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Term Sheet Basics

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Presentation on term sheets given to the MIT VC Competition (http://www.mitvccompetition.com/index.htm)

Presentation on term sheets given to the MIT VC Competition (http://www.mitvccompetition.com/index.htm)


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  • 1. Term sheet basics Mark Watkins, goby.com Twitter: @viking2917 “ If I have seen further it is by standing on the shoulders of giants”* *(i.e., most of this content came from somebody else…references at the end)
  • 2. some preliminaries
    • what kind of investors?
      • friends and family, corporate entities, Angels, VCs
    • how many investors?
      • usually, the earlier the company, the fewer investors there are
      • I’m going to assume 1, but there are often more
    • how do you pick your investors?
      • that topic is too big for today 8) – but as/more important than the terms themselves
    • how do you convince them to invest?
      • that topic is also too big for today 8)
    • for the rest of the deck, I’m assuming VCs / Angels
      • your mileage may vary
  • 3. a quick example
    • Let’s say you want to raise $1M
    • Let’s say the investor wants to own about 25% of the resulting company
    • Therefore the value of the company before the investment has to be $3M
      • ($1M is 25% of $4M)
      • After the investment the company is worth the $1M + whatever assets the company has
    • Ownership % determined by # of shares issued
      • # of shares somewhat arbitrary at this point
      • usually two classes of shares, Preferred (investors) and Common (founders)
      • share price = $4M / # of shares
      • For our example, let’s assume 2M shares issued, so share price is $2
  • 4. A twist
    • Classic VC is $ for equity (shares)
    • Newer trend is “convertible debt”
      • instead of shares, debt holders get right to convert to equity in a later financing
      • usually at a discount
      • debt can be simpler. Legal docs much less complicated
      • defers price discussion
      • at the seed stage, you can retain more control (e.g. board seats, voting rights)
    • sometimes called a “bridge” or “bridge loan”, especially for later rounds
  • 5. VC lingo
    • A “round” is a financing event
      • identified by letter progression mostly (Seed, A, B, C, etc)
    • “ Pre-money” valuation – the company’s worth before the investment round
      • “ pre” for short
    • “ Post-money” valuation – what the company is worth after the round
      • e.g. post-money = Pre-money plus invested capital.
      • “ post” for short
    • In our previous example:
      • $3M pre
      • $4M post
      • $2 per share
      • “ In my first round, I took 1 on 3”
  • 6. the basics – what’s a term sheet?
    • a preliminary agreement between an investor(s) and a company
      • will be followed by a much longer set of legal documents
    • basic variables
      • valuation (“pre”)
      • amount raised
      • option pool / option program details (e.g. vesting)
        • what shares are available for future employees?
      • price per share (this is derived, not a variable)
      • dilution – how much do you own before and after the financing?
        • not really a variable – it’s derived from the other variables.
      • term sheet will have a pile of other details…..
  • 7. advanced topics
    • founder vesting
      • is there any? (best practice is “yes”)
      • founder options vs. shares
      • accelerated vesting on change of control – single trigger, double trigger
    • board composition - how many members? who’s on it?
    • liquidation preferences & other preferences
    • anti-dilution – protects existing investors in a “down” round
    • pro rata – right to invest on a % basis in future funding rounds
    • protective provisions
      • protects investors against negative economics – e.g. change of bylaws, issuing preferred securities, paying dividends, taking on debt, board composition changes, etc.
    • future financing / acquisition scenarios
      • drag along: requires some shareholders to assent to sale if majority wants to
      • pay to play: you get converted to common stock if you don’t do your pro-rata
  • 8. a bunch of other stuff
    • closing dates, share price, pre/post
    • founders & investors
    • voting rights
    • cap table (including option pool)
    • matters requiring board approval (e.g. corporate loans/debts, permitted investments)
    • may require non-compete / nondisclosure agreements
    • shop / no shop
      • can the company talk with other investors after term sheet signed?
  • 9. the process
    • ideally you have more than one term sheet coming
      • gives you negotiating leverage, options
      • you want to keep them moving at more or less the same rate
    • Is the term sheet real?
      • high quality firms don’t issue term sheets if they don’t intend to fund
      • some firms issue term sheets before the real decision is made
      • as an entrepreneur, it’s important to know the difference
      • ? how often do your term sheets get turned into deals
      • ? what was the last term sheet that didn’t go to deal, and why?
    • an investment will come along with a “due diligence” process
      • you want as much of this as possible done ahead of the term sheet
    • shop / noshop can impact this
  • 10. warning signs & things to keep in mind
    • participating preferred
      • investors more than get their money back before founders/common holders get money
    • crazy protective provisions
    • shop/noshop should be mutual, ideally
    • when was the last time you signed a term sheet that didn’t close?
    • you get a term sheet too early
      • no references, no partner agreement/meeting, no business diligence is complete)
    • term sheet that requires “approval of investors partnerships”
      • your champion may not actually have the approval to do a deal.
    • objectionable employment agreement or other employment terms
    • some things are going to get renegotiated anyway.
      • e.g. accelerated vesting, registration rights, etc
  • 11. even more advanced topics
    • later rounds (B, C, D, E, F, Mezzanine, etc etc) will be more complicated
    • more than one investor will be more complicated
    • not going to go into that today
  • 12. Legal Stuff
    • use a law firm that does startup stuff
      • e.g. Gunderson Dettmer in Boston
      • your costs will be lower and you’ll get a better outcome
      • they typically have templates that VCs have seen/liked
    • template documents are available from a number of sources
      • National Venture Capital Association
        • http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136
      • Y Combinator
        • http://www.ycombinator.com/seriesaa.html
      • TheFunded Founder Institute
        • FFI - Plain Preferred Term Sheet
  • 13. resources & reading
    • National Venture Capital Association & NCVA Model Legal Documents
    • Venture Hacks: Term Sheet Hacks: Get a Great Deal - Venture Hacks
    • Brad Feld’s Term sheet series: Term Sheet Series Wrap Up
    • cdixon.org – chris dixon’s blog / Ideal first round funding terms
    • Jeff Bussgang: Seeing Both Sides: In VC deals, Price Doesn’t Matter - But The "Promote" Does
    • Mark Suster’s answer to What are examples of good startup term sheets? - Quora
    • Want to Know How VC’s Calculate Valuation Differently from Founders? | Both Sides of the Table
    • Mark Suster’s Cap Table Template: Venture Capital Valuation Spreadsheet
    • Standard Start Welcome – New York-based organization for template legal docs for startups