Hi everybody. My name’s Leo, and I’m going to explain a few things about venture capital term sheets. And I’ll try to talk a little slower than I did last time I was up here. Hopefully you’ll be able to follow along a little better.
I’ll start out by saying a little bit about what Venture Capital is, and when it’s appropriate for a startup. Then I’ll talk about term sheets, what they are, and some things to watch out for in them. And I also want to make sure you understand that there’s a reason for all the apparent wackiness that goes on here.
The first thing to understand about VC’s is that they’re not investing their own money. Venture capitalists start by raising money from a bunch of investors, and then distribute it to various startups. But the investors are expecting to get their money back, generally within 10 years of committing it to the fund.
So VC is appropriate when a company needs many millions of dollars to take advantage of a big opportunity and quickly generate a return. Venture backed companies usually only have 3-5 years to reach some kind of exit, generally either acquisition or IPO.
VC is not appropriate for slow-growth companies or lifestyle businesses. In fact venture capitalists call companies that are cash flow positive but are not going to be acquired or IPO “the living dead.”
Okay, so let’s talk about term sheets. The term sheet lays out all the interesting stuff before a real legal contract is written up. It’s just a lot easier to negotiate and bounce back and forth a short summary document than a hundred pages of legalese.
It says things like how much money is being invested, who is doing what, and how much everybody gets in the end. One key item is the pre-money valuation which is how much the company’s ideas are worth plus any assets before the investment. As you might guess, valuing ideas is somewhat arbitrary.
It determines amount of ownership, but don’t get too hung up on it. For example, let’s say I set the pre-money valuation at $6m for the work we’ve done so far. Then the VC’s put in all the actually money -- $2m of cold hard cash -- so they get 25% of the company.
So you might expect that when the company gets acquired for say $100m in a few years, that I’d get my 75% and the investors would get their $25 million, based purely on number of shares. But it doesn’t usually work out that way, because of something called Liquidation Preference.
This means that when there’s a liquidation event, the VC’s get preference. This is a kind of insurance for them in case the acquisition isn’t very big. They want to make sure they get their money back first, and if there’s anything left over, it will get shared amongst everybody.
Looking at it graphically we see that below a certain exit value the VC’s take everything, but above that the slopes of the payout lines are determined by the number of shares each party owns. So the valuation determines slopes, but intercepts are very important too.
If the company is very successful, and the exit value is very high, then I’m going to get close to my 75%. But at moderate to low exit values, VC’s take a disproportionate share.
The amount of the liquidation preference is set in the term sheet. Sometimes it’s just the amount invested. Sometimes it’s double the investment, and sometimes it’s triple. This is a key term to pay attention to.
Some look at this situation and think it’s completely bogus. The VC’s are just trying to screw *US* -- the entrepreneurs with the ideas who make things happen. Why do we need all these complex contracts anyway? Can’t they just take common stock like the rest of us?
Well, imagine if they did take common stock. Then they’d have 25% of the company, and no special privileges. That means they could be outvoted in any financial decisions -- which could lead to all sorts of mischief from management. [Devil image from www.devilspice.com ]
For example, right after that $2m check hits the company’s bank account, as the CEO I might decide that the best way to use that money is to give it back to the shareholders as a dividend. If they had common stock, VC’s would be powerless to stop me. So clearly they need some measure of control.
After all VC’s aren’t trying to cheat anybody, but they do need to protect their investments. And remember that without VC your idea wouldn’t be a company. It would just be an idea. And if you look into it, pretty much all of these terms have good reasons behind them.
For example, consider cumulative dividends. These cause the minimum amount the VC’s are guaranteed to increase over time. This is great because it clearly aligns the incentives of the management with what the investors want – a quick exit. And aligning incentives always makes for a good relationship.
So if you find yourself staring down a VC term sheet, get some advice. And be sure to look at what’s called a waterfall chart to see how the payouts will work. And try to understand their motivations -- don’t make it an US vs THEM situation, because then nobody’s gonna win.
I’d like to thank my finance professor at UW, Lance Young, for teaching me this stuff. And if you check my blog tomorrow I’ll have this deck and some spreadsheets and stuff for you to play with. Thanks.
Venture Capital Term Sheets or How you can make millions of dollars and keep none of it for yourself Leo Parker Dirac UW Business School MBA Candidate Supporter of the Robot Revolution