Presentation - Venture Capital Financing, Major Deal Elements
1. Major Deal Elements
Venture Capital Term Sheets Analysis
Daniel J. Piedra
J.D., expected ‘16
University of San Diego School of Law
2.
3. Major Deal Elements
1. A Preferred Return
2. Protection of Valuation
and Position re: Future
Money
3. Management of the
Investment
4. Exit Strategies
4. Preferred Return
❖ Perception of the VC Investor:
❖ When the Investor writes the check, he has done
almost everything he promised
❖ The entrepreneur has done nothing yet
❖ Result: The VC wants its money to be paid back
before the Entrepreneur gets his/her return.
❖ Instrument: CONVERTIBLE PREFERRED STOCK
5. Preferred Return
❖ Dividends:
❖ Paid to Preferred First
❖ Cumulative or Accruing
❖ Liquidation Preference
❖ “Straight” Liquidation Preference: The Preferred receives its original
investment amount plus accrued dividends (if any) before Common
receives anything.
❖ Participating (“Double Dip”) Preferred: The Preferred first gets its
liquidation preference and then shares any remaining proceeds with
Common. Increasingly subject to a cap of 3X or 4X (including preference).
6. Preferred Return: Liquidation Events
❖ Liquidation, dissolution, sale of assets
❖ Money comes into corporation
❖ Money paid out to stockholders to redeem stock
❖ “Deemed liquidation”— merger or other positive
event
❖ Consideration may be stock or cash
❖ Consideration may go directly to stockholders
7. Protection of Valuation:
Conversion and Anti-dilution
❖ Anti-dilution Adjustment increases the number of
shares received on conversion of Preferred
❖ What Triggers Anti-dilution Adjustment?
❖ Issuance or “deemed issuance” of Common at less than
preferred issuance price
❖ “Deemed issuance”— adjust upon issuance of derivative
security; if common never issued, readjust later
❖ Options, warrants
❖ Convertible securities
8. Protection of Valuation:
Conversion and Anti-dilution
❖ Conversion Events: When Does Preferred Convert Into Common?
❖ Voluntary
❖ Forced: often some % of Preferred can force conversion of all
❖ Automatic--upon “Qualified IPO”
❖ Minimum total offering; minimum share price (usually 3 to 5 times
initial purchase price)
❖ Conversion Ratio--initially 1:1
❖ Adjustments--stock splits, etc; price anti-dilution
❖ Exceptions--option pool, conversion of preferred, outstanding
warrants, other existing conditions, other special exceptions
9. Valuation
❖ Conversion Ratio:
❖ Original Purchase Price (OPP)/ Conversion Price (CP)
❖ Initially OPP = CP, so Conversion Ratio = 1:1
❖ “Full ratchet”: CP reset to equal price at which diluting security is sold
❖ “Weighted average”: CP new = CP old x R
❖ Where R = (N + M/CP old)/(N+S)
❖ N = old shares outstanding (fully diluted)
❖ S = new shares to be issued
❖ M = new money ($)
10. Protection of Position: Preemptive Rights
❖ Permits Investors to participate pro rata in future
financings, to preserve their percentage ownership
❖ Subject to exclusions:
❖ Option pool issuances
❖ Strategic alliances & licenses
❖ “Pay to Play”
11. Preemptive Rights, cont'd
❖ Granted by Founders/Other Investors
❖ First Refusal: Gives Investors the right to acquire
shares offered by the grantor, pro rata
❖ May be partial or “all or nothing”
❖ Tag Along (Co-Sale): Gives Investors the right to sell
shares pro rata if a Founder sells shares to others
❖ Helps lock in Founders
12. Management of the Investment
❖ Board Seat(s)
❖ Importance of the “Independent Director(s)”
❖ Business Approvals
❖ Capital Expenditures, etc.
❖ Approval of Annual Budget and Operating Plans
❖ Information Rights
❖ Reports, financial statements — NDA advised
13. Other Management Considerations
❖ Option Pools
❖ Traditionally 12% to 18% at Round One
❖ Two Year Pool
❖ Vesting of Founders/Key Management Stock
❖ Non-Competition and Invention Agreements
14. Exit Strategies
• IPOs and Registration Rights
• Sale/Acquisition
• Redemption of Stock
• Registration Rights
15. Registration Rights
❖ Shares cannot be freely sold without filing a
Registration Statement with the SEC
❖ Only the Company can file
❖ So the Investors negotiate for certain
Registration Rights to insure a contractual
ability to exit into the public markets
16. Registration Rights, cont’d
❖ Enables Investors to sell shares publicly by means
of a registered offering
❖ Sales prior to end of 1-year holding period
❖ Avoid compliance with volume limitations of
Rule 144
❖ Registration paid for by the Company
❖ Are Founders included?
17. Demand Registration Rights
❖ Exercisable after the IPO or within 3-7 years of
investment
❖ Can be exercised 1 to 3 times;
❖ Can be exercised by holders of 20-50% of the
registrable shares, with value of [$$$]
18. Piggyback Registration Rights
❖ Investors “piggyback” on another registration
❖ Can they participate in other shareholders’ demand
rights?
❖ Subject to underwriter “cutback”
❖ S-3 Registrations generally unlimited
❖ Acorn
❖ Beach
19. Redemption
❖ The Company’s repurchase of Preferred Stock at
the demand of the Investors
❖ When Used: When the Company hasn’t gone
public
❖ Because Founders Don’t Want To
❖ Because Business Doesn’t Develop Into an IPO
Type
20. Redemption, cont’d
❖ When Does Redemption Kick In?
❖ Typically after Five (5) years
❖ Often phased over Three (3) years
❖ Trigger
❖ Automatic
❖ Upon vote of Preferred
❖ Price
❖ Initial Purchase Price paid plus accrued dividends
❖ Sometimes additional return
❖ Different classes of preferred — later classes won’t let earlier investors out
first
21.
22. Macon, Inc.
Venture Capital Term Sheets Analysis
Daniel J. Piedra
J.D., expected ‘16
University of San Diego School of Law
29. Similarities
❖ Investment Amount: $5 million
❖ Series A Convertible Preferred Stock
❖ Conversion Rate
❖ Registration Rights
❖ Information Rights
❖ No Termination Rights
❖ Closing Conditions: Acorn — “Securities Purchase Agreement”;
Beach — “Conditions Precedent to Financing”
❖ No “No-shop” Provision
30. Differences
❖ Valuation
❖ Acorn: Pre-Calculated
❖ $7.53 million, with 3 million “performance shares”
❖ Performance Shares: “Shares held in escrow; non-
issuable if Macon doesn’t reach performance
milestone
❖ Beach: Standard, with employee option pool
31. Dividends (Differences)
❖ Acorn:
❖ Non-cumulative — $0.08 (standard) on a Series A Preferred
Outstanding, when and as declared by the Board of Directors
❖ Other dividends: Participates with Common Stock on an as-converted
basis
❖ Most beneficial to company
❖ Beach
❖ Cumulative — most beneficial to investors; bad for company
❖ 10% (above standard) per year commencing on one year
anniversary of issuance of Series A Preferred
❖ Ends when dividend accrual reaches 25% of Series A Purchase Price
❖ Can also cease with consent of Board of Directors
32. Liquidation (Differences)
❖ Acorn
❖ 3x multiple — A return of three times the initial pay
issuance price
❖ Lower than standard 5x
❖ Beach
❖ 1 1/4 multiple — A return of 1.25 the initial purchase
price plus all declared but unpaid dividends
❖ Pro rata distribution
33. Automatic Conversion (Differences)
❖ Acorn
❖ Majority of Preferred can consent to conversion
❖ No assurance that VC can control or at least veto and /or change
number of holders
❖ Valuation: $25 million offering at $5 million/share
❖ Beach
❖ Valuation: $25 million offering at $20/share
❖ Consent of Preferred not required
❖ Automatic conversion at IPO
34. Liquidation Differences, cont’d
Acorn:
❖ Better option
❖ Investor payment is approx. $5,330,000 at a $0.08 dividend
❖ Preferred is capped at three times initial investment amount
❖ Lower than standard (5x)
❖ Better for a merger and IPO because Investors are capped at
3x their initial investment
35. Liquidation Differences, cont’d
Beach:
❖ Larger initial payback to the investors of roughly
$7,500,000 at a $0.25 unpaid dividend
❖ Allows for pro rata distribution of remaining
proceeds to all shareholders
❖ No multiplier on distribution of remaining assets
❖ Excludes reference to subsequent financings
36. Anti-Dilution (Differences)
❖ Acorn
❖ Broad-based weighted average
❖ Carve out: No adjustment for issuance up to 3 million Common to
employees, directors, etc., pursuant to board-approved equity
incentive plans
❖ Helps to retain talent and incentivize employees
❖ Beach
❖ Weighted average
❖ Share issuance of less than 50% of Series A Purchase Prices slips to
full ratchet
❖ Conditional: Only if Series A holder invests its pro rata share
37. Voting Rights
Acorn
❖ Standard list that requires 60% approval of Preferred, including:
❖ Creation / issuance of senior securities
❖ Increase in number of authorized shares of Preferred
❖ Any changes in rights adverse to Preferred (typical)
❖ Change of control
❖ Dividend or distribution of capital stock
❖ Any transaction involving all or substantially all company assets
Beach
❖ Friendlier terms
❖ Class vote with Common on as-converted basis on all matters presented to stockholders
❖ Exception: Preferred entitled to separate vote under Protective Provisions —
supermajority (does not state exact number) consent required for corporate actions to be
agreed upon at a later date
38. Rights of First Refusal & Co-Sale
❖ Acorn
❖ Right of First Refusal
❖ Preferred has
❖ (1) pro rata right based on equity ownership to
participate in subsequent equity financings; and
❖ (2) right to consider purchase of any potential sale of
Common stock
❖ Right of Co-Sale: Except through an IPO sale, Preferred have
right to participate in Common transferring of shares
❖ Beach
❖ Neither Right of First Refusal nor Co-Sale Rights
40. Board Representation
❖ Acorn
❖ Favorable to investors
❖ If Performance Shares released, then investors have option to replace the
outside director with a investor-chosen director
❖ Harmful to control
❖ Beach
❖ More favorable to Founders
❖ Arrangements include:
❖ One member elected by the Founder;
❖ Two Series A Investor-elected representatives;
❖ One outsider company nominated; and
❖ One outsider company nominated and acceptable to all
41. #2: The No Frills
Term Sheet
On-its-Face
Selection of One Term
Sheet
42. Selection: Beach Fund
❖ Acorn has three investors;
potential conflicts
❖ Dividend term concerning but
negotiation — Board’s consent
authority mitigating factor
❖ Simple Board structure
❖ Acorn’s Registration Rights
potential to be expensive
❖ Better liquidation preference
(except for merger)
43. #3: Term Alterations During Negotiations
1.Valuation
2.Liquidation Preference
1. Caps
3.Anti-Dilution Provisions
4.Dividends
5.Voting Rights
6.Redemption Rights
7.Founders Vesting Rights
8.Board Composition
9.Miscellaneous
44. Valuation
❖ Risk of "counting chickens before the eggs have
hatched”
❖ Goal: Increase value placed on company to
minimize cost of VC investment
❖ Develop financial projections for time of likely VC
exit
45. Liquidation Preference
❖ Goal: Cap on Participating Preferred
❖ Non-Participating Preferred
❖ Cannot participate as common shareholders
❖ Aim for non-participating preferred shares, but
odds are slim
❖ IPO inapplicable
46. Dilution
❖ Focus on definition of “Outstanding Securities”
❖ Investors want full ratchet
❖ Conversion price of preferred is adjusted downward for a dilutive
issuance on a dollar-for-dollar basis
❖ Least favorable to company
❖ Always try to get a “floor” on ratchet
❖ Company wants broad-based provision
❖ Calculating dilution based upon a “weighted average” more beneficial to
the company
❖ Easily negotiable
47. Dividends
❖ “When as declared by Board” – a non-cumulative dividend
❖ If Board does not declare then there is no dividend
❖ Standard for an early stage company
❖ Typical not to get a dividend every year – VC more
interested in getting a bigger return at end, rather than a bit
back every year
❖ For later-stage companies, it is more common to see
cumulative dividend, generally paid out
❖ These companies have more money and investors may
want to start seeing return
48. Voting Rights
❖ Focus on limiting to events that directly impact preferred
rights or investments
❖ holder of Preferred will have the
❖ 1:1 votes / share ideal
❖ Avoid provisions that give investors too much management
control
❖ Acorn: Substantial control requirements
❖ Beach: Certain corporate actions requires “supermajority”
vote by Series A Preferred
❖ Indicated flexibility
49. Founders Vesting Rights
❖ Negotiate for acceleration in the event of change of
control or termination
❖ Request shorter vesting period
❖ Acorn: 4 years for employees with 12-month cliff
❖ Founders: 25% instant vesting, the rest spread out
for three years
❖ Beach: Same, except unvested portion subject to
buyback provision
50. Board Composition
❖ Heavily negotiated
❖ All about control
❖ Critical for exits
❖ Common for VCs to want at least one seat on the board (and perhaps
more depending on the amount invested)
❖ Focus on the final seat
❖ Will preferred and common vote together as a single class or
separately?
❖ Additional control granted if Company fails to meet benchmarks?
❖ Negotiations will focus on amount invested and level of control sought or
required
51. Rights of First Refusal & Co-Sale
Acorn
❖ Right of First Refusal too broad — includes all Series
A Preferred
❖ Recommended: Preferred may exercise such right
only at a price equal to the lower of:
❖ (i) the price offered by the proposed third party
purchaser; and
❖ (ii) the price most recently set by the Board of
Directors as the fair market value of the Common.
52. Miscellaneous
❖ Information Rights
❖ Seek appropriate restrictions such as a non-disclosure
agreement
❖ Protective Provisions
❖ Ensure that VCs do not have too much control
❖ Drag Along Rights
❖ Focus on appropriate thresholds
53. #4: Slow Growth or
Fast Growth
Benefits &
Drawbacks for
Company
54. • Instant growth mean results in higher valuation from subsequent investors
• If passion for company is high, then slow growth best option — but VC
investors wary
• Hobson’s Choice
• Key Determinant of Valuation: Risk
• Low valuation at start up
• Limit involvement with too many investors so as not to set unreachable
milestones
• Value of company grows and risks decrease as milestones are reached
• Result: Cost of company shares increase
• Ultimate Question: What is goal of company?
• Large Business
• Small Business
56. Acorn:
•Automatic Conversion: Upon IPO, preferred shares are converted to
common, whereas the VC loses liquidation preference
•Beneficial to Company
•Vesting Provision
•One-year accelerated vesting following change of control transaction
•Favorable to Founder
Beach:
•Automatic conversion: For IPO, subject to share price limitation and
aggregate proceeds offering
•70% preferred holders, acting as single voting class, can elect to not treat a
consolidation or merger as a dissolution or winding up
•Favorable to preferred, because liquidation preference survives merger or
consolidation
•Vesting Provision
•Restricts Founders’ access to shares with 48-month vesting period; early
exit poses challenge
58. •Reputation
•Good chemistry with leaders
•Experience
•Track record
•Length of operation
•Successful investments
•Post-exit relationships with previous partners
•Successful management and operational structure
Personalities, Management
& Track Record
59. VC Involvement:
Normally involves a representation on board
Other factors:
Active
•Value-added services (i.e., marketing, market knowledge, recruitment, etc.)
•An active partnership
Passive / Major Decisions
•Involvement in major decisions
•Appointed board member as watchdog
•Information rights (periodic statements of financial and other information.
•Get-in and get-out
60. Viability
Fund must have committed financiers who are “going for
the gold”
Flexibility:
• Founders should seek out flexible in adjusting to
unpredictable events and changes in Company
• Many VCs have rigid rules
Geographic Proximity
