• Share
  • Email
  • Embed
  • Like
  • Save
  • Private Content
OTAF Term Sheet Nuances July 2011
 

OTAF Term Sheet Nuances July 2011

on

  • 838 views

 

Statistics

Views

Total Views
838
Views on SlideShare
838
Embed Views
0

Actions

Likes
1
Downloads
26
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

    OTAF Term Sheet Nuances July 2011 OTAF Term Sheet Nuances July 2011 Document Transcript

    • 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
    • Term Sheet Tutorial 2 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
    • Term Sheet Tutorial 3 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
    • Term Sheet Tutorial 4 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 Tutorial 5 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 -
    • Term Sheet Tutorial 6 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.
    • Term Sheet Tutorial 7 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 Tutorial 8 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 Tutorial 9 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 Tutorial 10 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
    • Term Sheet Tutorial 11 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.”
    • Term Sheet Tutorial 12 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.
    • Term Sheet Tutorial 13 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,
    • Term Sheet Tutorial 14 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 Tutorial 15 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."
    • Term Sheet Tutorial 16 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 Tutorial 17 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: 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. 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: 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. 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
    • Term Sheet Tutorial 18 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
    • Term Sheet Tutorial 19 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. 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. 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. 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). 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.
    • Term Sheet Tutorial 20 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. 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. 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. 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 $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. 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. 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.
    • Term Sheet Tutorial 21 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. Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and 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. Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect 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.
    • Term Sheet Tutorial 22 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.
    • Term Sheet Tutorial 23 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 Tutorial 24 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:
    • Term Sheet Tutorial 25 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 Tutorial 26 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: 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 [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: 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 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: 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, 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: 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, 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
    • Term Sheet Tutorial 27 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
    • Term Sheet Tutorial 28 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."
    • Term Sheet Tutorial 29 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.
    • Term Sheet Tutorial 30 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 Tutorial 31 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.
    • Term Sheet Tutorial 32 "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 Tutorial 33 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: The holders of the Series [A] Preferred shall be entitled to receive 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: The holders of the Series [A] Preferred shall be entitled to receive 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 Tutorial 34 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
    • Term Sheet Tutorial 35 when declared by the board dividend is benign, rarely declared, and an artifact of the past, so we typically leave it in term sheets just to give the lawyers something to do. TERM SHEET: PAY-TO-PLAY Term Sheet: Pay-to-Play by Feld Thought "Pay-to-Play: In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated above under "Right of First Refusal" below will be converted into Common Stock. [(Version 2, which is not quite as aggressive): If any holder of Series A Preferred Stock fails to participate in the next Qualified Financing, (as defined below), on a pro rata basis (according to its total equity ownership immediately before such financing) of their Series A Preferred investment, then such holder will have the Series A Preferred Stock it owns converted into Common Stock of the Company. If such holder participates in the next Qualified Financing but not to the full extent of its pro rata share, then only a percentage of its Series A Preferred Stock will be converted into Common Stock (under the same terms as in the preceding sentence), with such percentage being equal to the percent of its pro rata contribution that it failed to contribute.] A Qualified Financing is the next round of financing after the Series A financing by the Company that is approved by the Board of Directors who determine in good faith that such portion must be purchased pro rata among the stockholders of the Company subject to this provision. Such determination will be made regardless of whether the price is higher or lower than any series of Preferred Stock. When determining the number of shares held by an Investor or whether this "Pay-to-Play" provision has been satisfied, all shares held by or purchased in the Qualified Financing by affiliated investment funds shall be aggregated. An Investor shall be entitled to assign its rights to participate in this financing and future financings to its affiliated funds and to investors in the Investor and/or its affiliated funds, including funds which are not current stockholders of the Company." We believe this is good for the company and its investors as it causes the investors "stand up" and agree to support the company during its lifecycle at the time of the investment. If they do not, the stock they have is converted from preferred to common and they lose the rights associated with the preferred stock. When our co-investors push back on this term, we ask: "Why? Are you not going to fund the company in the future if other investors agree to?" Remember, this is not a lifetime guarantee of investment, rather if other prior investors decide to invest in future rounds in the company, there will be a strong incentive for all of the prior investors to invest or subject themselves to total or partial conversion of their holdings to common stock. A pay-to-play term insures that all the investors agree in advance to the "rules of engagement" concerning participating in future financings. The pay-to-play provision impacts the economics of the deal by reducing liquidation preferences for the non-participating investors. It also impacts the control of the deal, as it reshuffles the future preferred shareholder base by insuring only the committed investors continue to have preferred stock (and the corresponding rights). When companies are doing well, the pay-to-play provision is often waived, as a new investor wants to take a large part of the new round. This is a good problem for a company to have, as it typically means there is an up-round financing, existing investors can help drive company-friendly terms in the new round, and the investor syndicate increases in strength by virtue of new capital (and – presumably – another helpful co-investor) in the deal.
    • Term Sheet Tutorial 36 Always think about the penalty for not paying (i.e. participating in a round). It can range from merely losing your pre-emptive Rights to being forcibly converted to common and silenced. Also: always see what impact it has on the Anti-dilution rights. Often if you don’t Pay you lose your Anti-dilution protection.
    • Term Sheet Tutorial 37 TERM SHEET: ANTI-DILUTION Anti-dilution Provisions Investor Favorable: The conversion price of the Series [A] Preferred will be subject to a full ratchet adjustment in the event that the Company issues additional equity securities (other than the reserved employee shares described under "Employee Pool") at a purchase price less than the applicable conversion price. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, recapitalizations, and the like. Middle of the Road: The conversion price of the Series [A] Preferred will be then subject to a weighted average adjustment (based on all outstanding shares of Preferred and Common Stock) to reduce dilution in the event that the Company issues additional equity securities (other than the reserved employee shares described under "Employee Pool") at a purchase price less than the applicable conversion price. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, recapitalizations, and the like. This anti-dilution protection is subject to a play-or-lose provision that provides that adjustments will be made to the Series [A] Conversion Price only if the Series [A] holder participates in such dilutive offering to the extent of its pro rata equity interest in the Preferred. Any investor who does not participate in a future financing forfeits the benefits of dilution protection [for all future rounds of financing/only for that financing round]. Company Favorable: The conversion price of the Series [A] Preferred will be subject to proportional adjustment for stock splits, stock dividends, recapitalizations, and the like. Dilution? By Frank Demmler Anti-dilution protection. Everyone has heard that phrase. Most people think they know what it means. Many first-time entrepreneurs don’t. That can lead to huge mistakes. One of the problems is that “dilution” has several meanings when it comes to doing a deal. Percentage-Based Dilution If you own 60% of the equity of your company before an investment and 30% afterward, that’s dilution. If an investor owns 40% of your company before a round of investment and 20% afterward, that’s dilution. BUT that’s NOT the kind of dilution that anti-dilution protection applies to. Share Price Dilution Let’s talk about the kind of dilution that investors do seek protection against. If an investor buys shares of stock in your business at $1.00 per share and the next round of investment is at $0.50 per share, now that’s dilution. Getting Back to Basics Let’s go back to some of the first things we talked about in this series of articles.  ·  · The value of a company is only known at the instant of a transaction when cash is being exchanged for equity. Deals are negotiated with percentages, but are structured with shares.
    • Term Sheet Tutorial 38  · The value of a company is determined by multiplying the total number of common shares by the most recent share price.  · Pre-Financing Value + Investment = Post-Financing Value.  · Pre-Financing Value = Post-Financing Value – Investment.  · Price per share = Amount of investment divided by the number of shares purchased. That’s all pretty dry and boring gobblygook, unless it’s your company and you’re doing the deal. The First Round Let’s translate some of this into an example.  ·  · Since you own all 600,000 shares of your company, I am offering to buy 400,000 new shares in order to acquire 40%.  · My investment of $400,000 divided by 400,000 shares that I’m buying yields a per share price of $1.00.  · Since you own 600,000 shares, that means the value of the stake in your company is $600,000, which is the pre-financing value.  ·  · That is confirmed by taking the total number of outstanding shares, 1,000,000 (your 600,000 and my 400,000) and multiplying that by the share price of $1.00.  · I offer to invest $400,000 in your company in exchange for 40% of it. Adding my $400,000 to that yields a post-financing value of $1,000,000. That also says that the post-financing value of your company is $1,000,000. Everything is in balance. The world is good. The Good Second Round: Share Price Increase As time progresses, you and your company forge ahead. It’s time to raise some more money. Fortunately for you, you are in a business that venture capital investors are interested in. Several of them are looking at you, and after a while you negotiate a deal with one of them.  · The new investor offers to invest $2,000,000 for 50% of your company.  · If 50% of the company is worth $2,000,000, then the total company must be worth $4,000,000.  · Since there are 1,000,000 shares outstanding today and they will represent 50% of the company after the financing, then the new investor is buying 1,000,000 shares.  ·  · Since I paid $1.00 per share, I’m happy. In fact, the 400,000 shares that I paid $400,000 for are now worth $800,000 (400,000 shares X $2.00 per share). The $2,000,000 investment divided by 1,000,000 shares yields a share price of $2.00.
    • Term Sheet Tutorial 39  ·  · Even though the percent of the company I own has decreased (been diluted) from 40% to 20%, I’m happy.  · By the same reasoning, your equity stake is now worth $1.2 million, and you’ve got $2,000,000 of investor’s money to pursue your dream! The value of my investment has appreciated (grown in value). Everything is in balance. The world is good. The Not-So-Good Second Round: Share Price Decrease Alternatively, as time progresses, you and your company move forward. It’s time to raise some more money. Unfortunately for you, you are in a business that venture capital investors shun. Only one expresses lukewarm interest. Finally, you extract a deal.  ·  · If 50% of the company is worth $500,000, then the total company must be worth $1,000,000.  · Since there are 1,000,000 shares outstanding today and they will represent 50% of the company after the financing, then the new investor is buying 1,000,000 shares.  ·  · Since I paid $1.00 per share, I’m not happy. In fact, the 400,000 shares that I paid $400,000 for are now worth $200,000 (400,000 shares X $0.50 per share).  ·  · In addition, the percent of the company I own has decreased (been diluted) from 40% to 20%.  · By the same reasoning, your equity stake is now only worth $300,000, and you’ve only got $500,000 of investor’s money to keep your business alive. The new investor offers to invest $500,000 for 50% of your company. The $500,000 investment divided by 1,000,000 shares yields a share price of $0.50. The value of my investment has been diluted.
    • Term Sheet Tutorial 40 Everything is in balance. The world is not so good. I want some protection against this form of dilution. Recap Dilution has several meanings in deal making. It is critical to understand the context. An investor is most concerned about the value of his investment. If a proposed transaction will reduce the value of the investor’s investment (a lower price per share than he paid), he will seek anti-dilution protection. Term Sheet : Anti-Dilution by Feld Thoughts Traditionally, the anti-dilution provision is used to protect investors in the event a company issues equity at a lower valuation then in previous financing rounds. There are two varieties: weighted average anti-dilution and ratchet based anti-dilution. Standard language is as follows: Anti-dilution Provisions: The conversion price of the Series A Preferred will be subject to a [full ratchet / broad-based / narrow-based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities (other than shares (i) reserved as employee shares described under the Company’s option pool,, (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 anti-dilution rights) at a purchase price less than the applicable conversion price. In the event of an issuance of stock involving tranches or other multiple closings, the antidilution adjustment shall be calculated as if all stock was issued at the first closing. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, combinations, recapitalizations and the like. Full ratchet means that if the company issues shares at a price lower than the Series A, then the Series A price is effectively reduced to the price of the new issuance. One can get creative and do "partial ratchets" (such as "half ratchets" or "two-thirds ratchets") which are a less harsh, but rarely seen. While full ratchets came into vogue in the 2001 – 2003 time frame when down-rounds were all the rage, the most common anti-dilution provision is based on the weighted average concept, which takes into account the magnitude of the lower-priced issuance, not just the actual valuation. In a "full ratchet world" if the company sold one share of its stock to someone for a price lower than the Series A, all of the Series A stock would be repriced to the issuance price. In a "weighted average world," the number of shares issued at the reduced price are considered in the repricing of the Series A. Mathematically (and this is where the lawyers get to show off their math skills – although you’ll notice there are no exponents or summation signs anywhere) it works like this (note that despite the fact one is buying preferred stock, the calculations are always done in as-if-converted to common stock basis): NCP = OCP * ((CSO + CSP) / (CSO + CSAP)) Where:    NCP = new conversion price OCP = old conversion price CSO = common stock outstanding
    • Term Sheet Tutorial 41   CSP = common stock purchasable with consideration received by company (i.e. "what the buyer should have bought if it hadn’t been a ‘down round’ issuance") CSAP = common stock actually purchased in subsequent issuance (i.e., "what the buyer actually bought") Recognize that we are determining a "new conversion price" for the Series A Preferred . We are not actually issuing more shares (you can do it this way, but it’s a silly and unnecessarily complicated approach that merely increases the amount the lawyers can bill the company for the financing). Consequently, "anti-dilution provisions" generate a "conversion price adjustment" and the phrases are often used interchangeably. Got it? I find it’s best to leave the math to the lawyers. You might note the term "broad-based" in describing weighted average anti-dilution. What makes the provision a broad-based versus narrow-based is the definition of "common stock outstanding" (CSO). A broad-based weighted average provision includes both the company’s common stock outstanding (including all common stock issuable upon conversion of its preferred stock) as well as the number of shares of common stock which could be obtained by converting all other options, rights, and securities (including employee options). A narrow-based provision will not include these other convertible securities and limit the calculation to only currently outstanding securities. The number of shares and how you count them matter – make sure you are agreeing on the same definition (you’ll often find different lawyers arguing over what to include or not include in the definitions – again – this is another common legal fee inflation technique). In our example language, we’ve included a section which is generally referred to as "anti-dilution carve outs" (the section (other than shares (i) … (iv)). These are the standard exceptions for share granted at lower prices for which anti-dilution does not kick in. Obviously - from a company (and entrepreneur) perspective - more exceptions are better – and most investors will accept these carveouts without much argument. One particular item to note is the last carve out: (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their anti-dilution rights. This is a carve out that started appearing recently which we have found to be very helpful in deals where a majority of the Series A investors agree to further fund a company in a follow-on financing, but the price will be lower than the original Series A. In this example, several minority investors signaled they were not planning to invest in the new round, as they would have preferred to "sit back" and increase their ownership stake via the anti-dilution provision. Having the larger investors (the majority of the class) "step up" and vote to carve the financing out of the anti-dilution terms was a huge bonus for the company common holders and employees who would have suffered the dilution of additional anti-dilution from investors who were not continuing to participate in financing the company. This approach encourages the minority investors to participate in the round in order to protect themselves from dilution. Occasionally, anti-dilution will be absent in a Series A term sheet. Investors love precedent (e.g. the new investor says "I want what the last guy got, plus more"). In many cases anti-dilution provisions hurt Series A investors more than prior investors if you assume the Series A price is the low watermark for the company. For instance, if the Series A price is $1.00, the Series B price is $5.00, and the Series C price is $3.00, then the Series B is benefited by an anti-dilution provision at the expense of the Series A. However, our experience is that anti-dilution is usually requested despite this as Series B investors will most likely always ask for it and – since they do – the Series A proactively asks for it anyway.
    • Term Sheet Tutorial 42 In addition to economic impacts, anti-dilution provisions can have control impacts. First, the existence of an anti-dilution provision incents the company to issue new rounds of stock at higher valuations because of the ramifications of anti-dilution protection to the common stock holders. In some cases, a company may pass on taking an additional investment at a lower valuation (although practically speaking, this only happens when a company has other alternatives to the financing). Second, a recent phenomenon is to tie anti-dilution calculations to milestones the investors have set for the company resulting in a conversion price adjustment in the case that the company does not meet certain revenue, product development or other business milestones. In this situation, the antidilution adjustments occur automatically if the company does not meet in its objectives, unless this is waived by the investor after the fact. This creates a powerful incentive for the company to accomplish its investor-determined goals. We tend to avoid this approach, as blindly hitting predetermined (at the time of financing) product and sales milestones is not always best for the longterm development of a company, especially if these goals end up creating a diverging set of goals between management and the investors as the business evolves. Anti-dilution provisions are almost always part of a financing, so understanding the nuances and knowing which aspects to negotiate is an important part of the entrepreneur’s toolkit. We advise you not to get hung up in trying to eliminate anti-dilution provisions – rather focus on (a) minimizing their impact and (b) building value in your company after the financing so they don’t ever come into play. (Source?) Consider this: Isn’t a Full Ratchet essentially, therefore, just a “Price Guarantee” while the Weighted Average Anti-Dilution protection is essentially just “Price Protection?” Practical Implications of Anti-Dilution Protection Getting real In recent articles we’ve looked at anti-dilution protection. Recapping:  · An investor in any given round of financing is concerned that the next round could be at a lower price per share than what he is paying this round.  ·  · There are two common types of anti-dilution protection: full ratchet and weighted average. The investor will insist upon anti-dilution protection. We’ve covered the mechanics of anti-dilution protection. Now let’s look at what it really means.
    • Term Sheet Tutorial 43 The Starting Position First we will review the example transactions. I agreed to invest $400,000 for 40% of your company’s equity. The results of this investment are shown in the following table. The Down Round It’s time to raise some more money. Unfortunately, the only investment offer you are able to attract is at a lower valuation than the prior round.  ·  · If 50% of the company is worth $500,000, then the pre-financing value of the company is $500,000.  · The $500,000 of pre-financing value is divided among you, my anti-dilution protection, and me. The new investor offers to invest $500,000 for 50% of your company. Let’s look at how this would play out with the two different types of protection. Full Ratchet Anti-Dilution Protection As a practical matter, full ratchet anti-dilution protection gives the original investor rights to that number of shares of common stock as if I paid the current round’s lower price. The share price must meet the conditions that the new investor gets 50% of the equity and I get my full ratchet antidilution protection. Instead of $0.50 per share as might be inferred from the investment offer, the actual share price is $0.1667. Weighted Average Anti-Dilution Protection Weighted average anti-dilution protection gives consideration to the relationship between the total shares outstanding as compared to the shares held by the original investor. The formula is CP 2 = CP1 * (A+B) / (A+C). These variables were defined in the prior article.
    • Term Sheet Tutorial 44 What Causes a Down Round? Very simply, a down round happens when you accept an investment at a price per share lower than that paid in a prior round. Notice that the emphasis is on “you accept…” Anyone can offer anything. It only matters if you accept the offer. Why would you accept such a deal? Most likely because you need the money and you don’t have any alternatives. How could you find yourself in this position? Some possible reasons include:  · You didn’t make your sales plan  · You didn’t complete your product  · Your current investors can’t invest any more money in your company  · Your current investors could invest more money in your company, but won’t  · Potential investors just don’t “get it”  · You’ve got too many people  · You’ve got too few people  · You have the right number of people, but they aren’t the “right” people  · Your business model is flawed  · You don’t have a business model  · Private equity markets suck and you’re lucky to get any offer The fact of the matter is that it doesn’t really matter why the down round happens. Participants in the Investment Let’s look at the participants in the investment, and their relative positions:  · You – You still believe in your dream. You are still convinced that you’ve got a great business opportunity. Sure, you haven’t hit plan, but what entrepreneur does? You are willing to accept a down round if it gives you another time at bat, and you’ve got enough equity in your company to make it worthwhile.  · Me (the current investor) – Even if you (and your company) have done everything that you “should” have (exceeded plan, built out the management team…), I’m aware that I am vulnerable if only one next-round investor is at the table. Knowing this, the primary way to avoid a down round is for the current investor(s) to do an “inside round,” in which the investors (at least the major investors, and quite possibly all investors) in previous rounds take their pro rata shares of an alternative round of financing. As mentioned in previous articles, such inside rounds are usually structured as an extension of the most recent round, or as a convertible note. If I don’t step up, I am pretty much at the mercy of the new investor. Yes, I’ve got all sorts of legal protections built into my deal, including anti-dilution protection, but how meaningful are they really?  · The New Investor – He wouldn’t be looking at the deal unless he thought the fundamental business was promising and that he could achieve a superior rate of return. Of course that rate of return will be greatly impacted by the valuation of the company at the time of his initial investment. Obviously, the lower that value, the better for the new investor. But no matter how low the valuation, if the business doesn’t have that promise, there’s no deal to be done at any price. OK, so how does the new investor view the other participants?
    • Term Sheet Tutorial 45 As far as the new investor is concerned, I don’t have much to offer. Unless I have agreed to invest a significant amount in the new investor’s round, he doesn’t have any incentive to care about me. You, though, are the jockey he’s betting on. The new investor has been able to understand how the company has gotten to this point, is willing to “give you the benefit of the doubt,” and is willing to back you. You are important to him. With these dynamics in place, the new investor will want to keep you relatively happy (under the circumstances) and is likely to dictate terms to me, insisting that I waive or significantly modify my rights and protective provisions. If only one investor is interested in doing the next round, the Golden Rule prevails – “He who has the gold rules!” Anti-dilution protection will receive particular attention. o o Note that in the case of full ratchet anti-dilution protection, your share of your company will drop from 60% to 10%! This will not be acceptable to the new investor. He wants you to be satisfied by the terms of the deal, and he doesn’t really care about me. The new investor will demand that I waive my full ratchet antidilution protection. This is likely to be presented as “take it, or leave it.” If I don’t agree, the new investor is likely to threaten to walk away from the deal. This is a game of Chicken that I’m not likely to win. o o With weighted average anti-dilution protection, your share of the company is reduced from 60% to 28%, almost all of which is caused by the valuation decline and not my anti-dilution protection. This level of protection is much more likely to be honored. The bottom line is that under most circumstances full ratchet anti-dilution protection will be completely waived, while weighted average is likely to be accepted. Full Ratchet Anti-Dilution Protection An investor in any given round of financing is concerned that the next round could be at a lower price per share than what he is paying this round. Therefore, the investor will insist upon anti-dilution protection. In recent weeks, we have discussed the two common types of anti-dilution protection: full ratchet and weighted average. In the event that the current round of investment is at a lower price per share, then:  · Full ratchet anti-dilution protection gives the original investor rights to that number of shares of common stock as if he paid the current round’s lower price.  · Weighted average anti-dilution protection gives consideration to the relationship between the total number of shares outstanding compared to the number of shares held by the original investor. You will prefer weighted average anti-dilution protection to full ratchet. While I know that several readers will not believe this, but what I’ve done in prior weeks is to try to simplify the calculations involved in the explanations of the various forms of anti-dilution protection. This week I will introduce one of the primary components of complexity – the treatment of stock options.
    • Term Sheet Tutorial 46 Fully Diluted Basis The strict definition of fully diluted basis is: Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an asconverted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing). In essence, an investor will phrase the terms of his investment as being calculated on a “fully diluted basis,” by including shares of common stock that are not currently outstanding, but the company is obligated to issue them based upon existing agreements (convertible preferred stock, options, etc.). The inclusion of these numbers in the share base can significantly impact the resulting outcomes. Let’s take a look at how option pools can impact full ratchet anti-dilution protection. The First Round Let’s review the example that we’ve been using in this series of articles.  ·  · Since you own all 600,000 shares of your company, I am offering to buy 400,000 new shares in order to acquire 40%.  · My investment of $400,000 divided by 400,000 shares that I’m buying yields a per share price of $1.00.  · Since you own 600,000 shares, that means the value of the stake in your company is $600,000, which is the pre-financing value.  ·  · That is confirmed by taking the total number of outstanding shares, 1,000,000 (your 600,000 and my 400,000) and multiplying that by the share price of $1.00.  · I offer to invest $400,000 in your company in exchange for 40% of it. Adding my $400,000 to that yields a post-financing value of $1,000,000. That also says that the post-financing value of your company is $1,000,000.
    • Term Sheet Tutorial 47 The terms of this deal include full ratchet anti-dilution protection for me. The Second Round It’s time to raise some more money. Unfortunately, the only investment offer you are able to attract is at a lower price per share than the prior round.  · The new investor offers to invest $500,000 for 50% of your company. Since I have full ratchet anti-dilution protection; that has to be included in the calculations.
    • Term Sheet Tutorial 48 As I noted in the original article, the full ratchet anti-dilution protection creates a pretty ugly outcome for you. The Investor Outcome The share price drops all the way to less than $0.17. The new investor buys 3,000,012 shares. I get 2,000,010 shares as a result of full ratchet anti-dilution protection. Your Outcome All of these adjustments have occurred to the investors’ positions. What happens to you? It isn’t pretty. As the number of shares for the investors ratchet higher and higher, your number of shares remains constant at 600,000. Your share of your company has fallen to 10%! The value of your shares has dropped to $100,000! But… As a practical matter, the investor in Round 2 would not do the deal without a provision for a management option pool. Let’s say that the investor call for a 9% pool. That gives us several values for variables that will allow us to calculate the resulting capitalization table.  You own 600,000 shares of common stock.  I have invested $400,000 with full ratchet anti-dilution protection.  The new investor has agreed to invest $500,000 for 50% of the company on a fully diluted basis after provision for a 9% option pool. Let’s take a look at the outcome.
    • Term Sheet Tutorial 49 The Investor Outcome The share price drops all the way to less than $0.02. The new investor buys 30,000,000 shares. I get 23,600,000 shares as a result of full ratchet anti-dilution protection. Your Outcome All of these adjustments have occurred to the investors’ positions. What happens to you? It is pretty ugly. As the number of shares for the investors have ratcheted higher and higher, your number of shares remains constant at 600,000. Your share of your company has fallen to 1%! The value of your shares has dropped to $10,000! Reviewing the Basics Let’s look at some of the relevant basics.  ·  · The value of a company is determined by multiplying the total number of common shares by the most recent share price.  · Deals are negotiated with percentages, but are structured with shares. Price per share = Amount of investment divided by the number of shares purchased. As I’ve said before, these may appear to be pretty dry and boring gobblygook, but as we’ve seen, they can have very significant consequences. Recap An investor in any given round of financing is concerned that the next round could be at a lower price per share than what he is paying this round. Therefore, the investor will insist upon anti-dilution protection.
    • Term Sheet Tutorial 50 An investor will invest on a fully diluted basis. Avoid any deal that has a non-diluted fixed percentage of the equity. If that’s unavoidable, at least negotiate for conditions under which that restriction goes away. Protective Covenants Protective covenants become more important depending on board composition. They matter more if angels don’t have a significant role on the board. I try to think of the protective covenants in two groups. The first category consists of actions which relate to the operations of the company, such as changes to the stock option pool, incurrence of debt, and certain kinds of licensing. These should require only a vote of the board including angel directors to authorize them. Once the board has spoken, why appeal to the stockholders? The second category includes actions which fundamentally affect the angels’ investment and should go back to them for authorization—for example amendments to the charter or bylaws or mergers and acquisitions.
    • Term Sheet Tutorial 51 TERM SHEET: INCENTIVE STOCK OPTIONS Incentive Stock Options (ISOs) Incentive stock options (ISOs) are a form of equity compensation that provides unique tax benefits — and significant tax complexity. In recent years their popularity has grown to roughly match the popularity of nonqualified stock options. Nonqualified options have two disadvantages compared to incentive stock options. One is that you have to report taxable income at the time you exercise the option to buy stock, and the other is that the income is treated as compensation, which is taxed at higher rates than long-term capital gains. Incentive stock options provide a way to avoid both of those disadvantages. There's no income to report at the time you exercise the option (unless you sell the stock at the same time you buy it). And if you hold the stock long enough to satisfy a special holding period, your gain from the stock will be treated as long-term capital gain. These tax advantages are partly offset by the alternative minimum tax (AMT). This is a complicated calculation that may cause you to pay tax at the time you exercise an ISO. But the amount of AMT you pay is less than the tax you would have paid if you exercised a nonqualified option — and you may be able to recover much or all of the your AMT payment by claiming an AMT credit in future years. How you get them Incentive stock options must be granted pursuant to a stock option plan that was adopted by the company's board of directors and approved by the shareholders. The board of directors, or a committee appointed by the board (usually called the compensation committee), may decide who receives the awards and the specific terms of the options. In some cases options are granted according to a formula. What you'll receive When a company grants an option it should provide certain documents. You should receive an option agreement, setting forth the specific terms of your option, and a copy of the plan, which provides some general rules that govern all options. In many cases the company also provides a summary of the plan. It's important to understand your rights under the agreement and the plan. You need to know:  What is the earliest date you can exercise the option? Does it become exercisable in stages?  What do you need to do when you exercise the option? Is cashless exercise available? Can you exercise using stock you own?  When will the option terminate? Can you exercise after your employment terminates? What if you die while holding the option? Make sure you keep these documents in a safe place. Be sure to review them from time to time for planning purposes. At a minimum, you want to think about your options before the end of each year to determine whether to exercise some or all of the options by December 31 as part of your tax planning. Terminology Here are some of the important terms used in connection with nonqualified options:  You receive the option when the company makes a grant or award.  You exercise an option when you take the action specified in the option agreement to buy the stock. Usually you have to fill out a form notifying the company that you are exercising the option and provide cash equal to the purchase price.  The exercise price (also called the strike price) is the amount you have to pay to purchase the stock.  The bargain element (also called the spread) is the difference between the value of the stock and the exercise price. For example, if the value of the stock is $24 and the exercise price is $19, the spread is $5. When the spread is a positive number, the option is in the money.  Options are under water (or out of the money) if the exercise price is higher than the value of the stock. There is no particular tax significance to an option being under water, but the practical significance is that the option will not become valuable until the price of the stock recovers. Typical terms
    • Term Sheet Tutorial 52 Companies have some flexibility in the terms they can offer for incentive stock options. Your option may differ from the typical option in a number of important ways. But it may be helpful to compare your option with the norm:  The exercise price is usually set at or near — and can't be below — the value of the stock at the time the option is granted.  The option becomes exercisable over a period of several years.  Cash payment is usually required at the time of exercise, but some companies make a form of "cashless exercise" available, and others will loan the money needed to exercise the option.  The option expires ten years after it was issued, or earlier if employment terminates. You may or may not have an opportunity to exercise options that are already vested (exercisable) at the time employment terminates. Options that are not exercisable at that time typically expire.
    • Term Sheet Tutorial 53 TERM SHEET: PROFIT INTEREST UNITS Profit Interest Units (PIUs) LLCs cannot have employee stock ownership plans (ESOPs), give out stock options, or provide restricted stock, or otherwise give employees actual shares or rights to shares. But many LLCs want to reward employees with an equity stake in the company. The most commonly recommended approach to sharing equity in an LLC is to share "profits interests." A profits interest is analogous to a stock appreciation right. It is not literally a profit share, but rather a share of the increase in the value of the LLC over a stated period of time. Vesting requirements can be attached to this interest. In the typical arrangement, an employee would receive an award and would be treated as if an 83(b) election had been made. An 83(b) election fixes the ordinary income tax obligation at the time of grant. The employee would pay taxes on the value of any difference between the grant price and any consideration paid at ordinary income tax rates, then pay no further taxes until paying capital gains tax on subsequent appreciation at sale. If there is no value at grant, then, the tax is zero, and taxes would only be paid when the interest is sold, at which time capital gains tax rates would apply. Proposed (but never finalized) Revenue Ruling 2005-43 stated that profits interests would not be taxed at grant if they would have no value if the company were liquidated at the same time. In other words, profits interests must only apply to the growth of the value of the company. Employees must also hold the interests for at least two years after grant. They also cannot be pegged to a certain stream of income, such as would be the case with a more conventional profit sharing plan. LLCs must enter into binding agreements to comply with these requirements. Grant agreements should also specify terms for the transferability of the interests, if any (generally, they would not be transferable). Profit interests can be tax-free at grant only if provided to employees or other service providers. If profit interests are held for at least one year after the interests vest, the amount received is treated as a long-term capital gain; otherwise, it is a short-term gain. In addition, if profits interest holders make an 83(b) election, they must be treated as if they had an actual equity stake in the company. That means that they would receive a K-1 statement attributing their respective share of ownership to them and would have to pay taxes on that. Distributions can be made by the LLC for this purpose. Income attributed to their limited partner status is not subject to employment taxes. If the employee forfeits the profits interest (because they never become vested, for instance), a special allocation must be made to reverse the effects of any gains or losses attributable to the employee. Employees would also be subject to self-employment taxes (FICA and FUTA) on their salaries. Some companies gross up employee pay to cover this additional tax. If an 83(b) election is not made, then the employee would not be subject to this tax treatment, but the employee would have to pay taxes on gains at vesting as ordinary income. (There is some dispute about whether an 83(b) election is really needed under the rules, but that is beyond this article). While there is no statutory requirement to do so, having an outside professional valuation of the profits interest at the time of grant is advisable. That establishes a defensible value on which to base the future benefits subject to taxation. Granting the interests at less than fair market value could also give rise to taxation on the bargain element at grant. Deferred compensation rules require that, at the least, the company find a way to estimate current fair market value in accordance to standards the regulations set out. Having the board simply pick a number based on some formula or back-of-theenvelope calculation would not meet these requirements. Distributions of earnings can be made to holders of the profits interests, but need not be in proportion to their equity stake. For instance, if the partners had contributed all the capitalization, they might not allow any allocation of distributions until a target return had been met. There are no statutory rules for how profits interests must be structured. Distributions of earnings normally
    • Term Sheet Tutorial 54 would just be based on vested units, but could be based on allocated units. Any vesting rules the company chooses can be used, although performance vesting would require variable accounting (adjusting the charge to earnings each year based on changes in value and the vested amounts). Otherwise, the charge must be taken at grant based on a formula (such as Black-Scholes) that calculates the present value of the award. Profit Interest vs. Alternatives Profit Interest Units Incentive Stock Options Nonqualified Stock Options Advantages To the holder: • Holder realizes capital gains on sale taxable at long-term rates if holding period is satisfied. • No downside risk. To the holder: • Holder realizes capital gains on sale taxable at long-term rates if holding period requirements are satisfied. • No downside risk To the holder: • No downside risk. To the company: • Taxable income realized by holder is deductible to the extent of the granting company’s taxable income. Restricted Stock To the holder: • Holder realizes capital gains on sale taxable at long-term rates if holding period is satisfied. To the company: • Traditional accounting (i.e., based on spread at grant). • Potentially better Disadvantages To the company: • Not deductible. • Accounting charge typically based on a binomial model and other complexities. To the company and the holder: • Issues such as self-employment taxes will need to be addressed if the holder of a profits interest is also employed by the LLC. To the holder: • $100,000/year vesting limit. • Holding period requirements: to receive long term capital gain treatment, holder cannot sell until at least one year after exercise and at least two years after grant. • Potential AMT on exercise. To the company: • Not deductible unless disqualifying disposition. • Accounting charge based on Black Scholes value at grant. To the holder: • Holder realizes taxable ordinary income upon exercise equal to difference between option price and fair market value of stock upon exercise. • IRC 409A effectively precludes grant price below FMV. To the company: • Accounting charge based on Black Scholes value at grant. To the holder: • If the recipient buys shares, he risks losing his capital if the value of the stock goes to zero. • If the restricted stock is granted for less than fair market value, the recipient taxable ordinary income on that value at time of grant, either out of pocket, via a company loan or via a (possibly grossed up) bonus. • If purchase is financed with a note, SOX requires executive recipients to repay the
    • Term Sheet Tutorial 55 incentive than option. note before the IPO filing. To the company: • Not deductible except to the extent that the stock is granted for less than FMV. TERM SHEET: PROTECTIVE PROVISIONS Protective Provisions Investor Favorable: The consent of the holders of at least two thirds of the Series [A] Preferred shall be required for any action that (i) alters or changes the rights, preferences, or privileges of the Series [A] Preferred; (ii) increases or decreases the authorized number of shares of Series [A] Preferred; (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences, or privileges senior or pari passu to those of the Series [A] Preferred; (iv) results in the redemption of any shares of Common Stock (other than pursuant to employee agreements); (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold or exclusively licensed; (vi) amends or waives any provision of the Company's Certificate of Incorporation or Bylaws; (vii) increases or decreases the authorized size of the Company's board; or (viii) results in the payment or declaration of any dividend on any shares of Common or Preferred Stock. Middle of the Road: For so long as at least [one-half of the shares originally issued] shares of Series [A] Preferred remain outstanding, consent of the holders of at least two thirds of the Series [A] Preferred shall be required for any action that (i) alters or changes the rights, preferences, or privileges of the Series [A] Preferred; (ii) increases or decreases the authorized number of shares of Common or Preferred Stock; (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences, or privileges senior to or pari passu with the Series [A] Preferred; (iv) results in the redemption of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services); (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold; or (vi) amends or waives any provision of the Company's Certificate of Incorporation or Bylaws relative to the Series [A] Preferred. Company Favorable: The consent of the holders of at least 50 percent of the Series [A] Preferred shall be required for any action that (i) adversely alters or changes the rights, preferences, or privileges of the Series [A] Preferred, or (ii) decreases the authorized number of shares of Series [A] Preferred. Term Sheet: Protective Provisions by Feld Thoughts A typical protective provision clause looks as follows: "Protective Provisions: For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or though any merger, recapitalization or similar event, that (i) alters or changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services), (v) results in any merger, other corporate
    • Term Sheet Tutorial 56 reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the Company’s Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of the Company’s Board of Directors, or (viii) results in the payment or declaration of any dividend on any shares of Common or Preferred Stock, or (ix) issuance of debt in excess of $100,000." Subsection (ix) is often the first thing that gets changed by raising the debt threshold to something higher, as long as the company is a real operating business rather than an early stage startup. Another easily accepted change is to add a minimum threshold of preferred shares outstanding for the protective provisions to apply, keeping the protective provisions from “lingering on forever” when the capital structure is changed – either through a positive or negative event. Many company counsels will ask for “materiality qualifiers” (e.g. that the word "material" or "materially" be inserted in front of subsections (i), (ii) and (vi), above.) We always decline this request, not to be stubborn (ok – sometimes to be stubborn), but because we don’t really know what "material" means (if you ask a judge, or read any case law, they will not help you either) and we believe that specificity is more important that debating reasonableness. Remember – these are protective provisions – they don’t “eliminate” the ability to do these things – they simply require consent of the investors. As long as things are “not material” from the VC’s point of view, the consent to do these things will be granted. We’d always rather be clear up front what the rules of engagement are, rather than having a debate over “what material means” in the middle of a situation where these protective provisions might come into play. When future financing rounds occur (e.g. Series B – a new “class” of preferred stock), there is always a discussion as to how the protective provisions will work with regard to the new financing. There are two cases: (a) the Series B gets its own protective provisions or (b) the Series B investors vote alongside the original investors as a single class. Entrepreneurs almost always will want a single vote for all the investors (case b), as the separate investor class protective provision vote means the company now has two classes of potential veto constituents to deal with. Normally new investors will ask for a separate vote, as their interests may diverge from those of the original investors due to different pricing, different risk profiles, and a false need for overall control. However, many experienced investors will align with the entrepreneur’s point of view of not wanting separate class votes as they do not want the potential headaches of another equity class vetoing an important company action. If your Series B investors are the same as your Series A investors, this is an irrelevant discussion, and it should be easy for everyone to default to case b. If you have new investors in the Series B, be wary of inappropriate veto rights for small investors (e.g. consent percentage required is 90% instead of a majority (50.1%), so a new investor who only owns 10.1% of the financing can effectively assert control over the protective provisions through his vote.) Some investors that feel they have enough control with their board involvement to ensure the company does not take any action contrary to their interests, and as a result will not focus on these protective provisions. During a financing, this is the typical argument used by company counsel to try to convince the VCs to back off of some or all of the protective provisions We think this is a shortsighted approach for the investor, for as a board member, an investor designee has legal duties to work in the best interests of the company. Sometimes the interests of the company and a particular class of shareholders diverge. Therefore, there can be times whereby an individual would legally have to approve something as a board member in the best interests of the company as a whole and not have a protective provision to fall back on as a shareholder. While this dynamic does not necessarily “benefit” the entrepreneur, it’s good governance, as it functionally separates the duties of a board member from that of a shareholder, shining a clearer lens on a area of potential conflict. While one could make the argument that protective provisions are at the core of the “trust” between a VC and entrepreneur, we think that’s a hollow and inappropriate statement. When an entrepreneur asks “don’t you trust me - why do we need these things?”, the simple answer is that it is not an issue
    • Term Sheet Tutorial 57 of trust. Rather, we like to eliminate the discussion about who ultimately gets to make which decisions before we do a deal. Eliminating the ambiguity in roles, control, and rules of engagement is an important part of any financing – the protective provisions cut to the heart of some of this. Protective Provisions Continued Protective provisions grant the investors the right to veto or block certain corporate actions. Accordingly, even if the Board of Directors authorizes a particular action, the consent of a certain percentage of the preferred stockholders would be required prior to the company taking such action. The rationale for these provisions is to protect the investors (who are usually the minority stockholder following a Series A financing) from the majority stockholders. Standard protective provisions: The following protective provisions are viewed as pretty standard and non-controversial (and are actually the provisions agreed-to in FourSquare’s Series B financing led by Andreessen Horowitz):  A sale of the company or other “Liquidation Event”  Any amendment to the company’s Certificate of Incorporation or Bylaws so as to alter or change the powers, preferences or special rights of the shares of Preferred Stock so as to affect them adversely  Any increase or decrease (other than by conversion) in the total number of authorized shares of Preferred Stock or Common Stock  The authorization or issuance of any equity security having a preference over, or being on a parity with, any series of Preferred Stock with respect to dividends, liquidation or redemption  The redemption or purchase of shares of Preferred Stock or Common Stock (subject to certain exceptions)  Any declaration or payment of any dividends or any other distribution on account of any shares of Preferred Stock or Common Stock  Any change in the authorized number of directors of the company. Non-standard/Controversial protective provisions: Beyond the usual provisions, some investors will push for additional items, such as the following:  Any hiring, firing or change in the compensation of any executive officers  The entering into any transaction with any director, executive or employee of the Company  Any incurrence of indebtedness in excess of $[100,000]  Any change in the principal business of the company or the entering into any new line of business  Any purchase of a material amount of assets of another entity. Founders should push back on these – and should be able to knock most (if not all) of them out if they have strong negotiating leverage. Other Key Issues: There are two other issues you should focus on. First, founders should require a minimum threshold of outstanding shares of Preferred Stock in order for the protective provisions to remain in place. Thus, language should be inserted into the term sheet providing that the protective provisions would only be applicable “so long as [25]% of the originally issued Series A Preferred remains outstanding.” Also, watch-out for high voting thresholds, particularly upon a Series B or later financing round. Founders are often able to negotiate a single vote for all investors (i.e., the Series B or later investors would not have a separate vote for their respective protective provisions). However, the requisite consent percentage should generally not be higher than 66 2/3 percent to avoid the scenario where an investor holding a small percentage of shares effectively has veto rights.
    • Term Sheet Tutorial 58 TERM SHEET: BOARD OF DIRECTORS Board Composition and Meetings Investor Favorable: The size of the Company's Board of Directors shall initially be set at [three]. The holders of the Series [A] preferred, voting as a separate class, shall be entitled to elect two members of the Company's Board of Directors, the holders of the Common Stock shall be entitled to elect one member, and the third member shall be mutually agreed upon. The Board shall initially be comprised of [____________], [_______________], and [_________________]. Board of Directors will be elected annually. Board of Directors meetings will be held at least four times per year. Until the Company is profitable or the Board otherwise agrees, Board meetings will be targeted for every two months, or six times per year. Middle of the Road: The size of the Company's Board of Directors shall be set at [five]. The Board shall initially be comprised of [____________], [_______________], [_________________], [_________________], and [______________]. At each meeting for the election of directors, the holders of the Series [A] Preferred, voting as a separate class, shall be entitled to elect one member of the Company's Board of Directors, the holders of Common Stock, voting as a separate class, shall be entitled to elect two members, and the remaining directors will be mutually agreed upon by the Common and Preferred. It is anticipated that the Company's CEO will occupy one of the remaining seats. Board of Directors meetings will be held at least four times per year. Until the Company is profitable or the Board otherwise agrees, Board meetings will be targeted for every two months, or six times per year. Company Favorable: The size of the Company's Board of Directors shall initially be set at [five]. All directors shall be elected by the shareholders voting on an as-converted basis. Term Sheet: Board of Members by Feld Thoughts A typical term sheet looks as follows: Board of Directors: The size of the Company’s Board of Directors shall be set at [n]. The Board shall initially be comprised of ____________, as the Investor representative[s] _______________, _________________, and ______________. At each meeting for the election of directors, the holders of the Series A Preferred, voting as a separate class, shall be entitled to elect [x] member[s] of the Company’s Board of Directors which director shall be designated by Investor, the holders of Common Stock, voting as a separate class, shall be entitled to elect [x] member[s], and the remaining directors will be [Option 1: mutually agreed upon by the Common and Preferred, voting together as a single class.] [ or Option 2: chosen by the mutual consent of the Board of Directors]. If a subset of the board is being chosen by more than one constituency (e.g., two directors chosen by the investors, two by founders / common holders and one by “mutual consent”), you should consider what is best: (a) chosen my mutual consent of the board (one person, one vote) or (b) voted upon on the basis of proportional share ownership on a common-as-converted basis. VCs will often want to include a board observer as part of the agreement either instead of or in addition to an official member of the board. This is typical and usually helpful, as many VC partners have an associate that works with them on their companies. While there’s rarely any contention about who attends a board meeting, most VCs will want the right to have another person from the firm at the board meeting, even if they are non-voting (an “observer”).
    • Term Sheet Tutorial 59 Many investors will mandate that one of the common-stockholder chosen board members be the then-serving CEO of the company. This can be tricky if the CEO is the same as one of the key founders – often you’ll see language giving the right to a board seat to one of the founders and a separate board seat to the then CEO – consuming two of the common board seats. Then – if the CEO changes, so does that board seat. While it is appropriate for board member and observers to be reimbursed for their reasonable outof-pocket costs for attending board meetings, we rarely see board members receive cash compensation for serving on the board of a private company. Outside board members are usually compensated with stock options – just like key employees – and are often invited to invest money in the company alongside the VCs. Special Board Approval Board approval will be required for: 1. Hiring of all officers of the Company. 2. Any employment agreements (approval by a majority of disinterested Directors, or a Compensation Committee when established). 3. Compensation programs including base salaries and bonus programs for all officers and key employees (approval by a majority of disinterested Directors or a Compensation Committee when established). 4. All stock option programs as well as issuance of all stock and stock options (approval by a majority of disinterested Directors or a Compensation Committee when established). 5. Annual budgets, business plans, and financial plans. 6. All real estate leases or purchases. 7. Execution of entrance obligations or commitments, including capital equipment leases or purchases, with total value greater than $[________] and which are outside the most recent business plan or budget approved by the Board of Directors. Board Control Controlling the board, of course, means controlling the corporation. Thus, the composition of the Board is an important and sensitive issue to founders. Sadly, we’ve all heard the horror stories of founders being “fired” from the company they founded. It has traditionally been rare for the founders to control the Board following a Series A financing (despite the fact that Series A investors do not generally acquire a majority stake in the venture). Sometimes the investors push to control the Board, but this is relatively uncommon as well. Instead, there is typically a “compromise” in which neither the investors nor the founders technically control the Board. Thus, in a five-member Board, two directors would be appointed by the investors, two would be appointed by the founders and one director would be independent (jointly appointed by the other directors). Similarly, in a three-member Board (which is more common these days), one director would be appointed by the investors, one would be appointed by the founders and there one be one independent. However, the pendulum has recently swung dramatically in the founders’ favor (particularly in the Bay area), giving the founders extraordinary negotiating leverage with investors if they have a “hot”
    • Term Sheet Tutorial 60 startup. One area where founders have exercised such leverage is in connection with Board composition. As Paul Graham, co-founder of Y Combinator, recently wrote: “Founders retaining control after a series A is clearly heard-of. And barring financial catastrophe, I think in the coming year it will become the norm.” Accordingly, if you have the leverage, push hard to maintain control of your Board post-closing. The entrepreneur-friendly VCs know what’s happening in the marketplace and are likely to capitulate and agree to a provision in the term sheet akin to the following: “Immediately following the Closing, the Board shall consist of three members. Holders of a majority of the Series A Preferred shall be entitled to elect one member, which member shall be designated by [Investor A], [who initially shall be __________]. Holders of a majority of the Common Stock shall be entitled to elect one member, which member shall initially be __________ [the Company’s Founder]. Holders of the Preferred Stock and Common Stock, voting as a single class on an as-converted basis, shall elect the remaining director.” It would also be prudent for the founders to require the investors to actually name their representative on the Board – to avoid a situation where some unknown junior staffer takes the seat (as opposed to the heavyweight partner who can clearly add value). All terms are negotiable – no matter what anyone tells you. TERM SHEET: PREFERRED STOCK Preferred Stock Preferred stock is called preferred for a reason. It provides the investor with certain preferences, some of which directly affect the value of his investment under different circumstances. Features of Preferred Stock Preferred stock is materially different than common stock in many important respects. Some of the terms and characteristics of preferred stock can have significant consequences. To a large degree, control and percentage of ownership become separate issues in deals including preferred stock….which is one of the real attractions of this paper! How preferred stock terms can affect valuation – a scenario Let’s take a look at how all of this can play out. The Original Investment Let’s say an investor invests $1 million in your company at a pre-financing value of $1 million [50-50 ownership]. Let’s also say that the investment purchases Participating Convertible Preferred Stock with a 10% dividend rate and a liquidation amount multiple of two. The Sale of The Company Two years after he investment, the company has stalled for some reason, and it has never really gotten significant commercial traction and probably never will. An opportunity comes up for the company to be acquired for $5 million. While not a home run, everyone should be relatively happy. Right? Maybe not. The Distribution of the Proceeds
    • Term Sheet Tutorial 61 After two years, the preferred stock purchase price plus accrued dividends has grown to $1.2 million. After applying the multiplier of two, the liquidation amount is $2.4 million, which the investor gets “off the top.” The remaining $2.6 million is divided pro rata with the as-converted shareholdings, or 50-50, meaning $1.3 million each. The investor has received $3.7 million and you get $1.3 million. Under these circumstances, what appeared to be a 50-50 deal at the outset became a 75-25 deal! Advice to Entrepreneurs  Valuation is only meaningful in the context of the complete deal.  Preferred stock provides the investor with extra benefits and rights as compared to the common stock shareholders.  Understanding the arithmetic of deals is very important.  Surround yourself with professionals, mentors, and advisors who can help you level the playing field. What’s so preferable about preferred stock? Overview of preferred stock The preceding fiction notwithstanding, preferred stock is the coin of the realm of virtually all institutional, and many private, investors. It is materially different than common stock in many important respects. Some of the terms and characteristics of preferred stock have important characteristics. Participation When preferred stock was originally created (see opening paragraph), it was intended to address the differences between the entrepreneur and the financial investor. In essence, if the financial out come was less than had been anticipate, the investor postured that he wanted the opportunity to some minimum return. What resulted was the creation of simple Convertible Preferred Stock.  Simple Convertible Preferred Stock In its infancy, preferred stock was an either-or proposition for the investor. Calculate the liquidation preference, calculate the value of the common stock if converted, and pick the one that is to the investor’s greater benefit. The logic is straightforward and the justification appears to be reasonable.  Participating Convertible Preferred Stock After a period of time, someone came up with the idea of Participating Convertible Preferred Stock. Its key feature was that the investor got the liquidation preference first, AND then participated in the distributions on an as-converted basis. The investors justify this on the basis of locking in as a good a return as possible in a less-than-desirable outcome. Entrepreneurs often take umbrage at this and consider it to be double dipping. This is a prime example of the Golden Rule: He who has the gold rules. Without negotiating leverage, if the investor seeks participating preferred, then that’s likely to be part of their investment style, and it’s unlikely that they will be willing to negotiate this feature. Anti-dilution protection If the company sells shares at some future date at a share price less than what the investor paid, the investor wants anti-dilution protection. Full-ratchet anti-dilution protection
    • Term Sheet Tutorial 62 The harshest form of protection from the entrepreneur’s perspective is full-ratchet. It says that the investor gets rights to that number of shares as if he had paid the lower price. If he paid $2.00 per share, and subsequent shares were sold for $1.00, his number of shares would double to compensate for this transaction. Weighted-average anti-dilution protection Weighted-average is less painful. It takes the share base of the company into consideration, they reducing the overall impact. For those of you who are interested, I “borrowed” the following language from the documents one of the deals with which I was involved. “Adjustment of Conversion Price Upon Issuance of Additional Shares of Common Stock. In the event that at any time or from time to time after the Original Issue Date for any series of Preferred Stock the Corporation shall issue Additional Shares of Common Stock (including, without limitation, Additional Shares of Common Stock deemed to be issued pursuant to Subsection 2(e)(iii)(1) but excluding Additional Shares of Common Stock deemed to be issued pursuant to Subsection 2(e)(iii)(2), which event is dealt with in Subsection 2(e)(vi)(1)), without consideration or for a consideration per share less than the Conversion Price of such series of Preferred Stock in effect on the date of and immediately prior to such issue, then and in such event, such Conversion Price of such series of Preferred Stock shall be reduced, concurrently with such issue, to a price (calculated to the nearest one tenth of one cent) determined in accordance with the following formula: (P1) (Q1) + (P2) (Q2) --------------------------Q1 + Q2 NCP = where: NCP = New Series A Conversion Price or Series B Conversion Price, as applicable P1 = Series A Conversion Price or Series B Conversion Price, as applicable, in effect immediately prior to new issue; Q1 = Number of shares of Common Stock outstanding, or deemed to be outstanding as set forth below, immediately prior to such issue; P2 =Weighted average price per share received by the Corporation upon such issue; Q2 = Number of shares of Common Stock issued, or deemed to have been issued, in the subject transaction; …provided that for the purpose of this Subsection 2(e)(iv), all shares of Common Stock issuable upon conversion of shares of Preferred Stock outstanding immediately prior to such issue shall be deemed to be outstanding, and immediately after any Additional Shares of Common Stock are deemed issued pursuant to Subsection 2(e)(iii), such Additional Shares of Common Stock shall be deemed to be outstanding.” Advice to Entrepreneurs     If you’re going to play the game, you need to understand the rules. Deals are complex. Ignorance is not a defense against unpleasant outcomes. Do everything that you can to prevent the investor from invoking the Golden Rule. Surround yourself with professionals, mentors, and advisors who can help you level the playing field.
    • Term Sheet Tutorial 63 TERM SHEET: LIQUIDATION PREFERENCE Liquidation In the world of private equity, the definition of liquidation encompasses most transactions, other than an initial public offering (IPO), through which the investor seeks to “liquidate” his investment. Liquidation Preference One of the key features of preferred stock is that higher in the pecking order of who gets paid what and when in the event of a liquidation. Preferred stock shareholders receive distributions from liquidation before common stock shareholders. Term Sheet: Liquidation Preference Investor Favorable: In the event of any liquidation or winding up of the Company, the holders of the Series [A] Preferred shall be entitled to receive in preference to the holders of the Common Stock an amount equal to the Original Purchase Price plus any accrued, or declared, but unpaid dividends (the "Liquidation Preference"). After the payment of the Liquidation Preference to the holders of the Series [A] Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series [A] Preferred on a common equivalent basis. A merger, acquisition, or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation. Middle of the Road: In the event of any liquidation or winding up of the Company, the holders of the Series [A] Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to the Original Purchase Price plus any declared but unpaid dividends (the "Liquidation Preference"). After the payment of the Liquidation Preference to the holders of the Series [A] Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series [A] Preferred on a Common Stock equivalent basis; provided that the holders of Series [A] Preferred will stop participating once they have received a total liquidation amount equal to [three] times the Original Purchase Price. A merger, acquisition, sale of voting control, or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation. Company Favorable: In the event of any liquidation or winding up of the Company, the holders of the Series [A] Preferred shall be entitled to receive in preference to the holders of the Common Stock an amount equal to the Original Purchase Price (the "Liquidation Preference"). After the payment of the Liquidation Preference to the holders of the Series [A] Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock. A merger, acquisition, or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation. (From the Spring 2008 edition of Entrepreneurs Report published by the Wilson Sonsini Goodrich & Rosati law firm: Liquidation Preference Continued As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.). Watch out for this one. It means the preferred stockholders are
    • Term Sheet Tutorial 64 entitled to a multiple of their original investment (double or triple the amount) before the common stockholders get anything. So, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios. For example, if your company were sold for $40 million, and the VC had invested $5 million for onethird of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million. The VC would thus receive 50 percent of the sale proceeds even though it only owned one-third of the company. Be safe: Do the math. Participating Preferences by Feld Thoughts A Participation Preference, or PP, is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the "preference" part of PP), and then participate as though they owned common stock in the business (or, more technically, on an "as converted basis" - the "participation" part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares). To illustrate, let's take a simple case - a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor. Obviously, this can get much more complicated as you start to have multiple rounds of investments with a PP feature. A simple way to think about how the economics of a PP works is that the total dollar amount of the preference will come off the top of the exit value (and go to the investors); everyone will then convert into common stock and share the balance based on their ownership percentages. For example, assume a company raises $40m over 3 rounds where each round has a PP feature and the investors own 70% of the company. If this company is sold for $200m, the first $40m would go to the investors and the remaining $160m would be split 70% to investors / 30% to everyone else. In this case, the investors would get a total of $152m, ($40m + $112m, or 76% of the proceeds - 6% more then they would have gotten if there was no PP.) If you sit and ponder the math, you'll realize that a PP usually has material impact on the economics in low to medium return deals, but quickly becomes immaterial as the return increases (or - more specifically - as the ratio of the exit value to invested capital increases). For example, if a company is sold for $500m, a $10m PP re-allocates a small portion of the deal ($10m of the $500m) to the investors vs. the $40m of $200m or $5m of $20m in the other preceding examples. As a result, a PP usually only matters in a low to medium return situation. If a company is sold for less than paid in capital, the liquidation preference will apply and the participation feature will not come into play. If a company is sold for a huge amount of money, the PP won't have much economic impact, as the preference feature of the PP becomes a small percentage of the deal total. In addition, in essentially
    • Term Sheet Tutorial 65 every case, PP's don't apply in an IPO where preferred stock (of any flavor) is typically converted into common stock at the time of the offering. As PP started showing up in more deals, some creative lawyer came out with a perversion on the preferred feature called a "cap on the participate" (also known as a "kick-out feature.") In this case, the participation feature of the PP goes away once the investor holding the PP reaches a certain multiple return of capital. For example, assume a 3x cap on a PP in a $5m Series A investment. In this case, the investor would benefit from their PP until their proceeds from the deal reached $15m. Once they reached this level, their shares are no longer counted in the cap structure and the other shareholders share the remaining proceeds. Of course, the investor always has the option to convert their shares to common stock and give up their preferred return (but participate fully in the proceeds). Put another way, at a high enough valuation the investor is better off simply converting to common (in the current example at an exit value above $30m). Participation caps, however, have a fundamental problem - they create a flat spot in most deal economics where the investor gets the same amount across a range of exit values. If we stay with the example above and assume a 50% ownership for the Series A, the PP would apply until the exit value reached $25m, at which point the investor receives $15m in proceeds. Between $25m and $30m, the investor would continue to receive this same $15m (this is the flat spot - it doesn't matter whether the exit value is $26m or $29m, the investor would get $15m). At exit values above $30m, the investor would convert to common stock and take 50% of the proceeds (i.e., their as-converted share of the proceeds would exceed the $15m cap so they would be better off converting to common and taking this share of the exit value). This is an odd dynamic, since the common shareholders are clearly not indifferent to exit values in this flat spot, but the investor is (and consider a case where this flat spot was much larger than the one in the example above). Any way you cut it there is misalignment, at least for a range of outcomes, between the investor and the rest of the shareholders. Another perversion is the "multiple participate". In this case, the investor gets some multiple of his participate off the top of the transaction. For example, a 3x multiple participate on a $40m investment would mean the first $120m would go to the investor (and then the remaining proceeds would be distributed to the investor and the rest of the shareholders). This type of PP only appeared for a short while when investors were doing recapitalizations without actually going through the mechanics of recapitalizing the company (more about this in a future blog post). Interestingly, there is a case to be made that PP in early financing rounds can actually end up disadvantaging early investors. The math on this gets complicated very quickly, but if you assume that every subsequent investment round has at least as favorable terms as the initial round (i.e., include a PP if the first round does) and that subsequent rounds include new investors there are many cases where the initial investor is actually disadvantaged by the existence of the PP (they would have been better off to have not put it in the initial round and because of that pushed for its exclusion from subsequent rounds). It's counterintuitive, but it actually works out this way in a number of very common financing scenarios. So - if PP simply relates to economics, why is it a term that brings out such emotion in entrepreneurs and investors alike? A close friend of mine who is an extremely successful entrepreneur recently told me "I've walked on every investment deal for any company that I've run that even smelled of multiple dips of participation - and spit back in the direction the term sheet came from!" We debated back and forth a while. For example, I asked him "would you take $5m for 33% of a company with no participate or 25% of a company with full participate?" He responded "I would go find a deal where I gave up 26.5% without a participate" which, while an emotional reaction, ironically reinforced my point that it was just economics. After pondering this term over the years, I've concluded that participating preferred is one of those terms that creates real tension between the entrepreneur and the investor - it forces the acknowledgement by the entrepreneur that a moderate return is not a success case for the investor and at the same time forces the investor to acknowledge that in those
    • Term Sheet Tutorial 66 moderate cases they believe it is fair to receive a greater percentage of the proceeds at the expense of the entrepreneur. Term Sheet: Liquidation Preference by Feld Thoughts The liquidation preference determines how the pie is shared on a liquidity event. There are two components that make up what most people call the liquidation preference: the actual preference and participation. To be accurate, the term liquidation preference should only pertain to money returned to a particular series of the company's stock ahead of other series of stock. Consider for instance the following language: Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference). This is the actual preference. In the language above, a certain multiple of the original investment per share is returned to the investor before the common stock receives any consideration. For many years, a "1x" liquidation preference was the standard. Starting in 2001, investors often increased this multiple, sometimes as high as 10x! (Note, that it is mostly back to 1x today.) The next thing to consider is whether or not the investor shares are participating. Again, note that many people consider the term "liquidation preference" to refer to both the preference and the participation, if any. There are three varieties of participation: full participation, capped participation and non-participating. Fully participating stock will share in the liquidation proceeds on a pro rata basis with common after payment of the liquidation preference. The provision normally looks like this: Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis. Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. Sample language is below. Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock. One interesting thing to note in the section is the actually meaning of the multiple of the Original Purchase Price (the [X]). If the participation multiple is 3 (three times the Original Purchase Price), it would mean that the preferred would stop participation (on a per share basis) once 300% of its original purchase price was returned including any amounts paid out on the liquidation preference. This is not an additional 3x return, rather an addition 2x, assuming the liquidation preference were a 1 times money back return. Perhaps because of this correlation with the actual preference, the term liquidation preference has come to include both the preference and participation terms. If the series is not participating, it will not have a paragraph that looks like the ones above.
    • Term Sheet Tutorial 67 Liquidation preferences are usually easy to understand and assess when dealing with a series A term sheet. It gets much more complicated to understand what is going on as a company matures and sells additional series of equity as understanding how liquidation preferences work between the series is often mathematically (and structurally) challenging. As with many VC-related issues, the approach to liquidation preferences among multiple series of stock varies (and is often overly complex for no apparent reason.) There are two primary approaches: (1) The follow-on investors will stack their preferences on top of each other: series B gets its preference first, then series A or (2) The series are equivalent in status (called pari passu - one of the few Latin terms lawyers understand) so that series A and B share pro-ratably until the preferences are returned. Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon. Most professional, reasonable investors will not want to gouge a company with excessive liquidation preferences. The greater the liquidation preference ahead of management and employees, the lower the potential value of the management / employee equity. There's a fine balance here and each case is situation specific, but a rational investor will want a combination of "the best price" while insuring "maximum motivation" of management and employees. Obviously what happens in the end is a negotiation and depends on the stage of the company, bargaining strength, and existing capital structure, but in general most companies and their investors will reach a reasonable compromise regarding these provisions. Note that investors get either the liquidation preference and participation amounts (if any) or what they would get on a fully converted common holding, at their election; they do not get both (although in the fully participating case, the participation amount is equal to the fully converted common holding amount.) Since we've been talking about liquidation preferences, it's important to define what a "liquidation" event is. Often, entrepreneurs think of a liquidation as simply a "bad" event - such as a bankruptcy or a wind down. In VC-speak, a liquidation is actually tied to a "liquidity event" where the shareholders receive proceeds for their equity in a company, including mergers, acquisitions, or a change of control of the company. As a result, the liquidation preference section determines allocation of proceeds in both good times and bad. Standard language looks like this: A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation. Ironically, lawyers don't necessary agree on a standard definition of the phrase "liquidity event." Jason once had an entertaining (and unenjoyable) debate during a guest lecture he gave at his alma mater law school with a partner from a major Chicago law firm (who was teaching a venture class that semester) that claimed an initial public offering should be considered a liquidation event. His theory was that an IPO was the same as a merger, that the company was going away, and thus the investors should get their proceeds. Even if such a theory would be accepted by an investment banker who would be willing to take the company public (no chance in our opinion), it makes no sense as an IPO is simply another funding event for the company, not a liquidation of the company. However, in most IPO scenarios, the VCs "preferred stock" is converted to common stock as part of the IPO, eliminating the issue around a liquidity event in the first place. Liquidation Preferences: What They Really Do By Craig Sherman, Partner, Seattle Office. Email: csherman@wsgr.com There are three fundamental types of liquidation preferences that are typically negotiated in connection with a financing involving the issuance of preferred stock to investors. These consist of
    • Term Sheet Tutorial 68 non-participating preferences, participating preferences and participating preferences that are “capped.” The general differences between these three categories of preferences are discussed in the data set of this report. To demonstrate the impact of the various types of liquidation preferences, let’s take a simple example of a company that sells 5 million shares of Series A Preferred Stock, equal to 1/3rd of its outstanding stock following the financing, to a venture capital firm for $5 million ($1.00 per share). For the sake of simplicity, we’ll assume that the remaining 2/3rd of the company’s equity (10 million shares) is in the form of common stock, and that there are no outstanding options or warrants. If that company is subsequently sold for $20 million, the distributions will vary significantly depending on the structure of the liquidation preference:  Participating Preferred: The first $5 million would be distributed to the holders of preferred stock, and the remaining $15 million would be distributed based on the pro rata ownership, with 1/3rd ($5 million) to the holders of preferred stock and 2/3rd ($10 million) to the holders of common stock. Therefore, the holders of preferred stock would receive $10 million total ($2.00 per share), and the holders of common stock would receive $10 million total ($1.00 per share).  Non-Participating Preferred: The first $5 million would be distributed to the holders of preferred stock, and the remaining $15 million would be distributed to the holders of common stock. Therefore, if the preferred stock chose not to convert, the holders of preferred stock would receive $5 million total ($1.00 per share), and the holders of common stock would receive $15 million total ($1.50 per share). However, the preferred stock would be better off converting into common stock, because by doing so, the holders of preferred stock would receive $6.67 million total ($1.33 per share), and the holders of common stock would receive $13.33 million total ($1.33 per share).  Participating Preferred with a 2x Cap: The first $5 million would be distributed to the holders of preferred stock, and the remaining $15 million would be distributed based on the pro rata ownership, with 1/3rd ($5 million) to the holders of preferred stock and 2/3rd ($10 million) to the holders of common stock. Therefore, the holders of preferred stock would receive $10 million total ($2.00 per share), and the holders of common stock would receive $10 million total ($1.00 per share). However, if the purchase price of the company increased above $20 million, no further proceeds would be distributed to the holders of preferred stock. If the company were sold for $25 million, the holders of preferred stock still would be capped at the $10 million total ($2.00 per share), and the holders of common stock would receive the remaining $15 million total ($1.50 per share). If the company were sold for $30 million, the holders of preferred stock still would be capped at the $10 million total ($2.00 per share), and the holders of common stock would receive the remaining $20 million total (also $2.00 per share). At a purchase price above $30 million, the holders of preferred stock will be better off converting to common stock, in order to receive the same value per share. Our data set shows that roughly two-thirds of preferred stock financings have a participating liquidation preference, with roughly half of those capped and half uncapped. The deals without a participation feature and with generally lighter terms on liquidation preference tend to be earlierstage deals led by West Coast venture capitalists. West Coast term sheets may be more favorable to the common stockholders, with a “1x” initial liquidation preference, no cumulative dividends and no participation. In particular, entrepreneurs may find that some of the better-known so-called “first tier” venture capitalists on the West Coast will offer the “softest” term sheets (though frequently coupled with a lower valuation), because these investors are the most focused on making their returns from “home run” investments.
    • Term Sheet Tutorial 69 It is critical to carefully negotiate the liquidation preference in the first preferred stock investment in the life of the company. In an early-stage financing, the investors often will be willing to agree to terms, including terms of liquidation preference, that are relatively favorable to the company’s founders. Because the terms of a subsequent venture financing typically will follow closely the terms of previous financings (and, of course, the terms of later financings rarely are more favorable to the founders than the terms of the earlier financings), the early investors believe that they will benefit in the future by not subjecting their own preferred stock to burdensome liquidation preferences and other onerous terms of the later financings. As the company raises additional rounds of preferred stock financing, or if the already outstanding preferred stock has a multiple liquidation preference or cumulative dividend, the liquidation preferences quickly add up, creating what is commonly referred to as a preference “overhang.” As a result, the holders of common stock (typically founders and management) may become disincentivized if the common stock would have little to no value in a sale of the company. Holders of common stock may demand a “recapitalization” of the company, where some or all of the outstanding preferred stock is converted to common stock in order to reduce or eliminate the liquidation preference overhang. Frequently, the liquidation preference is left in place but a “management retention plan” is layered on top of the liquidation preference to provide the key members of management with bonus payments that are paid prior to the liquidation preference if the company is sold. Disputes between management and investors over preference overhangs that are not resolved through a recapitalization or management-retention plan have led in some cases to business deadlocks and actual shutdowns of venture-backed companies. Term sheet overview: Liquidation Preference Want to Know How VC’s Calculate Valuation Differently from Founders? The second most important economic term in the term sheet other than price is “liquidation preference.” This states how the proceeds from a sale or dissolution of the company will be distributed. Investors will always want to get their money out of the company before founders, which in the case where the company is sold for a low price is fair. You almost certainly will have liquidation preferences if you raise VC so don’t worry about having them. But not all liquidation preferences are equal – we discuss all this in the video – some can have a “multiple” on top of them such as a 2x liquidation preference, which means that investors get 2x their money before founders get anything. In an early round of investment where there is not an extremely high price relative to normal valuations this is anything but benign. More likely what you’ll see if you have an aggressive term sheet is “participating preferred” stock. This means that investors get their money back AND they get to share in the proceeds. If you’ve raised $6 million in total and still own 40% of the company and sell for $10 million (not a great outcome but it happens) then with participating preferred investors would take $6 million off the top and then 60% of the remaining $4 million so the founder’s take would be $1.6 million (.4 * $4 million) and not $4 million. Note that it might be even less than $1.6m because liquidation preferences often have interest calculated on top of them. VC’s in early rounds will argue that “participation” is simply downside protection and if you sell for a lower price they should get more of the proceeds. While true, the problem I have is that any terms you have in your early stages will certainly be asked for by future investors in your later funding rounds so all of these terms pile up when you’ve been through 3-4 rounds of funding over a 5 year time frame. And by the time most companies get to an exit (which despite what you read on TechCrunch about all the high-profile early exits the most realistic case is still 8-10 years) often the founders own very little of the economic upside. This is a shame.
    • Term Sheet Tutorial 70 Privately some early-stage VC’s talk about participation helping them to “juice their returns” on smaller exits. This is silly talk. I don’t imagine any VC seriously makes money by having tons of small to mid-sized outcomes and therefore “juicing” to me is delusional. I think VCs make money by investing in 20-25 deals and finding 2-3 outliers that drive extra-ordinary returns. And those are often done by the best and smartest founders who have enough knowledge to know which VCs are juicers and which aren’t. You reap what you sow. I also won’t say there is never a time for “participating preferred” but it tends to be in later-stage rounds and particularly in the case where the founders are getting an exceedingly high valuation relative to the norm. In those cases there are all sorts of mathematical reasons why participation might make sense. These are edge cases. But for founders stuck in this negotiation about participation or not with VCs the most standard compromise is “participation with a cap” which is usually set at 2-3x their investment. This means that participation truly only applies in downside scenarios and once your exit outcome is above a certain price investors would still be better off converting to common stock and not taking their preference. I prefer to see no participation but this is a good compromise if you can’t get a straight 1x liquidation preference. Liquidation Amount This is the amount of money the investor in preferred stock has a right to receive before the common stock shareholders receive anything. The dollar amount is defined in the term sheet. It often starts with the investment amount plus accrued, but unpaid dividends. Then some sort of multiplier is usually applied to that amount. Participation Originally, preferred stock was an ‘either-or’ proposition for the investor in the event of liquidation. The investor would calculate the liquidation amount, calculate the value of the common stock if converted, and pick the one that yielded the higher amount. This is called non-participating preferred stock. The key feature of participating preferred is that the investor gets the liquidation amount first, AND then participates in the distributions on an as-converted basis. Limits On Participations (Three Alternative Examples) Liquidation preferences are a key term in the definition of preferred stock (it's generally acknowledged to be the second most important economic term). Earlier, I wrote about this and other terms in a post on negotiating a term sheet, but here I want to give some specific examples to illustrate why this is such an important term. You probably already know this, but it's worth repeating that liquidation preference refers to the procedure for paying investors off in a sale or winding up of the company. It typically includes two components: a preference (which is an amount that gets paid before others) and participation (the ability to "double dip"). Many folks have written on preferences in terms of definitions, so instead I'm going to give some simple examples. For simplicity sake, imagine a VC has $10MM invested in one class of preferred stock in a company, owns 40% and the company is sold for $50MM. Here’s how the three different scenarios in my previous post work (in a specific example):
    • Term Sheet Tutorial 71 (1) 1x preference w/ no participation. In this case, the VC has the choice to take $10MM (their 1x preference) or to convert to common and take $20MM (40% of the $50MM). Obviously, they’d want to do the latter. You might ask, what’s the value of the preference? Well, imagine if the company were sold for $15MM—in that case the VC would take the $10MM preference which would mean they really own 75% of the economics (not the 40% shown on the cap table). (2) 1x preference capped at 2x with participation. In that case, the VC would get $10MM off the top (1x preference) and then get 40% of the rest (or $16MM) but here the cap kicks in so instead of getting the extra $16MM, the VC would get only an additional $10MM for a total of $20MM (or 2x). It's helpful to look at a table of outcomes here: Sale As Preferred As Common 10 10 4 20 14 8 30 18 12 35 20 14 40 20 16 50 20 20 60 20 24 70 20 28 80 20 32 90 20 36 100 20 40 The first column is the sale price, the second is the value to the VC "as preferred" and the right column is the value to the VC if they convert to common (which they always have an option to do). You'll see how the cap creates a "donut hole" where the VC receives the same amount whether the company is sold for $35MM or $50MM (because the VC would convert to common in any sale over $50MM). (3) 1x preference with participation and no cap. In this case, the VC gets $10MM off the top, then they convert to common and get 40% of the rest (or $16MM) for a total of $26MM. In this case, the VC gets 52% as opposed to the 40% shown on the cap table. You can see with this simple example how the liquidation preference can add substantial returns for investors (which all comes out of the pocket of common). So my view is that, no participation is the best option for common, followed by a cap and the worst deal is the no cap participation scenario. Lastly, I would like to give a caveat on the cap scenario that is that the donut hole sometimes creates an unwelcome incentive. Imagine in the above example if there were two deals on the table: one for $35MM in cash and another for $35MM in cash plus a $15MM earn out. Further, imagine that the $35MM all cash deal is slightly more likely to close. In that scenario, the VC would be inclined to take the lower priced deal (remember they get paid the same in both scenario) but common would probably go for the higher deal.
    • Term Sheet Tutorial 72
    • Term Sheet Tutorial 73 TERM SHEET: PRICE Term Sheet: Price by Feld Thoughts Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a fully diluted basis, including shares reserved for any employee option 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. Alternatively: Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fullydiluted pre-money valuation of $ __ million and a fully-diluted post money valuation of $__ million. For purposes of the above calculation and any other reference to fully-diluted in this term sheet, fullydiluted assumes the conversion of all outstanding preferred stockof the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Companys existing option pool by [ ] shares prior to this financing. Recently, another term that has gained popularity among investors is warrants associated with financings. As with the stock option allocation, this is another way to back door a lower valuation for the company. 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, we recommend the entrepreneur negotiate for a lower pre-money valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with existing investors who - for some reason - want to artificially inflate the valuation since the warrant value is rarely calculated as part of the valuation (but definitely impacts the future allocation of proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as the bridge investor wants to get a lower price on the conversion of their bridge into the next round - it's not worth fighting these warrants. The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in his company - (economics 101: If you have more demand (VCs interested) than supply (equity in your company to sell) then price will increase.) In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors 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. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process. TERMINOLOGY The Off Road Investor OffRoad Investment Primer By Marc H. Morgenstern of Blue Mesa partners: this is a good compendium of legal terms for the Off Road Investor…..i.e. private equity investor (read online): http://www.bluemesapartners.com/images/DefinitiveDealDictionaryOffRoadCapit al1999.pdf
    • Term Sheet Tutorial 74 EQUITY VS. CONVERTIBLE NOTE Convertible notes The first decision is often whether to negotiate for Equity or a Convertible Note. Convertible notes: One of the benefits of notes is that if the company were to face an unpleasant ending, notes are higher in the pecking order for repayment in the case of liquidation or some similar event. A convertible note addresses these concerns. It is a note, with stated interest, but it may be converted into stock by the investor based upon some predefined circumstances, such as a following round of equity investment, and on terms that have been negotiated (usually a discount to the price per share of the equity round, or warrant coverage). Convertible notes are often used if you think there’s a compelling reason to avoid placing a valuation on the company at the time of the transaction. For example, if the company has received investment interest from a venture capital firm, but is only willing to proceed when certain accomplishments have been achieved (such as customer acceptance of a product or a patent issued). You will argue to the private investor that putting a value on the company today will establish a lower baseline from which the venture capital firm will establish its value for the next round. By doing a convertible note, you will add, the investor gets into a deal with an almost guaranteed return (the discount or warrants) with very little risk. Moving along the continuum, this structure is a commitment to sell equity, with many of the terms of the equity predetermined. The Conundrum of Convertible Notes Rationale for a convertible Note You’ve started your company and have done a great job of bootstrapping it so far. You’ve been able to convince some friends and business associates to join you, or to work nights and weekends, so that your product is really beginning to take shape. You know that it will just take a little bit more effort to do those things that will attract an investment from a venture capitalist. BUT, you need just a modest amount of money to make it from here to there [hence, the term, “bridge loan”]. You get linked up with some angel investors and they get excited about you, your company, and its investment return potential. At that point the conversation usually goes something like this. You: “Your modest investment will help me get to the point where venture capitalists will want to invest and then it’s all downhill from there.” Angel: “You’ve convinced me. What did you have in mind?” You: “We need to put together a convertible note with a premium for you for coming in now. That’s what all the companies at this stage do.” Angel: “I’m not sure I get it. Please explain.” You: “Once we have done the things that your money will enable us to do [gotten a customer, completed an alpha or beta test, attracted someone to the management team], the VC is going to want to invest. Since we can’t really value the company today, we’ll let the professional investor establish the value when he invests. In exchange for you coming in now, though, I will offer you a sweetener so that you will buy your stock in that round at a discount to the price the VC pays.
    • Term Sheet Tutorial 75 “By making it a note, if something were to go wrong, but nothing will, but if something did, your note will be higher in the pecking order for repayment than stock. “Besides, if we tried to value the company today, the VC would probably use that value against us when we negotiate his round. I’m just looking out for you so that you’re treated fairly.” Angel: “Gee, thanks. Who do I make the check out to? What do I need to sign?” As I’ve done before in this series, I’ve taken some poetic license, but it’s not too far from the truth. The logic appears to make sense. In many cases, both sides think that they’ve done the right thing and that it’s onward and upward. Standard features of a convertible note A convertible note is a loan to the company, with an interest rate, that the investor has the right to convert the entire principal amount of the note (and often any accrued interest) into equity when an institutional investor subsequently makes an investment. Usually there is a premium for investing at this time. More specifically: Principal Amount This is the amount that the company is “borrowing” from the investors. In most circumstances, each investor will an identical note with only the names of the note holder and the amount of the note being different. For example, a round of $100,000 might be shared by five investors investing $40,000, $25,000, $15,000, $10,000 and $10,000, respectively. Sometimes, a limited partnership, or its equivalent is formed; the investors invest in that; and then the LP becomes a single investor in the company. Interest Rate In my recent experience, annual interest rates on these loans are usually in the 6% - 10% range. Risk Premium In exchange for investing now, the investor is given additional consideration that effectively lowers his price per share as compared to the price paid by the subsequent investor. Often a specified discount in the range of 15-40% is used depending upon lots of circumstances. This number may be fixed or may increase over time. An alternative would be to issue warrants based upon an agreed to formula. Repayment Terms The convertible note is done with the presumption that it will, in fact, be converted. If it isn’t, then the method of repayment must be defined. Further, your private investor is doing this deal for the thrill of potentially making a lot of money. As such there will be restrictions, or prohibitions, related to prepayment. The interest may be treated in several ways. You may want to have the interest accrue so that it doesn’t impact your cash flow. That may be agreeable to the investor if the accrued interest will convert with the principal. Alternatively, you may want to pay the interest quarterly to avoid the additional dilution that would occur with it accruing and converting. Having current income from the investment may be desirable to your investors as well. Qualifying Transaction You have solicited this investment with the explanation that it will enable you to attract a significant investment on favorable terms. The investor will want to define what that means. Not that you would, but the investor doesn’t want your Uncle Charley to invest $1,000 at $10 per share, and have that cause his loan to be converted as well. Usually, there needs to be at least a minimum amount raised before the conversion would occur. Protective Provisions As in any such security transaction [and a loan of this type is a security and must comply with the relevant securities laws], the investors will have certain protective provisions. Usually, certain transactions will require a majority approval of the note holders for such things as taking out loans
    • Term Sheet Tutorial 76 above a certain amount, selling some or all of the important assets of the company, creating a new security that is senior to theirs, and the like. Maturity Date This is the date upon which your investor can seek repayment of the note. Depending upon circumstances, this might be as short as 30 days or could stretch over several years. Default & Remedies If your investor requests to be repaid per the terms of the agreement, and the company is unable, or unwilling, to make that payment, then your investor will have certain rights that he can invoke through the judicial system. Potential flaws of a convertible note While this may all sound reasonable, the consequences may not be. Operating objectives won’t be met on time Nine times out of ten (actually more), a first-time entrepreneur will not achieve the operating objectives on a timely basis. The consequence of this is more money will be needed, and guess who is the only likely source of that money? Look in the mirror. Achieving operating objectives doesn’t attract investment Even if the operating objectives are achieved, there’s no guarantee that an investor will be ready and willing to invest. The consequence of this is more money will be needed, and guess who is the only likely source of that money? Look in the mirror. Institutional investors may not honor the terms of the note Even if you hit your operating objectives and attract an investor to the bargaining table, there’s no guarantee that he will abide by the terms of your notes. If you only have one investor at the table, and you’re running out of cash [which are both highly likely if you get this far], the Golden Rule will prevail: He who has the gold rules. If a new investor agrees to invest only on the condition that the convertible note holders waive some, or all, of their rights, your original investors are between a rock and a hard place. They are faced with the decision of giving up all those financial benefits that you had promised them, coming up with additional money themselves, or let the company crater. Remember, a legal agreement is only the default if parties can’t negotiate an alternative agreement. In this example, the potential investor can choose not to accept the default, and just walk from the deal. Institutional investors will probably ignore your valuation as a frame of reference The premise that not valuing a round today will induce a higher value later is based upon a flawed premise. An institutional investor will establish what he believes to be the company’s value at the time of the investment consideration. Valuations of prior rounds, if any, may serve as points of reference, but will not be major determinants of the company’s current valuation. This is particularly true in today’s funding environment and applies to all new rounds, not just those funded by angels. The downside protections aren’t really fair If it gets to the point where the maturity date of the note comes and goes, it’s highly unlikely that will be because the company is so prosperous. More than likely, you have not been able to raise the follow on round of investment. As a result, it’s highly unlikely that you will be able to repay the notes when requested to do so. Further, the default provisions and remedies won’t yield much. You’ve heard the saying, “You can’t get blood from a stone”? Well, you can’t get cash out of a close-to-bankrupt company. Counterintuitive investment incentives Quite often, a first-time entrepreneur pitches the convertible note structure so long and so hard, that he begins to believe that the follow on investment by the institutional investor is inevitable. After all,
    • Term Sheet Tutorial 77 the convertible note is a “bridge” from here to there. That mind set can be very dangerous. The discipline of controlling cash flow can get lax. Another unintended consequence of this structure is that the institutional investors will have a disincentive to come to the bargaining table. Even if you do everything that you say you will do, you are still going to be an early stage company with lots of risks. The seasoned investor knows that when a first-time entrepreneur raises angel money, it is highly likely that the angels will pony up more money if there are no other alternatives. The investor knows that if he sits on the sidelines, you will further reduce risk with someone else’s money and that the Golden Rule is still likely to be in effect when he comes to the table. Appropriate Use of Convertible Notes I opened by saying that I didn’t like convertible notes except in specific circumstances. Since I’ve slammed them so hard, I owe it to you to give you my opinion as to when they are appropriate. I believe that they are absolutely the right vehicle for economic development organizations such as InnovationWorks, Idea Foundry, the Pittsburgh Digital Greenhouse, and the Pittsburgh Life Sciences Greenhouse. If their early funding launches a great success, then by all means, they deserve to participate on the upside. I know for a fact that if current policies had been employed by InnovationWorks’ predecessor organization when Sean McDonald launched Automated Healthcare, the return on its investment would have been staggering on a relative basis, and awfully darn good on an absolute basis. I also believe that convertible notes are appropriate investment vehicles for companies that have already raised money at a fixed price and all of the current investors are willing to take their pro rate share of the round. Advice to entrepreneurs  Think long and hard as to whether a convertible note is really the best way to structure a round of financing, even if it’s possible to do so.  A convertible note just delays the resolution of a fundamental difference of opinion about valuation. The passage of time and intervening events are likely to exacerbate those differences, not resolve them.  While likely to be painful for all involved parties, it is my sincere opinion that pricing the round, putting that issue behind you, and building value from that point forward will prove to be best for everyone.  Surround yourself with professionals, mentors, and advisors who have “been there, done that” and can help you level the playing field. Watch Out Angels When Buying Notes From An LLC:  If the worst happens….the venture goes out of business……then something even worse might occur to those investors who did not buy the notes  The venture in essence, benefits from the forgiveness of debt….which  Might be a taxable event for the LP’s of the LLC, so  Not only do they lose their investment, they must pay taxes  Of course if they hold the notes, they can offset the loss…..but if they do not then they cannot.
    • Term Sheet Tutorial 78 FINANCING Revenue Participation Certificates: Should I consider this alternative? WEEKLY WARNING: Make sure your attorney is aware of what you are doing. Avoid giving up equity Many entrepreneurs don’t want to give up any equity in their company. Such entrepreneurs often fall into one of two groups. First-time entrepreneurs rarely look at equity as a bargaining chip that they’re willing to bet. They view their equity as sacrosanct and won’t give it up for anything as crass as money. Secondly, sophisticated entrepreneurs who want to build their companies, but don’t want to take them to an exit that rewards equity investment (acquisition or IPO) will need to create a reward incentive that can be met through other means. We’ll look at some examples that satisfy these conditions. Revenue participation certificate This is a simple and relatively elegant investment vehicle. It’s really a royalty with a fancy name. Its essence says: I will pay you X% of revenues until you get Y times your money back. This has several appeals. Revenues are relatively straightforward to measure. Both sides know how much money is owed; the only variable is timing. X and Y will be negotiated in the context of your business plan. X will be large enough to provide a reasonable cash flow to the investor and Y will be set based upon perceived risk. Using your business plan as the basis, you will be able to tell the investor this deal will provide him with a particular annual rate of return. For the investor, this is structured so that the focus of the negotiation is on when he will get his return on investment, not if he will. If the company takes longer to grow sales than the plan anticipates, the rate of return will be reduced, but it is still likely to be attractive. For example, if it takes five years to provide the return rather than the three years that was anticipated when the deal was struck, that may mean the annual rate of return might be reduced from 30% to 17%. The persistence of the payment will be an incentive for you to pay the security off as quickly as possible. You will begin to look at those payments representing money that you could use to grow your business, or put in your own pocket. This base deal can be modified to accommodate specific circumstances. For example, the parties can agree to delay the commencement of payments until 6 or 12 months after closing so that the company has some runway to put the investment to work before impacting the company’s cash flow. Beyond the standard legal warning above, while the deal appears to be very simple, it will be a challenge from an accounting and tax basis, so get good professional advice if you go down this road. Put and call Another fairly simple structure is for you to sell a security to an investor that has a straightforward put and call. A put is an investor’s right to force the company to buy his security upon specified terms; to put the security to the company. A call is the company’s right to buy back the investor’s security on specified terms; to call the security. A deal using this structure might be phrased: The company has a call on the investor’s security at X times the investor’s investment amount until the third anniversary of the investment. After the third anniversary of the investment the investor may put his security to the company at X+1 times the invested amount.
    • Term Sheet Tutorial 79 Those multiples might be 2 and 3, for example, or 3 and 4, for that matter. The important point here is that you have a finite period of time to pay off your investor before the cost of that money increases significantly. Therefore you will manage your business with that in mind so that you can avoid that. By setting up these rules at the beginning, everyone knows the consequences of their actions. Special situation: unwinding a partnership While this is a little off topic, I offer it as another example of imaginative deal making. It is not unusual for two people to start a business and after a period of time realize that their goals are not the same. The worst thing that can happen is for the business to be paralyzed because no decisions can be made. Under these circumstances, a “divorce” is usually the best thing to do, and have one partner buy out the other. What if they can’t agree on how to do this? Here’s an approach that I have seen used:  Flip a coin.  The winner gets to choose whether he goes first or second.  The first person sets the price for the business.  The second person gets to decide whether he wants to buy or sell. Right or wrong, the conundrum gets resolved and each partner can get on with his life, and the business can prosper in the way that the buying partner envisioned. Advice to Entrepreneurs  There are ways to raise money without giving up equity.  Only a subset of potential investors will find such deals of interest.  Deal structures are only limited by the imaginations and expectations of the participating parties.  Surround yourself with professionals, mentors, and advisors who can help you level the playing field.
    • Term Sheet Tutorial 80 VALUATION How VCs Calculate Valuation (And How It's Different From The Way Founders Do It) Mark Suster, Both Sides of the Table How VC’s Calculate Valuation: We walked through a standard deal where you raise $1 million at a $3 million pre-money valuation leading to a $4 million post money valuation. The math works out that the investor owns 25% of the company post deal ($1 million invested / $4 million valuation) and assuming 1 million shares, each share would be valued at $3 / share ($3,000,000 pre-money / 1 million shares = $3 / share). Investors own 25%, the founders own 75%. NOTE: In the video I talked about how VC’s and entrepreneurs decide the total number of shares at the first major funding round and why it’s often a high number. But this example above is all entrepreneur math, not the VC’s. The VC assumes you’ll have an option pool. That’s normal. You’ll need to hire and retain talen to grow your company. Those options need to come from somewhere. The more senior members you have (say you already have a CEO, CTO, VP marketing, VP Biz Dev, VP Products) then the less options you’ll need and vice versa. Industry standard post your first round of funding will be 15-20%. I say “post” funding because you’ll need more than this amount pre-funding to get to this number after funding. We walk through this in the video. So taking the same fund raising round and assuming that the VC wants the options including before he or she funds (and before is totally standard) then the math works like this: Assuming a 15% option pool post funding then you need a 20% option pool pre funding (because the pool gets diluted by 25% also when the VC invests their money). So your 100% of the company is down to 80% even before VC funding. Normal. The VC’s $1 million still buys them 25% of your company – it’s you who has diluted to 60% ownership rather than 75%. The price / share is actually $2.40 (not $3.00), which is $3,000,000 premoney / 1,250,000 shares (because you had to create the 250,000 share options). Thus the “true” pre-money is only $2.4 million (and not $3 million) because $2.40 per share * 1 million pre-money outstanding shards = $2.4 million. Note that the term sheet you get will still say, “Pre-Money = $3 million” and there won’t be anywhere in the term sheet that says “true Pre-Money” or “effective Pre-Money” – that’s for you to calculate. So let’s start calling the term sheet listed pre-money valuation as the “nominal” pre-money valuation. Luckily you all now have the spreadsheet to download that will calculate both for you.
    • Term Sheet Tutorial 81 APPENDIX A Founders Shares Issues (Last update: July 23, 2011) Overview: It is common practice for professional outside investors to require the founders to agree to place a certain number (often all) of their fully vested and owned shares under a repurchase restriction. This “repurchase right” lapses over time, restoring the founders’ ownership to its original status before the financing round. The concept of vesting founder shares originally arose from co-founders’ desire to ensure that any founder who left the venture early it its life did not enjoy a “free ride” many years later when the liquidity event occurred. The underlying concept was that those founders who stayed with the venture drove its growth, and planned and executed a lucrative exit deserving much more of the fruits of their labor than an ex-founder who essentially got a “free ride.” Simply put, 100% of the venture’s value occurs at the exit, and those who are not present at that time cannot have made the same contribution as those who are. Professional investors use the buyback right for these reasons: A) The most critical component of the company’s success is the Founder who should be incented to stay with the company, realizing that he/she will not get a totally “free ride” if they leave prematurely (due to the forced sale of their unvested shares). B) The acceleration of vesting upon a change of control aligns the Founders’ and investors’ interest in seeking an exit prior to vesting expiry. C) If the Founder leaves he/she will likely leave a hole that must be filled by recruiting top talent from the outside. The relinquished (i.e. repurchased shares) enable the company to attract better talent that benefits the ex-founder (due to their retained vested shares). Summary of Issues to Consider: I. Vesting Issues: A) Whose Shares get vested per the vesting schedule? Founder; Employees; Directors; Consultants. B) Are they all treated the same, or does Founder get preferential treatment? C) If the vesting schedule is based on the passage of time, what is the commencement date for the vesting schedule to begin? Is any credit given for past service? How long is the vesting schedule (3 – 4 years) and how frequently are shares released from potential repurchase (annually, quarterly, monthly)? D) If milestone-based vesting is used, are the milestones not readily open to misinterpretation? (For instance, closing a financing round is rather clear, but achieving cash flow break even requires an unambiguous definition.) E) How many shares are subject to the vesting schedule? F) Be sure to file the 83 (b) form with the IRS within 30 days of a vesting schedule being put in place. If not filed then the value of the vested shares (between original cost and the then perceived value, such as derived from the financing round which prompted the vesting) will be taxed as ordinary income! Just imagine having a taxable event every month if monthly vesting were in place! II. Termination Issues: When does vesting cease?
    • Term Sheet Tutorial 82 A) Can the founder/employee/consultant continue vesting if they cease being on the payroll but retained as a consultant or Director? B) When fired for cause: Willful misconduct, gross negligence, fraudulent conduct, and breaking agreements with the company (n.b.: clashing with the new CEO is not “cause”). C) Constructive Termination: Leave for a “good reason” such as vastly diminished duties and compensation, required to move to distant location. Can be treated like a severance package (i.e. credit with six months continued vesting)? D) Quit: To join another venture (which might compete) or retire and leave the industry? E) Health: Disability or death. III. Repurchase Issues: A) What is repurchased? Only the unvested shares? (Never agree to have the repurchase apply to vested shares.) B) At what price? Original cost; Fair Market Value; lower or higher of the two? C) Should the price vary based on the reason for termination? Quitting and being fired for cause may warrant repurchase at cost; constructive termination may warrant FMV. D) What happens to the repurchased shares? Usually they are returned to “Authorized but unissued common shares” which obviously enables all shareholders to enjoy “reverse dilution” and makes these shares available to attract replacement talent. However, sometimes co-founders might try (usually unsuccessfully) to negotiate that these shares are re-allocated only among the founders and not the investors. IV. Acceleration of Vesting Schedule: A) Change of Control (COC): This can be defined to mean an IPO, an M & A event, or only an exit event which is substantially all cash. B) Single Trigger: This event can trigger a full or partial vesting acceleration (which in essence increases the cost of the acquisition) C) Double Trigger: Both the COC and the termination of the Founder must occur (how long, post COC, can be 6 – 12 months); and the second trigger can be tied to the reason for the termination (e.g. no vesting if fired for cause). The double trigger helps the acquirer believe the Founder will stay. D) Combination of the Single and Double Triggers: A portion of shares become vested upon COC, with the rest only if termination occurs thereafter within a specified time. V. Important Concepts: A) The “Free Rider” refers to those who have left the company early so have neither helped grow the company nor assisted in consummating the exit. They may have made no contributions for many years since leaving, yet are cheering from the sidelines for the exit (and voting their shares). Incidentally, be sure to consider “Drag Along Rights.” B) “Cash is fact; all else is opinion!” This refers to the reality that the company only has value when it is converted to cash either via a liquidation (admitting failure) or via a lucrative liquidity event. Up until the point that cash is paid for the company it really has no value, despite the opinions of its valuation by the founder, employees, and shareholders. Or, said differently, at all times the company’s only true value is how much cash someone will pay for it. In essence, this highlights the view that starting and growing a company is a wonderful adventure and should be highly respected. However, 100% of the value occurs at the time of the exit. C) Among every venture’s scare resources are time and money. There is no evidence to suggest that the more complex the term sheet, the more lucrative the exit. All the time and money (legal fees) devoted to negotiating the fine points of any funding round
    • Term Sheet Tutorial 83 would be much better spent in executing the business plan and growing a great company. D) This becomes painfully clear when either the next round or the exit occurs because all items are again opened up to negotiation. At that instant all the time spent haggling over all prior rounds was wasted. VI. Opposing Perceptions of “Fairness:” A) Founder: Usually thinks his/her baby is beautiful and would not even be alive today, let alone so healthy, were it not for his/her total immersion (nights and weekends) for which cash compensation has been woefully under market. The Founder carries the largest “reputation risk” by far, works the hardest, and feels the unrelenting pressure to succeed. The Founder has worked incredibly hard and also made huge personal sacrifices (family and financial deprivations). These are obviously neither grasped nor barely appreciated by these mere investors. Yet the Founder is serving up to this latest round of investors a fabulous opportunity to make them lots of money for comparatively little effort on their part. Moreover, the Founder currently has earned his/her ownership stake via an enormous amount of hard work to date. It feels like going backwards to subject this stake to a repurchase now that great momentum has been established. “Market terms” are irrelevant because they are so incredibly and profoundly inequitable and unjust they border on being immoral. This latest set of investors is obviously taking unfair advantage because they know we so badly need their capital. B) Latest Round of Investors: What this Founder has gone through is what every Founder we see has also experienced, yet the others are not whining (as much). No one forced the Founder (or anyone else on the team) to devote their past years to commercializing this idea. We see lots of babies and this one is certainly not the most beautiful we’ve seen. In fact, we’re looking at other babies right now just as attractive as this one, and they may take much less care and feeding. It is true there would be no company today without all of the Founder’s/team’s previous hard work, but there may not be a company going forward if we disengage now. We probably cannot adequately appreciate their past sacrifices, but then that’s why we have not chosen to be entrepreneurs ourselves. However, 100% of every venture’s value only occurs at the exit. Therefore, the Founder should show some appreciation for the value we will bring. We orchestrate exits for a living, but how many have they done? We see deals every day and so know the market. How many deals did they see last week? We cannot attract a co-investor unless the terms are “market.” All the successful entrepreneurs who have taken VC money and had successful homeruns accepted vesting. Vesting should not be a surprise because it’s been on the NVCA website for years and appears in all the standard term sheet books. Remember that our goals are identical to the Founders: To grow a highly valuable company that can be sold in a few years at a very substantial price. When that happens the details of this round will be irrelevant. Examples of legal wording from the two most popular model term sheet sources: Per page nine of Alex Wilmerding’s term sheet book (Term Sheets & Valuations; Aspatore Books; 2001): 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.
    • Term Sheet Tutorial 84 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. Per page 14 of the NVCA Model Term Sheet (revised April 2009) available on the NVCA website: Founders’ Stock: All Founders to own stock outright subject to Company right to buyback at cost. Buyback right for ( )% for the firs (12 month) after Closing; thereafter, right lapses in equal (monthly) increments over following ( ) months. Brad Feld: Term Sheet - Vesting A typical stock vesting clause looks as follows: 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
    • Term Sheet Tutorial 85 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.
    • Term Sheet Tutorial 86 Optimum Share and Option Vesting by Basil Peters Basil Peters (www.BasilPeters.com) See his book Early Exits (although none of this appears in his book) I believe vesting is the most important element of corporate structure. It is essential to ensuring that both entrepreneurs and investors are treated fairly and equitably. Vesting has incredibly powerful effects on the group psychology, culture and corporate performance. I have seen many companies literally fail due to flaws in their vesting. Widespread employee ownership is still a relatively new concept. Even as recently as the 1980s, there was still debate on the degree to which employee equity ownership affected corporate performance. Today, it is widely accepted in North America that companies with broad employee ownership create larger increases in shareholder value. After a couple of decades of experience and a few good analytical studies, there is now a broad consensus on the range of equity that is reasonable for a new CEO, or other senior employee, to expect when joining a company. Agreement on Magnitudes But Not Vesting Formula Even though there is now reasonable agreement on the ideal magnitudes of equity ownership, there is still discussion on the optimum vesting formula. In the mid-1980s, ten year linear vesting was common. As the technology industry matured during the later 1980s, vesting periods shortened. As tech gathered momentum through the 1990s, it became more difficult to hire and retain. Vesting periods got shorter and shorter. In Silicon Valley, in the mid and later 1990s, vesting periods were often as short as 18 months. Anyone who has built a company knows this doesn't make sense. It takes much longer than 18 months to get a return on the cost of recruiting and training a new employee. Many employees have not even reached their maximum level of productivity in a new job for the better part of a year. Interestingly, even though those short vesting periods did not make fundamental sense, they were widespread because the market for human resources is so efficient. Companies quickly realized if they did not offer short vesting periods, they would not be successful in recruiting new employees. Along with the equity markets, the pendulum swung back in the 2000s. As an example, recent vesting at Microsoft was over 4.5 years. Common ranges for vesting periods today are 4 to 6 years. Psychological Vesting One of the challenges in discovering the optimum vesting formula is 'psychological vesting'. Veteran serial entrepreneurs and investors usually agree that when someone is two-thirds vested, they reach
    • Term Sheet Tutorial 87 a psychological turning point where the vesting of the balance of their equity is much less meaningful to them. This means that six year vesting is really only effective as a retention mechanism for about four years. New Appreciation of the 'Contract' with Investors Experienced early-stage investors have also come to believe that one term in the fundamental 'contract' between the entrepreneurs and investors is that the employees will both increase the value of the investors' shares and ensure that at some point they also execute an exit. Investors in companies with large founders positions have often found themselves in situations where the founders have successfully increased the value of the shares but have either no motivation to create an exit or have left the company to pursue some new venture, leaving who ever comes next with the responsibility to create liquidity. Investors familiar with this phenomenon often describe themselves as 'stuckholders'. Up to Half the Value Can Be Created During The Exit There is also increasing agreement that up to half the value that an investor or entrepreneur realizes on an investment can be created during the last few months -- during the exit transaction. If an employee leaves before the exit, it does not seem fair that they participate in that final increase in value. The Optimum Vesting Formula The optimum vesting formula is the one that is most fair and equitable to both the entrepreneurs and the investors. I believe the best formula has to incorporate the implicit contract to execute an exit and realize on the 50% value increase that is often created at the exit. This means that the most fair and equitable structure, and the one that maximizes the alignment between the founders and the investors, is to vest:    50% of the shares daily over a three year period; and The other 50% when there is a sale of the Company. All vesting for senior employees accelerates on a sale of the Company. A sale of the company is an event where everyone in the company has an opportunity to exchange their shares for cash or shares with effectively immediate liquidity (for example, a stock with enough liquidity so everyone who wanted to could sell their shares). In this context an IPO is not a sale of the company. Neither is a conversion into restricted stock. In these situations, the board should develop a new formula to recognize the incremental or delayed liquidity created by this type of transaction. This vesting formula is built into the "one page term sheet". I've used this formula in virtually all of my angel investments for over 20 years. During that period, I've had a chance to watch how this vesting formula has affected the group psychology and increased the probabilities of success in over thirty companies. I am convinced this is as close as we can get to optimum.
    • Term Sheet Tutorial 88 Founders' Equity By Mary Beth Kerrigan and Shannon Zollo (October 2007) A highly negotiated, sensitive provision in a venture capital transaction centers on what percentage of founders’ stock should be subject to additional vesting and the ramifications that result. The following are key issues and suggested approaches to satisfy concerns of both founders and investors regarding this topic. Founders’ Perspective. Most founders receive their equity upon incorporation, which often is at least a year prior to the initial venture capital round. Therefore, founders are usually surprised by the vesting terms that venture capitalists will impose on their equity. From the founders’ perspective, they already own the stock and it is difficult to concede such ownership in order to satisfy the investors’ desire for the Company to retain the right to buy back unvested shares upon the founders’ employment termination. Investors’ Perspective. Venture capitalists will confirm that the two most important factors regarding an investment decision pertain to the (i) quality and experience of the founding team, and (ii) potential market size towards which the Company’s products or services are directed. Consequently, they want to protect against the possibility of prematurely losing founders, together with their full equity position, after their investment. Vesting of founders’ equity protects against this possibility because founders are motivated to stay the course to receive the benefit of their equity position and, should they prematurely leave or be terminated, the unvested shares can be (i) used to attract suitable replacements, or (ii) reallocated to other founders, management, or employees. Cliff Vesting. Standard vesting terms provide that 25% of founders equity will “cliff” vest after one year with the remaining 75% vesting quarterly or monthly over a three or four year period. This approach can be modified such that a negotiated percentage of equity immediately vests at closing (i.e., 25%), which is usually a function of how long the founders have been part of the Company (i.e., the longer the period the more likely the founders will attempt to negotiate a higher percentage of immediately vested equity). However, this effort is balanced against the investors’ desire to require that a larger portion of equity be subject to vesting in order to sufficiently incentivize the founders to continue to work for the Company. Another compromise is for the founders to have their unvested shares subject to a shorter time period (i.e., two years or less). Repurchase Price. A second approach often employed by founders pertains to the repurchase price paid by the Company for the founders’ equity if the founders leave the Company. The standard approach is to allow the Company to repurchase unvested shares at the nominal price paid by the founders for the stock if the founder leaves the Company for any reason. Alternatively, founders can request that the purchase price be equal to the fair market value (FMV) at the time of the repurchase (usually valued in good faith by the Board of Directors or at a price mutually agreed upon by the parties). Investors often view the founders as having not yet “earned” the stock upon premature departure or termination and, therefore, are generally reluctant to allow the founders to benefit from an increase in equity value. This view is bolstered by the fact that had the founders received an option in lieu of stock, the founders would not be entitled to exercise the unvested portion of their option upon departure. The usual compromise is to differentiate the purchase price based upon the reason the founders have left the Company. If the founders leave the Company voluntarily or are terminated for cause, the Company has the right to repurchase the shares at the price paid by the founders. However, if the founders are terminated without cause or constructively terminated (i.e., the founders leave for “good reason”), the shares are repurchased at the current FMV. Lastly, a very unusual scenario requires the founders to sell back vested shares at the FMV upon termination regardless of the reason.
    • Term Sheet Tutorial 89 Acceleration. Another common provision associated with founders’ equity relates to accelerated vesting upon a change of control of the Company (COC). Founders often request 100% of the unvested shares accelerate and vest immediately upon a COC. Investors are generally reluctant to accept a full acceleration clause as it could make the Company less attractive to a potential acquirer because the acquirer will want key management (oftentimes including the founders) to be motivated to remain with the Company after the acquisition for at least a transition period. The more traditional approach if a COC provision is accepted is to permit at least one year of accelerated vesting to occur. If not satisfied with this proposed percentage, the founders could request a “double trigger” (i.e., additional acceleration after the COC if certain events occur). The double trigger is generally tied to the termination of the founders (usually without cause) within a certain period of time after the COC. For example, if 25% of the founders’ stock accelerates upon a COC, the founders can also request that an additional 25% automatically accelerates in the event they are terminated without cause within six months thereafter. However, this practice can be difficult to implement if there is cash only consideration at closing as it is difficult to determine what percentage of the founders’ shares should be included in the sale and/or subject to the double trigger. Conclusion. Founders and investors must strive to effectively understand the key needs and requirements of the other as part of the negotiation of a successful venture capital transaction. The treatment of founders’ equity is one such key need and requirement. In light of the various alternatives that exist with respect to founders’ equity, consensus should be attainable regarding vesting, repurchase rights, and acceleration, which is desirable in order that all parties may focus their attention to growing the Company into a highly successful venture from which all can benefit. For more information on founders' equity, please contact the authors Mary Beth Kerrigan or Shannon Zollo. From the Wilson Sonsini Goodrich & Rosati Entrepreneurs’ Newsletter (Spring 2008): Vesting of Founders’ Stock: Beyond the Basics By Doug Collom, Partner (Palo Alto Office) One of the most fundamental elements in the issuance of founders’ stock in a startup company is vesting. Vesting is virtually universal as a convention, and is highly effective as a retention tool in connection with the grant of stock to founders and employees. Because common stock is a vital component of the compensation package for managers and employees, vesting is also the means by which the company conserves its equity for purposes of hiring new employees and retaining continuing employees. In a normal vesting arrangement, shares issued to an employee are subject to a repurchase right in favor of the company that typically lapses in a linear manner over a period of time, subject to the continued service of the employee. If the employee’s relationship with the company terminates for any reason, shares that have not vested may be repurchased by the company at their original purchase price. Thus, using a typical example, a founder may receive 1,000,000 shares of common
    • Term Sheet Tutorial 90 stock in a startup company, priced at $0.001 per share. Under the contractual stock purchase terms, these shares are subject to monthly vesting in equal amounts over a period of 48 months. In this example, if the founder’s employment relationship with the company is terminated at the end of three years (i.e., 36 months, or 3/4ths of the vesting period), the company as a matter of contract would have the right to repurchase from the terminated founder a total of 250,000 shares, representing the unvested portion of the total grant, by paying the sum of $250—even though the stock at that point in time may in fact be worth considerably more. So much for the basics. What are some of the more important elements of vesting that a founder might need to understand in establishing the organizational structure of the company at its inception? The Vesting Period. The predominant time period used by startup companies in establishing a vesting program, for founder- and non-founder employees alike, is four years. Although some venture firms require a five-year period for founders and employees of their portfolio companies, this is unusual and the convention in Silicon Valley and other technology-intensive areas continues to be the four-year vesting period. The vesting time period is highly relevant to the employee, since only vested shares end up in the employee’s hands following a termination of employment. It is equally relevant to the company’s venture investors—when shares have vested in the hands of founders or employees in accordance with the vesting period, this usually signals the need to provide a round of replenishment stock grants with new vesting schedules, which may dilute the ownership interest of the venture investors in the company. Credit for Vesting. It is almost invariably the case that when a founder has successfully attracted the attention of a venture investor, a discussion ensues about the vesting of the founder’s stock. Even in the instance where there is no disagreement on vesting philosophy, the founder may focus on how much “credit” the founder should receive in a time-based vesting arrangement for the time spent by the founder prior to the investor’s investment, or for the founder’s contribution to the startup in the form of technology, customer relationships, expertise, and the like. Some investors take the view that no credit should be given—the time-based vesting clock begins only at the time of the investment, thus subjecting the founder to a full four-year service requirement (in the case of a four-year vesting arrangement). Other investors will acknowledge the time and/or value already contributed by the founder, and offer “credit” for vesting, usually in a range of somewhere between 25 and 50% of the founder’s stock (i.e., the founder may immediately take claim to the “credited” portion of the stock as fully vested, and the remainder of the stock will be unvested and subject to the agreed upon vesting arrangement). This question of vesting “credit” is a matter of negotiation between the founder and the investor at the time of the investment. Time-Based or Performance-Based? Most vesting arrangements for early stage startup companies are based on vesting periods oriented around the passage of time. This structure is simple to administer by the company, and is readily understood by employees. Implicit in the time-based vesting arrangement is the understanding that if the founder’s or employee’s relationship with the company should terminate for any reason (e.g., death, disability, poor performance, etc.), the vesting of the stock immediately stops. With the advent of Financial Accounting Standard 123R in January 2006, the accounting penalties that companies used to face in granting stock with performance-based vesting have largely disappeared. As a result, many public corporations and some private companies use stock grants that vest, subject to the continued service of the employee, upon the achievement of identified performance milestones (e.g., first commercial release of a product, achievement of a specified revenue level, etc.). In the private company sector, the use of performance-based vesting arrangements requires careful planning. In large part this seems to be due to the highly changeable nature of the startup company business plan—a performance milestone that may make sense in June 2008 may be completely irrelevant six months later, or the likely timeframe in which the milestone
    • Term Sheet Tutorial 91 was supposed to occur has changed, or the priority assigned to achieving the milestone has changed in the face of overtaking business objectives. Any of these circumstances would frustrate the purpose of the performance-based arrangement. In addition, the use of performance-based vesting arrangements may have unfavorable tax consequences to the employee, particularly in the circumstance where the stock price continues to increase over the vesting period. As a result, performance-based vesting arrangements are not commonly used in private early stage companies. No-Fault Vesting. The conventional time-based vesting arrangement is typically set up as a “no-fault” arrangement; that is, vesting of the employee’s stock stops immediately upon the termination of the employment relationship, without regard to the circumstances of the termination. Many founders at least ask to themselves the question upon the issuance of founders’ stock in connection with the formation of the company—why should this be the case? After all, the founder may have spent long evenings and weekends over the last several years refining the scope and vision of the business plan, developing the technology, personally bootstrapping the outlay of capital costs, establishing the customer and support contacts—effectively putting together all the mission-critical elements of a promising startup company. Why should the founder accept a no-fault vesting arrangement that potentially could strip the founder of unvested stock if for any reason the investors on the board of directors decide that the founder is no longer useful to the company? Founders who take this view might seek protection in their employment arrangements with the company. Even in the “at will” employment relationships that are the convention for startup companies with all founders and employees, the founder may seek severance payment, acceleration of vesting or other separation benefits in the instance where the founder is terminated without cause, or voluntarily resigns for “good reason” (which might include a reduction in title or responsibilities or compensation, or relocation to a different office, etc.). However, before broaching this matter with the venture investor, it is important for the founder to understand the investor’s perspective. No-fault vesting, combined with the usual “at will” employment agreement, is fundamental to what the investor sees as a level playing field. The investor is putting up equity financing and has no guarantees that the business plan will succeed or that the founders will be up to the task of executing the plan. If a founder or the company underperforms, or if the investor and the founder fail to agree on the fundamental growth path of the company, the investor cannot withdraw the investment. Therefore, the investor has no recourse but to come up with a solution to set the company back on track—usually hiring a new manager or managers to carry on. The investor believes that providing the founder with protective separation arrangements that require accelerated vesting in circumstances where things don’t work out unfairly tilts the playing field in favor of the founder. And this protective arrangement is at the expense of not just the investor but the company as a whole—stock that, but for the accelerated vesting, would otherwise be unvested and repurchased by the company for use in hiring a replacement manager, is now held irrecoverably by the terminated founder and has no further incentive value to new or continuing employees of the company. The question as to whether a founder should be entitled to something more than the usual no-fault vesting arrangement is usually addressed, if at all, in the term sheet investment conditions that are offered by the interested venture investor. In most instances, founders understand that investors are planning for success when they make an investment and are betting on the founders as much as they are betting on the business plan. As a result, the no-fault vesting arrangement continues as an industry convention for founders and employees alike in venture-backed startup companies. As commonplace as vesting arrangements are, it is nevertheless important for founders to understand vesting conventions and the competing philosophies behind them. The implementation of vesting arrangements in many ways goes directly to the nature of the personal relationships and
    • Term Sheet Tutorial 92 chemistry that build between founders and venture investors. These arrangements also directly impact the wealth objectives of founders, the hiring and retention objectives of the company, and the dilution concerns of venture investors. As a result, founders need to approach vesting arrangements thoughtfully with all of these considerations in mind. Published online: 27 May 2003, doi: 10.1038/bioent736 The term sheet tango TERI WILLEY * & DAVID PARSIGIAN ** *Teri F. Willey is managing partner at ARCH Development Partners (tfw@archdp.com). **David Parsigian is attorney and counselor at law at Miller Canfield Paddock and Stone (parsigian@millercanfield.com). Vesting of founder's shares It's often said that VCs don't invest in ideas; they invest in people. In fact, they invest in good ideas being driven by people with the knowledge, skill and determination to turn them into a profitable enterprise. Without those people, the company isn't worth much and an investment is pointless. So to be sure that the founders stick around to turn their dream into economic reality, the investor is going to force the founders to earn the stock that they already own in the company. As you review the term sheet, you'll find a provision that says that if you fail to stay with the company, the company may repurchase your founder's shares at the price you paid for them, with that repurchase right reduced over time. For example, say you come to the table with 400,000 founder's shares. Based upon a typical four-year vesting schedule with a one-year 'cliff' and monthly vesting thereafter, your ownership of the first 100,000 of those shares won't be assured until one year after the investment closes, and the remainder will cease to be subject to the repurchase price in equal monthly 'installments' over the next three years. I once had a founder weep as he read these vesting terms. I was proposing to take his stock away and he'd barely gotten over the insult of the pre-money valuation I'd proposed! Nonetheless, expect to see vesting of founders shares in the term sheet. Focus your energy on how to align interests by exploring the option of accelerating your vesting based on reaching milestones that add to the company's value. Just remember, once the deal is done, you and your investors will be sitting on the same side of the table, trying to grow a successful company. So as you sort out the terms of the investment, acknowledge where you have a common interest with your investor and focus the negotiation on the areas where your interests differ from those of the investor. If you can get those interests aligned, you'll have a good deal. What should the vesting terms of founder stock be before a venture financing? I think that founders stock before a venture financing should be subject to the same general vesting terms as one would expect after a venture financing. A typical vesting schedule is four year vesting with a one year cliff. This means that 25% of the shares will vest one year from the vesting commencement date, with 1/48 of the total shares vesting every month thereafter, until the shares are completely vested after four years. The vesting commencement date can be the date of issuance
    • Term Sheet Tutorial 93 of the shares, or an earlier date, in order to give the founder vesting credit for time spent working on the company prior to incorporation and/or issuance of the shares. Some founders want to accelerate vesting upon a termination without cause or a constructive termination. (I will get around to defining these terms in future posts.) I’m not sure that this is really in the best interest of the founders. It is extremely difficult to terminate someone for cause, so termination of a founder will generally result in his/her shares being vested. For founders that have never worked with each other, I would generally counsel against acceleration of vesting upon a termination without cause or a constructive termination. If personalities clash or things don’t work out and a founder needs to be forced out, the remaining founder(s) will kick themselves for allowing the departing founder to leave with a significant equity stake. If there is acceleration upon a termination without cause or constructive termination, I think the amount of acceleration should be similar to the amount of severance that a person may receive in the same situation. If six to 12 months of severance might be justified if a person is terminated without cause, then six to 12 months vesting acceleration seems reasonable. Of course, the typical norm in technology companies is that there is no severance in any situation. In addition, some founders may want to accelerate vesting upon a change of control. Single trigger change of control vesting means that the shares accelerate upon a change of control. This isn’t in the best interest of investors because the fully vested founders have little incentive to continue to work for an acquiror after a change of control. In order to incentivize these people, additional options may need to be granted, which increases the cost of the acquisition to the acquiror, potentially to the detriment of the investors. Double trigger change of control vesting means that the shares accelerate upon a change of control AND the founder is terminated without cause or a constructive termination occurs within 12 months of the change of control. The amount of shares that accelerates upon these events can be 100%, or written as a certain number of months of vesting, such as twelve. I’ve had one VC express a strong opinion that the amount of vesting upon one of these events should not be 100%, but rather 12 to 24 months of vesting acceleration, due to the fact that it is extremely difficult to terminate someone without cause. I think that double trigger 100% acceleration for founders or certain executives is fairly accepted among investors. However, extending that protection to rank and file employees is not common. In any event, VCs are likely to impose their own vesting terms and acceleration upon a Series A financing, so it may not matter what terms are implemented when the initial founders shares are issued. However, reasonable vesting and acceleration terms may survive the Series A financing, especially if it would be difficult to renegotiate with a critical founder in a team with multiple founders. Vesting Founders Stock with a Vesting Schedule | Startup Lawyer July 2008 If your startup company launches with more than one founder and your startup plans to eventually be acquired or seek venture funding, your startup’s founders stock should vest over time according to a vesting schedule.
    • Term Sheet Tutorial 94 Founding teams might not stay together. And having a missing founder or two with a nice chunk of your startup’s common stock is not a scenario your startup wants when it comes time for an acquisition or venture capital financing. So instead of the founders getting all their shares of common stock on Day 1, the founders get their stock according to a vesting schedule. The standard vesting schedule for startup companies is four years with a one year cliff and monthly vesting thereafter until the founders reach 100%. The one year cliff means that the founders do not get vested with regards to any common stock until the startup’s first anniversary. Thereafter, the founders get vested every month at an amount equal to 1/48th of the their total common stock. If a founder leaves before the startup’s first anniversary, the founder leaves without any common stock. If a founder leaves after 15 months, the founder will have 31.25% of his common stock vested (25% after the first year, plus the 2.083% vesting each month for 3 months). Thus, the missing founder leaves the startup with much less shares than if the founders stock had vested immediately. This makes it easier to get the necessary approval (and other issues) to go forward with an acquisition or venture capital financing. Get vested for time served by Nivi on April 19th, 2007, Venture Hacks Your Series A investors will ask you to give all your founder’s shares back to the company and earn your shares back over four years. This is called vesting — see Brad Feld’s article on vesting if you need a primer. Vesting is a good idea: You are critical to the company and you have told your investors that you are committed to the business. They are simply asking you to put your shares where your mouth is: a vesting schedule demonstrates your commitment to the company. Vesting also ensures that a cofounder who leaves the company early doesn’t receive the same amount of equity as cofounders who stay in the business. Get vested for time served building the business. But don’t agree to vest all of your shares just because it is supposedly “standard”. If you have been working on the company full-time for one year, 25% of your shares should be vested up-front and the balance of your shares should vest over three to four years. The best vesting agreement we have seen for a founder in a Series A is 25% of shares vested up-front with the balance vesting over three years.
    • Term Sheet Tutorial 95 You should argue that, “New employees who join the company today will earn all their shares over four years. Employees who are already here should be credited for their time served.” We don’t recommend trying to escape a four-year commitment to the company (including time served). Four years is the typical commitment for a start up, high school, or college, as well as the span between Olympics and World Cups, and the term we give our Presidents to start as many wars as possible. Consider cliffs for newfound co-founders. One-year cliffs are typical for employees but are currently rare for founders. Nevertheless, consider negotiating one-year cliffs with newfound co-founders whom you haven’t worked with in the past. If a co-founder leaves the company after three months, you don’t want him walking out the door with a large chunk of the company. Over time, your continuing contributions to the company will become relatively less important to its success. But the number of shares you vest every month will stay relatively large. Founders generally make their greatest contributions at the early stages of the business but their vesting is spread evenly over three to four years. As your relative contribution to the company diminishes, everyone at the company has an incentive to terminate you and benefit ratably from the cancellation of your unvested shares. Nevertheless, in our experience, founders are allowed to vest in peace unless they are incompetent, actively harmful to the business, or clash with a new CEO. You will probably be terminated if you clash with a new CEO. By definition, a new CEO is hired to change the way things are and provide new leadership to the business. That he might clash with founders who previously ran the business is predictable. The CEO usually wins any disagreements or power struggles — he is the decider and he decides what is best. The investors, board, and management will almost certainly agree to fire your ass if you continuously clash with a new CEO and you will lose your unvested shares upon termination. Accelerate your shares if you are terminated. 50% to 100% of your unvested shares should accelerate if you are terminated without cause or you resign for good reason. Cause typically includes willful misconduct, gross negligence, fraudulent conduct, and breaches of agreements with the company. ‘Clashing with the CEO’ is not cause. Good reason typically includes a change in position, a reduction in salary or benefits, or a move to distant location.
    • Term Sheet Tutorial 96 Detailed definitions are included in the Appendix below. Make sure you receive this acceleration whether or not your termination or resignation is in connection with a change in control of the company, such as a sale of the business. You can clash with your acquirer too. Justify acceleration with the reciprocity norm. Acceleration may cause consternation among your investors but it is easy to justify: “A founder’s most important contributions generally occur in the early stages of a business but he earns his shares evenly over time. If I clash with a new CEO and he terminates me, I should receive the equity I earned with those contributions. Which will make me much more comfortable with hiring a new CEO. The founders agreed to a vesting schedule to demonstrate our long-term commitment to the business. You have told us that the founders are critical to the company — that we are the DNA of the business. Acceleration demonstrates the company’s long-term commitment to our continuing contribution.” This argument is an application of the reciprocity norm which requires your opponent to be fair to you if you are fair to him. Your vesting schedule locked you into a commitment to the company — that was fair — now acceleration locks the company into a commitment to you. It is even easy to justify 100% acceleration if you are the sole founder of the business: “Right now, I own 100% of my shares. After the financing, I will have to earn these shares back over the next four years — I’ve agreed to that. But if I’m removed from the business, I lose the right to earn my shares back. In that case, I should walk out the door with the shares I came in with.” Avoid unfair termination with a democratic board. As usual, the best way to avoid unfair termination and avoid hiring a bad CEO is to create a board that reflects the ownership of the company with hacks like making a new board seat for a new CEO. Acceleration for co-founders can do more harm than good. If you have a team of founders, acceleration upon termination can do more harm than good. A co-founder with acceleration upon termination who wants to leave the company can misbehave and engender his termination. If the company decides to terminate him without cause to avoid possible lawsuits, your co-founder will walk away with a lot of shares. In California, it is actually very difficult to prove cause unless an employee engages in criminal activity. If you trust your co-founders absolutely, you should negotiate as much acceleration upon termination as you can. Otherwise, you need to decide which is worse: the expected value of misbehaving co-founders who leave with a lot of shares or the expected value of leaving a lot of shares behind after your termination.
    • Term Sheet Tutorial 97 Your vesting should accelerate upon a change in control of the company, such as a sale of the business. Negotiate both single and double trigger acceleration. Your options for acceleration upon a change in control, from best to worst, include 1. 2. 3. Single trigger acceleration which means 25% to 100% of your unvested stock vests immediately upon a change in control. Single trigger acceleration does not reduce the length of your vesting period. It only increases your vested shares (and decreases your unvested shares by the same amount). Double trigger acceleration which means 25% to 100% of your unvested stock vests immediately if you are fired by the acquirer (termination without cause) or you quit because the acquirer wants you to move to Afghanistan (resignation for good reason). The hack for acceleration upon termination already provides double trigger acceleration and provides sample definitions of termination without cause and resignation for good reason. Zero acceleration which is a little better than getting shot in the head by the Terminator: The most common acceleration agreement these days combines 25% 50% single trigger acceleration with 50% - 100% double trigger acceleration. The median of this range is probably 50% single trigger combined with 100% double trigger. Justifying single trigger acceleration. You can justify single trigger acceleration by arguing that, “We didn’t start this company so we could work at BigCo X for two or three years. We’re entrepreneurs, not employees. We’re willing to work at BigCo, but not for that long. If we sell the company after two years, that just means we did what we were supposed to do, but we did it faster than we were supposed to. The investors will be rewarded for an early sale by receiving their profits earlier than they expected. We shouldn’t be penalized for an early sale by having to work at BigCo for years to earn our unvested shares. Single trigger acceleration reduces the effective time we have to work at BigCo and rewards us for creating profit for the investors ahead of schedule.” Justifying double trigger acceleration. You can justify 100% double trigger acceleration by arguing that,
    • Term Sheet Tutorial 98 “The aim of vesting is to make me stick around and create value — not to put me in a situation where I am deprived of the opportunity to vest because I am terminated for reasons beyond my control or I resign because the environment is intolerable. So, if I am terminated with no cause by the acquirer, I should vest all my stock. Or if the conditions at the acquirer are intolerable and I resign for good reason, I should vest all my stock.” The risk of termination at an acquirer is much greater than the risk of termination in a startup. Investors are generally investing in the future value of a startup — they’re investing in people. Acquirers are generally investing in the existing value in a startup — they’re investing in assets. Acceleration agreements give you leverage upon a sale. When you sell a company, the acquirer, founders, management, and investors will renegotiate the distribution of the chips on the table. It isn’t unusual to renegotiate existing agreements whenever one party has a lot of leverage over the others. To quote the fictional Al Swearengen, “Bidding’s open always on everyone.” Negotiating your acceleration agreement now gives you leverage in this upcoming multi-way negotiation. If an acquirer doesn’t like your acceleration agreement, they can decrease the purchase price and use the savings to retain you with golden handcuffs. A lower purchase price means less money for your investors. This provides you with negative leverage against your investors — you can decrease your investor’s profit if you refuse to renegotiate your acceleration. Or, the acquirer can increase the purchase price in return for reducing your acceleration. A higher purchase price means more money for your investors. This provides you with positive leverage against your investors — you can increase your investor’s profit if you agree to renegotiate your acceleration. Visible contributors benefit the most from the renegotiation. After this renegotiation, the CEO and key members of the management team often end up with better acceleration agreements than everybody else. That’s not a big surprise — the CEO is leading the renegotiation. Founders who are perceived as major contributors by the board and acquirer may also benefit from the negotiation. If you’re the Director of Engineering, you’re probably invisible to the acquirer — if you’re the VP of Engineering and involved in the negotiations, you may do much better. As always, the best defense against these shenanigans is to create a board that reflects the ownership of the company and to make a new board seat for a new CEO.
    • Term Sheet Tutorial 99 Supersize your vesting with these microhacks By Babak Nivi and Naval Ravikant, April 27, 2007 We offer a few “microhacks” for leveraging your vesting plan in various termination situations. 1. Reclaim a terminated co-founder’s unvested shares. A terminated co-founder’s unvested shares are typically cancelled. The resulting reverse dilution benefits the founders, employees, and investors ratably. Instead of canceling the shares, divide them among the remaining co-founders and employees ratably. You should argue that, “Cancelling a terminated co-founders shares puts a lot of pre-money into the investor’s pocket. Those shares should be distributed among the founders and employees who created that pre-money valuation.” This argument will carry more water if you offer to put a portion of the reclaimed shares into the option pool to hire a replacement for the co-founder. Reclaiming a terminated co-founder’s shares does not create an incentive for co-founders to terminate each other. Co-founders have an incentive to terminate each other even if the shares are cancelled. In our experience, this incentive is never a factor. Founders are almost always allowed to vest in peace unless they are incompetent, actively harmful, or clash with a new CEO. 2. Run screaming from the right to purchase vested stock. Some option plans provide the company the right to repurchase your vested stock upon your departure. The purchase price is ‘fair market value’. Guess whether the definition of fair market value is favorable to you or the company… Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully. 3. Accelerate your vesting upon hiring a new CEO. If you are having trouble applying any of the other vesting hacks, trade those chips in for six months of acceleration upon hiring a new CEO. Investors are usually eager to bring in “professional” management. They should agree to this term because it aligns your interests with theirs.
    • Term Sheet Tutorial 100 4. Keep vesting as a consultant or board member. If you have a lot of leverage, you may be able to negotiate an agreement to keep vesting if you are terminated but retained as a consultant or a board member. For example, the company may terminate you but keep you as a consultant to help decipher your spaghetti code. Some companies have been known to sneak this term into their closing documents. We’re not big fans of that approach. Again, if you are having trouble applying any of the other vesting hacks, you may be able to trade those chips in for this one. What entrepreneurs need to know about Founders’ Stock September 15, 2008 This is a guest post by John Bautista. John is a partner in Orrick’s Emerging Companies Group in Silicon Valley. John specializes in representing early stage companies. When entrepreneurs start a company, there are four things they need to know about their stock in the company: • Vesting schedule • Acceleration of Vesting • Tax traps • Potential for future liquidity VESTING SCHEDULE The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not vesting until the employee has remained with the company for at least 12 months (i.e. a one year “cliff”). Vesting stops when an employee leaves the company. Even Founders’ stock vests. This is to overcome the “free rider” problem. Imagine if you start a company with a co-founder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for much of the hard work. Founder vesting takes care of this issue. Even if you’re the sole founder, investors will want to see your founder’s stock vest. Your ability and experience is one of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company’s development and funding process, want to make sure that you are committed to the company long term. If you leave, the VCs also want to know that there is sufficient equity to hire the person or people who will assume your responsibilities. However, many times vesting of founders’ shares will follow a different schedule to that of typical startup employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history working with each other, and know and trust each other. In addition, most founders will start vesting of their shares from the date they actually started providing services to the company. This is possible even if you started working on the company prior to the issuance of founders’ stock or even prior to the date of incorporation of the company. As a result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.
    • Term Sheet Tutorial 101 This vesting is balanced by investors’ desire to keep the founders committed to the company over the long term. In Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the three or four years following the date of a Series A investment. ACCELERATION OF VESTING Founders often worry about what happens to the vesting of their stock in two key circumstances: 1. They are fired “without cause” (i.e. they didn’t do anything to deserve it) 2. The company gets bought. There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if they both occur (double trigger acceleration). “Single Trigger” Acceleration is rare. VC’s do not like single trigger acceleration provisions in founders’ stock that are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s services are terminated then the founders’ stock should not continue to vest. This is the “free rider” problem again. In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the company’s headquarters are moved). However, under most agreements, there is no acceleration if the founder voluntarily quits or is terminated for “cause”. A 6-12 month acceleration is also usual in the event of the death or disability of a founder. VC’s similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the company to a buyer. Acquirers typically want to retain the founders, and if the founders are already fully vested, it will be harder for them to do that. If founders and VC’s agree upon single trigger acceleration in these cases, it is usually 25-50% of the unvested shares. “Double Trigger” Acceleration is more common. While single trigger acceleration is often contentious, most VC’s will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the enterprise from the acquiring company’s perspective. It is arguably in the acquiring company’s control to retain the founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event of involuntary termination by the acquiring company. In Orrick’s experience, it is typical to see double trigger acceleration covering 50-100% of the unvested shares. TAX TRAPS If things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests, and before you have the cash to pay those taxes. There is a way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your Founder’s shares and paying your tax early on those shares. One of the most common mistakes I’ve encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company. Fortunately, over the years, I’ve developed a number of work-arounds (depending on the circumstances) and we can many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed. Nevertheless, this is one of the first things that your lawyer should check for you. Of course, you’ll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I’m sure you’ll be able and happy to pay!
    • Term Sheet Tutorial 102 POTENTIAL FOR FUTURE LIQUIDITY Founders’ stock is almost always common stock because VC’s purchase preferred stock with rights and preferences superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new security for founders which we call “Founders’ Preferred” which enables founders to hold some of their shares in the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale. The “Founders’ Preferred” is a special class of stock that founders can convert into any series of preferred stock sold by the company to VC’s in a future round of financing. The founders would only choose to convert these shares when they plan to sell those shares to VC’s or other investors in that round of financing. This special class of stock is convertible into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock is identical to common stock. The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price. Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as opposed to common stock. “Founders’ Preferred” can usually only be implemented at the time of the first issuance of shares to founders. Therefore, it is important to address the advantages and disadvantages of issuing “Founders’ Preferred” at the time of company formation. I normally recommend for founders who want to implement “Founders’ Preferred” that such shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance of “Founders’ Preferred” remains a new development in company formation structures. Therefore, it’s important to consult legal counsel before putting this special class of stock into effect. Many VCs do not like to see Founders’ Preferred in a capital structure. CONCLUSIONS As discussed above, there are a number of issues to address when issuing founders’ stock. In addition to business terms associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate important legal and tax considerations. My advice to founders is to make sure to “get it right” the first time. Although here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it is important that founders get the right business and legal advice, and not just use pre-packaged forms. This advice should begin at the time of company formation. A little bit of advice can go a long way! Ted Wang: Fenwick & West November 2006 [Editor's note: Ted Wang is an attorney at Silicon Valley law firm Fenwick & West. Disclosure: VentureBeat is a client of Fenwick's, though does not have a relationship with Ted.] The release of our firm’s Trends in Terms of Venture Financings shows that this remains a strong market for entrepreneurs to raise venture capital. The survey finds that valuations have continued to increase, while some tough terms negotiated by venture capitalists such as multiple liquidation preference and “ratchet” anti-dilution remain comparatively rare.
    • Term Sheet Tutorial 103 There is, however, a danger that the current climate is encouraging entrepreneurs to go too far. We are increasingly hearing requests for odd-ball terms such as very short vesting schedules (2 years?!) and founders’ protective provisions that recall the heady days of the Bubble. In my opinion founders should resist the temptation to think outside the box with respect to the terms in their founders’ agreements and financing documents. Obviously, valuation and liquidation preference are key areas of negotiation, but for other areas I am a strong believer in plain “vanilla” terms. If the market is good, why shouldn’t founders get the best terms that they can? My rationale is as follows:    Standard venture financing terms represent a compromise between investors and entrepreneurs that is informed by years of experience. Developing and negotiating unusual terms is a waste of a company’s two most precious resources, time and money. Unique terms are highly unlikely to provide any return on investment and are certainly not correlated to the potential success of the enterprise. With respect to founders’ vesting, the people who build the company are the most likely to be the ones who lose out with “creative” vesting schedules. Most founders think about how to protect themselves from being ejected by VCs, however, the vast majority of the time, it’s the founders who get rid of one another when someone is behaving badly or not pulling his or her weight. With aggressive vesting, this can result in an ex-founder owning a huge chunk of stock, while the remaining founders work like dogs to make it valuable. Someone out in the blogosphere has surely already begun typing, “Fenwick represents Kleiner, Sequoia and others and you’re just a shill for the VCs. Founders should get what they can, when they can!” In response, I note first that the vast majority of my clients are on the company (as opposed to the VC) side. Second, and far more importantly, this is the same advice I give to my company clients. It may seem counterintuitive not to push for the “best” terms, but in my experience the marginal value of improved terms is not worth the investment in time and effort required to incur such gains. This is an excellent time to form a start-up and raise venture capital. Use standard vesting, get a good valuation with a low liquidation preference and spend your time and effort building a great company. Posted on April 13, 2009 by Joseph M. Wallin Vesting Imposed On Founder Stock In Connection with Financing--Section 83(b) Election Required? It is fairly common in connection with a financing that an investor will require a founder to agree to place a certain number of the founder's fully vested and owned founders shares under an at-cost repurchase restriction, which at-cost repurchase right lapses over a new vesting period. The question that this raises from a federal income tax perspective is whether the founder should or needs to file a Section 83(b) election upon the imposition of the new vesting conditions. The IRS answered this question in Revenue Ruling 2007-49. "In Situation 1, in connection with the new investment, the substantially vested shares of Corporation X stock owned by A are subjected to a restriction causing them to be
    • Term Sheet Tutorial 104 “substantially nonvested”. Because the substantially vested shares of Corporation X stock are already owned by A for purposes of § 83, there is no “transfer” under § 83. Thus, the imposition of new restrictions on the substantially vested shares has no effect for purposes of § 83." Excerpts from the Revenue Ruling: Issues: 1) Is there a transfer of substantially nonvested stock subject to § 83 of the Internal Revenue Code where restrictions imposed on substantially vested stock cause the substantially vested stock to become substantially nonvested? FACTS Investors form Corporation X in 2004, by contributing $1,000 each to Corporation X in exchange for 100 shares of Corporation X stock. In exchange for Individual A’s agreement to perform services for Corporation X, Corporation X issues 100 shares of its stock to A. The fair market value of the Corporation X stock on that date is $10 per share. The shares of Corporation X stock transferred to A are “substantially vested” within the meaning of § 1.833(b) of the Income Tax Regulations. For the 2004 taxable year, the amount included in A’s income under § 83(a) is $1,000 (the fair market value of the stock ($10 x 100 shares) less the amount paid ($0)). A’s basis in the stock is $1,000. Situation 1. In connection with its plan to start a new business venture, Corporation X seeks financing from Investor M on July 9, 2007. Investor M agrees to invest funds in Corporation X in exchange for a specified number of shares and the further requirement that A agree to subject A’s shares to a restriction that will cause the stock to be “substantially nonvested” within the meaning of § 1.83-3(b). Under this restriction, if the employment of A with Corporation X terminates before July 9, 2009, A must sell the shares to Corporation X in exchange for the lesser of $150 per share (the fair market value of Corporation X stock on July 9, 2007) or the fair market value at the time of forfeiture. In addition, the shares are nontransferable before that date. A remains employed with Corporation X, and on July 9, 2009, the fair market value of Corporation X stock is $250 per share. In Situation 1, in connection with the new investment, the substantially vested shares of Corporation X stock owned by A are subjected to a restriction causing them to be “substantially nonvested”. Because the substantially vested shares of Corporation X stock are already owned by A for purposes of § 83, there is no “transfer” under § 83. Thus, the imposition of new restrictions on the substantially vested shares has no effect for purposes of § 83. Note to Founders: Have Vesting 07/22/2007 Not vesting their stock is a common legal mistake new startup founders make.
    • Term Sheet Tutorial 105 Early on in our funding cycles, I help the founders set up all the initial legal and incorporation paperwork. (I’m not a lawyer, but I’ve gone through it about 60 times by now.) Y Combinator’s philosophy on legal paperwork is that it should be as simple and straightforward as possible. We hate it as much as founders do. When we first started out, we didn’t include vesting in the paperwork because we didn’t want to be overbearing investors. Boy, am I singing a different tune more than 2 years and 5 funding cycles later. It’s like I’ve taken a “Scared Straight” course in corporate law. I’m exaggerating a bit, but the point is that there are so many disasters looming out there for startup founders, why not arrange to avoid one? What is vesting? It’s when the founders voluntarily agree that instead of getting all their stock up front, they’ll earn it over time. There's no set rule for vesting schedules, but the most common are 25% per year (vesting monthly or quarterly) over 4 years, or 20% per year over 5. Usually there's a 1-year "cliff," meaning people who leave after less than a year get nothing. Once you’ve issued your stock, you then need to file a form called an 83(b) election with the IRS. You have 30 days to do this or you can face hideous tax repercussions. Many paperwork oversights can be fixed later, but this one can’t. Yawn. You must now realize why founders don’t want to deal with all this: it’s boring! Why attend to legal paperwork when you can be working on your software and planning to take over the world? Because if you don’t have vesting and one of the founders leaves with a large chunk of your startup’s stock, you will waste a lot of time and money to fix this situation. One YC-funded startup that didn’t have vesting had one of its founders leave within the first year. Here’s what one of the remaining founders told me about the aftermath: “The biggest thing by far was the legal and accounting fees we had to incur (+$20k) and the time and stress associated with dealing with something like this. Hours and hours on the phone, reading over documents that weren't explained well by lawyers, trying to understand from an accounting and tax perspective what we were getting ourselves into, etc. If we had the vesting agreement, it would have ALL been unnecessary. Everything is roses when the company is first starting-- you're excited, you're even thinking about the people you're working with differently, i.e. any misgivings you may have you're lessening in a ‘let's see how it goes’ attitude, or ‘things will be fine once we get started’ attitude, so obviously you don't worry about it as much.” Several of our startups have had founders leave early on. For those groups without vesting, some founders gave back the stock voluntarily and some didn’t. But you don’t want to have to rely on your cofounder’s opinion about how much stock he/she deserves to keep. You want to be clear from the start about what someone will walk away with if they leave. I couldn’t blame someone for leaving. It usually means things aren’t going well for the startup-- you can’t get users, you can’t get funding, your bank account is dwindling, you are demoralized-- and you need to pay your bills after all. But what about the founder who sticks around, making huge sacrifices to keep the startup alive a la Evan Williams? How would that founder like to be broke and working around-the-clock on the startup while the founder who left is sharing equally in the upside? Kind of embittered I think. Also, think of your future investors. It will be a major red flag if you have to inform them that someone who owns 25% of the company now works elsewhere and doesn’t have anything to do with the startup. They don’t like it when someone owns a large portion of stock and isn’t “adding value.” They’d want (as you should too) that stock to be motivating a new employee who would be busting his hump on the startup.
    • Term Sheet Tutorial 106 Professional investors expect vesting and will likely impose it upon the founders anyway as part of their investment. If you are lucky enough to afford lawyers to set up your corporation, they will obviously help you with all this. But many founders can’t afford their fees so early on. If you are using online services to incorporate (which I wouldn’t recommend), make sure you set up vesting. If you have already issued stock to the founders without vesting, look into setting it up retroactively. I think it’s pretty easy to do. Most founders don’t think they are going to need vesting, but roughly 20% of the startups we’ve funded had a founder leave within the first year. So if you are thinking, “We don’t need vesting,” you are in the company of a lot of people who were wrong. MIT Blog: Editor's Article By James L. Woodward, Editor Three Questions - Part ll (Did you miss Part l?) Recently I was asked three good questions by one of the Founders of a company I’m mentoring. Space allows only one answer per month -- this is number two. Question: “What does it mean to be a Founder, legally ... pros/cons for having more or fewer founders.” Disclaimer: I’m painting with a very broad brush here -- there are complications and exceptions in both corporation law and tax law that can apply. ----There is no particular legal meaning to the term "Founder" -- but let's assume that we mean "someone who buys stock before the corporation receives outside financing" -- that is, at the time when it's arguably worth only the modest amount the Founders pay for their shares (and modest it will be -- the last time I bought Founders’ shares, the total amount paid by all the Founders was US$100.) As a legal matter, as a Founder (or any other investor) you are not generally responsible for the actions of the corporation. So, if you pay attention to the tax rules, there is no downside to being a Founder, except, of course, the possible loss of your modest investment and the time you invest in getting the business going. Note, however, that this very general statement applies to you only in your role as Founder/investor. Being a Founder does not give you a blanket exemption from responsibility for actions taken as an Officer or Director of the corporation. Any transfer of shares can have tax consequences. Buying shares at the beginning is almost free from
    • Term Sheet Tutorial 107 the tax man’s evil eye, so it is the best time to put shares into the hands of the people who matter. Any later transfer must be at fair market value or there will be taxes -- as the corporation grows and prospers this can be considerable. Therefore, you want to make sure that everyone -- at least those that you’ve identified -- that will be a part of the future of the corporation buys his or her shares at the beginning. On the other hand, it's a zero sum game and more players mean fewer shares for everyone. Dividing up the shares is the subject of the third question, a future column. All of this brings us to vesting -- the concept that an employee -- Founder or not -- should not automatically get his or her shares unless he or she works for the corporation for some time -usually four or five years. Founders object to this, “I founded the company. Why shouldn’t I get all my shares even if I leave.” The simple answer is “fairness”. One of my companies had no vesting plan and a Founder who had 20% of the initial shares. A few months after the company was incorporated, he got an offer from another startup and left us. We had to struggle to fill his position and give a significant number of shares to his replacement. Four years later he got a check for a couple of million dollars for his few months of night and weekend work. So, I like a vesting schedule for everybody -- a straight monthly vest over sixty months for Founders (each month one-sixtieth of the shares vest) and a sixty month schedule with a one year cliff (one fifth of the shares vest on the first anniversary and the rest one-sixtieth per month after that) for everyone hired after the Founders. If any of your fellow Founders objects, tell him or her my story and that outside investors, angels or VCs, will almost certainly insist on it. I should add that there’s a complication that needs attention with Founders’ vesting -- since you bought the shares for fair market value (close to nothing, but the company has nothing, so that’s fair) there would be no tax consequences to the purchase except for the vesting. The IRS treats vesting shares as not bought until the vesting lapses, so you become taxable on the value of the shares (much more than you paid, we all hope) that vest over the five years. You can avoid this by filing an 83b election -- ask your lawyer -- it’s costless under these circumstances, but must be done promptly. I should note that although we’re talking about Founders’ shares here, an 83b election is usually a good idea for all shares that have a vesting schedule. So, more Founders are generally OK. Vesting is good, as it protects those who put in the work against those who Found and run. There are wrinkles, so good counsel is always a good idea. 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 By Jonathan D. Gworek (December 2007) Know your target market. It is one of the most fundamental principals of any successful marketing strategy. Investors who understand what the founders of a startup really care about will stand a better chance of winning the competitive deal. This article, which is the second in a two part series, will discuss several provisions that investors can use to make a term sheet more attractive to founders of a startup. Specifically this article describes the following: acceleration of vesting for founders' shares; the re-allocation of unvested founders shares upon a founder's termination; sharing the dilutive impact of the option pool, and founder liquidity. While these terms are seen with varying degrees of frequency, and are not necessarily what would be considered "market", they all
    • Term Sheet Tutorial 108 have precedent. And for investors the timely use of any one or more of these provisions might be the difference between winning or losing a highly sought after investment opportunity. In the end, giving up marginal deal protections will prove a shrewd strategy if the result is a stronger portfolio of companies. Forfeiture of Unvested Stock One of the great and unpleasant surprises to many founders is the realization that venture investors will require that their stock be subject to vesting. In short, this means that the founders need to earn the right to keep their stock after the financing is complete by continuing as an employee. The vesting period is typically three or four years, with the stock vesting on monthly or quarterly basis over this period. Once the stock is vested, the founder typically retains the stock even if he leaves the company. But if the founder leaves the employment of the company before this time period has elapsed, the founder forfeits the unvested portion of the stock. This vesting requirement puts all founders at risk that they could be divested of a significant portion of their stock if the board of directors determines that a founder is no longer a "good fit". Risk of forfeiture of unvested stock also arises in the context of an acquisition. For a full discussion of stock vesting, see "Founders' Equity," by Mary Beth Kerrigan and Shannon Zollo, VC Spotlight, Q3 07. Underlying the question of whether and when stock should be forfeited is the fact that in most cases the forfeited stock returns to the status of authorized but unissued common stock. As a result, a founder's loss inures to the benefit of all the remaining stockholders, both common and preferred, whose ownership percentages in the company all increase proportionately. In this way, vesting creates an inherent conflict between founders and those who might benefit from their termination. This dynamic is not lost on well informed or advised founders, and heightens a founder's sensitivity to the risks of forfeiture.1 Acceleration Upon Termination Without Cause To alleviate a founder's legitimate and very real concerns, an investor could agree to allow the founder to retain all or a significant portion of his unvested stock — in essence "accelerating" the founder's vesting schedule — if the founder is terminated without "cause".2 While the definition of "cause" becomes critically important in this context, if the founder avoids conduct that constitutes cause, the founder maintains control of his own destiny as it relates to stock retention. The downside to the company and the investors is that a departed founder will need to be replaced, and the person replacing the departed founder will require equity. While this is likely to be true, given the disproportionately high equity stakes that founders have, it is unlikely that the founder's replacement will require as much equity as was accelerated upon termination without cause.3 Acceleration Upon Change of Control Founders may also be at risk of forfeiting equity in connection with an acquisition or other change in control of the company. At the time of such an event the founder's stock may only be partially vested under the original vesting schedule. The question arises at this time as to what should happen to the unvested stock of the founder, and more specifically whether such stock should be treated as though it was either fully or partially vested and therefore participate in the proceeds distributed out at the time of the acquisition.4 Venture capitalists often resist "acceleration" upon an acquisition. A number of rationales may be offered. Investors will argue that the purpose of vesting is to keep founders incentivized for the agreed upon period of the vesting schedule, and that the founder has not "earned" his stock until this period has elapsed. Investors might add that if the founder is allowed to accelerate, the founder may have "walk away" money thereby impairing the enterprise value to a potential acquirer who will be required to pay extra to retain the founder going forward. In theory it is also possible that the founder may not be retainable at any cost because of the "walk away" money that results from acceleration. Alternatively stated, the acceleration will require the buyer to offer incentives for the founder which costs the buyer will need to factor into the cost of acquiring the company. This in turn
    • Term Sheet Tutorial 109 will depress the aggregate consideration to the other stockholders. Another reason that investors may resist acceleration upon a change in control is that to the extent unvested equity is forfeited, the ownership percentages of the other equity holders goes up proportionately. While a windfall of this nature would certainly be a nice result to the investors even if unplanned and unanticipated, investors should not be planning on this outcome when they make their investment decision so this rationale seems to be without any strong, underlying principal. The founders naturally have a different perspective. They argue that the purpose of vesting is to keep them invested through a successful liquidity event,5 and that once this objective is satisfied the vesting no longer serves any meaningful purpose. Moreover they feel that their hard efforts contribute significantly to the company's ability to attract a buyer, and the founder should be compensated for these successful efforts and contributions. In addition, founders will point out that they may not realize "walk away" money upon an acquisition, or alternatively that they could retain a high level of passion and personal motivation for additional monetary or other reasons. They may also question the validity of a rationale that suggests that they should bear their own cost of retention post-acquisition believing that this cost is more appropriately borne by the buyer. Finally, they may point out the conflict described above and the fact that the forfeiture of their unvested stock benefits the investors by increasing their ownership stake.6 Any venture firm seeking to win a deal with a group of founders that appreciate the implications of vesting can improve their prospects with the founders by allowing the founders to vest, either in whole or in part, if they are terminated without cause. Similarly, the terms of a venture financing can be made more attractive to founders if their stock accelerates in whole or in part upon an acquisition. Reallocation of Founders Stock Among Founders Upon Forfeiture As discussed above, unvested stock that is forfeited by a departing founder is typically repurchased by the company at nominal cost as a result of which all the stockholders end up with a higher ownership percentage. But this is not the necessary result, and founders often question whether this outcome is the right one. While certainly not common, an alternative would be to have the stock that would otherwise be forfeited be automatically transferred to the other founders rather than reverting back to the company. This would result in no change in ownership to the venture capitalist, the departing founder would end up with the correct percentage he had earned, and the remaining founders' ownership would increase. Investors may object to this reallocation scheme for several reasons in addition to the fact that it is not customary. Investors point out that the departing founder's stock needs to be recaptured by the company so it can be re-deployed to find a replacement. Investors may also feel that the reallocation approach would result in a windfall to the remaining founders who have no greater a claim on the forfeited stock than any other stockholder. And as mentioned above, there is also the underlying fact that investors prefer the more customary approach as a result of which their percentage ownership would go up substantially. These points all have merit as do the typical founder responses. As noted above it is very unlikely that the full block of forfeited stock would be needed to hire the departing founder's replacement. The broader question is whether it is fair that all ownership positions, including the investor's, should go up proportionately if a founder forfeits stock. There is no correct answer to this question and perceptions of fairness predictably turn on whether one is an investor or founder. The fact is that the founders allocated their stock between themselves before the investors became involved in the business, and that such allocations were based on the assumption that the founders were committed to the enterprise. Any founder who was not committed or well suited to the enterprise would not have gotten as much equity at the outset had this information been known at the time of formation. Rather, that founder's share of the initial equity would have been allocated to the other founders who by definition accounted for one-hundred percent of the initial equity. On this basis founders
    • Term Sheet Tutorial 110 rationalize that the stock of any founder which is forfeited should revert to the other founders and that otherwise the investors enjoy an unfair windfall. A venture firm seeking to do a deal with a group of founders that are sensitive to this re-allocation issue can improve their prospects with the founders by allowing the founders to re-allocate forfeited stock among themselves. To be clear this is by no means customary. If investors are open to this idea but concerned about the need to attract a replacement for the founder, a middle position can be agreed upon whereby the departing founder's forfeited stock is re-allocated to the other founders except for that amount that is necessary to attract his replacement. This amount would revert to the company so that it can be re-deployed for that purpose. Sharing the Dilutive Impact of the Option Pool The size of the equity plan reserve required in a venture transaction is often a point of heavy negotiation. Investors typically insist that an equity plan be established in order to attract and retain future employees. This pool of shares is then factored into the pre-investment capitalization when arriving at the price per share of preferred stock to be paid by the investors.7 When calculated this way, investors are not diluted by grants out of the plan, only the pre-existing shareholders-the founders in particular — are diluted. Founders are often unaware of this very significant term until they learn about it in their first venture financing and it can be a very unpleasant realization. As a result, the number of shares reserved under the equity incentive plan is of high importance to both investors and common stockholders alike. While this approach is typical, there is no requirement that the option pool dilute only the founders in the manner described above. To improve the terms for the founders, investors might agree that the dilutive impact of the option pool reserve will be borne by both common stockholders and preferred stockholders equally after the funding. Alternatively, part of the dilutive impact can be shared by the preferred stockholders. Founder "Liquidity" In certain venture financings, in particular later stage financings, it is not unusual for investment proceeds to be distributed out to existing stockholders as part of a redemption offer. This distribution of proceeds out to founders is common in early stage financings other than in situations in which there is significant deferred salary or founder that has been used to fund operations. But founder liquidity does not necessarily need to be reserved for later stage venture transactions. Like most terms, this too is a matter of negotiation. Since founders are typically very much aware of the riskiness of the business enterprise, they might well be motivated by the offer of some liquidity. Offering founder liquidity might also result in the investors getting more of the company which in the end might prove to be benefit for the investors. Summary While some of these terms may negatively impact the return on investment with respect to underperforming investments, if the result is that a fund includes a higher percentage of winners in its portfolio, the overall return on investment to the fund should be improved. In addition, developing a reputation as an investor that is "founder friendly" will result in more deal flow in the long run. (Footnotes to above article) 1. For example, assume a company with two founders each of whom own 50.00% of the company. Also assume that this company completes a round of venture financing after which each of the founders owns 25% of the company and the venture capitalist owns 50% of the company. Now assume that one of the founders, who was also the chief technical officer, leaves the company before all of his stock is vested as a result of which 1/2 of his stock, or 12.5% of the stock of the company,
    • Term Sheet Tutorial 111 reverts to the status of authorized but unissued stock. If this were the case, the rest of the issued and outstanding stock, including the venture capitalists stock and the departing founder's earned stock, would all increase as a percentage of the company by 12.5%. 2. While beyond the scope of this article, provision can also be made for acceleration in the event of constructive termination or what is commonly referred to as resignation for "good reason". 3. To continue the example from footnote 1, the founding CTO was terminated and forfeited 12.5% of the capital stock of the company, but in most cases it is unlikely that the company will need to use the full 12.5% forfeited to attract a replacement CTO for a venture backed company. 4. While outside of the scope of this article, there are a number of ways of dealing with acceleration upon a change in control including the so-called double trigger by which stock vests only upon some second trigger following an acquisition-typically termination without cause or resignation for good reason. The double trigger approach really is best suited for situations in which the target option holders are offered substantially equivalent replacement equity in the buyer. This is often not the case such as in an all cash deal. While cash escrows can be established to mirror the continued vesting of stock in cash deals, such arrangements can become complicated and cumbersome. 5. As a result, it is not unusual to see definitions of "acquisition" that distinguish true liquidity events, such as an IPO or cash or public company stock acquisition, from lesser liquidity events such as a private stock deal. Alternatively, though less common, "acquisition may be defined by reference to a dollar threshold. 6. The investors are not the only stockholders who are potentially conflicted in this way. Any stockholder whose stock is not subject to vesting may be conflicted as they stand to have their ownership interests, and share of the acquisition proceeds, increase proportionately to the extent unvested stock is forfeited. 7. For example, assume that the venture investors are putting in $5,000,000 at a $5,000,000 premoney valuation for a 50% ownership stake in the company. Further assume that the venture investors will require a 25% option pool post-funding. These requirements imply that the "rest" of the capitalization at the time of the funding must be comprised of 2,500,000 founder shares, and 2,500,000 shares reserved for future issuance under an equity incentive plan. Section 83 (b) Issues: What is an 83(b) election and how does it work in practice? Introduction Founders in a startup ought to have a working knowledge of the 83(b) election and this faq seeks to give it to them. This is a complex tax area and what is presented here is intended only to give a general picture of how 83(b) works. Work with skilled tax professionals in this area to avoid the landmines.
    • Term Sheet Tutorial 112 Here is the working rule for founders: 83(b) applies only where a founder owns stock and can potentially forfeit its economic value. Where these conditions exist, it is normally vital that a founder file the 83(b) election within 30 days of getting the stock grant or face potentially bad tax consequences. That's the general picture. The tax theory and a more detailed explanation follows. IRC Section 83 Applies to Service Providers Who Receive Property in Exchange for Services Section 83(b) is part of Internal Revenue Code section 83, which specifies how service providers who receive property in exchange for their services are to be taxed on the value of that property. Section 83(b) is intimately connected with section 83(a) and works really only to modify certain tax consequences that would otherwise apply to service providers under 83(a). Therefore, 83(b) cannot really be understood without a basic understanding of 83(a). Section 83(a) Specifies How and When Such Service-Related Income Is Taxed Under 83(a), if I get property in exchange for my services, I pay tax on the excess of the fair market value of that property over what I paid for it. Section 83(a) applies, then, to service providers who take property as payment for services. Who is the major service provider in a startup? No, it is not the outside consultant. It is the founder who works for sweat equity. But let us take the cases in sequence. If I am a consultant, and I get $5,000 worth of stock for my work done for a startup, I pay tax on $5,000 worth of service income - that is, on the difference between the worth of the stock ($5,000) and what I paid for it ($-0-). That difference is taxable to me. So far so good. That much is intuitive. But 83(a) is more complex than that. The founder who has to earn his shares over time is also treated by the IRS as a service provider under 83(a). The founder may pay nominal cash for the shares and may own them, but as long as that ownership can be forfeited when the founder’s service relationship to the startup is terminated, the IRS sees the stock as having been granted in exchange for services. Thus, founder grants that must be earned out (i.e., are subject to a risk of forfeiture) fall within and are subject to tax under 83(a). But 83(a) does not impose an immediate tax on such grants at the time they are made. It has a special rule that taxes such grants only when they are no longer subject to a "substantial risk of forfeiture." It is this special rule that creates traps for the unwary in the startup context. The Nightmare Tax Scenario for Founders
    • Term Sheet Tutorial 113 Let's assume that a founder is granted 2 million shares at $.001 per share and pays $2,000 for them. The shares vest ratably over 4 years at the rate of 1/48th per month. How does 83(a) apply to this scenario? Under 83(a), the tax authorities see the grant initially as being 100% "subject to a substantial risk of forfeiture." Thus, no tax arises at the outset. But what then happens each month as 1/48th of the shares vest? Well, those shares are no longer subject to any risk of forfeiture as they vest. Under 83(a), then, each incremental vesting event creates a potentially taxable event for the founder holding such shares. The risks to the founder may be slight at first when the stock remains priced by the company at the $.001 per share level. But what happens on first funding? Of course, the price of the stock goes up, often dramatically. Let’s say, after a Series A round, the company prices its common stock at $.20 per share. Once that happens, under 83(a) the founder holding the original grant is required to pay tax at each of his vesting points. How is he taxed? On the difference between the then fair market value of the stock which has just vested (because the forfeiture restrictions lapsed as to that stock), on the one hand, and the price he paid for that stock, on the other. In our example, this would mean the founder realizes taxable income on the difference between $.20 per share and $.001 per share for each of the shares that vest each month. If another funding occurs, and the common stock is re-priced to $1.00 per share, then all of the founder’s shares that vest after that re-pricing event trigger a tax on the difference between $1.00 per share and $.001 per share. In other words, the founder finds himself in the middle of a potential tax nightmare. With each of his multiple remaining vesting points, he faces a new and potentially large tax hit. He would have 12 taxable events during the final year alone of his vesting cycle and (assuming the common stock were valued at $1.00 per share during that period) would realize taxable income of just a shade under $500,000 - all for the privilege of holding a piece of paper which he could not liquidate even if he tried! With this background, we can understand the importance and the essence of an 83(b) election. Section 83(b) Comes to the Rescue While 83(a) sets out the general rules for how service providers are taxed when they exchange services for stock, 83(b) gives them an out from the nightmare tax scenario just noted. Under 83(b), a recipient of stock that is subject to a substantial risk of forfeiture can make a one-time election to have his entire interest taxed once-and-for-all at inception instead of having it taxed incrementally over time as the restrictions on forfeiture lapse. This means that, if the founder mentioned above makes a timely 83(b) election on his 2 million share grant, he elects to pay tax on the difference, as of the date of grant, between the fair market value of the property received (i.e., the stock, valued at $.001 per share), on the one hand, and the amount he paid for it ($.001 per share), on the other. In other words, the founder will pay tax on the difference between the $2,000 that the stock is worth and the $2,000 he paid for it. Since there is no difference between the two, the tax is $-0-. This 83(b) process is in lieu of the 83(a) treatment that would otherwise apply and eliminates the nightmare tax scenario discussed above. With the 83(b) election once made, the founder pays no tax on the grant at inception and incurs no taxable income as the shares vest over time. His holding period commences at inception for capital gains purposes and the only tax that would apply to such shares would be a capital gains tax at the time of sale. So much for theory.
    • Term Sheet Tutorial 114 Tips for How 83(b) Applies in Practice What does this mean in practice for founders? 1. Many founders routinely assume they need to do 83(b) filings in connection with their stock grants because "that is how startups work." In fact, 83(b) filings are only required in cases where the founder grants consist of so-called "restricted stock," which is a form of stock where the founder’s stock is subject to forfeiture on termination of his service relationship with the company. 2. If unrestricted stock grants are made to founders or others, 83(b) elections do not apply because the stock is not subject to a substantial risk of forfeiture. 3. While not often used in startups, in conventional buy-sell agreements, if a company can buy back even the vested stock of a departing founder at its fair market value on termination of a service relationship, 83(b) doesn't apply. If the buy-back is at fair market value, there is no substantial risk of forfeiture of the economic value of the stock. Thus, no 83(b) filing is necessary. 4. When a startup grants stock options to its key people, vesting is almost invariably used. Options in themselves are subject to a complex set of tax rules but 83(b) has no bearing on any of them except for one special case. If options are granted to key people who are given the right to exercise them early, and such right is in fact exercised, such recipients will get stock that is subject to forfeiture in the event they do not earn it out through a prescribed period of service. Because of the risk of forfeiture, an 83(b) election needs to be filed at the time such options are exercised or these recipients may wind up being taxed incrementally at every vesting point, just as described in the example above with the founder. Apart from this special case of early-exercise options, 83(b) does not apply to stock options. 5. Not every 83(b) election will wind up benefitting the service provider. Sometimes an employee in a mature startup is granted restricted stock at a steeply discounted price and that employee, by filing an 83(b) election, elects to pay an immediate tax on the spread between the market value of the stock and the discounted price paid. During the bubble era, such grants were often made anticipating that the recipient would profit after a company went public. In such a case, the recipient may wind up paying a substantial tax in connection with making the 83(b) election - a tax paid, in essence, for the privilege of holding a piece of paper. If the company then fails, the 83(b) election in such a case can lead to payment of a gratuitously high tax for nothing (a tax payment which is not deductable either). An 83(b) election needs to be made very carefully whenever a significant tax becomes due upon its making. 6. Procedurally, an 83(b) election must be made within 30 days of the date of grant. This is done by a filing with the IRS. The election must be signed by the recipient and any spouse. The taxpayer must also file a copy of the 83(b) election with his tax return for that year. These rules are strict and must be complied with to the letter. Signing Deadlines and No Shop Agreements If a VC gives you a term sheet, they want you to sign it — not shop it. That’s why a term sheet will often include language about it expiring if not signed by a certain date – commonly referred to an “exploding term sheet”. That’s also why most term sheets include language prohibiting the company from negotiating with other parties for a period of time once it has been executed – commonly referred to as a “no shop” or “exclusivity” provision.
    • Term Sheet Tutorial 115 Let’s look at each of those in the context of your question. Exploding Term Sheets. An exploding term sheet like yours is a huge red flag. What a way to start a relationship – a relationship that could last 5-10 years. You’ve been given 24+ hours to sign the term sheet, which is ridiculous (and which I assume has already passed). My advice is to just ignore this paragraph. You should get on the phone with the VC and advise him/her that you’re going to need a little time to review the term sheet with your lawyer and to check references (i.e., to speak to a few of the CEO’s at the VC’s portfolio companies). Indeed, this will slow the process down in a respectful manner – and you should be diligencing your investors in any event. If that creates a problem for the VC, I strongly suggest that you find another VC. No Shop Provision. I can understand that your VC doesn’t want to expend time and money for legal fees, etc. after the term sheet has been executed only to have you shop the deal to another VC. However, 90 days is way over the top. You should push back hard on this and try to limit it to a few weeks (with 30 days being a reasonable compromise). If you have a lot of leverage (such as multiple VCs interested in your company), you may be able to knock this provision out entirely. Remember: every term is negotiable – no matter what anyone tells you. This is an important issue because if your VC walks away after you sign the term sheet (which happens from time to time), your company may be considered damaged goods and it will be difficult for you to find another investor. Accordingly, if you get any indication that your VC is getting cold feet, you want to be able to move quickly to re-kindle discussions with other investors, if possible. Moreover, the no-shop provision is not reciprocal – meaning your VC can be out in the marketplace talking to other startups while negotiating your definitive agreements and can walk away from your deal with no legal recourse. Some pro-entrepreneur VCs, like Fred Wilson, do not require no-shop provisions. Indeed, Fred noted 10 deal rules he follows in a relatively recent post. Here is #4: Don’t pressure the entrepreneur to make a decision. Don’t issue exploding term sheets. Don’t put no shops into your term sheets. Those kinds of things are signs of insecurity. I prefer to tell people that we’ll have an exclusive relationship when the deal closes and not before then. If someone wants to leave me at the altar, better it happens then than after we are married. Those are the kind of VCs you should partner with, but they’re hard to find. Stock Options Explained
    • Term Sheet Tutorial 116 The issuance of stock options by startups is quite common, because it gives key employees an opportunity to benefit directly from any increase in the company’s value, but doesn’t require any cash outlays by the company. That makes them an important tool to attract talented staffers. Accordingly, the VC firms will likely require your company to establish a large pool of unallocated options for future employees. In fact, you will probably see language in the term sheet similar to this (with the blanks filled-in): “The price per share is based upon a fully-diluted pre-money valuation of $_________ and a fully-diluted post-money valuation of $________ (including an employee pool representing __% of the fully-diluted post-money capitalization).” The pre-money valuation (or “pre”) is the value of the company prior to the VC investment (I cover it in more depth in this previous column), and the post-money valuation is equal to the pre plus the amount of the investment. For example, if you and the VC negotiate a pre of $6 million, and the VC has agreed to invest $2 million, then the post-money valuation would be $8 million. Accordingly, absent an employee option pool, the VC would own 25 percent of your company post-money ($2 million divided by $8 million), and you and your co-founder would own 75 percent. It’s the parenthetical language – “including an employee pool representing __% of the fully-diluted post-money capitalization” – that many entrepreneurs do not understand. Unfortunately, that clause can substantially dilute their share, but not the VC’s. (Note that it’s a little confusing in the term sheet because the dilution results from the way the price per share of the company is calculated.) Most venture capitalists utilize an unusual methodology for calculating the price per share of a company after the determination of its pre-money valuation. Here’s how it works: the post-money valuation is divided by the “fully diluted” number of shares outstanding (in other words, the total number of shares, options and warrants that have been issued by the company), plus all of the shares or options that will be issued in the future as part of the employee pool. So, if we stick with the example above, if the employee pool were 20 percent of the fully-diluted postmoney capitalization (which is fairly typical, though sometimes higher), you and your co-founder would only own 55 percent of the company post-money (75 percent minus 20 percent). The VC would still own 25 percent and 20 percent would allocated to the employee pool. The founders, as you see, shoulder all of the dilution. The 20 percent employee pool is calculated as if the VC’s shares of preferred stock have already been issued to the VC. It actually can get worse. If your company were sold prior to a Series B financing, all of the unissued and unvested options would be cancelled, and the VC would share the additional sale proceeds proportionally with you and your co-founder – even though those options came out of your pocket. Ultimately, it’s evidence of the “golden rule”: He who has the gold makes the rules. The bottom line is that you need to fully understand the economics of a VC financing, which include liquidation preferences and the option pool. Drag-Along Provisions Overview
    • Term Sheet Tutorial 117 Drag-along provisions grant the investors the right to compel the founders and other stockholders to vote in favor of (or otherwise agree to) the sale, merger or other “deemed liquidation” of the company. Investors view such provisions as an important protection, particularly if they seek to exit their investment and sell the company for a price less than the amount of their liquidation preference. If the founders have strong negotiating leverage, they can push back and knock-out the drag-along provisions or at least insert certain reasonable protections (discussed below) which will make such provisions less draconian. What is a typical drag-along provision? Here’s what a typical drag-along provision may look like in the initial draft of the term sheet: The holders of the Common Stock shall be required to enter into an agreement with the holders of the Series A Preferred that provides that all such holders of Common Stock and the remaining holders of the Series A Preferred will vote their shares in favor of a transaction in which 50% or more of the voting power of the Company is transferred or any other Deemed Liquidation and which is approved by the holders of 50% of the outstanding shares of Series A Preferred, on an as-converted basis. What are some key issues for founders? There are several issues founders should focus on. First, they should require a higher threshold than a majority of the Preferred shareholders to trigger the drag-along (say, 2/3 rather than 51 percent) and also perhaps Board approval (though recent Delaware case law may make this problematic). Founders should also push for approval by a majority of the Common Stock. If the investors object, a reasonable compromise would be to allow the investors to convert their Preferred to Common Stock to create a majority (which would lower the liquidation preference). Second, to avoid a situation where the founders get no consideration because they are forced to vote in favor of a transaction at sales price lower than they believe they should take, the founders should push for a minimum sales price to trigger the drag-along (e.g., a price greater than 2 times the aggregate liquidation preference). Obviously, the investors will push back very hard on this. Third, founders should push for certain significant limitations relating to the representations, warranties and covenants they are required to make in the definitive acquisition agreement in the event of the sale or merger of the company. For example, founders should push for what is called “several” (not joint) liability – to avoid a situation where they are liable for misrepresentations of any other sellers; and they should also push to limit their liability to an amount not in excess of the cash (or the value of the consideration) they receive. Drag-along provisions can be important from a housekeeping perspective to avoid a situation where a few minority stockholders are holding-up a transaction approved by a super-majority of the stockholders — thus requiring, for example, a freeze-out merger. The company should also include a similar provision (and a waiver of dissenter’s rights) in its stock option agreements. However, a drag-along provision that is designed to grant the investors the unilateral right to force a sale (without the founders’ approval) is a big red flag. Pay-To-Play Provisions Overview
    • Term Sheet Tutorial 118 Pay-to-play provisions are designed to provide a strong incentive for investors to participate in future financings. In their simplest form, such provisions require existing investors to invest on a pro rata basis in subsequent financing rounds or they will lose some or all of their preferential rights (such as anti-dilution protection, liquidation preferences or certain voting rights). This can happen in two ways: Either by automatic conversion into a “shadow” series of preferred stock (with the applicable rights stripped-out) or by automatic conversion into common stock, resulting in the loss of all preferential rights (so-called “strongman” pay-to-play). Pay-to-play provisions are often hotly negotiated in the context of a “down” round, particularly where a subset of existing investors is leading such a round and requires the other existing investors to participate or, in effect, be punished. (That’s called “eve of financing” pay to play). Pay-to-play provisions can, however, be drafted to apply to any future financing, regardless of whether it is a down round or not, to ensure the future support of all investors. What does a typical example look like? Here’s what a typical pay-to-play provision may look like in the term sheet (the bracketed language offers various alternatives): [Unless the holders of [__]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors. All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose liquidation preferences] [lose the right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat, if applicable]. What are some key issues for founders? There are several issues founders should focus on. First, they must understand that pay-to-play provisions will not typically be included in a Series A term sheet – and that’s something they’ll need to raise and appropriately discuss with the investors. A reasonable position might begin like this: “We are looking for investors who are in for the long haul and will agree to support the company throughout its lifecycle.” From there, pay careful attention to how the investors respond. (There may be disagreement within a syndicate.) If you encounter resistance, offer to limit the pay-to-play provisions to down rounds – the reasoning being that investors who are not willing to support the company in the event of a hiccup should not benefit from the anti-dilution protection (particularly if it’s a full ratchet) and should lose some or all of their preferential rights. It may be unrealistic to expect angel and certain non-lead investors (including strategic investors) to participate in future financing rounds. Accordingly, appropriate carve-outs should be negotiated and inserted into the term sheet, and the pay-to-play provisions will need to be contractual (i.e., outside of the Certificate of Incorporation) because each share of the same series needs to have the same rights, preferences and privileges as other shares of that series in the company’s charter. Finally, from a capitalization (and drafting) perspective, it’s simpler to have the preferred stock automatically convert to common stock rather than a new class of shadow preferred. Moreover, automatic conversion into common stock obviously provides a stronger incentive to the investors to participate in a future financing round and has the added benefit of reducing the company’s “preference overhang.”