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Understanding VC Term Sheets
- 1. 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.
- 2. These materials have been prepared solely for educational
purposes. The presentation of these materials does not establish
any form of attorney-client relationship with the author or Foley
Hoag LLP. Specific legal issues should be addressed through
consultation with your own counsel, not by reliance on this
presentation or these materials. Attorney Advertising. Prior results
do not guarantee a similar outcome. © Foley Hoag LLP 2013.
United States Treasury Regulations require us to disclose the
following: Any tax advice included in this document and its
attachments was not intended or written to be used, and it cannot
be used by the taxpayer, for the purpose of (i) avoiding penalties
under the Internal Revenue Code or (ii) promoting, marketing or
recommending to another party any transaction or matter
addressed herein.
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 2
- 3. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 3
- 4. 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)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 4
- 5. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 5
- 6. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 6
- 7. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 7
- 8. 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.
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 8
- 9. Post-Money Valuation
Post-money valuation is the sum of the pre-money valuation plus
the amount invested.
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 9
- 10. 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?
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 10
- 11. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 11
- 12. 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…
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 12
- 13. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 13
- 14. 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:
– Preferred Stock: $10 million (33% of proceeds)
– Common Stock: $20 million
1x preference, participation capped at 3x:
– Preferred Stock: $13.3 million (44% of proceeds)
– Common Stock: $17.7 million
3x preference, full participation:
– Preferred Stock: $20 million (67% of proceeds)
– Common Stock: $10 million
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 14
- 15. Math Geek Part 2
Now assume it was only one week later and for $15 million:
1x preference, no participation:
– Preferred Stock: $5 million (33% of proceeds)
– Common Stock: $10 million
1x preference, full participation:
– Preferred Stock: $8.3 million (55% of proceeds)
– Common Stock: $7.7 million
1x preference, participation capped at 2x:
– Preferred Stock: $8.3 million (55% of proceeds)
– Common Stock: $7.7 million
1x preference, participation capped at 3x:
– Preferred Stock: $8.3 million (55% of proceeds)
– Common Stock: $7.7 million
3x preference, full participation:
– Preferred Stock: $15 million (100% of proceeds)
– Common Stock: $0
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 15
- 16. Math Geek Part 2
Source: www.wikipedia.org
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 16
- 17. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 17
- 18. 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.
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 18
- 19. 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)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 19
- 20. 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)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 20
- 21. 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).
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 21
- 22. 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 B: 25% ($2.5 million)
– 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 B: 25% ($2.5 million)
– Series A: 27.5% ($2.75 million)
– Common: 47.5% ($4.75 million)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 22
- 23. 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%
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 23
- 24. 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”
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 24
- 25. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 25
- 26. 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.
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 26
- 27. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 27
- 28. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 28
- 29. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 29
- 30. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 30
- 31. 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)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 31
- 32. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 32
- 33. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 33
- 34. 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)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 34
- 35. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 35
- 36. 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)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 36
- 37. What is Market? (Series A)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 37
- 38. What is Market? (B and later)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 38
- 39. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 39
- 40. 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!)
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 40
- 41. 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
© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 41
- 42. Questions?
Mark A. Haddad
Partner
617-832-1724
mhaddad@foleyhoag.com
© 2013 Foley Hoag LLP. All Rights Reserved.