Understanding VC Term Sheets

Understanding VC Term Sheets
Presentation to TiE Challenge
January 9, 2013
Mark A. Haddad
Partner
617-832-1724
mhaddad@foleyhoag.com

© 2013 Foley Hoag LLP. All Rights Reserved.

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

What is a term sheet?

 aka- “Letter of Intent,” “Memorandum of
Understanding,” “Agreement in Principle”
 Basic agreement on the material terms of the
transaction
–Road map, marching orders
 More detail is generally better (especially for
the company)
 Legally binding? For the most part, no, but…..
 If you really want to mess up your transaction,
this is the place to do it


Non Binding

 A term sheet is not a binding agreement to fund
– Subject to actual documents
– Subject to due diligence
– Subject to other closing conditions (legal opinion, etc.)
 Confidentiality
– Term sheets typically have a binding confidentiality provision
prohibiting disclosure of the terms and the existence of the term
sheet
 Exclusivity
– Term sheets typically give the investor some period of
exclusivity (30 to 60 days)


Types of Early Stage Financing Deals

 Seed Financing:
–Convertible Notes
–“Series Seed” or “Series AA” (i.e. Series A light)
 Series A
 Series B and later rounds


Series A

 Takes the form of “Convertible Preferred Stock” with
lots of contractual protections and benefits
 Control issues:
– Voting control, board seats, veto powers, forced sale
– “CEO” and the three envelopes
 Economic issues:
– Make sure you understand how the economics work and are not
comparing apples to oranges


Convertible Preferred Stock

 Why Convertible Preferred Stock?
–“Preferred” - Preference over common stock on
dividends, distributions, liquidation, redemption
–“Convertible” - All of the upside of common stock


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

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

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


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


Math Geek Part 1

 Offer 1: Pre-Money Value of $10 million, $5
million investment, 10% Post-Money Option
Pool
 Offer 2: Pre-Money Value of $11 million, $5
million investment, 20% Post-Money Option
Pool

 Which is the better offer?


Math Geek Part 1 Answer
 Offer 1, even though it’s a lower “pre-money valuation.” It values the
outstanding common stock higher because it includes a smaller post-
money option pool. Here’s the math:
 Offer 1 Values: O/S % FD %
– Preferred Stock $ 5,000,000 37% 33%
– Option Pool 1,500,000 NA 10%
– Common Stock 8,500,000 63% 57%
– Total Post-money $15,000,000
 Offer 2 Values:
– Preferred Stock $ 5,000,000 39% 31%
– Option Pool 3,200,000 NA 20%
– Common Stock 7,800,000 61% 49%
– Total Post-money $16,000,000


CAUTION!
 Valuation is only one of many economic terms.
 As the saying goes, a VC will gladly let you pick the
valuation if they get to pick all the other terms. You can
construct the other economics in many ways, the
easiest of which is the liquidation preference…


Liquidation Preference
 Liquidation preference = the right of the holders of preferred stock
to get their money back (and perhaps more) before the common
stock when a “liquidation event” occurs (generally, an M&A
transaction). Sometimes “multiples” are used (1x, 2x, 3x).
 Sometimes accruing dividends are included (essentially like adding
an interest rate component to the preference– range of 4% to 9%
in Q3).
 “Preference overhang” refers to the total amount of liquidation
proceeds that go to the holders of preferred stock before the
holders of the common stock begin to share in the liquidation
proceeds.
 Three main flavors:
– No participation
– Participating preferred (aka “Piggy Preferred”)
– Capped participation


Math Geek Part 2
 Assume we took Offer 1 ($10m pre and $15m post) and a year later we sold the
company for $30 million (with the option pool fully issued/vested for simplicity).
Here are how different preferences and participation rights would play out:
 1x preference, no participation:
– Preferred Stock: $10 million (33% of proceeds)
– Common Stock: $20 million
 1x preference, full participation:
– Preferred Stock: $13.3 million (44% of proceeds)
– Common Stock: $17.7 million
 1x preference, participation capped at 2x:


Math Geek Part 2
 Now assume it was only one week later and for $15 million:
 1x preference, no participation:
– Common Stock: $0


Math Geek Part 2

Source: www.wikipedia.org


Liquidation Preference- Take Aways
 Having a preference is standard, but focus on trying to minimize
participation and accruing dividends.
 Understand how the preferences interplay so that everyone’s
incentives are aligned. It can get very complicated when multiple
rounds are stacked up. In some cases you can have flat spots or
even drastic jumps that create divergent incentives.
 The early rounds set a precedent for later rounds, so early
investors that are too greedy on terms may live to regret it (use this
argument to your advantage in negotiating favorable terms in the
early rounds).
 Sometimes preference can be used to bridge a valuation gap, but
again, worry about the precedent in that case.
 Generally not applicable in IPO


Uncommon but BIG Traps

 Dividends paid in equity
–Example: Series A priced at $1 per share. 8%
accruing dividend, can convert to common at $1 per
share.
 Liquidation preference that converts into equity
–Example: Upon conversion, in addition to the
preferred stock converting to equity (initially one for
one) the liquidation preference is paid out in the form
of common stock at current fair market value. In the
upside scenario this is simply extra juice in an IPO
(that the VC would have gotten in a sale at the same
value) but in a downside this is essentially full ratchet
antidilution and then some.

Antidilution Protection

 Addresses Investors’ concern re: valuation
 Changes the conversion price used to calculate the
number of shares of common stock issued when a
share of preferred stock converts
 Helps protect investors in the case of a “down round,”
when new money comes in at a total pre-money
valuation (or price per share) that is lower than the
previous round’s post-money valuation.
 Two main flavors:
– Full ratchet
– Weighted average (broad-based and narrow based)


Weighted Average
 Weighted average anti-dilution adjustment takes into account the
proportional relevance (or weight) of each component in the
calculation rather than treating each component similarly.
 In a down round, the conversion price of the Series A is lowered to
a price that is an average of the price at which the company sold
the new stock, valuing the common stock outstanding at the pre-
adjusted conversion price.
 Sometimes formulated as “broad-based” and sometimes as
“narrowly-based.” (“narrowly-based” is more favorable to the
protected preferred stock.)
 More common than full ratchet, and much less onerous to un-
protected stockholders.
 Formula:
New price= (P1)(Q1) + (P2)(Q2)
(Q1) + (Q2)

Full Ratchet

 The conversion ratio of the protected preferred stock is
“ratcheted down” to the lowest price at which securities
are sold in the down-round (where stock is sold at a
price lower than the earlier protected round). This
applies even if only one share is sold. It treats all
subsequent down-round stock issuances similarly,
resulting in an adjustment to the conversion ratio
regardless of the number of shares issued.
 Very onerous, and increasingly less common (although
makes a comeback at times, like in 2008-2009 decline).


Math Geek Part 3
 Assume again Offer 1 is closed on ($10m pre and $15m post). Subsequently, the
company has to raise an additional $2.5 million in a Series B at a $7.5 million pre-
money valuation (a 50% decline from the $15 million post-money).
 If the Series A had no antidilution, the resulting cap table would be:
– Series B: 25% ($2.5 million)
– Series A: 25% ($2.5 million)
– Common: 50% ($5.0 million)
 If the Series A had “full ratchet” antidilution, the resulting cap table would be:
– Series A: 50% ($5 million)
– Common: 25% ($2.5 million)
 If the Series A had “weighted average” antidilution, the resulting cap table would be:
– Series A: 27.5% ($2.75 million)
– Common: 47.5% ($4.75 million)


Math Geek Part 3

 Weighted Average Math:
New price= (P1)(Q1) + (P2)(Q2)
(Q1) + (Q2)
= ($1)(15,000,000) + ($0.475)(5,263,158)
(15,000,000) + (5,263,158)
= $0.86363…
Fully diluted A = (5,000,000)/($0.86363…) = 5,789,474

Common: 10,000,000 42.5%
Series A: 5,789,474 27.5%
Series B: 5,263,158 25%
Total: 21,052,632 100%


Board Seats

 Usually investors require one or more board seats
 Challenge: What is the proper balance between
founders, investors (both existing and new), and
outside directors?
 Keep board size manageable – bigger is not always
better
 Sometimes a “board observer” rather than board seat
 Think carefully about “CEO board seat” and consider
“Founder board seats”


Protective Provisions

 aka “Negative covenants,” “Veto rights” or “blocking
rights”
 Essentially a list of things you can’t do without
investors’ prior consent
- Consent at either the Board or Stockholder level
 Usually hotly negotiated
 This is a foot on the break, not on the accelerator
 Gets complicated in later rounds; interests of investors
can diverge
 The relevant thresholds are very important depending
on the dynamics of your investor base


Other Key Terms

 Co-sale (“tag along”) rights
– Ability to sell along side founders/management (and sometimes
also other investors)
 Right of first refusal
– Ability to purchase shares for sale by founders/management
(and sometimes also other investors)
 Founder vesting
– Will often get renegotiated. Focus on what is vested up front
and what happens on change of control.
 Drag along rights
– Ability to force all stockholders to go along with a sale that
meets certain conditions. Focus on appropriate thresholds for
founders/common stock.


Other Key Terms (cont’d)

 Pre-emptive rights
– Right to participate in future financings
– Make sure it is based on fully diluted ownership, not % of
preferred
 Pay to Play
– Ability for investors to force each other to invest in future rounds.
 Information rights
– Make sure appropriate restrictions on use and not sent to
competitors
 Registration rights (IPO)
– Standard and not worth negotiating as long as reasonable


Series B and later

 Series B and later will usually piggy back off of the
Series A terms
– Realize you will have to live with the Series A, generally terms
can only get worse, not better
– Further dilution and control issues
 Growth equity
– Could be similar terms or could be opportunity to recap and
cash out prior investors (and some portion of founder equity)
 IPO
– The big homerun, but liquidity for the founders is still not
necessarily immediate


What is a Convertible Note

 First and foremost, it is debt, so it sits above
any equity (stock) in the capital stack
 However, it also has an equity feature in that it
converts upon specified events into stock of the
company
 The most common conversion is upon a
“qualified financing” (generally an equity
financing of a certain size), but notes can also
provide for conversion on other events


Key Features
 Conversion rate:
– Fixed discount or increasing discount over time
– Can have caps and collars (maximum and/or minimum
conversion price)
– If using caps, try to set a fixed price based on today’s cap table
 Automatic conversion on qualified financing
– e.g. upon an equity financing of $1m
 Optional conversion (sometimes included)
– By investor to common at cap price or other negotiated price
– By company to common at floor price or other negotiated price
upon maturity
 Interest
– Converts along with principal
– Interest rate is generally modest (for example, 5%), unless that
is being used with a smaller discount


Example

 $100k convertible note, 5% interest, 25%
discount upon qualified financing
 Company raises qualifying Series A at $1.00
per share one year after issuing the note
 Note converts into shares of Series A:
–Principal + interest = $105k
–Note converts at 25% discount, so at a price of $0.75
per share
–$105k / $0.75 = 140,000 shares of Series A (instead
of 100,000 shares that a “new money” $100k
investment would purchase)


Key Features (cont’d)

 Payment on acquisition:
– Can be based on the discount, can convert at pre-determined
price or can be a formula (e.g. 2x return)
 Maturity date
– Later the better
– Give yourself enough runway to get to the next milestone and
have at least a 6 month cushion beyond that
 Collateral (secured or not)
 Amendment of notes
– Use a single note purchase agreement that lets a majority of the
principal amount of all notes amend the terms


When to use Convertible Notes
 In most cases, will be simpler, faster and cheaper than
doing a preferred stock financing, but not always
 Generally speaking
– $500k or less, use convertible notes
– $1m or more, use preferred stock (even if “seed preferred”)
– But there are exceptions to both of these
 Consider your future financing needs:
– If you may never need to raise more money, do a stock deal or
build in an automatic (or optional) conversion of the notes at
maturity
 Consider if you are able to value the stock:
– Often convertible notes are a way to treat friends and family
money fairly by deferring a valuation until “sophisticated
investors” can negotiate with the company


Company Pros and Cons

 Faster and cheaper to execute
 More control over your company (notes do not vote,
and generally you don’t give board seats or significant
protective provisions to note holders)
 Delays dilution until you can increase the valuation
 Risk of getting to maturity date without resources to
repay or a “plan B”
 Quickly “insolvent” on paper as the money is spent
(although this helps with valuation position with respect
to employee options and equity)


Investor Pros and Cons
 Faster and cheaper to execute
 Discount can be small compared to the relative risk of
the investment (misalignment of interests)
– Valuation is too high in “homeruns” (can be mitigated by the use
of caps)
 Having “debt” in an insolvent entity is not much
protection
 Less control over the investment (delaying typical
investor protections until conversion, but can negotiate
for some, like pre-emptive rights or info rights)
 Capital gains treatment does not start until conversion
happens


Seed Preferred Alternative
 Increasingly, a number of “Series A Lite” or “Seed Preferred” deals
are being done as an alternative to convertible notes
 Provides for equity without all of the usual bells and whistles of a
full Series A deal
 Usually has at least a liquidation preference and pre-emptive
rights, but may not have many more investor protections than that
 A few sets of standardized documents that are open source and
available for use to keep transaction costs down:
– Series Seed (seriesseed.com)
– YCombinator (ycombinator.com/seriesaa.html)
– TechStars (techstars.com/docs)


What is Market? (Series A)


What is Market? (B and later)


Final Thoughts

 Generate scarcity and interest:
– best terms will come from competition
– try to land multiple term sheets in a short window to increase
your leverage and options
 Choose your investors wisely:
– like a marriage, you will be with them for a long time
– think about how it positions you for the next round, including
issues like signaling and available dry powder
– all money is not created equal
– do reference checks on your investors with others they have
funded


Final Thoughts (cont’d)

 Choose your fights wisely:
– make sure you know what really matters to you, and understand
the market dynamics.
– don’t be afraid to ask “why do you need that?”
 Choose your legal advisors wisely. This stuff gets
complicated fast. And do it early (before negotiating the
term sheet!)


Other Resources

 Foley Hoag Venture Perspectives (our quarterly
publication tracking terms of New England VC
deals)
 NVCA Model Venture Capital Financing
Documents (including model term sheet):
–www.nvca.org (click “Resources” then “Model Legal
Documents”) or use http://bit.ly/bj7Pn
–Forms are intended as starting point only


Understanding VC Term Sheets

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