what entrepreneurs need to know about term sheets

www.JerryRmitchell.com November 9,2007

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Financing Business from Start-Ups to Mature Companies

Presented To the Illinois State Bar Association


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First, You're Probably Asking Yourself: "Why Should I Listen To Him?

That's a fair question. Why Would You Listen To Me?


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My background:

Been in high tech industry since 1961

Held positions of: Salesman, Sales Manager, Vice- president Sales, Vice-president Marketing, Executive Vice president Sales and Marketing, President/CEO.

Been a partner/founder with 12 companies that received over 50% international revenue 8 of which successfully went public or were sold/merged


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Been president of Jerry R. Mitchell and Associates since 1985

Described in Fortune Magazine November 1997 as serial entrepreneur


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President of The Midwest Entrepreneurs Forum since its formation

Publisher of Bootstrapping newsletter

Advisory board member of DePaul Universities Coleman Entrepreneurship Center

Chairman Modularis Inc

Chairman/CEO Apsiva

Partner Asian Business Company

Partner Qingdao You Ji Le Construction Paint Company Ltd


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I have chosen to address what I believe are the most important discussed terms in a venture financing term sheet.


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Entrepreneurs need to understand that they might negotiate a term sheet once every few years. They negotiate their most important term sheet (Series A) when they have no experience. On the other hand the venture capitalist issues several term sheets a month. They have developed their standard term sheet that has been used by all the venture capital firms.


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With few exceptions, most law firms advise their clients to accept “standard” terms. Most law firms do a lot more business with VCs than they are likely to do with you. VCs refer new clients to the law firms, hire the law firms regularly, and know the attorneys socially. Where do you think the law firms’ loyalty lies? Entrepreneurs choosing lawyers during the term sheet negations need to ask them for references. Ask them for, CEOs they have worked with. Only afterchecking should you retain a law firm.


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The basic incentives between you, your law firm, and your prospective investors are not in your favor. Your lawyers make money by executing transactions and your investors simply bring more transactions to your lawyers than you do.


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The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in their company.

If entrepreneurs have more interested venture capitalists than equity in their company to sell then the term price will increase.


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Entrepreneurs dealing with venture capitalists during the term sheet negations need to ask them for references. Ask them for: CEOs they have worked with including a CEO they have had to fire/replace. Most venture capitalists will provide you with a complete list of everyone they have ever funded.


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Before signing a term sheet, entrepreneurs should educate themselves on exactly what a term sheet is and what to expect while negotiating it.

One important action item entrepreneurs need to do before talking to venture capitalists is how much they think their company is worth.


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If there are going to be multiple venture capital firms syndicated in the offering entrepreneurs must insist on only one investor counsel as well as a lead investor. If the entrepreneur gets this term it will save the millions of dollars in needless attorney fees.


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This also forces the venture capital firms to cooperate with each other especially when these venture capital firms have invested in different rounds of your companies financing. The entrepreneur should act as the mediator between these firms to protect their interests and to ensure all the firms reach an agreement


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In early rounds, entrepreneur’s first venture capitalist investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, existing venture capitalists will often argue for the highest price for new investors in order to limit the existing investors’ dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round.


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One example I am using in this seminar that participants can use is if the company needs to raise $3,000,000 to build their business how much of their equity should that be worth? Only after determining that percentage should entrepreneurs talk to venture capitalists. One of the first questions that entrepreneurs are asked by the venture capitalist is: is the valuation pre or post money.


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One of the first things unknowledgeable entrepreneurs argue over is the price of the deal. One thing every entrepreneur needs to understand before they start is pre-money vs. post money valuations.

Pre-money valuation is what the investor is valuing the company at today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount.


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If a venture capitalist offers to sign a term sheet with your company, you can be sure that they are interested in investing in your company. However, a term sheet is essentially just that—an expression of interest. It is by no means a done deal! Specifically, a term sheet is a preliminary offer to invest in your company and summarizes the size and conditions of the investment as expected by the investor.


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There are only two things that venture funds really care about when doing investments: return on their investment and control. Return on investment refers to the end of the deal return the investor will get and the terms that have direct impact on their return. The term "control" refers to the terms which allow the venture capitalist to either affirmatively exercise control over the business or allow them to veto certain decisions the company can make.


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If you value your company for example at $7,000,000 pre money then $3,000,000 could be worth 43% of the company.

There still could be a problem for example: the entrepreneur and the venture capitalist agree on two terms (A) a $7,000.000 valuation and (B) a $3,000,000 equity investment.


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Now the entrepreneur and the venture capitalist agree that the venture capitalist gets 3, 000,000 shares for $3,000,000. The venture capitalist has thought that he received 3, 000,000 shares for $3,000,000 or 43% of the company because 3,000,000 out of 7,000,000 =43%. The entrepreneur believes that $3,000,000 is worth 30% because 3,000,000 shares out of 10,000,000 = 30%


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The critical issue here is whether the agreed value of $7 million to be assigned to the company was prior to or after the investor's contribution of cash (pre-money) or post-money. Now real negotiations begin.

You both agree that the venture capitalist investment is worth 30% of the company now you must discuss the terms (control).


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The second term entrepreneurs need to understand is warrants associated with the deal. This is another item that will affect the valuation of the term sheet.

Warrants as part of a venture financing - especially in an early stage investment - tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, I always recommend the entrepreneur negotiates for a lower pre-money valuation to try to eliminate the warrants.


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Don't make the mistake of only focusing on valuation: Most term sheets will include dozens of financial and governance terms that will affect your equity stake and control of the business following the investment, and which you need to consider carefully.


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Venture capitalists care about control provisions in order to keep an eye on their investment as well as in some cases -comply with certain federal tax statutes that are a result of the types of investors that invest in venture capital funds. One of the key control mechanisms is the election of the board of directors.


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While the valuation your company receives from the investor obviously has a significant impact on the value you will get from your founder's stock in a liquidity event, it is only the start. Beyond valuation, there are other important financial terms contained in every term sheet that can have a great impact on the value of your equity down the road, which include the investor's liquidation preference, dividend rights, anti-dilution protection and redemption rights.


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Additionally, there are critical terms in every term sheet that can greatly affect how much control of the company the founders must give up following the closing, which include board provisions, and protective voting rights. Make sure you understand each term and how it can affect you and your company, and keep in mind that a favorable valuation is only one ingredient of a good term sheet.


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In a term sheet there is always a paragraph called an election paragraph that details how the board of directors will be chosen.

The entrepreneur must be quite adamant about what the proper balance should be between venture capitalists, company founders, and outside representatives.


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One example of how the board might be chosen is: two directors chosen by the founders, two directors chosen by the venture capitalist, and one chosen by mutual consent.


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How you structure the selection of the person chosen by mutual consent is very important i.e.; chosen with the consent of the board with each member having one vote, chosen based on number of shares held by founders or venture capitalists.


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Venture capitalists often ask for the right to have another member of their firm attend board meetings even if they only attend as an observer.


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In most term sheets venture capitalists will insist that one of the founders board members be the CEO of the company. One thing entrepreneurs must consider is that should the current CEO be replaced so does the board seat. That may very well change the founder’s position on the board.


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The venture capitalists insist on receiving preferred shares of the company for their investment. The founders on the other hand have common stock shares.


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Preferred stock has various "preferences" over common stock. These preferences can include liquidation preferences, dividend rights, redemption rights, conversion rights and voting rights.


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When a company raises venture capital in a preferred stock financing,it typically designates the shares of preferred stock sold in that financing with a letter. The shares sold in the first financing are usually designated "Series A", the second "Series B", the third "Series C" and so forth. Shares of the same series all have the same rights, but shares of different series can have very different rights. All series of preferred stock will, of course, be "senior" to the common stock simply by virtue of having a liquidation preference


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Preferred Shares is the most typical form of security issued in connection with a venture capital financing of an emerging growth company. This is because of the many advantages that preferred shares offer an investor - it can be converted into common shares, and it has dividend and liquidation preference over common shares.

It also has anti-dilution protection, mandatory or optional redemption schedules, and special voting rights and preferences.


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Venture capitalists will normally require your principal shareholders to become parties to a shareholders’ agreement as a condition to closing on the investment. It is not uncommon for investors to require that the shareholders’ agreement be unanimous (i.e. all shareholders execute it). Any existing shareholders’ or buy/sell agreements will also be carefully scrutinized and may need to be amended or terminated as a condition to the investment.


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The shareholders’ agreement will typically contain certain restrictions on the transfer of your company's securities, voting provisions, rights of first refusal and co-sale rights in the event of a sale of the founder's securities, anti-dilution rights, and optional redemption rights for the venture capital investors.


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For example, the investors may want to reserve a right to purchase additional shares of your preferred shares to preserve their respective equity ownership in the company in the event that you later issue another round of the preferred shares. This is often accomplished with a contractual pre-emptive right as opposed to such a right being contained in the corporate charter, which would make these rights available to all holders of the preferred shares.


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Venture capitalists will also often require key members of a management team to execute certain agreements as a condition to the investment. Normally, these agreements include: Employment Agreements; Non-disclosure and Intellectual Property Assignment Agreements; and, Share Repurchase Agreements.


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These agreements will define each employee’s obligations, the compensation package, the grounds for termination, the obligation to preserve and protect the company's intellectual property, and post-termination covenants, such as covenants not to compete or to disclose confidential information.


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Share repurchase agreements apply specifically to the company’s key founders. Essentially, they operate like a “reverse option” where the company retains the right to repurchase a declining number of your founders shares if your employment is terminated before the end of the share repurchase period.


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The term sheet will include a bunch of requirements for the entrepreneur to provide the venture capitalist regular reports on how the company’s doing.


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One of the worst terms is a ratchet requirement ·. This protects the venture capitalist that has in their $3,000,000 investment. The companies not reaching its goals, they’re out trying to raise additional financing from other venture capitalists by trying to raise a (B) round of financing and the new venture capitalists tell you that the value they place on your company is not $10,000,000 but $5,000,000.


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The ratchet term states that the dollar value of the original venture capitalist is not allowed to decrease. Now that the company is now valued at $5,000,000 their $3, 000,000 investment is now worth 60% of the company and you’re required to issue them enough shares to get them there.


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This term ratchet puts the entrepreneurs in a position where they have to totally swing for the fences and take insane risks if they’re ever going to see a penny; the notion of building a nice stable growing business and cashing out a few years later for a solid profit is just not on, because you won’t see any of it.


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Another item in the term sheet that provides venture capitalists more control is tranches. Following our example once again the venture capitalist agrees in the term sheet to invest $3,000,000. The term in the term sheet called tranches states that they are not providing the entire $3, 000,000 up front the give you $750,000 at closing, and if in six months you’ve reached certain milestones which most times are revenue related: the give you another $750,000, and they will give you the remaining $1,500,000 in six months again depending on the company achieving its revenue targets.


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Entrepreneurs hate tranches with a passion, because most successful companies have had changes in direction, which tend to make former milestones irrelevant, and if you miss a target you’ve probably been spending money to get there, so if the company misses the revenue target their back is to the wall and their going to have to renegotiate the terms just to keep their doors open and most likely at a much lower valuation.


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Always remember that venture capitalists do spend real money in getting all the contracts and other legal work completed and they don’t pay for it because you are required to pay for this out of the funds they provide. Every entrepreneur finds this very irritating as they feel the investment is to grow their business not pay the venture capitalists legal bills.


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VC's are not fans of entrepreneurs who raise capital and then turn around and give themselves $200,000 salaries. Knowledgeable entrepreneurs also usually don't do this since this is expensive, dilutive capital they have raised. They are taking significant dilution in order to gain incremental salary. If the deal is successful, every early dollar will turn into $15-25 worth of foregone equity at the exit! So, it is a bit of an IQ test from the VC's perspective. Generally, the entrepreneur passes and takes a $60-100,000 salary early on and moves this up once the company is more mature.


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As a company grows, it takes on multiple rounds of investment. This usually constitutes several "classes" of convertible preferred stock, with each designated alphabetically (Series A, Series B, etc). The founders and angel investors often have common stock which is junior to the various preferred stock series.


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Each new round usually has at least one, if not more, new investor's to price the round and set the terms independently. The new class of stock is usually senior in liquidation to the series before it. So, if Company A raises $2M of Series A, $5M of Series B and $10M of Series C, investors in Series C get their money first, Series B next and then Series A. If there is enough left over, the common gets the remaining unless it is participating preferred. This means the preferred get their money out and then participate in the remainder with common based on their % ownership in the company.


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Different classes with different rights and seniority creates a broad array of misaligned interests:

Acquisitions: If the Company gets and acquisition offer for $11M, the Series C investors might push to sell if they have lost faith in the business. They get their $10M back (and the Series B gets $1M). However, the B and Series A would not want to sell since they get little. If they have blocking rights, they will prevent the sale from occurring.


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This happens when major decisions (sale, new capital, etc) must be voted on individually by each class versus combined by everyone (pari passu) "at the same time", . In the later case, the C would be able to push through a combined vote since its $10M is greater than the $7m from the other two classes combined (assuming simple majority, etc).


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New Capital: When new rounds of capital are raised, all kinds of games can begin. If the older investors are tapped out, the recent investors are not overly excited about carrying the company for the free riders. So, they throw in a pay to play. In this situation, old investors have to invest their pro rata (% ownership of the preferred) or their preferred stock gets pushed to common.


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This means that even if you are a Series B investor, if you don't invest your full amount, your Series B stock converts to common and falls behind the remaining Series A, B and C stock. This is particularly nasty if there has been a lot of money raised. Let's say there is $20M in each of the classes and you are a Series C investor. Before the new financing, you needed a $20M exit to get your money back (C comes out first and was $20m in total).


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If new money comes in (say $10m) and you don't invest your pro rata, you get pushed to common and now need a $70m (minus your investment) exit just to get your first dollar out (A,B &C are $20m each and the new D is $10m). You then participate with everyone based on your % owned in the company. If you invested $10m and own 20%, then you would get your full money back $50M later. So, before, you needed a $20m exit to get all of your capital out and after the Series D came in, you need a $120M exit ($70m in preference ahead of you and $50m for ownership).


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It is for these reasons, that investors like to have blocking rights on sales and financings. This means that they own enough of a Series (or they and "aligned co-investors") that the Company needs their approval to sell or raise. This prevents a pay-to-play from being crammed down on them.


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The name of the game for VC's is called "exits". An "exit" happens when a VC sells its ownership in a portfolio company. Venture is really a simple business. You make money by "exiting" a company (either because the company gets sold or it has an IPO and the shares can be sold) at a price higher than what you paid. That's the bottom line.


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Today Entrepreneurs are selling less of their companies to venture investors in a strong market for promising start-ups, according to the latest Dow Jones Venture Capital Deal Terms Report


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The median share of companies sold to investors in first rounds has declined to 38% from 50% two years ago. Company-unfriendly provisions that gained notoriety after the tech bubble burst remained relatively rare, affecting mostly companies whose business had faltered.


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Three quarters of U.S. companies closing second rounds, which are a strong indicator of the state of the venture industry, said their valuations increased. And 80% of U.S. companies said they received a term sheet from at least one potential new investor, indicating healthy interest from company outsiders.


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In most U.S. deals, investors settled for liquidation preferences equal to the amount they invested. Only 20% of companies reported a preference higher than 1x and most of those said it was 2x or less. Company-unfriendly full-ratchet dilution protection appeared in 16% of financings surveyed, most often in financings where the company's valuation fell from its prior round.


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Pay-to-pay provisions, aimed at keeping investment syndicates on the same page if a company runs into trouble, are becoming less common. Only 21% of U.S. respondents said their term sheet included this clause, down from a high of 37% in the survey covering April 2003 through March 2004. Under this provision, investors who fail to participate in a subsequent round in which the company's valuation falls, can have their preferred shares converted to common stock or stripped of certain rights.


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The market also found that founders and prior investors usually did not sell shares to investors in the latest round, despite a longer wait for liquidity. But with more founders bootstrapping companies before seeking an initial venture financing, the rate was highest in first rounds with 16% of those deals affording founders the opportunity to sell some stock.


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This tale of turmoil is both true and surprisingly common. The early stages of a venture company are not unlike the heady, exciting days of a new romance. The founder of a company, passionate about an idea, consumed with making it happen, meets a VC who is interested in investing. Their discussion focuses on the CEO’s strengths, accomplishments, and dreams for the future. The founder envisions a perfect marriage in which his or her sweat equity, technical expertise, and/or market knowledge are valued by the VCs, as evidenced by a large dollar investment and generous compensation. The deal is done, the VCs join the board, and the founder assures the management team that the board is fully aligned with the CEO’s vision for the company


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Well now that we have defined term sheets lets look at the itemsyou as lawyers should be concerned about representing your clients best interests during these negotiations.


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Understanding the Legal Documents you as Lawyers are responsible for:

The actual executed legal documents described in the term sheet must reflect the end result of the negotiation process between you and the venture capitalist. These documents contain all of the legal rights and obligations of the parties, and they generally include:

Share Purchase Agreement ("Subscription Agreement"); Shareholders Agreement;

Employment and Confidentiality Agreements and Intellectual Property


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Assignments, and Share Repurchase Agreements;

Warrant (where applicable), Debenture or Notes (where applicable); Preferred Share Resolution (to amend the corporate charter) (where applicable); and,

Contingent Proxy, Legal Opinion of Company Counsel and a Registration Rights Agreement.

what entrepreneurs need to know about term sheets

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