Transcript Document 7566508

12 Term Sheet Issues
(8 that matter
and 4 you should understand….)
SLP | Startup Leadership Program
Issues
1.
2.
3.
4.
5.
6.
7.
8.
Valuation & Cap Table
Dividends
Liquidation Preferences
Board Seats
Option Pool
Anti-dilution Protection
Drag Along
Founder Restricted Stock
9.
10.
11.
12.
Pay-to-play
Right of First Refusal and Co-Sale
Redemption
Pre-emptive Rights
Source: Richard Kimball, EAPD
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
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
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
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
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
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
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 30-90 days
• “Double trigger” vesting is common – you get
accelerated only if buyer fires you. Ask for single trigger!
You own 2% of the company.
VCs invest $4MM on $6MM premoney
and company sells for $20MM
$000
2010
2011
2012
2013
No $118
Acceleration
$222
$316
$400
50% $294
Acceleration
$333
$368
$400
100% $471
Acceleration
$444
$421
$400
Source: SLP
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%
6,000,000
6,000,000
32.3%
8.6%
Pool
2,571,429
15%
2,571,429
2,571,429
13.8%
3.7%
Series A
8,571429
50%
8,996,458
60,000,000
48.5%
86.2%
1,000,000
1,000,000
5.4%
1.4%
Series B
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
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 repurchased
@ 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
And Some That Aren’t
(but you should what they mean)
9. Pay-to-play
In the event of a Qualified Financing (as defined below),
shares of Series A Preferred held by any Investor which is
offered the right to participate but does not participate
fully in such financing by purchasing at least its pro rata
portion as calculated above under “Right of First Refusal”
below will be converted into Common Stock.
• Don’t see it often
• Good for the company (usually) unless you lose a
strategic investor (bad messaging to the market)
• Matters investors, not for Founders/Employees
• Can be a BIG issue between preferred shareholders
• “Pay-to-play” can wipe out clutter of investors
Source: Legal extract from learnvc.com, Advice from SLP
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
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
More Perspectives
on termsheets
Opening Remarks:
“Don’t be paranoid”
• 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
More perspectives
• 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 look @ the whole picture
• I know a VC that fired a CEO @ 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
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
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
• Source:
Lead
VCs like to build their own syndicate
SLP
Appendix
Valuation Deep Dive
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
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
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
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
Valuation: Post Closing Cap Table
Holders
Pre-money
(Founders)
Investors
Option Pool
Totals
Source: EAPD
Number of
Shares
6,000,000
Percentage
8,571,429
50%
2,571,429
15%
17,142,858
100%
35%
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
3. Illustrating Participating
Preferreds:
VCs invest $10M: Take 50%
70
60
1x Convert Pfd
50
1x Part Pfd
40
30
2x Part Pfd
20
1x Part Pfd 2x
cap
10
0
Source: SLP
$10m
$20M
$50M
$100M
Payouts @ different
Preferreds
3. Liquidation Preference: 1x
Source: Leo Parker, UW Business School
3. Liquidation Preference: 2x
Source: Leo Parker, UW Business School
3. Liquidation Preference: 3x
Source: Leo Parker, UW Business School