Understanding VC Term Sheets
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Understanding VC Term Sheets

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Presentation to TiE Challenge on January 9, 2012. Discussion of VC term sheets, including Series A, Convertible Notes

Presentation to TiE Challenge on January 9, 2012. Discussion of VC term sheets, including Series A, Convertible Notes

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    Understanding VC Term Sheets Understanding VC Term Sheets Presentation Transcript

    • Understanding VC Term Sheets Presentation to TiE Challenge January 9, 2013 Mark A. Haddad Partner 617-832-1724 mhaddad@foleyhoag.com© 2013 Foley Hoag LLP. All Rights Reserved.
    • These materials have been prepared solely for educational purposes. The presentation of these materials does not establish any form of attorney-client relationship with the author or Foley Hoag LLP. Specific legal issues should be addressed through consultation with your own counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. © Foley Hoag LLP 2013. United States Treasury Regulations require us to disclose the following: Any tax advice included in this document and its attachments was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 2
    • What is a term sheet? aka- “Letter of Intent,” “Memorandum of Understanding,” “Agreement in Principle” Basic agreement on the material terms of the transaction –Road map, marching orders More detail is generally better (especially for the company) Legally binding? For the most part, no, but….. If you really want to mess up your transaction, this is the place to do it© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 3
    • Non Binding A term sheet is not a binding agreement to fund – Subject to actual documents – Subject to due diligence – Subject to other closing conditions (legal opinion, etc.) Confidentiality – Term sheets typically have a binding confidentiality provision prohibiting disclosure of the terms and the existence of the term sheet Exclusivity – Term sheets typically give the investor some period of exclusivity (30 to 60 days)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 4
    • Types of Early Stage Financing Deals Seed Financing: –Convertible Notes –“Series Seed” or “Series AA” (i.e. Series A light) Series A Series B and later rounds© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 5
    • Series A Takes the form of “Convertible Preferred Stock” with lots of contractual protections and benefits Control issues: – Voting control, board seats, veto powers, forced sale – “CEO” and the three envelopes Economic issues: – Make sure you understand how the economics work and are not comparing apples to oranges© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 6
    • Convertible Preferred Stock Why Convertible Preferred Stock? –“Preferred” - Preference over common stock on dividends, distributions, liquidation, redemption –“Convertible” - All of the upside of common stock© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 7
    • Pre-Money Valuation “Pre-Money Valuation” is the value given to the company before the transaction. It allows for the calculation of the share price, which is equal to the pre-money valuation divided by the number of shares “outstanding” before the transaction: Share Price = Pre-money Valuation / Pre-money Shares Outstanding Critical Issue –What shares are being counted in the “Shares Outstanding” number? (All outstanding options? Options reserved under the option pool? What is the size of the option pool?). The higher the number of shares deemed “outstanding,” the higher the number of shares (and “actual” percentage of the company) that the investors receive for the same dollar amount of investment.© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 8
    • Post-Money Valuation Post-money valuation is the sum of the pre-money valuation plus the amount invested.© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 9
    • Math Geek Part 1 Offer 1: Pre-Money Value of $10 million, $5 million investment, 10% Post-Money Option Pool Offer 2: Pre-Money Value of $11 million, $5 million investment, 20% Post-Money Option Pool Which is the better offer?© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 10
    • Math Geek Part 1 Answer Offer 1, even though it’s a lower “pre-money valuation.” It values the outstanding common stock higher because it includes a smaller post- money option pool. Here’s the math: Offer 1 Values: O/S % FD % – Preferred Stock $ 5,000,000 37% 33% – Option Pool 1,500,000 NA 10% – Common Stock 8,500,000 63% 57% – Total Post-money $15,000,000 Offer 2 Values: – Preferred Stock $ 5,000,000 39% 31% – Option Pool 3,200,000 NA 20% – Common Stock 7,800,000 61% 49% – Total Post-money $16,000,000© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 11
    • CAUTION! Valuation is only one of many economic terms. As the saying goes, a VC will gladly let you pick the valuation if they get to pick all the other terms. You can construct the other economics in many ways, the easiest of which is the liquidation preference…© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 12
    • Liquidation Preference Liquidation preference = the right of the holders of preferred stock to get their money back (and perhaps more) before the common stock when a “liquidation event” occurs (generally, an M&A transaction). Sometimes “multiples” are used (1x, 2x, 3x). Sometimes accruing dividends are included (essentially like adding an interest rate component to the preference– range of 4% to 9% in Q3). “Preference overhang” refers to the total amount of liquidation proceeds that go to the holders of preferred stock before the holders of the common stock begin to share in the liquidation proceeds. Three main flavors: – No participation – Participating preferred (aka “Piggy Preferred”) – Capped participation© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 13
    • Math Geek Part 2 Assume we took Offer 1 ($10m pre and $15m post) and a year later we sold the company for $30 million (with the option pool fully issued/vested for simplicity). Here are how different preferences and participation rights would play out: 1x preference, no participation: – Preferred Stock: $10 million (33% of proceeds) – Common Stock: $20 million 1x preference, full participation: – Preferred Stock: $13.3 million (44% of proceeds) – Common Stock: $17.7 million 1x preference, participation capped at 2x: – Preferred Stock: $10 million (33% of proceeds) – Common Stock: $20 million 1x preference, participation capped at 3x: – Preferred Stock: $13.3 million (44% of proceeds) – Common Stock: $17.7 million 3x preference, full participation: – Preferred Stock: $20 million (67% of proceeds) – Common Stock: $10 million© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 14
    • Math Geek Part 2 Now assume it was only one week later and for $15 million: 1x preference, no participation: – Preferred Stock: $5 million (33% of proceeds) – Common Stock: $10 million 1x preference, full participation: – Preferred Stock: $8.3 million (55% of proceeds) – Common Stock: $7.7 million 1x preference, participation capped at 2x: – Preferred Stock: $8.3 million (55% of proceeds) – Common Stock: $7.7 million 1x preference, participation capped at 3x: – Preferred Stock: $8.3 million (55% of proceeds) – Common Stock: $7.7 million 3x preference, full participation: – Preferred Stock: $15 million (100% of proceeds) – Common Stock: $0© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 15
    • Math Geek Part 2 Source: www.wikipedia.org© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 16
    • Liquidation Preference- Take Aways Having a preference is standard, but focus on trying to minimize participation and accruing dividends. Understand how the preferences interplay so that everyone’s incentives are aligned. It can get very complicated when multiple rounds are stacked up. In some cases you can have flat spots or even drastic jumps that create divergent incentives. The early rounds set a precedent for later rounds, so early investors that are too greedy on terms may live to regret it (use this argument to your advantage in negotiating favorable terms in the early rounds). Sometimes preference can be used to bridge a valuation gap, but again, worry about the precedent in that case. Generally not applicable in IPO© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 17
    • Uncommon but BIG Traps Dividends paid in equity –Example: Series A priced at $1 per share. 8% accruing dividend, can convert to common at $1 per share. Liquidation preference that converts into equity –Example: Upon conversion, in addition to the preferred stock converting to equity (initially one for one) the liquidation preference is paid out in the form of common stock at current fair market value. In the upside scenario this is simply extra juice in an IPO (that the VC would have gotten in a sale at the same value) but in a downside this is essentially full ratchet antidilution and then some.© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 18
    • Antidilution Protection Addresses Investors’ concern re: valuation Changes the conversion price used to calculate the number of shares of common stock issued when a share of preferred stock converts Helps protect investors in the case of a “down round,” when new money comes in at a total pre-money valuation (or price per share) that is lower than the previous round’s post-money valuation. Two main flavors: – Full ratchet – Weighted average (broad-based and narrow based)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 19
    • Weighted Average Weighted average anti-dilution adjustment takes into account the proportional relevance (or weight) of each component in the calculation rather than treating each component similarly. In a down round, the conversion price of the Series A is lowered to a price that is an average of the price at which the company sold the new stock, valuing the common stock outstanding at the pre- adjusted conversion price. Sometimes formulated as “broad-based” and sometimes as “narrowly-based.” (“narrowly-based” is more favorable to the protected preferred stock.) More common than full ratchet, and much less onerous to un- protected stockholders. Formula: New price= (P1)(Q1) + (P2)(Q2) (Q1) + (Q2)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 20
    • Full Ratchet The conversion ratio of the protected preferred stock is “ratcheted down” to the lowest price at which securities are sold in the down-round (where stock is sold at a price lower than the earlier protected round). This applies even if only one share is sold. It treats all subsequent down-round stock issuances similarly, resulting in an adjustment to the conversion ratio regardless of the number of shares issued. Very onerous, and increasingly less common (although makes a comeback at times, like in 2008-2009 decline).© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 21
    • Math Geek Part 3 Assume again Offer 1 is closed on ($10m pre and $15m post). Subsequently, the company has to raise an additional $2.5 million in a Series B at a $7.5 million pre- money valuation (a 50% decline from the $15 million post-money). If the Series A had no antidilution, the resulting cap table would be: – Series B: 25% ($2.5 million) – Series A: 25% ($2.5 million) – Common: 50% ($5.0 million) If the Series A had “full ratchet” antidilution, the resulting cap table would be: – Series B: 25% ($2.5 million) – Series A: 50% ($5 million) – Common: 25% ($2.5 million) If the Series A had “weighted average” antidilution, the resulting cap table would be: – Series B: 25% ($2.5 million) – Series A: 27.5% ($2.75 million) – Common: 47.5% ($4.75 million)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 22
    • Math Geek Part 3 Weighted Average Math:New price= (P1)(Q1) + (P2)(Q2) (Q1) + (Q2)= ($1)(15,000,000) + ($0.475)(5,263,158) (15,000,000) + (5,263,158)= $0.86363…Fully diluted A = (5,000,000)/($0.86363…) = 5,789,474Common: 10,000,000 42.5%Series A: 5,789,474 27.5%Series B: 5,263,158 25%Total: 21,052,632 100%© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 23
    • Board Seats Usually investors require one or more board seats Challenge: What is the proper balance between founders, investors (both existing and new), and outside directors? Keep board size manageable – bigger is not always better Sometimes a “board observer” rather than board seat Think carefully about “CEO board seat” and consider “Founder board seats”© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 24
    • Protective Provisions aka “Negative covenants,” “Veto rights” or “blocking rights” Essentially a list of things you can’t do without investors’ prior consent - Consent at either the Board or Stockholder level Usually hotly negotiated This is a foot on the break, not on the accelerator Gets complicated in later rounds; interests of investors can diverge The relevant thresholds are very important depending on the dynamics of your investor base© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 25
    • Other Key Terms Co-sale (“tag along”) rights – Ability to sell along side founders/management (and sometimes also other investors) Right of first refusal – Ability to purchase shares for sale by founders/management (and sometimes also other investors) Founder vesting – Will often get renegotiated. Focus on what is vested up front and what happens on change of control. Drag along rights – Ability to force all stockholders to go along with a sale that meets certain conditions. Focus on appropriate thresholds for founders/common stock.© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 26
    • Other Key Terms (cont’d) Pre-emptive rights – Right to participate in future financings – Make sure it is based on fully diluted ownership, not % of preferred Pay to Play – Ability for investors to force each other to invest in future rounds. Information rights – Make sure appropriate restrictions on use and not sent to competitors Registration rights (IPO) – Standard and not worth negotiating as long as reasonable© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 27
    • Series B and later Series B and later will usually piggy back off of the Series A terms – Realize you will have to live with the Series A, generally terms can only get worse, not better – Further dilution and control issues Growth equity – Could be similar terms or could be opportunity to recap and cash out prior investors (and some portion of founder equity) IPO – The big homerun, but liquidity for the founders is still not necessarily immediate© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 28
    • What is a Convertible Note First and foremost, it is debt, so it sits above any equity (stock) in the capital stack However, it also has an equity feature in that it converts upon specified events into stock of the company The most common conversion is upon a “qualified financing” (generally an equity financing of a certain size), but notes can also provide for conversion on other events© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 29
    • Key Features Conversion rate: – Fixed discount or increasing discount over time – Can have caps and collars (maximum and/or minimum conversion price) – If using caps, try to set a fixed price based on today’s cap table Automatic conversion on qualified financing – e.g. upon an equity financing of $1m Optional conversion (sometimes included) – By investor to common at cap price or other negotiated price – By company to common at floor price or other negotiated price upon maturity Interest – Converts along with principal – Interest rate is generally modest (for example, 5%), unless that is being used with a smaller discount© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 30
    • Example $100k convertible note, 5% interest, 25% discount upon qualified financing Company raises qualifying Series A at $1.00 per share one year after issuing the note Note converts into shares of Series A: –Principal + interest = $105k –Note converts at 25% discount, so at a price of $0.75 per share –$105k / $0.75 = 140,000 shares of Series A (instead of 100,000 shares that a “new money” $100k investment would purchase)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 31
    • Key Features (cont’d) Payment on acquisition: – Can be based on the discount, can convert at pre-determined price or can be a formula (e.g. 2x return) Maturity date – Later the better – Give yourself enough runway to get to the next milestone and have at least a 6 month cushion beyond that Collateral (secured or not) Amendment of notes – Use a single note purchase agreement that lets a majority of the principal amount of all notes amend the terms© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 32
    • When to use Convertible Notes In most cases, will be simpler, faster and cheaper than doing a preferred stock financing, but not always Generally speaking – $500k or less, use convertible notes – $1m or more, use preferred stock (even if “seed preferred”) – But there are exceptions to both of these Consider your future financing needs: – If you may never need to raise more money, do a stock deal or build in an automatic (or optional) conversion of the notes at maturity Consider if you are able to value the stock: – Often convertible notes are a way to treat friends and family money fairly by deferring a valuation until “sophisticated investors” can negotiate with the company© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 33
    • Company Pros and Cons Faster and cheaper to execute More control over your company (notes do not vote, and generally you don’t give board seats or significant protective provisions to note holders) Delays dilution until you can increase the valuation Risk of getting to maturity date without resources to repay or a “plan B” Quickly “insolvent” on paper as the money is spent (although this helps with valuation position with respect to employee options and equity)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 34
    • Investor Pros and Cons Faster and cheaper to execute Discount can be small compared to the relative risk of the investment (misalignment of interests) – Valuation is too high in “homeruns” (can be mitigated by the use of caps) Having “debt” in an insolvent entity is not much protection Less control over the investment (delaying typical investor protections until conversion, but can negotiate for some, like pre-emptive rights or info rights) Capital gains treatment does not start until conversion happens© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 35
    • Seed Preferred Alternative Increasingly, a number of “Series A Lite” or “Seed Preferred” deals are being done as an alternative to convertible notes Provides for equity without all of the usual bells and whistles of a full Series A deal Usually has at least a liquidation preference and pre-emptive rights, but may not have many more investor protections than that A few sets of standardized documents that are open source and available for use to keep transaction costs down: – Series Seed (seriesseed.com) – YCombinator (ycombinator.com/seriesaa.html) – TechStars (techstars.com/docs)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 36
    • What is Market? (Series A)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 37
    • What is Market? (B and later)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 38
    • Final Thoughts Generate scarcity and interest: – best terms will come from competition – try to land multiple term sheets in a short window to increase your leverage and options Choose your investors wisely: – like a marriage, you will be with them for a long time – think about how it positions you for the next round, including issues like signaling and available dry powder – all money is not created equal – do reference checks on your investors with others they have funded© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 39
    • Final Thoughts (cont’d) Choose your fights wisely: – make sure you know what really matters to you, and understand the market dynamics. – don’t be afraid to ask “why do you need that?” Choose your legal advisors wisely. This stuff gets complicated fast. And do it early (before negotiating the term sheet!)© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 40
    • Other Resources Foley Hoag Venture Perspectives (our quarterly publication tracking terms of New England VC deals) NVCA Model Venture Capital Financing Documents (including model term sheet): –www.nvca.org (click “Resources” then “Model Legal Documents”) or use http://bit.ly/bj7Pn –Forms are intended as starting point only© 2013 Foley Hoag LLP. All Rights Reserved. Understanding VC Term Sheets | 41
    • Questions? Mark A. Haddad Partner 617-832-1724 mhaddad@foleyhoag.com© 2013 Foley Hoag LLP. All Rights Reserved.