MassChallenge angel and venture term sheets


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June 28, 2012 - Angel and Venture Term sheets presentation from MassChallenge Bootcamp

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MassChallenge angel and venture term sheets

  1. 1. Venture Capital Term Sheets June 28, 2012© 2012 Foley Hoag LLP. All Rights Reserved. 1  
  2. 2. These  materials  have  been  prepared  solely  for  general  informa6on  and  educa6onal  purposes.  The  informa6on  protected  does  not  cons6tute  legal  advice,  nor  does  it  establish  any  form  of  a;orney-­‐client  rela6onship  with  the  author  or  Foley  Hoag  LLP.  Specific  legal  issues  should  be  addressed  through  consulta6on  with  your  own  counsel,  not  by  reliance  on  this  presenta6on  or  these  materials.  A;orney  Adver6sing.  Prior  results  do  not  guarantee  a  similar  outcome.  ©  Foley  Hoag  LLP  2012.  United  States  Treasury  Regula6ons  require  us  to  disclose  the  following:  Any  tax  advice  included  in  this  document  and  its  a;achments  was  not  intended  or  wri;en  to  be  used,  and  it  cannot  be  used  by  the  taxpayer,  for  the  purpose  of  (i)  avoiding  penal6es  under  the  Internal  Revenue  Code  or  (ii)  promo6ng,  marke6ng  or  recommending  to  another  party  any  transac6on  or  ma;er  addressed  herein.   2  
  3. 3. Speakers:   Paul  Sweeney     Ma7  Witheiler     Jerry  King  Corporate  lawyer     Principal     Former  COO     Foley  Hoag  LLP   Flybridge  Capital   Where,  Inc.   Moderator:   Vinit  Nijhawan   Managing  Director,  Technology  Development     MBA  Lecturer     Boston  University   3  
  4. 4. Definition: Term Sheet•  a/k/a-­‐  “Le;er  of  Intent,” “MOU,” “Agreement  in   Principle”    •  First  major  step  in  transac6on,  when  material  terms  of  deal   are  nego6ated  and  agreed  to   –  Focus  on  the  deal  is  at  its  maximum   –  Gives  road  map  for  lawyers  to  draZ  actual  docs  •  How  much  detail?    Beware  of:  “The  defini6ve  documents   will  contain  customary  provisions  regarding  liquida6on   preference,  an6-­‐dilu6on  protec6on,  board  composi6on,   and  required  consents.”     4  
  5. 5. Non binding (to a point…..)•  Limited  provisions  are  legally  binding   –  Confiden6ality  (can’t  disclose  terms)   –  Exclusivity  (can’t  shop  deal  -­‐  usually  30-­‐90  days)    •  Ordinarily,  term  sheet  otherwise  not  legally  binding     –  Either  party  can  walk   –  Subject  to  nego6a6ng  actual  docs,  due  diligence,  closing   condi6ons     –  But  terms  are  “morally”  binding  –  if  you  really  want  to   mess  up  your  transac6on,  the  term  sheet  is  the  place  to  do   it   5  
  6. 6. VC/Angel financing at its core•  A  sophis6cated  investor  (or  group  of  investors)  puts  money   into  the  company  in  return  for  newly-­‐issued  shares  of  the   company,  along  with  certain  contractual  rights.    •  Shares  are  usually  conver6ble  preferred  stock   –  “Stock”  –  equity  ownership  ( junior  to  debt)   –  “Common  Stock”  –  basic  unit  of  equity  ownership;  issued   to  founders/employees/consultants.   –  “Conver6ble”  –  converts  into  common  stock   –  “Preferred”  –  has  preference  over  common  stock    -­‐     dividends,  distribu6ons,  liquida6on,  redemp6on,  etc.   6  
  7. 7. Economics of the deal•  Key  terms  •    -­‐  Pre-­‐Money  and  Post-­‐Money  Valua6on  •    -­‐  Op6on  Pool  •    -­‐  Liquida6on  Preference  •    -­‐  An6-­‐Dilu6on  Protec6on  •    -­‐  Dividends   7  
  8. 8. Pre-Money Terminology•  “I’ll  give  you  $2  million  at  a  3  pre.”  •  “We  want  to  end  up  with  two-­‐fiZhs  post,  with  a  total   investment  of  $2  million.”  •  “The  company  is  worth  $3  million,  and  so  I’m  looking  to  own   40%  when  we’re  done.”     8  
  9. 9. Pre-Money and Post-Money Valuation•  If  my  money  is  buying  me  shares,  then  how  many  shares  do  I   get  and  what  percentage  of  the  company  do  those  shares   represent  immediately  aZer  my  investment?  •  Side  note:  Remember,  the  number  of  shares  you  hold  only   tells  you  half  the  story.    Be  careful  of  op6cs.  •  Compare  Warren  Buffet’s  350,000  shares  of  Berkshire   Hathaway  (33.1%  of  1,060,000)  with  350,000  shares  of  Google   Inc.  (0.1%  of  324,890,000)   9  
  10. 10. Pre-Money and Post-Money Valuation•  “Pre-­‐Money  Valua6on”  =  dollar  value  of  the  company  before   the  new  money  is  invested  •  “Post-­‐Money  Valua6on”  =  pre-­‐money  valua6on  +  the  amount   invested.       10  
  11. 11. Why is it important?  Allows  us  to  calculate  the  share  price  and  the  %  of  company  being  sold.      Price        =      Pre-­‐Money  Valua6on________                          Pre-­‐Money  Shares  Outstanding    %  Sold    =      Shares  Issued_______  =      New  $___________                        Post-­‐money  Shares  O/S            Pre-­‐Money  +  New  $    Pop  Quiz:  “I’ll  invest  $5  million  at  a  $10  million  ‘pre’.”  Ques6on:  What  percentage  would  the  investor  own  aZer  the  investment?    A:  33%    B:  50%    C:  It’s  too  soon  aZer  lunch  for  a  math  quiz   11  
  12. 12. What shares are “outstanding”?•  Price          =      Pre-­‐Money  Valua6on    •                     Pre-­‐Money  Shares  Outstanding  •  “Op6on  Pool”  is  cri6cal  issue   –  Do  we  have  a  sufficient  number  of  shares  “reserved”  to   compensate  and  mo6vate  exis6ng  and  future  employees?   –  The  higher  this  number,  the  lower  the  share  price,  and   thus  the  higher  the  number  of  shares  issued  for  the  same   amount  of  money  invested   –  Bigger  always  be;er?     12  
  13. 13. Option Pool•  Pre  Money  Valua6on  (Without  Op6on  Pool)   13  
  14. 14. Option Pool•  Pre  Money  Valua6on  (With  Op6on  Pool)   14  
  15. 15. Easy Math Question•  Offer  1:  Pre-­‐Money  Value  of  $10  million,  $5  million   investment,  10%  Post-­‐Money  Op6on  Pool  •  Offer  2:  Pre-­‐Money  Value  of  $11  million,  $5  million   investment,  20%  Post-­‐Money  Op6on  Pool  •  Which  is  the  “be;er”  offer  for  the  founders?   15  
  16. 16. Easy Math Answer•  Offer  1,  even  though  it’s  a  lower  “pre-­‐money  valua6on.”    Founders’  shares  retain   more  value  due  to  the  smaller  post-­‐money  op6on  pool.      •  Offer  1  Values:   –  Preferred  Stock  $    5,000,000   –  Op6on  Pool          1,500,000    (10%)   –  Common  Stock          8,500,000   –  Total  Post-­‐money  $15,000,000  •  Offer  2  Values:   –  Preferred  Stock  $    5,000,000     –  Op6on  Pool          3,200,000  (20%)   –  Common  Stock          7,800,000   –  Total  Post-­‐money  $16,000,000   16  
  17. 17. What does the term sheet say?•  Pre  Money  Valua6on  and  Op6on  Pool  •    “Pre  Money  Valua6on:  The  Per  Share  Purchase  Price  will  be  $ [___],  which  is  based  upon  a  fully-­‐diluted  pre-­‐money   valua6on  of  $10  million,  represen6ng  [__]%  ownership  on  a   fully-­‐diluted  basis  (including  an  employee  pool  represen6ng   20%  of  the  fully  diluted  post-­‐money  capitaliza6on,  which  will   be  reserved  pre-­‐closing).”     17  
  18. 18. Related terminology•  “Up  round”  –  where  subsequent  round  is  at  a  pre-­‐money   valua6on  that  is  higher  than  post-­‐money  valua6on  of  the   prior  round  •  “Flat  round”  and  “down  round”  •  “Value”  is  some6mes  the  tail  wagging  the  dog  –  in  early  stage   companies,  investors  are  oZen  looking  for  a  certain   percentage  of  the  company,  and  will  back  into  a  “valua6on”   that  fits  their  math  •  “Cap  table”  skills  highly  rewarded   18  
  19. 19. We got a high valuation! 19  
  20. 20. We got a high valuation!“You  can  set  the  pre-­‐ money  valuaAon…   …if  I  can  set  all  the   other  terms”   20  
  21. 21. Liquidation Preference•  Applies  when  a  “liquida6on  event”  occurs  (sale,  merger,  liquida6on)    •  When  distribu6ng  liquida6on  proceeds,  preferred  stock  has  right  to   receive  a  certain  mul6ple  of  its  money  before  the  common  stock  gets   anything  (“preference”).       21  
  22. 22. Liquidation Preference•  Some6mes  “mul6ples”  are  used  (1x,  2x,  3x  the  investment   amount)  •  Some6mes  accruing  dividends  are  added  on.  •  Some6mes  the  “preference  overhang”  (total  amount  of   proceeds  due  to  the  preferred  stock)  is  so  great  that  the   common  stock  is  effec6vely  worthless.     22  
  23. 23. Participating vs. Non-Participating•  Three  main  flavors  (ranked  in  order  of  bi;erness):   –  Non-­‐par6cipa6ng   –  Par6cipa6ng  preferred  (with  cap)   –  Par6cipa6ng  preferred  (without  cap)     –  Note:  preferred  always  get  the  greater  of  either  their   preference  or  what  they  would  receive  if  they  converted  to   common  stock   23  
  24. 24. What does the term sheet say?•    “In  the  event  of  any  liquida6on,  dissolu6on  or  winding  up  of  the   Company,  the  proceeds  shall  be  paid  as  follows:  •  Alterna6ve  1  (Non-­‐Par6cipa6ng  Preferred  Stock):    “First  pay  the  Original   Purchase  Price  on  each  share  of  Series  A  Preferred.    ThereaZer,  the   balance  of  any  proceeds  shall  be  distributed  pro  rata  to  holders  of   Common  Stock.”  •  Alterna6ve  2  (Par6cipa6ng  Preferred  Stock  with  Cap):    “First  pay  the   Original  Purchase  Price  on  each  share  of  Series  A  Preferred.    ThereaZer,   Series  A  Preferred  par6cipates  with  Common  Stock  on  an  as-­‐converted   basis  un6l  the  holders  of  Series  A  Preferred  receive  an  aggregate  of  [two]   6mes  the  Original  Purchase  Price.”  •  Alterna6ve  3  (Par6cipa6ng  Preferred  Stock):    “First  pay  the  Original   Purchase  Price  on  each  share  of  Series  A  Preferred.    ThereaZer,  the   Series  A  Preferred  par6cipates  with  the  Common  Stock  on  an  as-­‐converted   basis.”   24  
  25. 25. Examples of Liquidation Preferences•  Assume  a  $5m  Series  A  investment  at  $20m  pre-­‐money  valua6on  (resul6ng  in   the  Series  A  investors  owning  20%  of  the  company).    The  company  ends  up   being  sold  for  $40m  without  any  addi6onal  shares  issued  aZer  the  Series  A   investment.    •  A  “1X  Non-­‐Par6cipa6ng  Preferred”  means  Series  A  get  the  greater  of  their   $5m  preference  or  what  they  would  receive  if  they  converted  to  common  (i.e.,   20%  of  $40m,  or  $8m).  •      Result:  $8m  goes  to  the  Series  A;  $32m  goes  to  the  common  stock.   (20%)  •  A  “1X  Par6cipa6ng  Preferred  with  a  2X  Cap”  means  Series  A  get  their  $5m   preference  plus  20%  of  the  remaining  $35m  up  to  a  total  2X  cap  ($10m).      •      Result:  $10m  goes  to  the  Series  A;  $30m  goes  to  the  common  stock.   (25%)  •  A  “1X  Par6cipa6ng  Preferred  without  a  cap”  means  Series  A  get  their  $5m   preference  (the  “preferred”)  plus  20%  of  the  remaining  $35m,  or  $7m  (the   “par6cipa6ng”).  •    Result:  $12m  goes  to  the  Series  A;  $28m  goes  to  the  common  stock.  (30%)   25  
  26. 26. Liquidation Preference – Take Aways•  Calcula6ng  Liquida6on  Preference  gets  VERY  complicated,  especially  when   mul6ple  rounds  of  preferred  are  “stacked.”    •  Liquida6on  preference  is  almost  never  nego6able,  but  par6cipa6ng   preferred  is  almost  always  is.    •  Liquida6on  preference  becomes  less  meaningful  in  very  large  exit  events,   and  par6cipa6ng  preferred  can  be  meaningless  in  very  small  exit  events.  •  “Flat  spots”  can  create  divergent  incen6ves  •  Early  round  investors  oZen  regret  having  received  very  rich  terms,  as  these   set  a  precedent  for  later  rounds.  •  Only  applicable  in  a  “liquida6on  event.”    There  are  some  “exits”  (e.g.  IPO)   where  preferred  get  converted  to  common,  and  liquida6on  preference   becomes  meaningless.   26  
  27. 27. Anti-Dilution Protection•  Protects  investors  in  a  “down  round”  -­‐  when  new  money   comes  in  at  a  pre-­‐money  valua6on  (or  price  per  share)  that  is   lower  than  the  previous  round’s  post-­‐money  valua6on.    •  An6-­‐dilu6on  protec6on  is  triggered  when  company  issues   shares  (with  some  cri6cal  excep6ons)  at  a  lower  valua6on   27  
  28. 28. Anti-Dilution Protection•  How  does  it  work?    At  the  beginning,  preferred  stock  converts   to  common  stock  at  a  1-­‐for-­‐1  ra6o.    •  When  the  an6-­‐dilu6on  protec6on  is  triggered,  the  conversion   ra6o  is  adjusted,  resul6ng  in  the  preferred  stock  gexng  more   shares  of  common  stock  upon  conversion.  •  2  Types:  “Weighted  Average”  and  “Full  Ratchet”  •  Don’t  fight  the  concept  -­‐  focus  on  mi6ga6ng  the  impact  (e.g.   weighted  average  with  broad  list  of  excep6ons)   28  
  29. 29. Control – Board of Directors•  Usually  investors  require  one  or  more  board  seats  •  Challenge:  What  is  proper  balance  between  founders,   investors  (both  exis6ng  and  new),  and  outside  directors?  •  Keep  board  size  manageable  –  bigger  is  not  always  be;er    •  Some6mes  a  “board  observer”  rather  than  board  seat   29  
  30. 30. Control – Protective Provisions•  aka  “Nega6ve  covenants,” “Veto  rights”  or  “blocking  rights”  •  Essen6ally  a  list  of  things  you  can’t  do  without  investors’   prior  consent  •    -­‐  Consent  at  either  the  Board  or  Stockholder  level  •  Usually  hotly  nego6ated  •  This  is  a  foot  on  the  break,  not  on  the  accelerator  •  Gets  complicated  in  later  rounds;  interests  of  investors  can   diverge  •  Dependent  on  retaining  level  of  ownership?   30  
  31. 31. Dividends•  Another  “debt-­‐like”  feature  •  Automa6c  vs.  declared  •  Cumula6ve  vs.  non-­‐cumula6ve  •  Compounding  vs.  non-­‐compounding  •  Dividends  ma;er  more  with  disappoin6ng  investments  than   with  home  runs   31  
  32. 32. Maintaining / Increasing Equity Position•  Pre-­‐emp6ve  /  Par6cipa6on  Rights  (Company’s  stock)  •    -­‐  Right  to  buy  shares  in  future  company  financing  •    -­‐  Major  investors  some6mes  eat  up  unsubscribed  shares  •    -­‐  “Pay  to  Play”  •  Rights  of  First  Refusal  (Founder’s  Stock)   32  
  33. 33. Liquidity•  Drag-­‐Along  Rights  (M&A)   –   triggered  by  required  percentage  of  preferred   –   forces  founders  and  common  holders  to  vote  in  favor  of   deal   –   makes  “dissenters  rights”  moot  •  Tag-­‐Along  Rights  (Co-­‐sale  with  founder)  •  Registra6on  Rights  (IPO)  •  Redemp6on  Rights   33  
  34. 34. Founders Restricted Stock•  Company  has  right  to  purchase  “unvested”  shares  if   founder’s  employment  terminates  •  Ves6ng  usually  4  years,  with  one-­‐year  cliff  •  Some6mes  founders  get  “credit”  for  prior  ves6ng,  or  a   shorter  ves6ng  period  •  Forfeited  shares  have  “an6-­‐dilu6ve”  effect  on  all  other  equity  •  Single  and  double  trigger  accelera6on  on  change  of  control  •  Possible  tax  complica6ons   34  
  35. 35. A Word on Convertible Notes•  Automa6c  conversion  on  qualified  financing  •  Discounts  are  becoming  increasingly  common;  some6mes   coupled  with  a  cap  on  valua6on    •  Paid  or  converted  upon  acquisi6on  •  Interest  Rate  •  Maturity  Date  •  Collateral  (secured  or  not)  •  %  of  noteholders  needed  to  amend  terms   35  
  36. 36. Final Thoughts 36  
  37. 37. Final Thoughts 37  
  38. 38. Final Thoughts•  Choose  your  legal  advisors  wisely.  This  stuff  gets  complicated   fast.    And  do  it  early  (before  nego6a6ng  the  term  sheet!)  •  Choose  your  investors  wisely.    All  money  is  not  created  equal   –  their  belief  in  you  and  your  team  is  more  important  than   their  capital.  •  Choose  your  fights  wisely.    Make  sure  you  know  what  really   ma;ers  to  you,  and  understand  the  market  dynamics.  Don’t   be  afraid  to  ask  “why  do  you  need  that?”   38  
  39. 39. Other Resources•   –  Glossary  (commonly  used  terms)   –  EEC  Perspec6ves  (Foley  Hoag’s  quarterly  publica6on   tracking  terms  of  North  East  VC  deals)  •  NVCA  Model  Venture  Capital  Financing  Documents  (including   model  term  sheet):   –  (click  “Resources”  then  “Model  Legal   Documents”)  or  use  h;p://   –   Forms  are  intended  as  star6ng  point  only   39  
  40. 40. Questions?•  •  Paul  Sweeney  •  Ma;hew  Witheiler  ma;  •  Jerry  King  •  Vinit  Nijhawan   40