early stage capital: term sheets 101 - mit opencourseware · 2020-01-04 · early stage capital:...
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1
Early Stage Capital:
Term Sheets 101
15.391 Fall 2010
Shari Loessberg
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Team Sign Up Team formation
• list of members • team name • Team contact
Send schedule availability by email to James:
• lawyer rounds • VC rounds
Deadline: email by 8:00 pm Monday, November 1
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Overview
Mechanics and Industry Trends
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Overview:
VC Investment Process
Step 1: Pitching to Investors: investor high-level due diligence: 2 weeks-2 yrs Step 2: Decision by investor to invest:
2 weeks-4 months Step 3: Term sheet negotiation: 2-4
weeks
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Overview:
VC Investment Process
Step 4: Financing Documentation: Lawyer Time: 4-12 weeks Legal and continuing business ―due diligence‖ Draft big thick legal docs: Purchase Agreement;
Articles of Incorporation; Voting Agreements, etc. Prepare closing deliverables: legal certificates,
government filings, etc.
Step 5: Sign and close: MONEY
Step 6: Additional closings: milestones,
tranches, etc.
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Venture Investment Trends
Source: PWCMoneytree.com 2010
$ in millions14,000
12,000
10,000
8,000
6,000
4,000
2,000
0Quarter Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q1Q2 Q3 Q4
[854] [871] [704] [758] [717] [745] [792] [800] [731] [865] [702] [858] [738] [836] [800] [835] [883] [970] [920] [964] [874][1,064] [1,012][1,077][1,020][1,066] [996] [913] [635] [607] [704] [832] [681]
6,521
5,843
4,297
4,282
4,104
4,735
5,451
5,213
6,087
4,783
5,815
5,051
6,259
6,798
5,766
6,3107,008
6,648
6,268
7,349
7,321
7,790
8,0197,745
7,3507,070
5,836
3,364
4,142
5,100 5,175
4,727
4,765
'02 '03 '04 '05 '06 '07 '08 '09 '10
Number of deals
Image by MIT OpenCourseWare.
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Early vs. Later Rounds
Source: PWCmoneytree.com 2010
212107159175243224187205221
610778
Later Stage
Expansion
Early Stage
Stratup/Seed
F of deals 0 500 1,000 1,500 2,000
1,453.9
918.51,609.0
1,753.8
735.51,646.4
1,528.91,544.4
1,000.5
256.2391.2
422.3
Q1 09 Q4 09 Q1 10
Image by MIT OpenCourseWare.
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Term Sheets 101
Today’s Goal: • Get everyone to a low common denominator re
term sheet jargon and VC practice
No jargon without explanation
Questions and Discussion
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Term Sheet Basics
―No questions are dumb today‖
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Term Sheet/VC Resources
Endless, rich resources online Hundreds of blogs NVCA model documents PWCMoneytree & law firm statistics TIE, TCN events VC Conference, 100K, VCPE Club,
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Term Sheet Definitions
“Term Sheet”
guts of the business deal
NOT a ―legal‖ document
short (~5-8 pages)
VC offers its template
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Term Sheet Definitions
“Common Stock”
what Founders and Employees get
has voting rights but not much else
very cheap, especially at A round
options and restricted stock
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what VCs get ―preferred‖ because it’s got better rights
and protections than common stock also costs more than common
exact definition of preferences is key
focus of negotiation (and this course)
Term Sheet Definitions
“Preferred Stock”
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Term Sheet Definitions
“Valuation”
―Pre-money‖: value before financing
―Post-money‖: pre-money plus
financing
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Term Sheet Definitions
“Valuation”
VC stake stated as percentage of post-money:
―4 on 6‖ =
$6M pre-money with $4M round =
$10M post-money; VCs own 40% of the
company
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Valuation Jargon
You be the VC:
“5 on 10” =
$____ M pre with $ __ M round =
$____ M post; VCs own ____%
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Valuation Jargon
You be the VC:
“5 on 10” =
$ 10M pre-money looking for $ 5 M round =
$15 M post; VCs own 33 %
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Valuation Jargon
“5 on 10” =
$10 Million pre-money valuation with $5 Million of investment =
$15 Million post-money valuation; VCs own 33% (5/15)
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Control, Ownership &
Economic Power
5 Key Terms to Negotiate: Board of Directors
Vesting
Option Pool
Preferred Stock Perks: Participation
Preferred Stock Perks: Anti-Dilution
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Board of Directors
Governing group of company
Approves major strategic decisions
Does not have operating role
Shareholders elect, often by class vote
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Board of Directors
Not legally subject to public company
regulations like Sarbanes-Oxley Pre-money--usually consists of
employees only Post-money--a mix of VCs, employees,
outsiders
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Board of Directors:
Term Sheet Issues
Composition post-money: • Will investors have majority?
• % VC ownership highly indicative
• 4-6 members post A Round
• Aim for “2-2-1”?
– Who is the “1”?
– How chosen?
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Vesting
You don’t really own the shares you thought
you did
Legal mechanism: if you quit/get fired, the Company can buy back, at your cost basis (probably 0), some percentage of your stock
Typically, stock vests with the passage of time, but big events may accelerate vesting schedule
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Vesting is artificially imposed by a separate contract, and typically is heavily negotiated in first rounds
―Vested‖ stock is yours to keep, forever; Company’s
buyback right is only for ―unvested‖ stock
Note: Founders are often issued ―restricted‖ stock,
which has an analogous feature like vesting
Vesting
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Vesting:
Term Sheet Issues
Term: ~3-4 years; varies by sector and region
Schedule: ―cliff‖; quarterly; monthly ―Upfront”: getting credit for work previously
done—important for founders
“Acceleration”: extra credit when big things happen: change of control or getting booted if you ―don’t work out‖
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Option Pool
Percentage of company’s total stock
post-money that is reserved to grant to future hires
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Typical A round: 15-25% Pool always comes out of founders’, not
VC’s, share How complete is your team? Do you
have a hiring plan?
Option Pool
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Rough Ranges of Option Grants
(i) CEO – 5% to 10%; 5.40% avg. (ii) COO – 2% to 4%; 2.58% avg. (iii) CTO – 2% to 4%; 1.19% avg. (iv) CFO – 1% to 2%; 1.01% avg. (v) VP Engineering – .5% to 1.5%;
1.32% avg. (vi) Director – .4% to 1%
Source: CompStat
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Option Pool
Typical ―Cap Table‖ post-money:
Series A Preferred:
VC 1 35% VC 2 15% total: 50%
Common:
Founders 30% Option Pool 20%
total: 50%
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Option Pool
Typical ―Cap Table‖ post-money:
Series A Preferred:
VC 1 35% VC 2 15% total: 50%
Common:
Founders 30%
Option Pool 20% total: 50%
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Option Pool:
Term Sheet Issues
Use the hiring plan to minimize Argue for smaller pool now and wait for a
―recharge‖--when dilution affects VCs as well Pool is necessity; don’t cheap out. What’s
the right percentage for your stage?
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Preferred Stock Perks:
Participation
Certain rights that VC’s stock gets upon ―liquidation‖ (M&A; sale of assets) 1. ―Liquidation preference‖: VCs get 100% of
original money back before Common gets one penny
2. ―Participating preferred‖ permits VCs to share the leftovers ―pro rata‖ with Common
Irrelevant in grand slam; matters only in middling or lousy outcome
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Participating Preferred
Example Co. raises $50 on $50.
VC takes standard participating preferred.
Co. is acquired for $200 two years later.
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Participating Preferred
Co. has $50 pre-money valuation
VC puts in $50
Co. has $100 post-money valuation
VC owns 50% (5/10)
2 years later, Co. sold for $200...
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Participating Preferred
Starting with $200 proceeds: VC gets--
$50 back right off the top (liquidation preference),
plus $75 = 50% of $150 (VC’s percentage ownership of leftover
assets: participation perk)
$125 total (62.5% of Co. value, although
only 50% Co. ownership)
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Participating Preferred
Starting with $200 proceeds: Common is left with--
$200 50 (―VC’s preference‖) - 75 (―VC’s participation‖)
$75 total (37.5% of Co. value, despite
50% of Co. ownership. . .
and having done all the work to create the
value . . .)
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Participating Preferred
In sum, the power of Participating Preferred
cushions VCs with “juiced” returns:
VCs get: Common gets:
$125 total
62.5% of Co. value,
although
only 50% Co.
ownership
$75 total 37.5% of Co. value,
despite
50% Co.
ownership
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―Participating Preferred‖ variants: None: Investors get no ―double dip;‖ only their
liquidation preference: ―straight preferred‖ Multiple Liquidation Participating Preferred: Rare
but very nasty; usually later rounds Full Participation: Investors share PRO RATA with
Common, without limit Capped Participation: Investors share Pro Rata
with Common but only UNTIL ~2-5X return received
Preferred Stock Perks:
Participation
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Preferred Stock Perks:
Multiple Liquidation Participation
Uncommon, brutally unfair Devastating in middling and poor outcomes VCs take a multiple of their liquidation
preference out before Common has a chance to see a penny In 5 on 5 example, with 3X MLP and $20M
exit: VCs get $15 back(3 x 5), off the top Then share 50% of remaining 5M – That is, $17.5M to them $2.5 M to Common Even though each class owns 50%
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Preferred Stock Perks:
Convertibility
Preferred stock will always be convertible, at the investor’s option, into
common stock Initial conversion ratio is 1:1; will
change over time Standard
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Capped Participating Preferred Assume $5M preferred investment for 50% of Company
Sale of
Company
@
No Cap 3X Cap Convert
to
Common
VC’s Choice
if capped
$12M $8.5M (5 + 3.5)
$8.5M* (5 + 3.5)
$6M Preferred
$40M $22.5M (5 + 17.5)
$20M (5 + 15)
$20M Indifferent
$41M $23M (5 + 18)
$20M (5 + 15)
$20.5M Convert
$225M $115M (5 + 110)
$20M (5 + 15)
$112.5M
Convert
$1005M $505M (5 + 500)
$20M (5 + 15)
$502.5M Convert
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Participating Preferred
VCs never give up their right to participate in upside Currently, used in about ~50% of deals
Through the conversion feature, VCs will
always have alternative forms of payout, guaranteeing them (at least) the better of:
• a straight liquidation preference or • pro rata share on as-converted basis
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Participating Preferred
Term Sheet Issues:
Can you ―push back on‖ the participating
and get it out altogether? Can you get a ―cap‖ on the participation
feature?
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Other Terms that Matter
Protective provisions Founder reps Tranched investment No-shop provisions
You will take these up in Tuesday’s
class and in your lawyer rounds
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Term Sheet Subtext
It’s all about the relationships: Between VC and founders Between VC and its LPs Between VCs within syndicate
Trust and comfort level are surprisingly big drivers
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Just the beginning . . .
Conversion Rights Redemption Rights Pay to Play provisions Redemption Rights Dividends Rights of First Refusal Information Rights Piggyback Registration Rights Drag-Along Rights Tag-Along Rights
. . . This is what lawyers are for--
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Preferred Stock Perks:
Anti-Dilution Protection
VC’s protection in event of ―down
round‖ so that A Round investors’
―conversion ratio‖ is equal to
subsequent investors’.
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Anti-Dilution Protection
2 flavors: ―full ratchet‖ and ―weighted
average.‖ Full Ratchet: draconian; ―if only one
new share is issued‖ in B round, all A
round investors entitled to B round’s
conversion ratio. iow, A round is effectively repriced to B round’s (lower)
price. Rare today.
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Weighted Average: Less harsh; takes into account the true dilutive effect of the subsequent down round.
• broad-based (founder friendly) • narrow-based (almost like full ratchet)
Weighted Average is standard today
Anti-Dilution Protection
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Anti-Dilution Protection
Term Sheet Issues:
Can you get VC to agree to broad-
based, weighted average anti-dilution? Can you get VC to take out full ratchet
after B round? After hitting targets?
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15.391 Early Stage CapitalFall 2010
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