, substantiatingthe need to issue new classes of securities at eachsuccessive financing.

Typically, for example, common stock is issued when acompany is founded. Everybody shares in the same level ofrisk. It's just common stock, meaning angel investors andfounders receive common shares on equal terms. Acompany grows in size and sophistication and then tries toattract new money. A successive round of funding mightinvolve a venture or corporate investor. Preferred shareswill be issued to those investors, because the pricing andvalue of the shares will presumably be different from thatof the common shares. At the very least, the investors in asuccessive round will require certain levels of influence andrights that the common shareholders do not hold.

Those investors, having agreed to finance the company ondifferent terms from the common, ask for certain rights, in


terms of influence. This is done to compensate for what istypically a minority position at a higher price than commonor to retain a level of influence over whether the companyentertains future financings, on what terms those financingsmay occur, and in the event that the company doesn'tperform or meet the expectations, over how and when thecompany may need to be liquidated. Allocating a certainnumber of seats on the board that are attributable to thatseries of preferred investors is one way of securinginfluence. So if there were five board members before thepreferred shares are issued for example, the company mightagree to ask two existing board members to step down inorder to issue two new board seats to the investors of thatpreferred round. The board could also be expanded.

Unless there is a change in the future board compositionthat is agreed to by the preferred investors, they will alwayskeep those seats and always have that level of influence. Infact, they will probably ask that the company's charter ischanged to reflect an agreed upon number of seats. In thisway, if any change in size of the board is contemplated, thepreferred investors would have to agree; if they did not, thecompany's charter typically could not be amended.

Assuming that the company's articles of incorporationreflect that there will be a five-person board, the preferredinvestors are being assured of retaining a 40 percentinfluence at the board level. In this example, the investorsas a class of preferred stock could therefore only have a 15percent interest in the company and yet retain close to amajority of control at the board level. In fact, if one of theremaining three board members is an independent, it would


be possible that the "block" could retain a controllinginfluence on the board.

In some cases new classes of stocks will have the samerights as all previous preferred series of shares. So a Bcould be issued after an A, and the B investors have thesame rights as the A. In this case, the pricing and boardrepresentation might be the only difference. But typically,the lower in the alphabet the series of shares, the moreinfluence the most recent series might have over thatcompany and the higher the likelihood that all existingpreferred shares are sharing any rights they have with thatcurrent round. So either the most current round has moreinfluence, or at the very least, shares all the rights of aprevious round.

The most significant change will be in valuation. Thehigher in the alphabet series of shares, most probably thelower the price of the shares if a company is performingwell.

Total Amount Raised, Number of Shares, andPurchase Price Per ShareEach of the Total Amount Raised, Number of Shares, andPurchase Price Per Share sections (see Figure 2) are fairlyself-explanatory. Total Amount Raised refers to specificelements to the total amount to be raised by the proposedfinancing; Number of Shares is the number of shares thatwill result as a result of the proposed financing; andPurchase Price Per Share is the purchase price per share ofthe shares in the proposed financing. The Total AmountRaised should equal the product of the Number of Sharesplus the Purchase Price Per Share.


Post-Financing CapitalizationThe purpose of the Post-Financing Capitalization section isto summarize what the capital structure of the companywill look like after the proposed new financing. Some termsheets include a Current Securities section at the verybeginning of the term sheet; in our example (in Figure 1),there is no Current Securities section. Typically, had onebeen included, no Post-Financing Capitalization would beincluded in the term sheet; instead the Current Securitiessection would, when considered together with the NewSecurities Offered section, provide enough information forthe reader to put together a capitalization table. The Post-Financing Capitalization included in Figure 2 summarizessuccinctly what the capital structure should look like afterthe proposed financing and includes summaries of bothcurrent and new securities.

The information in this section allows the reader todetermine the pre-money and post-money or TotalEnterprise Value valuations of the company. To determinethe pre-money valuation, one must examine the Post-Financing Capitalization section and multiply the totalnumber of sharesexcluding the number of NewSecurities Offered shares but including the number ofoptions and warrants issuedby the Proposed PurchasePrice Per Share noted in Figure 2. To ascertain the post-money valuation or Total Enterprise Value, multiply thenumber of Total Common Equivalent shares by thePurchase Price Per Share proposed in the term sheet.

It is also possible to determine the Total Common StockEquivalent number. To do so one should add the number ofcommon stocks, options and warrants, and any preferred


stock that had been issued prior to the proposed financingtogether with the number of shares to be purchased as partof the proposed financing. The Total Common Equivalentassumes that preferred stock and common as well asoptions and warrants are treated equally in valuing thecompany. This approach to valuing the company isfactually accurate at the time of a financing but may not,when considering preferred stock, reflect the value ofpreferred stock if converted to common at some point in thefuture. Preferred stock can, as the next section explains,carry a dividend that could accrue and, in some cases, beadded to the original value of the stock should it be paidback under certain circumstances, in liquidation forexample.


FIGURE 2

New Securities Offered: Newly issued shares of the Company'sSeries [A] Preferred (the "Preferred")Total Amount Raised: [$ ]Number of Shares: [ / To be determined to resultin the Post-financing Capitalization below.]Purchase Price Per Share: [$ / To be determined toresult in the Post-financing Capitalization below (the "OriginalPurchase Price").]Post-Financing Capitalization: Common Stock

Founders:[Name] [[Name] [[Name] [Sub-Total [

]]]]

Stock Option Program[CEO] [[Others] [Sub-Total [

]]1

Preferred Stock[ ] Ventures, L.P.,[Co-Investor(s)] [Sub-Total [

[]

]Total Common Equivalent [ ]

Total Enterprise Value L J

Dividend ProvisionsThe true value of preferred stock will therefore be afunction of a number of provisions detailed throughout theterm sheet. Figure 3 highlights the type of clauses that arelikely to detail the economic effect that DividendProvisions can have in increasing the value of preferredstock over time.


Dividend provisions are one of the critical tools that allowVCs to protect their investment and to get out of aninvestment with at least some prospect of a return in theevent of liquidation of the company. The dividendprovisions are what the board will live by when they eitherconsider issuing or are required to issue dividends.

There are three dividend provision clauses outlined inFigure 3: Investor Favorable, Middle of the Road, andCompany Favorable. Only one form of these three wouldexist in the term sheen proposed by an investor. Theseprovisions are a mix of weighted variables: neutral,negative, or positive in the favor of investor or company.The differences between the economic effect of the wayeach of the Investor Favorable, Middle of the Road, andCompany Favorable sections are structured is a function ofthe percentage of return assumed for the preferred stock,whether the dividend is cumulative or non-cumulative, orwhether issuance of a dividend for preferred stock shouldtake preference over issuance of a dividend for any existingshares that have rights to dividends.

An entrepreneur must not underestimate the economiceffect and difference between cumulative and non-cumulative dividends. If the dividend is non-cumulativeand the company doesn't make a decision to issue adividend in year one, or doesn't have the resources to doso, the subsequent year the slate is clean and the companythereafter is not obligated to make good on the issuance ofdividends for any previous years. This means that if thedividend is not issued in year one and a dividend were to beissued in a subsequent year, the company would not berequired to issue dividends cumulatively or retroactively


for previous years in which the company was unable toissue a dividend.

Let us consider the case of the Investor Favorable exampleof Dividend Provisions below. As this term sheet details afirst round of preferred shares, Series A, the investorwould, should the term sheet include the Investor Favorabletext in Figure 3, expect to receive dividends at a specificrate of return, in this case at 15 percent. If therefore,dividends were to be issued by the company, dividendswould need to be issued to the Series A preferred at acumulative rate of 15 percent per annum before anydividends could be issued for common shares. Even if thecommon stock stipulated a return of say 8 percent, thisclause would require the board to make a decision to issuedividends to preferred investors. Whatever funds wereavailable would first have to provide the Series A investorswith a 15 percent return on their invested capital. Only afterthis is done would any funds be used to generate a dividendfor common stock.

FIGURE 3Rights, Preferences, and Privileges of the Series[A] Preferred.(1) Dividend Provisions:Investor Favorable: The holders of the Series [A] Preferred shallbe entitled to receive cumulative dividends in preference to anydividend on the Common Stock at the rate of 15 percent of the OriginalPurchase Price per annum, when and as declared by the Board ofDirectors.

Middle of the Road: The holders of the Series [A] Preferred shallbe entitled to receive non-cumulative dividends in preference to any


dividend on the CommonStock at the rate of 8 percent of the OriginalPurchase Price per annum, when and as declared by the Board ofDirectors. The Series [A] Preferredalso will participate pro rata in anydividends paid on the Common Stock on an as-converted basis.

Company Favorable: The holders of the Series [A] Preferred shallbe entitled to receive non-cumulative dividends in preference to anydividend on the Common Stockat the rate of 8 percent of the OriginalPurchase Price per annum, when, as and if declared by the Board ofDirectors.

Liquidation PreferenceLiquidation means closing down the company. That doesn'tnecessarily have to be devastating for a VC if appropriateprotections have been incorporated into a term sheet. Theliquidation preference clause is a tool that enables favorabletreatment for preferred shareholders in the event ofliquidation.

The most significant variable to consider in the liquidationpreference section is the multiple on the value of theirinitial investment that preferred and common shareholderswill receive as a result of this clause (see Figure 4). So,Investor Favorable terms will generally provide thepreferred investor a multiple on the value of the initialinvestment of say three times. In the event of a sale orbankruptcy proceedings, preference would be given to thepreferred investor to receive a three-times return on theirinitial investment, before any proceeds are used to payanything to any other shareholders, including commonshareholders who do not retain these rights. That is in oneversion of the most investor-favorable situation.

In the case of the Middle of the Road clause in Figure 4,proceeds are distributed so that they are given first to


preferred shareholders but in a less preferential manner.The preferred would, in this case, get their originalpurchase price plus any declared but unpaid dividends.Thereafter, common and preferred shareholders share inproportion to their ownership position the remainingdistributions until such time as the preferred has receivedthree times their original purchase price.

VCs are highly sensitive to the time value of money. Areturn of 3 times over 4 years actually equates to only a 32percent annualized return. The net return to an investor,when deducting a venture fund's fees, would be below 25percent, which is not considered an extraordinarilyattractive venture capital return.

FIGURE 4

(2) Liquidation Preference:Investor Favorable: In the event of any liquidation or winding upof the Company, the holders of the Series [A] Preferred shall be entitledto receive in preference to the holders of the Common Stock an amountequal to the Original Purchase Price plus any accrued, or declared, butunpaid dividends (the "Liquidation Preference"). After the payment ofthe Liquidation Preference to the holders of the Series [A] Preferred,the remaining assets shall be distributed ratably to the holders of theCommon Stock and the Series [A] Preferred on a common equivalentbasis. A merger, acquisition, or sale of substantially all of the assets ofthe Company in which the shareholders of the Company do not own amajority of the outstanding shares of the surviving corporation shall bedeemed to be a liquidation.

Middle of the Road: In the event of any liquidation or winding upof the Company, the holders of the Series [A] Preferred shall be entitledto receive in preference to the holders of the Common Stock a per shareamount equal to the Original Purchase Price plus any declared but


unpaid dividends (the "Liquidation Preference"). After the payment ofthe Liquidation Preference to the holders of the Series [A] Preferred,the remaining assets shall be distributed ratably to the holders of theCommon Stock and the Series [A] Preferred on a Common Stockequivalent basis; provided that the holders of Series [A] Preferred willstop participating once they have received a total liquidation amountequal to [three] times the Original Purchase Price. A merger,acquisition, sale of voting control, or sale of substantially all of theassets of the Company in which the shareholders of the Company donot own a majority of the outstanding shares of the survivingcorporation shall be deemed to be a liquidation.

CompanyFavorable: In the event of any liquidation or winding upof the Company, the holders of the Series [A] Preferred shall be entitledto receive in preference to the holders of the Common Stock an amountequal to the Original Purchase Price (the "Liquidation Preference").After the payment of the Liquidation Preference to the holders of theSeries [A] Preferred, the remaining assets shall be distributed ratably tothe holders of the Common Stock. A merger, acquisition, or sale ofsubstantially all of the assets of the Company in which the shareholdersof the Company do not own a majority of the outstanding shares of thesurviving corporation shall be deemed tobea liquidation.

RedemptionRedemption clauses are the one way for VCs to ensure thata company does not become a lifestyle company that isonly in business to give its founders and management asalary or become what VCs consider to be part of the"living dead." Entrepreneurs need to remember that mostfunds function as limited partnerships with a finite numberof years of life. The purpose of the Redemption clause is toprovide a structure (see Figure 5) that makes certain thatthe investors do not invest in companies that are unable togenerate liquidity.

The redemption clause puts a finite number of years on thelife of an investment, by assuming that the investment is


able to generate a return. In so doing it stipulates that atsome point in the future if a liquidity event has nothappened, then the company will become obligated toredeem the investor's interest in a specific time frame. Aliquidity event is a way of providing the investor with acurrency through which to phase out of the investment, likea public offering or a buyout that allows the investors'interest to be purchased. Those time frames and variablesare stipulated in the examples of Redemption clauses citedin Figure 5. Clauses that are Investor Favorable requireredemption relatively rapidly and over a defined andshorter number of years. Clauses that are Middle of theRoad are less rapid. The Company Favorable flavor of thisclause would of course be no clause at all.

Here is an example of how a redemption clause works:WidgetCompany.com receives $10 million in proceedsfrom the sale of preferred stock. If on the company's thirdanniversary it has not generated any opportunity forliquidity for the investor, the Investor Favorable clauserequires that, if an election by holders of preferred stockforces them to do so, the company will be required toredeem or pay back one third of the outstanding preferred.In doing so the company must redeem these preferredshares at a rate of three times their Original Purchase Priceplus any accrued or unpaid dividends on those shares. Inthis case the cost to the company would be $10,000,000after three years plus accrued and unpaid dividends onthese shares. The clause goes on to require payment of onehalf of the outstanding preferred on the fifth anniversary atthe same multiple plus accrued and unpaid dividends onthis portion of securities. It then requires that remainder ofunredeemed shares be treated similarly on the sixth


anniversary of the initial investment. The company'smanagement team is basically on notice and reminded thatin three years the company must have generated some wayin which to pay back investors or it will need to begin toprovide them some liquidity so that holders of the stock arenot motivated to exercise this right.

This clause in the Investor Favorable format is more stickthan carrot. While the three-year wake-up call is moreaggressive than what one typically sees in early orexpansion stage term sheets, it would make sense for a laterstage deal that is expensive and touting to generate liquidityfor investors in short order.

The Middle of the Road format is just that. For an early orexpansion stage deal it is an eminently reasonablecompromise. It is probably generous to rich and moreCompany Favorable from the VC perspective if the pricingof a deal is expensive and the entrepreneur is pitchingliquidity and an exit for the venture investor in less than 5years time.

FIGURE 5

(3) Redemption:Investor Favorable: Redemption at Option of Investors:At the election of the holders of at least [a majority] of the Series [A]Preferred, the Company shall redeem 1/3 of the outstanding Series [A]Preferred on the [third] anniversary of the Closing, 1/2 of theoutstanding Series [A] Preferred on the fifth anniversary of the Closingand all of the remaining outstanding Series [A] Preferred on the sixthanniversary of the Closing. Such redemptions shall be at a purchaseprice equal to [three] times the Original Purchase Price plus accruedand unpaid dividends.


Middle of the Road: Redemption at Option of Investors:At the election of the holders of at least [two thirds] of the Series [A]Preferred, the Company shall redeem the outstanding Series [A]Preferred in three equal annual installments beginning on the [fifth]anniversary of the Closing. Such redemptions shall be at a purchaseprice equal to the Original Purchase Price plus declared and unpaiddividends.

Company Favorable: None.

Conversion and Automatic ConversionConversion (see Figure 6) is a short clause that is notconsidered Investor nor Company Favorable, because whenconversion happens, it is always assumed to be at an eventin which preferred convert to common shares on a 1:1basis. The purpose of this clause is to enable preferredshareholders to convert in the event of a liquidity event thatis likely to generate a return that is higher than the multiplethat is prescribed as mandated in the Liquidation Preferencesection. Investors who are only purchasing preferred stockwill often give up their preferred rights if a transactionwould yield a higher return. Many of the issues thatpreferred investors have about control and preferred stockbecome secondary in a liquidity event that promises themgreater upside than that dictated in the LiquidationPreference clauses previously discussed.

Consequently, it is important to consider the relationshipbetween the Liquidation Preference Clause and theConversion Clause.

In the face of an IPO, the preferred investor will haveunique concerns, which are addressed in the AutomaticConversion clause that is proposed in the term sheet. TheAutomatic Conversion clause, described in Figure 6,


specifically describes the range of powers which preferredinvestors may strive to require in the event a companypushes to go public.

IPOs are not a panacea when it comes to liquidity. Asecond-rate underwriter who pushes to raise a small amountof money through an IPO could well set a company up toperform poorly on the public markets. If the stock is thinlytraded, the preferred investor is left with little ability totrade out of the stock and analysts and market makers havelittle motivation to follow the stock. Consequently, thereare two variables that differentiate the Investor Favorableand Company Favorable clauses in Figure 6. They are thenumber of times the originalpurchaseprice of the preferredstock will automatically convert into common and facilitatea public offering, and the amount of money that willqualify an IPO as acceptable to the preferred. The preferredinvestor will contend that the extent to which the multipleis high and the amount of money that is raised is high willdetermine the success of the IPO.

The choice of language in this clause qualifies the type ofunderwriter who is likely to be involved in an IPO. The sizeof the IPO, whether it is Investor Favorable or CompanyFavorable, scales downwards as it is considered to be moreCompany Favorable. In the event that a smaller-sizeoffering is contemplated, the type of underwriter is likely tobe less established, because the fees involved and the floatwould only be inviting to a less-established firm.

So the modus operandi of the investor and of management,should an IPO be contemplated that will generate a greateramount of liquidity, is to work together. The higher number


of times the original purchase price at which an investorstates he will be comfortable converting is really a way forthe investor and the investor class to protect itself and tomake sure that the IPO will generate liquidity of a certainmultiple. It is difficult to generalize, but depending on theinvestor, investors are looking at a two- to three-year timeframe, and a minimum of a three to four times return in thatperiod if not greater. If one considers a net return of 35percent to the investor in a VC fund to be a goal that aninvestor may be looking for, the VC will have to returnclose to 50 percent on all his or his investments in order toproduce this return net of fees. An investment would haveto do eight times in five years in order to produce a grossreturn of 52 percent; the effective gross return of the VCsportfolio will of course be significantly lower and the needfor the VC to get a return of over 50 percent higher if thesuccess of the one investment must make up for other failedcompanies in the VCs portfolio. The time value of moneyweighs heavily in a VCs assessment of an opportunity.

Entrepreneurs' projections of returns are likely to be moreaggressive than the actual performance of a company. Sowhen VCs make their predictions and entrepreneurs takeexception to what appear to be the aggressive multiples ofVCs, what entrepreneurs may fail to accept or realize is thatVCs will by their nature be likely to discount anentrepreneurs projections. It is for this reason thatmilestones can be a middle ground tool in balancing theexpectations of VCs and entrepreneurs.


FIGURE 6

(4) Conversion: [Investor Favorable, Middle of the Road andCompany Favorable are the same.]

The holders of the Series [A] Preferred shall have the right to convertthe Series [A] Preferred, at any time, into shares of Common Stock.The initial conversion rate shall be 1:1, subject to adjustment asprovided below.

(5) Automatic Conversion:

Investor Favorable: The Series [A] Preferred shall beautomatically converted into Common Stock, at the then applicableconversion price, (i) in the event that the holders of at least two thirdsof the outstanding Series [A] Preferred consent to such conversion or(ii) upon the closing of a firmly underwritten public offering of sharesof Common Stock of the Company at a per share price not less than [3times the Original Purchase Price] per share and for a total offeringwith net proceeds to the Company of not less than $40 million (a"Qualified IPO").

Middle of the Road: The Series [A] Preferred shall beautomatically converted into Common Stock, at the then applicableconversion price, (i) in the event that the holders of at least two thirdsof the outstanding Series [A] Preferred consent to such conversion or(ii) upon the closing of a firmly underwritten public offering of sharesof Common Stock of the Company at a per share price not less than [2times the Original Purchase Price] per share and for a total offeringwith gross proceeds to the Company of not less than $25 million (a"Qualified IPO").

Company Favorable: The Series [A] Preferred shall beautomatically converted into Common Stock, at the then applicableconversion price, (i) in the event that the holders of at least a majorityof the outstanding Series [A] Preferred consent to such conversion or(ii) upon the closing of a firmly underwritten public offering of sharesof Common Stock of the Company at a per share price not less thantwo times the Original Purchase Price (as adjusted for stock splits andthe like) and for a total offering of not less than $5 million, before


deduction of underwriters commissions and expenses (a "QualifiedIPO").

Dilution ClausesThe single most important consideration when raisingfunds is anticipating how, as a company grows, new roundsof financing will affect the value of the shares ofcompany's existing shareholders. Dilution clauses are thesingle most important tool for investors who want to ensurethat any subsequent financing will, at the very least, notdilute the value of their investments below the price theypaid in a prior round. The Internet craze produced someexcellent examples of this. Companies that were able toraise millions with only a business plan at high pre-moneyvaluations quickly found themselves and their shareholdersin a very unhappy position when they went out forsubsequent rounds of funding in a bear funding market.Many companies that had actually executed to plan foundthat they were unable to raise money at higher valuationsand, in some cases, had to accept lower pre-moneyvaluations in subsequent rounds than their post-moneyvaluations in prior rounds.

Dilution clauses are important in the event that acompany's future financing results in a round of financingat the same price as the previous round, called a flat round,or in a round in which share prices are, when takingdilution into account, lower than the share prices of aprevious round, called a down round. The three clauses inFigure 7 stipulate ways of calculating conversion prices inthe event that a future share price is dilutive to the investorsof the preferred round.


The most Investor Favorable clause implements what iscalled a full ratchet, which means that the effective cost andownership percentage in the company for the preferredinvestor who invested at a given price in a prior roundadjusts so that the cost and ownership percentage to the oldinvestor is as if that investor invested in the new roundside-by-side. So, if a share price at a Series A Preferredround is $2, and subsequently there is a down round and theshare price in a Series B Preferred round is $1, the fullratchet would allow the Preferred A investor to benefit atthe time of conversion into common from an adjustmentthat ensures that the conversion price ofhis shares is $1, thesame conversion price of the new Series B. Because thevalue per purchase price for Preferred B investors may dropto $1, the conversion price at which that Preferred Binvestor may convert to common will be set at $1. With afull ratchet, the conversion price at which the Preferred Ainvestor will be allowed to convert his shares will beadjusted in the company charter from $2 to $1, prior to anyadjustments for cumulative dividends for example. At thatpoint in time when the Preferred A investor chooses toconvert his shares to common, he will convert at a price of$1 instead of $2. The cost for this is to the holders ofcommon stock, whose shares will be the ones to get diluted.Hence the conundrum for companies that are able toreceive high pre-money valuations early in the life of acompany. The entrepreneur may think that this is a riskworth taking, however valuations that are prematurely highin early rounds can adversely affect the marketability of acompany in a later round. Investors who come to the tablemay sense that the management and its previous investorshad lofty and inappropriate expectations and that as a resultmanagement may be difficult to work with or to rely on


when it comes to future performance. The economicconsequences of a down round can also be devastating forexisting shareholders whose impatience and soureddemeanor can create a less than welcoming environmentfor new investors.

The Middle of the Road clause results in some dilution forexisting preferred shareholders in the event of a futureround at a lower price. The clause requires a weightedaverage conversion which means that the conversion pricewhich is established for an existing class of preferredshares must be changed. The conversion price is simply theprice at which the preferred would convert to common. Acompany's charter will typically state that each share ofpreferred will convert into the number of shares of commonthat you get when you divide the preferred price, which inour example above was $2, by the preferred conversionprice, which in this case would initially be stated as $2 inthe company's charter. In a down-round which effects aweighted average adjustment, the conversion price which isstated in the company's charter must be adjusted and thenumber of common shares which the preferred is then ableto purchase upon conversion is determined by a newconversion price. The following formula on the next page isused to determine the new conversion price for thepreferred when a weighted average adjustment is broughtinto effect:


# of Shares ofCommonwhich amount paid forPreferred B would

# of Shares ofCommon + Purchase ifat oldEquivalent Outstanding Prior to Preferred A

Old Preferred A Preferred B Round Conversion PriceConversion Price X

# of Shares ofCommon Equivalent + # ofNew SharesOutstanding Prior to Preferred B Round of Preferred B

Issued

In applying this formula, consider the example used in thefull ratchet discussion: a $2 Conversion Price for PreferredA that must be adjusted when a subsequent Preferred Bround of 4 million shares is priced at $1 per share. Let usassume that the company had 13 million commonequivalent shares outstanding prior to the Preferred Bround. Let us also assume that 2 million shares or $4million had been received from the Preferred A investors inthe prior round. Were $4 million to purchase Common atthe Conversion Price for the Preferred A as established inthe company's charter at the time of the Preferred A round,it would in effect have the buying power to purchase 2million shares. The resultant weighted average price pershare for the Preferred A investor in this scenario would be$1.76 per share; this was derived by applying the formulaand our assumptions as follows:

Common which# of Shares of Amount Paid forCommon Equivalent Preferred B wouldoutstanding Prior to Purchase if at oldPreferred B Round Preferred A

(13,000,000) + Conversion PriceOld Preferred A (2,000,000)Conversion Price X

($2)# of Shares of Common # ofNew Shares ofEquivalent outstanding Preferred B issued

prior to Preferred B Round + (4,000,000)(13,000,000)


It is important to note that the Middle of the Road examplebelow includes a "play-or-lose" provision which is notalways seen in deals. The provision in this case wouldrequire a prior investor to invest his pro-rata share of asubsequent round.

The Company Favorable scenario is one in which there isno dilution protection for the investor. This is typically onlyseen in first angel rounds, in which all common stocks andstockholders are treated equally.

FIGURE 7

(6) Anti-dilution Provisions:

Investor Favorable: The conversion price of the Series [A]Preferred will be subject to a full ratchet adjustment in the event thatthe Company issues additional equity securities (other than the reservedemployee shares described under "Employee Pool") at a purchase priceless than the applicable conversion price. The conversion price will alsobe subject to proportional adjustment for stock splits, stock dividends,recapitalizations, and the like.

Middle of the Road: The conversion price of the Series [A]Preferred will be then subject to a weighted average adjustment (basedon all outstanding shares of Preferred and Common Stock) to reducedilution in the event that the Company issues additional equitysecurities (other than the reserved employee shares described under"Employee Pool") at a purchase price less than the applicableconversion price. The conversion price will also be subject toproportional adjustment for stock splits, stock dividends,recapitalizations, and the like. This anti-dilution protection is subject toa play-or-lose provision that provides that adjustments will be made tothe Series [A] Conversion Price only if the Series [A] holderparticipates in such dilutive offering to the extent of its pro rata equityinterest in the Preferred. Any investor who does not participate in a


future financing forfeits the benefits of dilution protection [for allfuture rounds of financing/only for that financinground].

Company Favorable: The conversion price of the Series [A]Preferred will be subject to proportional adjustment for stock splits,stock dividends, recapitalizations, and the like.

Voting RightsVoting rights means that in the event that a shareholdervote is called, all shares are treated equally (see Figure 8).It is important to note that there are certain protectiveprovisions that are articulated in Section 8 of this sampleterm sheet (see Figure 9) that will allow the preferredinvestor to have powers that do not require the vote of allshareholders. Clearly therefore, voting rights are importantto preferred investors, but their level of influence issupplemented by additional powers, examples of which arearticulated in Figure 9.

FIGURE 8

(7) Voting Rights: [Investor Favorable, Middle of the Road andCompany Favorable are the same.]

The Series [A] Preferred will vote together with the Common Stockand not as a separate class except as specifically provided herein or asotherwise required by law. Each share of Series [A] Preferred shallhave a number of votes equal to the number of shares of CommonStock then issuable upon conversion of such share of Series [A]Preferred.

Protective ProvisionsProtective provisions effectively enable the class of sharesthat are being contemplated to have certain powers


associated with them (see Figure 9). Any action taken bythe class of shares holding protective provisions wouldrequire consent of some proportion of the shareholders ofthat class. The extent to which these protective provisionsare Investor Favorable or Company Favorable will dependupon the type of powers and to what extent the powers arein favor of the investors or the company.

Typically, the concerns that new investors will have, whichare often written into the protective provisions section,include whether new shares can be issued with or withoutthe approval of the class of shareholders holding theprotective provisions. This means that the preferred shareswould, in the case of the Investor Favorable and Middle ofthe Road examples in Figure 9, like to have an influenceand the power to approve any future round of financing thatwill have a dilutive effect on the value of their securities. Inthe Investor Favorable example, the preferred will requirethat the rights and preferences associated with the previousstock cannot be changed without a majority approval ofthat class of preferred. The preferred may want to be surethat redemption of common stock by employees who maywish to sell the stock cannot transpire without theirapproval, and that significant events that would affect thecourse of the company's business cannot transpire withoutthe approval of that series of preferred. These wouldinclude a merger, a reorganization, a sale, amendments tothe company's certificate of incorporation, amendments toits bylaws, increases or decreases in the company's numberof authorized shares or the size of the board, as well aspayments of or the declaration of dividends.


The Middle of the Road example shows powers that arediluted or reduced when compared to the InvestorFavorable version. In the Company Favorable example,these powers are virtually eliminated.

The Protective Provisions section is significant in that itarticulates and captures the extent to which the investorsare expecting to influence certain actions by the company.

FIGURE 9

(8) Protective Provisions:Investor Favorable: The consent of the holders of at least twothirds of the Series [A] Preferred shall be required for any action that (i)alters or changes the rights, preferences, or privileges of the Series [A]Preferred; (ii) increases or decreases the authorized number of shares ofSeries [A] Preferred; (iii) creates (by reclassification or otherwise) anynew class or series of shares having rights, preferences, or privilegessenior or pari passu to those of the Series [A] Preferred; (iv) results inthe redemption of any shares of Common Stock (other than pursuant toemployee agreements); (v) results in any merger, other corporatereorganization, sale of control, or any tran

[wilmerding, 2001] term sheets & valuations

Documents