OTAF Term Sheet Nuances July 2011

TERM SHEET NUANCES
A Compendium of Elucidations

Edited By:
Jason Soll
Victor Thorne
John Huston

Term Sheet Tutorial 1

INTRODUCTION

At an early Angel Capital Association Summit in Kansas City many years ago,
attendees received a copy of Alex Wilmerding’s well-known book, Term Sheets &
Valuations: An Inside Look at the Intricacies of Term Sheets & Valuation (Aspatore,
2001). Since then, many books have been written about angel and VC term sheets, and
the topic has become a blogosphere favorite. We felt our members might benefit from
having this compendium of the most insightful explications of the intricate details and
nuances of term sheet issues we have collected over the last decade.

Our goal has been to provide an exceedingly comprehensive reference guide which
illuminates all of the key term sheet issues from the viewpoint of both investors and
entrepreneurs.

Please note: Please accept our apology for the sophomoric and profane blog post
language prevalent in some sections; we felt it inappropriate to recast others’ words.
Furthermore, as editors of this book, we claim no credit for writing the content on these
pages. As a collection of various authors’ works, this book shall neither be sold nor
distributed without the explicit permission of the Ohio TechAngel Funds.

Jason Soll, Victor Thorne & John Huston
Ohio TechAngel Funds
August 2011


Table of Contents

TERM SHEET

5

THE SCIENCE & ART OF TERM SHEET NEGOTIATION

5

RESTRICTION ON SALES, PROPRIETARY INVENTIONS, AND CO-SALE AGREEMENT

8

VOTING RIGHTS AND EMPLOYEE POOL

9

OPTION POOL

10

OPTION POOL SHUFFLE
10
MASTERING THE VC GAME: A VENTURE CAPITAL INSIDER REVEALS HOW TO GET FROM START-UP TO IPO ON
YOUR TERMS
13
RIGHT OF FIRST REFUSAL

15

RIGHT OF FIRST REFUSAL BY FELD THOUGHTS
RIGHT OF FIRST OFFER VERSUS RIGHT OF FIRST REFUSAL

15
16

INFORMATION AND REGISTRATION RIGHTS

17

INFORMATION AND REGISTRATION RIGHTS BY FELD THOUGHTS
REGISTRATION RIGHTS

17
19

VESTING

21

VESTING BY FELD THOUGHTS
VESTING OF FOUNDERS SHARES BY JOHN HUSTON

21
23

CONDITIONS PRECEDENT TO FINANCING

24

CONDITIONS PRECEDENT TO FINANCING BY FELD THOUGHT

24

CONVERSION

26

AUTOMATIC CONVERSION
CONVERSION BY FELD THOUGHT
CONVERSION RIGHTS

26
28
29

REDEMPTION RIGHTS

31

REDEMPTION RIGHTS BY FELD THOUGHTS

31

COMPELLED SALE RIGHT

32

DIVIDENDS

33

DIVIDEND PROVISIONS
DIVIDENDS BY FELD THOUGHTS

33
34

PAY-TO-PLAY

35

PAY-TO-PLAY BY FELD THOUGHT

35

ANTI-DILUTION

37

DILUTION? BY FRANK DEMMLER
ANTI-DILUTION BY FELD THOUGHTS
PRACTICAL IMPLICATIONS OF ANTI-DILUTION PROTECTION
FULL RATCHET ANTI-DILUTION PROTECTION
PROTECTIVE COVENANTS

37
40
42
45
50

INCENTIVE STOCK OPTIONS

51

PROFIT INTEREST UNITS

50

PROFIT INTEREST VS. ALTERNATIVES

51

PROTECTIVE PROVISIONS

52

PROTECTIVE PROVISIONS BY FELD THOUGHTS
PROTECTIVE PROVISIONS CONTINUED

55
57

BOARD OF DIRECTORS

58

BOARD COMPOSITION AND MEETINGS
BOARD OF MEMBERS BY FELD THOUGHTS
SPECIAL BOARD APPROVAL
BOARD CONTROL

58
58
59
59

PREFERRED STOCK

60

HOW PREFERRED STOCK TERMS CAN AFFECT VALUATION – A SCENARIO
WHAT’S SO PREFERABLE ABOUT PREFERRED STOCK?
OVERVIEW OF PREFERRED STOCK
ANTI-DILUTION PROTECTION
ADVICE TO ENTREPRENEURS

60
61
61
61
62

LIQUIDATION PREFERENCE

63

LIQUIDATION PREFERENCE
LIQUIDATION PREFERENCE CONTINUED
PARTICIPATING PREFERENCES BY FELD THOUGHTS
LIQUIDATION PREFERENCE BY FELD THOUGHTS
LIQUIDATION PREFERENCES: WHAT THEY REALLY DO
TERM SHEET OVERVIEW: LIQUIDATION PREFERENCE
LIQUIDATION AMOUNT
PARTICIPATION
LIMITS ON PARTICIPATIONS (THREE ALTERNATIVE EXAMPLES)

63
63
64
66
67
69
70
70
70

PRICE

73

PRICE BY FELD THOUGHTS

73

TERMINOLOGY

73

THE OFF ROAD INVESTOR

73

EQUITY VS. CONVERTIBLE NOTE

74

CONVERTIBLE NOTES
THE CONUNDRUM OF CONVERTIBLE NOTES
RATIONALE FOR A CONVERTIBLE NOTE
STANDARD FEATURES OF A CONVERTIBLE NOTE
POTENTIAL FLAWS OF A CONVERTIBLE NOTE
APPROPRIATE USE OF CONVERTIBLE NOTES
ADVICE TO ENTREPRENEURS
WATCH OUT ANGELS WHEN BUYING NOTES FROM AN LLC:

74
74
74
75
76
77
77
77

FINANCING

78

REVENUE PARTICIPATION CERTIFICATES: SHOULD I CONSIDER THIS ALTERNATIVE?

78

VALUATION

80

HOW VCS CALCULATE VALUATION (AND HOW IT'S DIFFERENT FROM THE WAY FOUNDERS DO IT)

80

APPENDIX A

81

FOUNDERS SHARES ISSUES
81
EXAMPLES OF LEGAL WORDING FROM THE TWO MOST POPULAR MODEL TERM SHEET SOURCES:
83
BRAD FELD: TERM SHEET - VESTING
84
OPTIMUM SHARE AND OPTION VESTING BY BASIL PETERS
86
FOUNDERS' EQUITY BY MARY BETH KERRIGAN AND SHANNON ZOLLO
88
VESTING OF FOUNDERS’ STOCK: BEYOND THE BASICS
89
THE TERM SHEET TANGO
92
WHAT SHOULD THE VESTING TERMS OF FOUNDER STOCK BE BEFORE A VENTURE FINANCING?
92
VESTING FOUNDERS STOCK WITH A VESTING SCHEDULE | STARTUP LAWYER
93
GET VESTED FOR TIME SERVED
94
SUPERSIZE YOUR VESTING WITH THESE MICROHACKS
99
WHAT ENTREPRENEURS NEED TO KNOW ABOUT FOUNDERS’ STOCK
100
TED WANG: FENWICK & WEST
102
VESTING IMPOSED ON FOUNDER STOCK IN CONNECTION WITH FINANCING--SECTION 83(B) ELECTION
REQUIRED?
103
NOTE TO FOUNDERS: HAVE VESTING
104
THE MAKING OF A WINNING TERM SHEET: UNDERSTANDING WHAT FOUNDERS WANT - PART II. VESTING
ACCELERATION, REALLOCATION OF FOUNDER'S STOCK, OPTION POOL DILUTION AND FOUNDER LIQUIDITY 107
WHAT IS AN 83(B) ELECTION AND HOW DOES IT WORK IN PRACTICE?
111
SIGNING DEADLINES AND NO SHOP AGREEMENTS
114
STOCK OPTIONS EXPLAINED
115
DRAG-ALONG PROVISIONS OVERVIEW
116
PAY-TO-PLAY PROVISIONS OVERVIEW
117


TERM SHEET

The Science & Art of Term Sheet Negotiation
By the time I was in the 9th grade, I had been playing chess for a few
years (as in I knew the rules) but I didn't play seriously and more
often than not I lost. Then one day at the library (remember, preinternet) I happened to find a book on chess. So I read the book and
almost overnight I became one of the chess "stars" in high school. In
one of the funnier incidents, I started playing chess during lunch hour
and was "hustling" money that on one occasion resulted in a kid
pulling a knife on me after I relieved him of a few bucks. True story.
What was it in that book that allowed me to take advantage of the situation? Well, there was a lot of
basic stuff, some general rules and even some strategy, however, the most useful bit of information,
initially, was a table on the relative value of pieces. You know, a pawn is worth 1, a knight/bishop 3,
rook 5, a queen 9 and the king "infinite" unless it's the endgame then it's more like a 4. Experienced
players have a "feel" for this from many games played and they can also break the "rules" by, for
example, sacrificing a queen for a rook to get better position. But these are all things learned from
experience and best not tried by a novice. If you are new to the game, you have no idea. When you
are starting out, having some rules of thumb can make all the difference between winning and getting
hustled.
What does this have to do with negotiating term sheets? Well, I think a lot of newbies get hustled
when negotiating term sheets because they don't know the relative importance of the various terms.
Have you heard the joke about the VC who says, "I'll let you pick the pre money valuation if I get to
pick the terms?" My goal here is to provide a framework that gives relative value of various terms on
a term sheet and allows you to compare them on two dimensions: economics and control (or as my
friend Noam Wasserman likes to say, "rich" versus "king"). In the same way that a chess grand
master doesn't need rules of thumb from someone else, if you're a seasoned negotiator of term
sheets then this is probably equally useless. And no, this is not based on any academic or scientific
study. It's based on my own experience and, more importantly, that of a few other experts like Dave
Kimelberg (Softbank's GC).
In my view there are 12 important terms on a typical Series A / B term sheet. Yes there are other
terms and yes sometimes they are important, but if you go with the thesis of keep it simple, then 12 is
the magic number. In terms of rating, the rich/king differentiation is important as different people
are after different things so depending upon your motivation you may be inclined to pay more
attention to one column than the other. So without further adieu, below is a table showing them as
well as the relative importance:

Term
1. Investment / price
2. Board of directors
3. Option pool refresh
4. Preemptive rights
5. Andi-dilution protection
6. Registration rights
7. Drag along rights
8. Right of first refusal / co-sale
9. Dividend right

Rich
10
10
1
5
1
1
5
5

King
8
3
1
5
-

10. Liquidation preference
11. Protective provisions
12. Redemption

7
1

8
-

Here a 10 means it is really important to get as favorable a result as possible on this term, a 1 means
it is not so important and a "-" means it doesn't apply (i.e. a zero). The cool thing about having
something like this is you can use it as a tool to compare term sheets (provided you can determine
how favorable or unfavorable each individual term is...more on that below).
The next part of this post is to provide a range of typical results for each term which will give you a
means to rank each term in each term sheet with a "1,3 or 5" where 1 is "unfavorable", 3 is "fair" and
5 is "favorable." If you aren't already familiar with the terms in a term sheet, you should check out
the model term sheet (basically a template) put together by the National Venture Capital
Association. They have other model agreements too, but you will see with the term sheet that they
include various options, some discussed here. Below is a scale for each of the 12 key terms across the
two dimensions:
1.

2.

3.

4.

5.

6.

Investment/price. I think there are two ways you can rank price. One is to rate it relative
to your expectation and another is to rate it relative to similar companies (in terms of stage,
geography, sector, etc.). If you don't have comparables, you can fairly easily get them, for
example Dow Jones puts out a quarterly survey of VC deal terms that includes pre-money
valuation (send me an email if you want a copy). If you're less than 80% of your benchmark,
that's probably unfavorable, if you are within +/- 20% than that's fair and if you're over
120%, then it's favorable.
Board of directors. This term comes down to simple math. If you give up and don't have
control of the board, that's unfavorable, if it's tied, call it fair and if you control it, which is
quite favorable. BTW, the reason I didn't rate the board control a "10" on the "king" scale is
because even when you give up control, your board members are bound by fiduciary
obligations to the firm, i.e. they can't do whatever they want.
Option pool refresh. Often time this will show up as a separate term in the term sheet,
however it is actually just another bite at the apple in terms of price. Traditionally there is a
refresh pre-deal so that after the round the company can execute on its hiring plan without
needing to expand the pool for 12-18 months. You will have to develop your hiring budget if
you haven't already. Given that benchmark and your hiring equity budget, I'd say less than
12 months is favorable, 12-18 months is fair and more than 18 months is unfavorable.
Preemptive rights. As you know, preemptive rights give your investor the right to invest in
future rounds. This is of moderate economic value, however you are giving up some control
of future financings. There is remarkably little variation in how this term gets negotiated,
probably because of its relatively low importance in the grand scheme. I'm told the only
area that gets negotiated is whether the investor has an "overallotment right" whereby they
can take a portion or all of the pro rata of another investor in the same series who didn't
participate. That said, unless something unusual is in your term sheet, it's probably a 3 for
both rich and king.
Anti-dilution protection. Anti-dilution is a pretty important economic term. In terms of
the range of possibilities, no anti-dilution would be a 5, broad-based weighted average
would be a 3 and full-ratchet would be a 1. I think the vast majority of deals end up as
broad-based weighted average. Very few deals avoid it altogether, but it can be done,
particularly in later stage or very hot deals.
Registration rights. Reg rights have some economic value and in theory you do give up
some control, but in reality they're close to worthless. You can push on these and most
investors will give in when pressed. You can negotiate when the right kicks in and cutbacks.
But bear in mind that investors will love it if you waste time negotiating this because it is not
an important term. Unless something unusual is going on, I'd rate this a 3 on both
dimensions.

7.

Drag along rights. Most deals include drag along rights and like many of the other terms,
the key is in the voting thresholds. I rated this a 1/5 on the rich/king scale. In terms of
economics the issue is with regard to a sale of the company where the preferred stock,
because of special rights, is indifferent to a deal that would be better for Common. However,
the bigger issue is on the control side of the equation where you could get dragged into a sale
that you don't want to do. So in terms of rating both the economic and control sides, I would
say that if the thresholds are such that a single investor can unilateral drag along, that's a 1, if
it takes 2 or more investors that's a 3 and if it takes investors plus either a neutral party or
Common (you) then it's a 5.
8. Right of first refusal / co-sale. I rated this a 5 because this is essentially a "lock-up" on the
founders stock that seriously affects liquidity and thus value. It doesn't really affect control
issues. If you read the actual section of the stock purchase agreement that describes this
term it's several pages of bureaucratic procedures for a sale that in the real world you can't
imagine ever occurring (which they don't). As a result, the only real counter party for selling
common stock is the other investors or the company with the investors’ approval and
they're all quite likely to low ball. Unfortunately, I've never heard of avoiding this term
completely, so in terms of how to rate it, I'd say that if you can negotiate a right to sell some
portion (say 20% on an annual basis) you're at a 5 otherwise if it's a standard lockup then
you're at 3.
9. Dividend right. I rate this a 5 on the economic scale. In terms of the range, there is no
dividend that is a 5, then there is a simple interest dividend which I'd say is a 3 and a 5
would be a compounding dividend. For some reason, the dividend rate has been 8% ever
since I've seen term sheets. You can negotiate the rate, but the bigger battle is whether you
pay a dividend and how the rate compounds.
10. Liquidation preference. This is a very important economic term that doesn't have any
importance in terms of control. The issue here is during a sale, how do investors get paid
out. I'd say about 1/3 of deals have a preference at 1X but no participation, another 1/3
have a preference with a cap and participation and the balance a preference with no cap plus
participation and that's pretty much how I'd rate it, i.e. 5 for 1X preference/no participation,
3 if with a cap in the 2-4X range and 1 if with no cap and participation.
11. Protective provisions. This is very important from a control perspective but not so
economically. While there are a ton of these protective provisions, the key ones relate to
sale/merger of the company and future rounds of financing. As with other control rights, the
key is in the voting thresholds so I'd assess this the same as 7 (drag along rights).
12. Redemption. Finally, we get to number twelve, redemption rights. This is an almost
worthless economic right. I've never seen or heard of this being exercised and most
investors will acquiesce if you push on this. Unless you see something unusual, I'd rate this a
3.
Ultimately the individual rating combined with the overall importance of each term will allow you to
create a weighted average total for each term sheet on both the rich and king dimensions. While you
wouldn't want to make a decision to take an investment on this alone, it will give you a basic idea of
where the strengths and weaknesses of particular term sheets lie. It also gives some tips for
negotiating. For example, you don't want to waste your time negotiating redemption rights and
attorney's fees and instead, you want to go to the core of what's important to you on the rich/king
scale.


TERM SHEET: RESTRICTION ON SALES, PROPRIETARY INVENTIONS, AND CO-SALE
AGREEMENT

Term Sheet: Restriction on Sales, Proprietary Inventions, and
Co-Sale Agreement
Almost every term sheet we’ve ever seen has a “Restrictions on Sales” clause in it that looks
something like: “Restrictions on Sales: The Company’s Bylaws shall contain a right of first refusal on all
transfers of Common Stock, subject to normal exceptions. If the Company elects not to exercise its right,
the Company shall assign its right to the Investors.”
Management / founders rarely argue against this as it helps control the shareholder base of the
company which usually benefits all the existing shareholders (except possibly the one who wants to
bail out of their private stock.) However, we’ve found that the lawyers will often spend time arguing
how to implement this particular clause. Some lawyers feel that putting this provision in the bylaws
is the wrong way to go and prefer to include such a provision in each of the company’s option
agreements, plans and stock sales. Personally, we find it much easier to include in the bylaws.
Next up is the ubiquitous proprietary information and inventions agreement clause: “Proprietary
Information and Inventions Agreement: Each current and former officer, employee and consultant of
the Company shall enter into an acceptable proprietary information and inventions agreement.”
This paragraph benefits both the company and investors and is simply a mechanism that investors
use to get the company to legally stand behind the representation that it owns its intellectual
property. Many pre-Series A companies have issues surrounding this, especially if the company
hasn’t had great legal representation prior to its first venture round. We’ve also run into plenty of
situations (including several of ours – oops!) where companies are loose about this between
financings and - while a financing is a good time to clean this up – it’s often annoying to previously
hired employees who are now told “hey – you need to sign this since we need it for the venture
financing.” It’s even more important in the sale of a company, as the buyer will always insist on clear
ownership of the IP. Our best advice here is that companies should build these agreements into their
hiring process from the very beginning (with the advice from a good law firm) so that there are never
any issues around this, as VCs will always insist on it.
Finally, a co-sale agreement is pretty standard fare as well: “Co-Sale Agreement: The shares of the
Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain
reasonable exceptions) with the Investors such that the Founders may not sell, transfer or exchange
their stock unless each Investor has an opportunity to participate in the sale on a pro-rata basis. This
right of co-sale shall not apply to and shall terminate upon a Qualified IPO.”
If you are a founder, you are probably asking why we did not include the co-sale section in the “really
matter section.” The chance of keeping this provision out of a financing is close to zero, so we don’t
think it’s worth the battle to fight it. Notice that this only matters while the company is private – if
the company goes public, this clause no longer applies.


TERM SHEET: VOTING RIGHTS AND EMPLOYEE POOL

Term Sheet: Voting Rights and Employee Pool
“Voting Rights: The Series A Preferred will vote together with the Common Stock and not as a separate
class except as specifically provided herein or as otherwise required by law. The Common Stock may be
increased or decreased by the vote of holders of a majority of the Common Stock and Series A Preferred
voting together on an as if converted basis, and without a separate class vote. Each share of Series A
Preferred shall have a number of votes equal to the number of shares of Common Stock then issuable
upon conversion of such share of Series A Preferred.”
Most of the time voting rights are simply an “FYI” section as all the heavy rights are contained in
other sections such as the protective provisions.
“Employee Pool: Prior to the Closing, the Company will reserve shares of its Common Stock so that __%
of its fully diluted capital stock following the issuance of its Series A Preferred is available for future
issuances to directors, officers, employees and consultants. The term “Employee Pool” shall include both
shares reserved for issuance as stated above, as well as current options outstanding, which aggregate
amount is approximately __% of the Company’s fully diluted capital stock following the issuance of its
Series A Preferred.”
The employee pool section is a separate section in order to clarify the capital structure and
specifically call out the percentage of the company that will be allocated to the option pool associated
with the financing. Since a cap table is almost always included with the term sheet, this section is
redundant, but exists so there is no confusion about the size of the option pool.


TERM SHEET: OPTION POOL

Option Pool
Note: Watch out for those who try to slip in the option pool after the pre-money valuation has
been established, thereby diluting the series A preferred holders. This will automatically
increase the pre-money valuation by diluting the series A! The term sheet must stipulate that
the pre-money valuation is on a fully diluted basis (after taking into consideration the option
pool).!!!
Before discussing the Option Pool Shuffle, it is helpful to review how VC’s look at valuation, versus
the first time entrepreneur.

Option Pool Shuffle
You have successfully negotiated a $2M investment on an $8M pre-money valuation by pitting the
famous Blue Shirt Capital against Herd Mentality Management. Triumphant, you return to your
company’s tastefully decorated loft or bombed-out garage to tell the team that their hard work has
created $8M of value.
Your teammates ask what their shares are worth. You explain that the company currently has 6M
shares outstanding so the investors must be valuing the company’s stock at $1.33/share:
$8M pre-money ÷ 6M existing shares = $1.33/share.
Later that evening you review the term sheet from Blue Shirt. It states that the share price is $1.00…
this must be a mistake! Reading on, the term sheet states, “The $8 million pre-money valuation
includes an option pool equal to 20% of the post-financing fully diluted capitalization.”
You call your lawyer: “What the heck?!”
As your lawyer explains that the so-called pre-money valuation always includes a large unallocated
option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am
I going to explain this to the team?”
If you don’t keep your eyes on the option pool, your investors will slip it in the pre-money and cost
you millions of dollars of effective valuation. Don’t lose this game.
The option pool lowers your effective valuation.
Your investors offered you a $8M pre-money valuation. What they really meant was,
“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the
value of your company, and call their sum your $8M ‘pre-money valuation’.”
For all of you MIT and IIT students out there:
$6M effective valuation + $2M new options + $2M cash = $10M post
or

60% effective valuation + 20% new options + 20% cash = 100% total.
Slipping the option pool in the pre-money lowers your effective valuation to $6M. The actual value of
the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share
price from $1.33/share to $1.00/share:
$8M pre ÷ (6M existing shares + 2M new options) = $1/share.
Update: Check out our $9 cap table which calculates the effect of the option pool shuffle on your
effective valuation.
The shuffle puts pre-money into your investor’s pocket.
Proper respect must go out to the brainiac who invented the option pool shuffle. Putting the option
pool in the pre-money benefits the investors in three different ways!
First, the option pool only dilutes the common stockholders. If it came out of the post-money, the
option pool would dilute the common and preferred shareholders proportionally.
Second, the option pool eats into the pre-money more than it would seem. It seems smaller than it is
because it is expressed as a percentage of the post-money even though it is allocated from the premoney. In our example, the new option pool is 20% of the post-money but 25% of the pre-money:
$2M new options ÷ $8M pre-money= 25%.
Third, if you sell the company before the Series B, all un-issued and un-vested options will be
cancelled. This reverse dilution benefits all classes of stock proportionally even though the common
stock holders paid for all of the initial dilution in the first place! In other words, when you exit, some
of your pre-money valuation goes into the investor’s pocket.
More likely, you will raise a Series B before you sell the company. In that case, you and the Series A
investors will have to play option pool shuffle against the Series B investors. However, all the unused
options that you paid for in the Series A will go into the Series B option pool. This allows your
existing investors to avoid playing the game and, once again, avoid dilution at your expense.
Solution: Use a hiring plan to size the option pool.
You can beat the game by creating the smallest option pool possible. First, ask your investors why
they think the option pool should be 20% of the post-money. Reasonable responses include
1.
2.
3.

“That should cover us for the next 12-18 months.”
“That should cover us until the next financing.”
“It’s standard,” is not a reasonable answer. (We’ll cover your response in a future hack.)

Next, make a hiring plan for the next 12 months. Add up the options you need to give to the new
hires. Almost certainly, the total will be much less than 20% of the post-money. Now present the plan
to your investors:
“We only need a 10% option pool to cover us for the next 12 months. By your reasoning we only need
to create a 10% option pool.”

Reducing the option pool from 20% to 10% increases the company’s effective valuation from $6M to
$7M:
$7M effective valuation + $1M new options + $2M cash = $10M post
or
70% effective valuation + 10% new options + 20% cash = 100% total
A few hours of work creating a hiring plan increases your share price by 17% to $1.17:
$7M effective valuation ÷ 6M existing shares = $1.17/share.
How do you create an option pool from a hiring plan? #
To allocate the option pool from the hiring plan, use these current ranges for option grants in Silicon
Valley:

Title

Range (%)

CEO

5 – 10

COO

2–5

VP

1–2

Independent Board Member

1

Director

0.4 – 1.25

Lead Engineer

0.5 – 1

5+ years experience Engineer

0.33 – 0.66

Manager or Junior Engineer

0.2 – 0.33

These are rough ranges – not bell curves – for new hires once a company has raised its Series A.
Option grants go down as the company gets closer to its Series B, starts making money, and
otherwise reduces risk.
The top end of these ranges are for proven elite contributors. Most option grants are near the bottom
of the ranges. Many factors affect option allocations including the quality of the existing team, the size
of the opportunity, and the experience of the new hire.
If your company already has a CEO in place, you should be able to reduce the option pool to about
10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce
the option pool to about 15% of the post-money.
Bring up your hiring plan before you discuss valuation.

Discuss your hiring plan with your prospective investors before you discuss valuation and the option
pool. They may offer the truism that “you can’t hire good people as fast as you think.” You should
respond, “Okay, let’s slow down the hiring plan… (and shrink the option pool).”
You have to play option pool shuffle.
The only way to win at option pool shuffle is to not play at all. Put the option pool in the post-money
instead of the pre-money. This benefits you and your investors because it aligns your interests with
respect to the hiring plan and the size of the option pool.
Still, don’t try to put the option pool in the post-money. We’ve tried – it doesn’t work.
Your investor’s norm is that the option pool goes in the pre-money. When your opponent has
different norms than you do, you either have to attack his norms or ask for an exception based on the
facts of your case. Both straits are difficult to navigate.
Instead, skillful negotiators use their opponent’s standards and norms to advance their own
arguments. Fancy negotiators call this normative leverage. You apply normative leverage in the
option pool shuffle by using a hiring plan to justify a small option pool.
You can’t avoid playing option pool shuffle. But you can track the pre-money as it gets shuffled into
the option pool and back into the investor’s pocket, you can prepare a hiring plan before the game
starts, and you can keep your eye on the money card.

Mastering the VC Game: A Venture Capital Insider Reveals How
to Get from Start-up to IPO on Your Terms
By Jeffrey Bussgang
Determining the pre-money valuation is an art, not a science, and many entrepreneurs get
frustrated with what seems like an opaque process. Unlike what you learn in a finance class in
business school, where you calculate discounted cash flows and apply a weighted average cost of
capital, there is no magic formula. The valuation for entrepreneurial ventures is set in a back-andforth negotiation based on three factors: (1) the amount of capital that the entrepreneur is trying to
raise in order to prove out the first set of milestones; (2) the VC’s target ownership (often 20-30
percent); (3) how competitive the deal is (that is, if the entrepreneur has numerous VCs chasing
them, they can drive up the price). I’ve seen pre-money valuations range from a typical $3-$6 million
all the way up to $80 million, which is what our pre-money valuation was in our first round of
financing at Upromise. That was an unusual time in history, the late 1990s and early 2000, where
companies with only a few million dollars in revenue were going public for billion-dollar valuations.
In most situations today, the initial pre-money valuation is under $ 10 million. In the end, the VC has
to be convinced that he can make five to ten times his money in three to five years and so backs into
the valuation with that heuristic in mind.
But the pre-money isn’t the only term that defines price: the post-money plays a part as well.
The post-money is the pre-money plus the money raised. That is, if a company raises $4 million at a
pre-money valuation of $ 6 million, then the post-money is $ 10 million. Thus, the investors who
provided the $4 million own 40 percent of the company and the management team (founders,
employees, executives) owns 60 percent.
Another term that impacts the price is the size of the option pool. Most VCs invest in
companies that need to hire additional management team members, sales and marketing personnel,

and technical talent to build the business. Some start-ups begin life with a founding team that aspires
to hire a strong outside executives as CEO. There new hires typically receive stock options, and the
issuance of those stock options dilutes the other shareholders.
In anticipation of those hiring needs, many VCs will require that an option pool with
unallocated stock options be created, thereby forming a stock option budget for new hires that will
be set aside to avoid further dilution. The stock option pool typically comes out of the management
team allocation (i.e., the option pool is included in the pre-money valuation), independent of the VC
investment ownership. In the example above of $ 4 million invested in a $ 6 million pre-money
valuation (known in VC-speak shorthand as “4 on 6”), if the VCs insist on an unallocated stock option
pool of 20 percent, then the VC investors still own 40 percent and the remaining 60 percent is split
between a 20 percent unallocated stock option pool at the discretion of the board and a 40 percent
stake owned by the management team. In other words, the existing management team/founders
have given up 20 percentage points of their 60 percent ownership in order to reserve it for future
management hires.
This relationship between option pool size and price isn’t always understood by
entrepreneurs, but is well understood by VCs. I learned it the hard way in the first term sheet that I
put forward to an entrepreneur. I was competing with another firm, we put forward a “6 on 7” deal
with a 20 percent option pool. In other words, we would invest (alongside another VC) $ 6 million at
a $ 7 million pre-money valuation to own 46 percent of the company (6 divided by 6+7). The
founders would own 34 percent and would set aside a stock option pool of 20 percent for future
hires. One of my competitors put forward a “6 on 9” deal, in other words, $ 6 million invested at $ 9
million pre-money valuation to own 40 percent of the company (6 divided by 6+9). But my
competitor inserted a larger option pool than I did – 30 percent – so the founders would only receive
30 percent of the company as compared to my offer that gave them 34 percent. The entrepreneur
chose the competing deal. When I asked why, he looked me in the eye and said, “Jeff-their price was
better. My company is worth more than seven million.”
At the time, I wasn’t facile enough with the nuances to argue against his faulty logic. But
later, we instituted a policy at Flybridge to talk about the “promote” for the founding team rather
than just the “pre”. The “promote,” as we have called it, is the founding team’s ownership percentage
multiplied by the post-money valuation.
Back to my example of the “6 on 7” deal with the 20 percent option pool. The founding team
owns 34 percent of a company with a $ 23 million post-money valuation. In other words, they have a
$ 4.4 million “promote” (13 * 0.34) in exchange for their founding contributions. Note that in the “6
on 9” deal, the founding team had a nearly identical promote: 30 percent of $ 15 million post-money
valuation, or $ 4.5 million. In other words, my offer was basically identical to the competing offer; it
just had a lower pre-money valuation and a smaller option pool.
Not that this pricing framework assumes that the financing is the first money that has been
invested in the company (i.e., it is the Series A round of financing). If there is already invested capital
in the company (i.e., someone has already invested in a Series A and the entrepreneur is now raising
a Series B round of financing), then the Series A investors have two competing motivations. Assuming
they want to put more money into the company, they will either seek to raise capital at the highest
price possible from outside investors in order to limit dilution on their earlier money (and limit the
amount of new capital they put in at the higher price) or invest their own capital at a price lower than
(down round) or equal to (flat round) the previous round. It all depends on how bullish they are
about the company’s future and how much money they have invested in the company already as
compared to their target figure as a function of their overall fund size.


TERM SHEET: RIGHT OF FIRST REFUSAL

Right of First Refusal
Investor Favorable:
The Investors shall have the right in the event the Company proposes to
offer equity securities to any person (other than securities issued pursuant to employee benefit plans
or acquisitions, in each case as approved by the Board of Directors, including the director elected by
holders of the Series [A] Preferred) to purchase on a pro rata basis all or any portion of such shares.
Any securities not subscribed for by an Investor may be reallocated among the other Investors. If the
Investors do not purchase all of such securities, that portion that is not purchased may be offered to
other parties on terms no less favorable to the Company for a period of sixty (60) days. Such right of
first refusal will terminate upon a Qualified IPO.
Middle of the Road:
Investors holding at least [one eighth of the shares originally issued] shares
of Registrable Securities shall have the right in the event the Company proposes to offer equity
securities to any person (other than securities issued pursuant to employee benefit plans or pursuant
to acquisitions) to purchase their pro rata portion of such shares. Any securities not subscribed for
by an eligible Investor may be reallocated among the other eligible Investors. Such right of first
refusal will terminate upon a Qualified IPO.
Company Favorable:
Each Investor holding at least [one quarter of the shares originally issued]
shares of Series [A] Preferred shall have the right in the event the Company proposes to offer equity
securities to any person (other than securities issued to employees, directors, or consultants or
pursuant to acquisitions, etc.) to purchase its pro rata share of such securities (based on the total
fully diluted number of common stock equivalents outstanding). Such right of first refusal will
terminate upon an underwritten public offering of shares of the Company.

Term Sheet: Right of First Refusal by Feld Thoughts
Today's "term that doesn't matter much" from our term sheet series is the Right of First Refusal.
When we say "it doesn't matter much", we really mean "don't bother trying to negotiate it away - the
VCs will insist on it.” Following is the standard language:
"Right of First Refusal: Investors who purchase at least (____) shares of Series A Preferred (a "Major
Investor") shall have the right in the event the Company proposes to offer equity securities to any person
(other than the shares (i) reserved as employee shares described under "Employee Pool" below, (ii)
shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or
similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan
or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar
financial institution approved by the Board; and (iv) shares with respect to which the holders of a
majority of the outstanding Series A Preferred waive their right of first refusal) to purchase [X times]
their pro rata portion of such shares. Any securities not subscribed for by an eligible Investor may be
reallocated among the other eligible Investors. Such right of first refusal will terminate upon a Qualified
IPO. For purposes of this right of first refusal, an Investor’s pro rata right shall be equal to the ratio of
(a) the number of shares of common stock (including all shares of common stock issuable or issued upon
the conversion of convertible securities and assuming the exercise of all outstanding warrants and
options) held by such Investor immediately prior to the issuance of such equity securities to (b) the total
number of share of common stock outstanding (including all shares of common stock issuable or issued
upon the conversion of convertible securities and assuming the exercise of all outstanding warrants and
options) immediately prior to the issuance of such equity securities."

There are two things to pay attention to in this term that can be negotiated. First, the share threshold
that defines a "Major Investor" can be defined. It's often convenient - especially if you have a large
number of small investors - not to have to give this right to them. However, since in future rounds,
you are typically interested in getting as much participation as you can, it's not worth struggling with
this too much.
A more important thing to look for is to see if there is a multiple on the purchase rights (e.g. the "X
times" listed above). This is an excessive ask - especially early in the financing life cycle of a company
- and can almost always be negotiated to 1x.
As with "other terms that don't matter much", you shouldn't let your lawyer over engineer these. If
you feel the need to negotiate, focus on the share threshold and the multiple on the purchase rights.

Right of First Offer Versus Right of First Refusal:
Clearly the ROFO favors the company, while all investors would prefer a ROFR because:
1) If an investor wants to sell shares to someone else and one of the original investors is
interested in buying them then the original investor must “do the work” to make an
offer. If he/she is too busy to do so then the ROFO has been passed by.
2) However under a ROFR the company first goes to an interested buyer and after that
party “does the work” to formulate a bid price/offer then the other investors can decide
if they want to match it and buy the shares.
3) No VC’s will settle for a ROFO. They’ll demand a ROFR.


TERM SHEET: INFORMATION AND REGISTRATION RIGHTS

Information Rights
Investor Favorable:
So long as an Investor continues to hold shares of Series [A]
Preferred or Common Stock issued upon conversion of the Series [A] Preferred, the Company shall
deliver to the Investor audited annual financial statements, audited by a Big Five accounting firm, and
unaudited quarterly financial statements. In addition, the Company will furnish the Investor with
monthly and quarterly financial statements and will provide a copy of the Company's annual
operating plan within 30 days prior to the beginning of the fiscal year. Each Investor shall also be
entitled to standard inspection and visitation rights.
Middle of the Road:
deliver to the Investor audited annual financial statements audited by a Big Five accounting firm and
unaudited quarterly financial statements. So long as an Investor holds not less than [one quarter of
the Shares originally issued] shares of Series [A] Preferred (or [one quarter of the Shares originally
issued] shares of the Common Stock issued upon conversion of the Series [A] Preferred, or a
combination of both), the Company will furnish the Investor with monthly financial statements
compared against plan and will provide a copy of the Company's annual operating plan within 30
days prior to the beginning of the fiscal year. Each Investor shall also be entitled to standard
inspection and visitation rights. These provisions shall terminate upon a public offering of the
Company's Common Stock.
Company Favorable:
deliver to the Investor audited annual financial statements audited by a Big Five accounting firm and
unaudited quarterly financial statements. Each Investor shall also be entitled to standard inspection
and visitation rights. These provisions shall terminate upon a registered public offering of the
Company's Common Stock.

Term Sheet: Information and Registration Rights by Feld
Thoughts
"Information Rights: So long as an Investor continues to hold shares of Series A Preferred or Common
Stock issued upon conversion of the Series A Preferred, the Company shall deliver to the Investor the
Company’s annual budget, as well as audited annual and unaudited quarterly financial statements.
Furthermore, as soon as reasonably possible, the Company shall furnish a report to each Investor
comparing each annual budget to such financial statements. Each Investor shall also be entitled to
standard inspection and visitation rights. These provisions shall terminate upon a Qualified IPO."
Information rights are generally something companies are stuck with in order to get investment
capital. The only variation one sees is putting a threshold on the number of shares held (some finite
number vs. "any") for investors to continue to enjoy these rights.
Registration Rights are more tedious and tend to take up a page or more of the term sheet. The
typical clause(s) follows:
"Registration Rights: Demand Rights: If Investors holding more than 50% of the outstanding shares of
Series A Preferred, including Common Stock issued on conversion of Series A Preferred ("Registrable
Securities"), or a lesser percentage if the anticipated aggregate offering price to the public is not less

than $5,000,000, request that the Company file a Registration Statement, the Company will use its best
efforts to cause such shares to be registered; provided, however, that the Company shall not be obligated
to effect any such registration prior to the [third] anniversary of the Closing. The Company shall have
the right to delay such registration under certain circumstances for one period not in excess of ninety
(90) days in any twelve (12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand right
provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty (180)
day period commencing with the date of the Company’s initial public offering, or (ii) if it delivers notice
to the holders of the Registrable Securities within thirty (30) days of any registration request of its
intent to file a registration statement for such initial public offering within ninety (90) days.
Company Registration: The Investors shall be entitled to "piggy-back" registration rights on all
registrations of the Company or on any demand registrations of any other investor subject to the right,
however, of the Company and its underwriters to reduce the number of shares proposed to be registered
pro rata in view of market conditions. If the Investors are so limited, however, no party shall sell shares
in such registration other than the Company or the Investor, if any, invoking the demand registration.
Unless the registration is with respect to the Company’s initial public offering, in no event shall the
shares to be sold by the Investors be reduced below 30% of the total amount of securities included in the
registration. No shareholder of the Company shall be granted piggyback registration rights which
would reduce the number of shares includable by the holders of the Registrable Securities in such
registration without the consent of the holders of at least a majority of the Registrable Securities.
S-3 Rights: Investors shall be entitled to unlimited demand registrations on Form S-3 (if available to the
Company) so long as such registered offerings are not less than $1,000,000.
Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and
commissions) of all such demands, piggy-backs, and S-3 registrations (including the expense of one
special counsel of the selling shareholders not to exceed $25,000).
Transfer of Rights: The registration rights may be transferred to (i) any partner, member or retired
partner or member or affiliated fund of any holder which is a partnership, (ii) any member or former
member of any holder which is a limited liability company, (iii) any family member or trust for the
benefit of any individual holder, or (iv) any transferee satisfies the criteria to be a Major Investor (as
defined below); provided the Company is given written notice thereof.
Lock-Up Provision: Each Investor agrees that it will not sell its shares for a period to be specified by the
managing underwriter (but not to exceed 180 days) following the effective date of the Company’s initial
public offering; provided that all officers, directors, and other 1% shareholders are similarly bound.
Such lock-up agreement shall provide that any discretionary waiver or termination of the restrictions of
such agreements by the Company or representatives of underwriters shall apply to Major Investors, pro
rata, based on the number of shares held.
Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to
registration rights as are reasonable, including cross-indemnification, the period of time in which the
Registration Statement shall be kept effective, and underwriting arrangements. The Company shall not
require the opinion of Investor’s counsel before authorizing the transfer of stock or the removal of Rule
144 legends for routine sales under Rule 144 or for distribution to partners or members of Investors."
Registration rights are also something the company will have to offer to investors. What is most
interesting about this section is that lawyers seem genetically incapable of leaving this section
untouched and always end up "negotiating something." Perhaps because this provision is so long in
length, they feel the need to keep their pens warm while reading. We find it humorous (so long as we

aren’t the ones paying the legal fees), because in the end, the modifications are generally innocuous
and besides, if you ever get to the point where registration rights come into play (e.g. an IPO), the
investment bankers of the company are going to have a major hand in deciding how the deal is going
to be structured, regardless of the contract the company entered into years before when it did an
early private financing.

Registration Rights
Investor Favorable:
Demand Rights: If Investors holding at least 30 percent of the outstanding
shares of Series [A] Preferred, including Common Stock issued on conversion of Series [A] Preferred
("Registrable Securities"), request that the Company file a Registration Statement having an
aggregate offering price to the public of not less than $5,000,000, the Company will use its best
efforts to cause such shares to be registered; provided, however, that the Company shall not be
obligated to effect any such registration prior to the second anniversary of the Closing. The Company
shall have the right to delay such registration under certain circumstances for two periods not in
excess of ninety (90) days each in any twelve (12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand
right provisions, and shall not be obligated to effect a registration (i) during the ninety (90) day
period commencing with the date of the Company's initial public offering, or (ii) if it delivers notice
to the holders of the Registrable Securities within thirty (30) days of any registration request of its
intent to file a registration statement for a Qualified IPO within ninety (90) days.
registrations of the Company or on any demand registrations of any other investor subject to the
right, however, of the Company and its underwriters to reduce the number of shares proposed to be
registered pro rata in view of market conditions. If the Investors are so limited, however, no party
shall sell shares in such registration other than the Company or the Investor, if any, invoking the
demand registration. No shareholder of the Company shall be granted piggy-back registration rights
that would reduce the number of shares includable by the holders of the Registrable Securities in
such registration without the consent of the holders of at least two thirds of the Registrable
Securities.
S-3 Rights: Investors shall be entitled to an unlimited number of demand registrations on Form S-3
(if available to the Company) so long as such registered offerings are not less than $500,000. The
Company shall not be obligated to file more than one S-3 registration in any six month period.
special counsel of the selling shareholders).
Transfer of Rights: The registration rights may be transferred to (i) any partner or retired partner of
any holder which is a partnership, (ii) any family member or trust for the benefit of any individual
holder, or (iii) any transferee who acquires at least [one quarter of the shares originally issued]
shares of Registrable Securities; provided the Company is given written notice thereof.
Standoff Provision: No Investor holding more than 1 percent of the Company will sell shares within
120 days of the effective date of the Company's initial public offering if all officers, directors, and
other 1 percent shareholders are similarly bound.

Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect
to registration rights as are reasonable, including cross-indemnification, the period of time in which
the Registration Statement shall be kept effective, and underwriting arrangements.
Middle of the Road:
Demand Rights: If Investors holding more than 50 percent of the
outstanding shares of Series [A] Preferred, including Common Stock issued on conversion of Series
[A] Preferred ("Registrable Securities"), request that the Company file a Registration Statement
having an aggregate offering price to the public of not less than $5,000,000, the Company will use its
best efforts to cause such shares to be registered; provided, however, that the Company shall not be
obligated to effect any such registration prior to the third anniversary of the Closing. The Company
shall have the right to delay such registration under certain circumstances for one period not in
excess of ninety (90) days in any twelve (12) month period.
The Company shall not be obligated to effect more than two (2) registrations under these demand
right provisions, and shall not be obligated to effect a registration (i) during the one hundred eighty
(180) day period commencing with the date of the Company's initial public offering, or (ii) if it
delivers notice to the holders of the Registrable Securities within thirty (30) days of any registration
request of its intent to file a registration statement for such initial public offering within ninety (90)
days.
registrations of the Company or on any demand registrations of any other investor subject to the
right, however, of the Company and its underwriters to reduce the number of shares proposed to be
registered pro rata in view of market conditions. If the Investors are so limited, however, no party
shall sell shares in such registration other than the Company or the Investor, if any, invoking the
demand registration. No shareholder of the Company shall be granted piggy-back registration rights
that would reduce the number of shares includable by the holders of the Registrable Securities in
such registration without the consent of the holders of at least two thirds of the Registrable
Securities.
S-3 Rights: Investors shall be entitled to two (2) demand registrations on Form S-3 (if available to the
Company) so long as such registered offerings are not less than $500,000.
special counsel of the selling shareholders not to exceed $15,000).
Transfer of Rights: The registration rights may be transferred to (i) any partner or retired partner of
any holder which is a partnership, (ii) any family member or trust for the benefit of any individual
holder, or (iii) any transferee who acquires at least [one eighth of the shares originally issued] shares
of Registrable Securities; provided the Company is given written notice thereof.
Lock-Up Provision: If requested by the Company and its underwriters, no Investor will sell its shares
for a specified period (but not to exceed 180 days) following the effective date of the Company's
initial public offering; provided that all officers, directors, and other 1 percent shareholders are
similarly bound.
to registration rights as are reasonable, including cross-indemnification, the period of time in which
the Registration Statement shall be kept effective, and underwriting arrangements.
Company Favorable:
Company Registration: The Investors shall be entitled to
"piggy-back" registration rights on all registrations of the Company subject to the right, however, of
the Company and its underwriters to reduce the number of shares proposed to be registered pro rata
among all Investors in view of market conditions.


S-3 Rights: Investors shall be entitled to two (2) demand registrations on Form S-3 (if available to the
Company) so long as such registered offerings are not less than $500,000.
commissions) of all such piggy-backs, and S-3 registrations (including the expense of a single counsel
to the selling shareholders not to exceed $5,000).
Standoff Provision: If requested by the underwriters no Investor will sell shares of the Company's
stock for up to 180 days following a public offering by the Company of its stock.
Termination of Rights: The registration rights shall terminate on the date three (3) years after the
Company's initial public offering, or with respect to each Investor, at such time as (i) the Company's
shares are publicly traded, and (ii) the Investor is entitled to sell all of its shares in any ninety (90)
day period pursuant to SEC Rule 144.
to registration rights as are reasonable and standard, including cross-indemnification, the period of
time in which the Registration Statement shall be kept effective, and underwriting arrangements.

TERM SHEET: VESTING

Term Sheet: Vesting by Feld Thoughts
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors,
consultants and other service providers will be subject to vesting provisions below unless different
vesting is approved by the majority (including at least one director designated by the Investors) consent
of the Board of Directors (the "Required Approval"): 25% to vest at the end of the first year following
such issuance, with the remaining 75% to vest monthly over the next three years. The repurchase option
shall provide that upon termination of the employment of the shareholder, with or without cause, the
Company or its assignee (to the extent permissible under applicable securities law qualification) retains
the option to repurchase at the lower of cost or the current fair market value any unvested shares held
by such shareholder. Any issuance of shares in excess of the Employee Pool not approved by the Required
Approval will be a dilutive event requiring adjustment of the conversion price as provided above and
will be subject to the Investors' first offer rights.
The outstanding Common Stock currently held by _________ and ___________ (the "Founders") will be
subject to similar vesting terms provided that the Founders shall be credited with [one year] of vesting
as of the Closing, with their remaining unvested shares to vest monthly over three years.
Industry standard vesting for early stage companies is a one year cliff and monthly thereafter for a
total of 4 years. This means that if you leave before the first year is up, you don't vest any of your
stock. After a year, you have vested 25% (that's the "cliff"). Then - you begin vesting monthly (or
quarterly, or annually) over the remaining period. So - if you have a monthly vest with a one year cliff
and you leave the company after 18 months, you'll have vested 37.25% of your stock. Often, founders
will get somewhat different vesting provisions than the balance of the employee base. A common
term is the second paragraph above, where the founders receive one year of vesting credit at the
closing and then vest the balance of their stock over the remaining 36 months. This type of vesting
arrangement is typical in cases where the founders have started the company a year or more earlier
then the VC investment and want to get some credit for existing time served.

Unvested stock typically "disappears into the ether" when someone leaves the company. The equity
doesn't get reallocated - rather it gets "reabsorbed" - and everyone (VCs, stock, and option holders)
all benefit ratably from the increase in ownership (or - more literally - the reverse dilution.") In the
case of founders stock, the unvested stuff just vanishes. In the case of unvested employee options, it
usually goes back into the option pool to be reissued to future employees.
A key component of vesting is defining what happens (if anything) to vesting schedules upon a
merger. "Single trigger" acceleration refers to automatic accelerated vesting upon a merger. "Double
trigger" refers to two events needing to take place before accelerated vesting (e.g., a merger plus the
act of being fired by the acquiring company.) Double trigger is much more common than single
trigger. Acceleration on change of control is often a contentious point of negotiation between
founders and VCs, as the founders will want to "get all their stock in a transaction - hey, we earned
it!" and VCs will want to minimize the impact of the outstanding equity on their share of the purchase
price. Most acquires will want there to be some forward looking incentive for founders, management,
and employees, so they usually either prefer some unvested equity (to help incent folks to stick
around for a period of time post acquisition) or they'll include a separate management retention
incentive as part of the deal value, which comes off the top, reducing the consideration that gets
allocated to the equity ownership in the company. This often frustrates VCs (yeah - I hear you
chuckling "haha - so what?") since it puts them at cross-purposes with management in the M&A
negotiation (everyone should be negotiating to maximize the value for all shareholders, not just
specifically for themselves.) Although the actual legal language is not very interesting, it is included
below.
In the event of a merger, consolidation, sale of assets or other change of control of the Company and
should an Employee be terminated without cause within one year after such event, such person shall be
entitled to [one year] of additional vesting. Other than the foregoing, there shall be no accelerated
vesting in any event."
Structuring acceleration on change of control terms used to be a huge deal in the 1990's when
"pooling of interests" was an accepted form of accounting treatment as there were significant
constraints on any modifications to vesting agreements. Pooling was abolished in early 2000 and under purchase accounting - there is no meaningful accounting impact in a merger of changing the
vesting arrangements (including accelerating vesting). As a result, we usually recommend a balanced
approach to acceleration (double trigger, one year acceleration) and recognize that in an M&A
transaction, this will often be negotiated by all parties. Recognize that many VCs have a distinct point
of view on this (e.g. some folks will NEVER do a deal with single trigger acceleration; some folks don't
care one way or the other) - make sure you are not negotiating against and "point of principle" on
this one as VCs will often say "that's how it is an we won't do anything different."
Recognize that vesting works for the founders as well as the VCs. I've been involved in a number of
situations where one or more founders didn't work out and the other founders wanted them to leave
the company. If there had been no vesting provisions, the person who didn't make it would have
walked away with all their stock and the remaining founders would have had no differential
ownership going forward. By vesting each founder, there is a clear incentive to work your hardest
and participate constructively in the team, beyond the elusive founders "moral imperative."
Obviously, the same rule applies to employees - since equity is compensation and should be earned
over time, vesting is the mechanism to insure the equity is earned over time. Of course, time has a
huge impact on the relevancy of vesting. In the late 1990's, when companies often reached an exit
event within two years of being founded, the vesting provisions - especially acceleration clauses mattered a huge amount to the founders. Today - as we are back in a normal market where the
typical gestation period of an early stage company is five to seven years, most people (especially
founders and early employees) that stay with a company will be fully (or mostly) vested at the time
of an exit event.

While it's easy to set vesting up as a contentious issue between founders and VCs, we recommend the
founding entrepreneurs view vesting as an overall "alignment tool" - for themselves, their cofounders, early employees, and future employees. Anyone who has experienced an unfair vesting
situation will have strong feelings about it - we believe fairness, a balanced approach, and
consistency is the key to making vesting provisions work long term in a company.

Vesting of Founders Shares by John Huston
For a thorough review of the issues associated with the highly contentious topic
of vesting of founders shares please see Appendix A


TERM SHEET: CONDITIONS PRECEDENT TO FINANCING

Conditions Precedent
Investor Favorable: This proposal is non-binding, and is specifically subject to:
1. Completed due-diligence reviews satisfactory to [Investor] and Investors' counsel,
specifically including review of [Investor Counsel].
2. Customary stock purchase and related agreements satisfactory to [Investor] and Investors'
counsel, including stock option plan.
3. Intellectual property, confidentiality, and non-compete agreements with all key employees
of the Company satisfactory to Investors' counsel.
4. Satisfactory review of the Company's compensation programs and stock allocation and
vesting arrangements for officers, key employees, and others, as well as any existing
employment or similar agreements.
5. Both the Company and Investors will negotiate exclusively and in good faith toward an
investment as outlined in this proposal and agree to "no-shop" provisions for reasonable and
customary periods of time.
6. Conversion of all outstanding convertible securities (e.g., convertible notes or preferred
stock issued prior to the date of this Series A financing).
Middle of the Road and Company Favorable: This proposal is non-binding, and is specifically subject
to:
1. Completed due-diligence reviews satisfactory to [Investor] and Investors' counsel,
specifically including review of [Investor Counsel].
2. Customary stock purchase and related agreements satisfactory to [Investor] and Investors'
counsel, including stock option plan.
3. Both the Company and Investors will negotiate exclusively and in good faith toward an
investment as outlined in this proposal and agree to "no-shop" provisions for reasonable and
customary periods of time.

Term Sheet: Conditions Precedent to Financing by Feld Thought
A typical conditions precedent to financing clause looks as follows:
"Conditions Precedent to Financing: Except for the provisions contained herein entitled "Legal Fees
and Expenses", "No Shop Agreement", and "Governing Law" which are explicitly agreed by the Investors
and the Company to be binding upon execution of this term sheet, this summary of terms is not intended
as a legally binding commitment by the Investors, and any obligation on the part of the Investors is
subject to the following conditions precedent: 1. Completion of legal documentation satisfactory to the
prospective Investors; 2. Satisfactory completion of due diligence by the prospective Investors; 3.
Delivery of a customary management rights letter to Investors; and 4. Submission of detailed budget for
the following twelve months, acceptable to Investors."
Notice that the investor will try to make a few things binding – specifically (a) that his legal fees get
paid whether or not a deal happens, (b) that the company can’t shop the deal once the term sheet is
signed, and (c) that the governing law be set to a specific domicile – while explicitly stating "there are
a bunch things that still have to happen before this deal is done and I can back out for any reason."
There are a few conditions to watch out for since they usually signal something non-obvious on the
part of the investor. They are:

1. "Approval by Investors’ partnerships" – this is super secret VC code for "this deal has not
been approved by the investors who issued this term sheet. Therefore, even if you love the
terms of the deal, you still may not have a deal.
2. "Rights offering to be completed by Company" – this indicates that the investors want the
company to offer all previous investors in the company the ability to participate in the
currently contemplated financing. This is not necessarily a bad thing – in fact in most cases
this serves to protect all parties from liability - but does add time and expense to the deal.
3. "Employment Agreements signed by founders as acceptable to investors" – beware what
the full terms are before signing the agreement. As an entrepreneur, when faced with this,
it’s probably wise to understand (and negotiate) the form of employment agreement early in
the process. While you’ll want to try to do this before you sign a term sheet and accept a noshop, most VCs will wave you off and say “don’t worry about it – we’ll come up with
something that works for everyone.” Our suggestion – at the minimum, make sure you
understand the key terms (such as compensation and what happens on termination).
There are plenty of other wacky conditionals – if you can dream it, it has probably been done. Just
make sure to look carefully at this paragraph and remember that just because you’ve signed a term
sheet, you don’t have a deal.


TERM SHEET: CONVERSION

Automatic Conversion
Investor Favorable:
The Series [A] Preferred shall be automatically converted into
Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least
two thirds of the outstanding Series [A] Preferred consent to such conversion or (ii) upon the closing
of a firmly underwritten public offering of shares of Common Stock of the Company at a per share
price not less than [3 times the Original Purchase Price] per share and for a total offering with net
proceeds to the Company of not less than $40 million (a "Qualified IPO").
Middle of the Road:
Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least
two thirds of the outstanding Series [A] Preferred consent to such conversion or (ii) upon the closing
of a firmly underwritten public offering of shares of Common Stock of the Company at a per share
price not less than [2 times the Original Purchase Price] per share and for a total offering with gross
proceeds to the Company of not less than $25 million (a "Qualified IPO").
Company Favorable:
Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least a
majority of the outstanding Series [A] Preferred consent to such conversion or (ii) upon the closing of
a firmly underwritten public offering of shares of Common Stock of the Company at a per share price
not less than two times the Original Purchase Price (as adjusted for stock splits and the like) and for a
total offering of not less than $5 million, before deduction of underwriters commissions and
expenses (a "Qualified IPO").
(15) Purchase Agreement:
Investor Favorable:
The investment shall be made pursuant to a Stock Purchase
Agreement reasonably acceptable to the Company and the Investors, which agreement shall contain,
among other things, appropriate representations and warranties of the Company, representations of
the Founders with respect to patents, litigation, previous employment and outside activities,
covenants of the Company reflecting the provisions set forth herein, and appropriate conditions of
closing, including an opinion of counsel for the Company. The Stock Purchase Agreement shall
provide that it may only be amended and any waivers thereunder shall only be made with the
approval of the holders of two thirds of the Series [A] Preferred. Registration rights provisions may
be amended or waived solely with the consent of the holders of two thirds of the Registrable
Securities.
Middle of the Road:
among other things, appropriate representations and warranties of the Company, covenants of the
Company reflecting the provisions set forth herein, and appropriate conditions of closing, including
an opinion of counsel for the Company. The Stock Purchase Agreement shall provide that it may only
be amended and any waivers thereunder shall only be made with the approval of the holders of two
thirds of the Series [A] Preferred. Registration rights provisions may be amended or waived solely
with the consent of the holders of two thirds of the Registrable Securities.
Company Favorable:
among other things, appropriate representations and warranties of the Company, covenants of the
Company reflecting the provisions set forth herein, and appropriate conditions of closing, including
an opinion of counsel for the Company. The Stock Purchase Agreement shall provide that it may only

be amended and any waivers thereunder shall only be made with the approval of the holders of 50
percent of the Series [A] Preferred. Registration rights provisions may be amended or waived solely
with the consent of the holders of 50 percent of the Registrable Securities.
(16) Employee Matters:
Investor Favorable:
Employee Pool: Upon the Closing of this financing there will be [______] shares of issued and
outstanding Common Stock held by the Founders and an additional [_______] shares of Common Stock
reserved for future issuance to key employees.
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors and
consultants will be subject to vesting as follows: 20 percent to vest at the end of the first year
following such issuance, with the remaining 80 percent to vest monthly over the subsequent four
years. The repurchase option shall provide that upon termination of the employment of the
shareholder, with or without cause, the Company or its assignee (to the extent permissible under
applicable securities law qualification) retains the option to repurchase at cost any unvested shares
held by such shareholder.
The outstanding Common Stock currently held by the Founders will be subject to similar vesting
terms, with such vesting period beginning as of the Closing Date.
Restrictions on Sales:
Stock.

The Company shall have a right of first refusal on all transfers of Common

Proprietary Information and Inventions
Agreement:
Each officer, employee and consultant of the Company shall enter into an
acceptable proprietary information and inventions agreement.
Co-Sale Agreement:
The shares of the Company's securities held by the Founders of the
Company shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the
holders of the Series [A] Preferred such that the Founders may not sell, transfer or exchange their
stock unless each holder of Series [A] Preferred has an opportunity to participate in the sale on a pro
rata basis. This right of co-sale shall not apply to and shall terminate upon a Qualified IPO.
Key-Man Insurance:
As soon as reasonably possible after the Closing, the Company shall procure
a key-man life insurance policy for [_________] in the amount of $1,000,000, naming the Company as
beneficiary; provided, however, that at the election of holders of a majority of the outstanding Series
[A] Preferred, such proceeds shall be used to redeem shares of Series [A] Preferred.
Management:
The Company will, on a best efforts basis, hire a chief [_________] officer
within the six (6) month period following the closing of the financing.
Middle of the Road:
Employee Pool: Upon the Closing of this financing there will be [______] shares of issued and
outstanding Common Stock held by the Founders and an additional [_______] shares of Common Stock
reserved for future issuance to key employees. Promptly after the Closing, Messrs. [____________] and
[____________] will be granted incentive stock options from the [_____________] share pool in the amount
of [_____________] shares each exercisable at $0.10 per share, which options will vest in accordance
with the following paragraph.
Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors,
consultants and other service providers will be subject to vesting as follows: [20 percent to vest at
the end of the first year following such issuance, with the remaining 80 percent to vest monthly over

the next four years.] The repurchase option shall provide that upon termination of the employment
of the shareholder, with or without cause, the Company or its assignee (to the extent permissible
under applicable securities law qualification) retains the option to repurchase at cost any unvested
shares held by such shareholder.
The outstanding Common Stock currently held by the Founders will be subject to similar vesting
terms, provided that the Founders shall be credited with two years of vesting as of the Closing, with
their remaining unvested shares to vest monthly over three years.
Restrictions on Sales:
The Company shall have a right of first refusal on all transfers of Common
Stock, subject to normal exceptions.
Proprietary Information and Inventions
Agreement:
Each officer and employee of the Company shall enter into an acceptable
proprietary information and inventions agreement.
Co-Sale Agreement:
The shares of the Company's securities held by [________________],
[_______________], [______________] and [______________] (the "Founders") shall be made subject to a co-sale
agreement (with certain reasonable exceptions) with the holders of the Series [A] Preferred such that
the Founders may not sell, transfer or exchange their stock unless each holder of Series [A] Preferred
has an opportunity to participate in the sale on a pro rata basis. This right of co-sale shall not apply to
and shall terminate upon the Company's initial public offering.
Key-Man Insurance:
The Company shall procure a key-man life insurance policy for [_____________]
in the amount of $1,000,000, naming the Company as beneficiary.
Company Favorable:
Closing Date:

None.
[_____________], 200[_] (the "Closing Date").

Legal Counsel:
The Company shall select legal counsel acceptable to [Investor]
([_____________]). Unless counsels agree otherwise, Investors' counsel [_____________] shall draft the
financing documents for review by Company counsel.
Expenses:
Investor Favorable:
The Company shall pay the reasonable fees and expenses of
Investors' counsel and Company counsel.
Middle of the Road:
The Company shall pay the reasonable fees for one special counsel
to the Investors, expected not to exceed $[25,000 – $35,000], and for Company counsel.
Company Favorable:
The Company and the Investors shall each bear their own legal fees
and expenses in connection with the transaction.
Finders:
The Company and the Investors shall each indemnify the other for
any finder's fees for which either is responsible.

Term Sheet: Conversion by Feld Thought
"Conversion: The holders of the Series A Preferred shall have the right to convert the Series A Preferred,
at any time, into shares of Common Stock. The initial conversion rate shall be 1:1, subject to adjustment
as provided below."

This allows the buyer of preferred to convert to common should he determine on a liquidation that
he is better off getting paid on a pro rata common basis rather than accepting the liquidation
preference and participating amount. It can also be used in certain extreme circumstances whereby
the preferred wants to control a vote of the common on a certain issue. Do note, however, that once
converted, there is no provision for "re-converting" back to preferred.
A more interesting term is the automatic conversion, especially since it has several components that
are negotiable.
"Automatic Conversion: All of the Series A Preferred shall be automatically converted into Common
Stock, at the then applicable conversion price, upon the closing of a firmly underwritten public offering
of shares of Common Stock of the Company at a per share price not less than [three] times the Original
Purchase Price (as adjusted for stock splits, dividends and the like) per share and for a total offering of
not less than [$15] million (before deduction of underwriters commissions and expenses) (a "Qualified
IPO"). All, or a portion of, each share of the Series A Preferred shall be automatically converted into
Common Stock, at the then applicable conversion price in the event that the holders of at least a
majority of the outstanding Series A Preferred consent to such conversion."
In an IPO of a venture-backed company, the investment bankers will want to see everyone convert
into common stock at the time of the IPO (it is extremely rare for a venture backed company to go
public with multiple classes of stock – it happens – but it’s rare). The thresholds of the automatic
conversion are critical to negotiate – as the entrepreneur; you want them lower to insure more
flexibility while your investors will want them higher to give them more control over the timing and
terms of an IPO.
Regardless of the actual thresholds, one thing of crucial importance is to never allow investors to
negotiate different automatic conversion terms for different series of preferred stock. There are
many horror stories of companies on the brink of going public and having one class of preferred
stockholders that have a threshold above what the proposed offering would consummate and
therefore these stockholders have an effective veto right on the offering. We strongly recommend
that – at each financing – you equalize the automatic conversion threshold among all series of stock.

Conversion Rights
As you likely know, VC investors are typically issued shares of preferred stock, not common stock.
Preferred stock, as the name suggests, is preferable to (and more valuable than) common stock
because it grants certain key rights to the holders, one of which is conversion rights.
A conversion right is the right to convert shares of preferred stock into shares of common stock.
There are two types of conversion rights: optional and mandatory.
Optional conversion rights – Optional conversion rights permit the holder to elect to convert its
shares of preferred stock into shares of common stock, initially on a one-to-one basis. These rights
are related to the investor’s liquidation preference.
For example, let’s assume that the Series A investor has a $5 million, non-participating liquidation
preference (with a 2x multiple) representing 30 percent of the outstanding shares of the company,
and the company is sold for $100 million. The investor would thus be entitled to the first $10 million
pursuant to its liquidation preference, and the remaining $90 million would be distributed ratably to
the common stockholders.

If the investor, however, elects to convert its shares to common stock pursuant to its optional
conversion rights (thereby giving-up the liquidation preference), it would receive $30 million.
Optional conversion rights are typically non-negotiable and will look like this in the term sheet:
“The Series A Preferred initially converts 1:1 to Common Stock at any time at the option of the holders,
subject to adjustments for stock dividends, splits, combinations and similar events, as described below.”
Mandatory conversion rights - Mandatory conversion rights require the holder to convert its
shares of preferred stock into shares of common stock. This happens automatically and is sometimes
referred to as “automatic conversion”.
Mandatory conversion rights are always negotiable and will look like this is in the term sheet (the
blanks are thresholds that require negotiation, as discussed below):
“All of the Series A Preferred shall be automatically converted into Common Stock, at the then
applicable conversion rate, upon (i) the closing of a [firm commitment] underwritten public offering of
Common Stock at a price per share not less than ___ times the Original Purchase Price (subject to
adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the
Company of not less than $_______ ; or (ii) the written consent of the holders of ___% of the Series A
Preferred.”
What are the key issues for founders? There are several issues founders should focus on in
connection with either type of conversion rights. First, founders should push for a low multiple of
the Original Purchase Price (for example, two or three times the Original Purchase Price) to create
more flexibility with regard to an IPO.
Similarly, founders should push for “gross” (not “net”) proceeds and an amount in the range of $1015 million – or, even better, “for a total offering of not less than [$10-15] million (before deduction of
underwriters’ commissions and expenses).”
Sometimes experienced counsel can persuade the investors to eliminate these thresholds entirely (to
avoid the possibility of having to obtain last-minute waivers when pricing the IPO). If not, the
company has to ensure the thresholds are the same for all series of preferred stock.
Finally, founders should push for a majority threshold with respect to an automatic conversion upon
written consent of the Series A Preferred. And if more than one series of preferred stock is issued, the
holders should be required to vote as a class (otherwise a single series could block the transaction).


TERM SHEET: REDEMPTION RIGHTS

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
the outstanding Series [A] Preferred on the fifth anniversary of the Closing and all of the remaining
outstanding Series [A] Preferred on the sixth anniversary of the Closing. Such redemptions shall be at
a purchase price equal to [three] times the Original Purchase Price plus accrued and 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 purchase price equal to the Original
Purchase Price plus declared and unpaid dividends.
Company Favorable:

None.

Term Sheet: Redemption Rights by Feld Thoughts
Redemption rights usually look something like:
"Redemption at Option of Investors: At the election of the holders of at least majority of the Series A
Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments
beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal
to the Original Purchase Price plus declared and unpaid dividends."
There is some rationale for redemption rights. First, there is the "fear" (on the VCs part) that a
company will become successful enough to be an on-going business, but not quite successful enough
to go public or be acquired. In this case, redemption rights were invented to allow the investor a
guaranteed exit path. However, any company that is around for a while as a going concern that is not
an attractive IPO or acquisition candidate will not generally have the cash to pay out redemption
rights.
The second reason for redemption rights pertains to the life span of venture funds. The average
venture fund has a 10 years life span to conduct its business. If a VC makes an investment in year 5 of
the fund, it might be important for that fund manager to secure redemption rights in order to have a
liquidity path before his fund must wind down. As with the previous case, whether or not the
company has the ability to pay is another matter.
Often, companies will claim that redemption rights create a liability on their balance sheet and can
make certain business optics more difficult. In the past few years, accountants have begun to argue
more strongly that redeemable preferred stock is a liability on the balance sheet, not an equity
feature. Unless the redeemable preferred stock is mandatorily redeemable, this is not the case and
most experienced accountants will be able to recognize the difference.
There is one form of redemption that we have seen in the past few years and we view as
overreaching – the adverse change redemption. We recommend you never agree to the following
which has recently crept into terms sheets.

"Adverse Change Redemption: Should the Company experience a material adverse change to its
prospects, business or financial position, the holders of at least majority of the Series A Preferred shall
have the option to commit the Company to immediately redeem the outstanding Series A Preferred.
Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and
unpaid dividends."
This is just too vague, too punitive, and shifts an inappropriate amount of control to the investors
based on an arbitrary judgment. If this term is being proposed and you are getting pushback on
eliminating it, make sure you are speaking to a professional investor and not a loan shark.
In our experience – just like Jack’s behavior - redemption rights are well understood by the market
and should not create a problem, except in a theoretical argument between lawyers or accountants.

TERM SHEET: COMPELLED SALE RIGHT

Compelled Sale Right
So long as VC (together with its permitted transferees) continues to hold at least 10% of the outstanding
common shares (on an as-converted basis), and so long as an IPO has not been completed, then, at any
time from and after the seventh anniversary of the transaction, if VC or the Company shall receive a
bona fide offer from an unaffiliated third party to purchase 100% of the equity of the Company, VC shall
have the right to cause each other stockholder to sell such stockholder’s equity securities on the same
terms and conditions applicable to VC.
My first reaction was “what the @X#%?” My second reaction was “eh – this is just a different twist on
redemption rights.” But - then I thought about it some more and thought “you’ve got to be kidding
me!”
So – after seven years, if there hasn’t been a liquidity event, a VC that owns at least 10% of the
company can force all the other shareholders to sell their shares to an unaffiliated third party. Read
it slowly and think about it. Basically, this term gives a minority shareholder the right to sell the
company after 7 years, with no input from any other shareholders.
Be forewarned - this is not a nice term.


TERM SHEET: DIVIDENDS

Dividend Overview
What is a dividend? A dividend is, in essence, a distribution of the company’s profits to its
shareholders, which is generally paid in cash or stock. Cash dividends are obviously rare in earlystage companies because there are usually no profits (or cash) to distribute - and if there were, they
would generally be re-invested in the growth of the company. Stock dividends are problematic due
to their dilutive effect.
There are two types of dividends: non-cumulative and cumulative. With a non-cumulative dividend,
if the Board of Directors does not declare a dividend during a particular fiscal year, the right to
receive the dividend extinguishes for such year.
With a cumulative dividend, the dividend is calculated for each fiscal year and the right to receive the
dividend is carried forward until it is paid or until the right is terminated. In short, it accumulates
(and sometimes investors require compounding).
Cumulative dividends as a protective device - Cumulative dividends are relatively rare (10
percent or less of financings have them). However, investors sometimes push for some form of
cumulative dividend as a protective device to provide a minimum annual rate of return on their
investment (say, 7-10 percent) – and it is thus tied-into the liquidation preference.
If the company capitulates on this issue, it must make clear in the term sheet that cumulative
dividends will only be payable if there is a liquidation event (such as the sale of the company) and
will be forfeited in the event of an IPO or upon the conversion of preferred stock into common stock
(because the protection is not needed in such cases).
This provision would look like something like this in the term sheet: “The Preferred Stock will carry
an annual __% cumulative dividend [compounded annually], payable solely upon a liquidation [or
redemption]….”

Dividend Provisions
Investor Favorable:
The holders of the Series [A] Preferred shall be entitled to receive
cumulative dividends in preference to any dividend on the Common Stock at the rate of 15 percent of
the Original Purchase Price per annum, when and as declared by the Board of Directors.
Middle of the Road:
non-cumulative dividends in preference to any dividend on the Common Stock at the rate of 8
percent of the Original Purchase Price per annum, when and as declared by the Board of Directors.
The Series [A] Preferred also will participate pro rata in any dividends paid on the Common Stock on
an as-converted basis.
Company Favorable:
non-cumulative dividends in preference to any dividend on the Common Stock at the rate of 8
percent of the Original Purchase Price per annum, when, as and if declared by the Board of Directors.


Term Sheet: Dividends by Feld Thoughts
For early stage investments, dividends generally do not provide "venture returns" – they are simply
modest juice in a deal. Let’s do some simple math. Assume a typical dividend of 10% (dividends will
range from 5% to 15% depending on how aggressive your investor is – we picked 10% to make the
math easy). Now – assume that you are an early stage VC (painful and yucky – we understand – just
try for a few minutes). Success is not a 10% return – success is a 10x return. Now, assume that you
(as the VC) have negotiated hard and gotten a 10% cumulative (you get the dividend every year, not
only when they are declared), automatic (they don’t have to be declared, they happen automatically),
annual dividend. Again – to keep the math simple – let’s assume the dividend does not compound –
so every year you simply get 10% of your investment as a dividend. In this case, it will take you 100
years to get your 10x return. Since a typical venture deal lasts 5 to 7 years (and you’ll be dead in 100
years anyway), you’ll never see the 10x return from the dividend.
Now – assume a home run deal – assume a 50x return on a $10m investment in five years. Even with
a 10% cumulative annual dividend, this only increases the investor return from $500m to $505m
(the annual dividend is $1m (10% of $10m) times 5 years).
So – while the juice from the dividend is nice, it doesn’t really move the meter in the success case –
especially since venture funds are typically 10 years long – meaning as a VC you’ll only get 1x your
money in a dividend if you invest on day 1 of a fund and hold the investment for 10 years. (NB to
budding early stage VCs – don’t raise your fund on the basis of your future dividend stream from
your investments).
This also assumes the company can actually pay out the dividend – often the dividends can be paid in
either stock or cash – usually at the option of the company. Obviously, the dividend could drive
additional dilution if it is paid out in stock, so this is the one case where it is important not to get head
faked by the investor (e.g. the dividend simply becomes another form of anti-dilution protection –
although in this case one that is automatic and simply linked to the passage of time).
Of course – we’re being optimistic about the return scenarios. In downside cases, the juice can
matter, especially as the invested capital increases. For example, take a $40m investment with a 10%
annual cumulative dividend in a company that was sold at the end of the fifth year to another
company for $80m. In this case, assume that there was a straight liquidation preference (e.g. no
participating preferred) and the investor got 40% of the company for her investment (or a $100m
post money valuation). Since the sale price was below the investment post money valuation (e.g. a
loser, but not a disaster), the investor will exercise the liquidation preference and take the $40m plus
the dividend ($4m per year for 5 years – or $20m). In this case, the difference between the return in a
no dividend scenario ($40m) and a dividend scenario ($60m) is material.
Mathematically, the larger the investment amount and the lower the expected exit multiple, the more
the dividend matters. This is why you see dividends in private equity and buyout deals, where big
money is involved (typically greater than $50m) and the expectation for return multiples on invested
capital are lower.
Automatic dividends have some nasty side effects, especially if the company runs into trouble, as they
typically should be included in the solvency analysis and – if you aren’t paying attention – an
automatic cumulative dividend can put you unknowingly into the zone of insolvency (a bad place –
definitely one of Dante’s levels – but that’s for another post).
Cumulative dividends can also annoying and often an accounting nightmare, especially when they are
optionally in stock, cash, or a conversion adjustment, but that’s why the accountants get paid the big
bucks at the end of the year to put together the audited balance sheet. That said, the non-cumulative

OTAF Term Sheet Nuances July 2011

OTAF Term Sheet Nuances July 2011

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OTAF Term Sheet Nuances July 2011