Financing Business from Start-Ups to Mature Companies
Presented To the Illinois State Bar Association
First, You're Probably Asking Yourself: "Why Should I Listen To
That's a fair question. Why Would You Listen To Me?
Been in high tech industry since 1961
Held positions of: Salesman, Sales Manager, Vice- president Sales,
Vice-president Marketing, Executive Vice president Sales and
Been a partner/founder with 12 companies that received over
50% international revenue 8 of which successfully went public
or were sold/merged
Been president of Jerry R. Mitchell and Associates since 1985
Described in Fortune Magazine November 1997 as serial
President of The Midwest Entrepreneurs Forum since its
Publisher of Bootstrapping newsletter
Advisory board member of DePaul Universities Coleman
Chairman Modularis Inc
Partner Asian Business Company
Partner Qingdao You Ji Le Construction Paint Company
I have chosen to address what I believe are the most important
discussed terms in a venture financing term sheet.
Entrepreneurs need to understand that they might negotiate a term
sheet once every few years. They negotiate their most important
term sheet (Series A) when they have no experience. On the other
hand the venture capitalist issues several term sheets a month.
They have developed their standard term sheet that has been
used by all the venture capital firms.
With few exceptions, most law firms advise their clients to accept
“standard” terms. Most law firms do a lot more business with VCs
than they are likely to do with you. VCs refer new clients to the law
firms, hire the law firms regularly, and know the attorneys socially.
Where do you think the law firms’ loyalty lies? Entrepreneurs choosing
lawyers during the term sheet negations need to ask them for
references. Ask them for, CEOs they have worked with. Only after
checking should you retain a law firm.
The basic incentives between you, your law firm, and your
prospective investors are not in your favor. Your lawyers make
money by executing transactions and your investors simply bring
more transactions to your lawyers than you do.
The best way for an entrepreneur to negotiate price is to have
multiple VCs interested in investing in their company.
If entrepreneurs have more interested venture capitalists than
equity in their company to sell then the term price will increase.
Entrepreneurs dealing with venture capitalists during the term
sheet negations need to ask them for references. Ask them for:
CEOs they have worked with including a CEO they have had to
fire/replace. Most venture capitalists will provide you with a
complete list of everyone they have ever funded.
Before signing a term sheet, entrepreneurs should educate
themselves on exactly what a term sheet is and what to expect
while negotiating it.
One important action item entrepreneurs need to do before talking
to venture capitalists is how much they think their company is worth.
If there are going to be multiple venture capital firms syndicated
in the offering entrepreneurs must insist on only one investor
counsel as well as a lead investor. If the entrepreneur gets this
term it will save the millions of dollars in needless attorney fees.
This also forces the venture capital firms to cooperate with each
other especially when these venture capital firms have invested
in different rounds of your companies financing. The entrepreneur
should act as the mediator between these firms to protect their
interests and to ensure all the firms reach an agreement
In early rounds, entrepreneur’s first venture capitalist investors will
likely be looking for the lowest possible price that still leaves enough
equity in the founders and employees hands. In later rounds, existing
venture capitalists 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.
One example I am using in this seminar that participants can use is if
the company needs to raise $3,000,000 to build their business how
much of their equity should that be worth? Only after determining
that percentage should entrepreneurs talk to venture capitalists.
One of the first questions that entrepreneurs are asked by the
venture capitalist is: is the valuation pre or post money.
One of the first things unknowledgeable entrepreneurs argue
over is the price of the deal. One thing every entrepreneur needs
to understand before they start is pre-money vs. post money
Pre-money valuation is what the investor is valuing the company
at today, before investment, while the post-money valuation is
simply the pre-money valuation plus the contemplated aggregate
If a venture capitalist offers to sign a term sheet with your company,
you can be sure that they are interested in investing in your
company. However, a term sheet is essentially just that—an
expression of interest. It is by no means a done deal! Specifically,
a term sheet is a preliminary offer to invest in your company and
summarizes the size and conditions of the investment as expected
by the investor.
There are only two things that venture funds really care about when
doing investments: return on their investment and control. Return
on investment refers to the end of the deal return the investor will
get and the terms that have direct impact on their return. The term
"control" refers to the terms which allow the venture capitalist to
either affirmatively exercise control over the business or allow
them to veto certain decisions the company can make.
If you value your company for example at $7,000,000 pre money
then $3,000,000 could be worth 43% of the company.
There still could be a problem for example: the entrepreneur and the
venture capitalist agree on two terms (A) a $7,000.000 valuation and
(B) a $3,000,000 equity investment.
Now the entrepreneur and the venture capitalist agree that the
venture capitalist gets 3, 000,000 shares for $3,000,000. The
venture capitalist has thought that he received 3, 000,000 shares
for $3,000,000 or 43% of the company because 3,000,000 out of
7,000,000 =43%. The entrepreneur believes that $3,000,000 is
worth 30% because 3,000,000 shares out of 10,000,000 = 30%
The critical issue here is whether the agreed value of $7 million
to be assigned to the company was prior to or after the investor's
contribution of cash (pre-money) or post-money. Now real
You both agree that the venture capitalist investment is worth
30% of the company now you must discuss the terms (control).
The second term entrepreneurs need to understand is warrants
associated with the deal. This is another item that will affect the
valuation of the term sheet.
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, I always recommend the entrepreneur negotiates for
a lower pre-money valuation to try to eliminate the warrants.
Don't make the mistake of only focusing on valuation: Most term
sheets will include dozens of financial and governance terms that
will affect your equity stake and control of the business following
the investment, and which you need to consider carefully.
Venture capitalists care about control provisions in order to keep
an eye on their investment as well as in some cases -comply with
certain federal tax statutes that are a result of the types of investors
that invest in venture capital funds. One of the key control
mechanisms is the election of the board of directors.
While the valuation your company receives from the investor
obviously has a significant impact on the value you will get from
your founder's stock in a liquidity event, it is only the start. Beyond
valuation, there are other important financial terms contained in
every term sheet that can have a great impact on the value of your
equity down the road, which include the investor's liquidation
preference, dividend rights, anti-dilution protection and redemption
Additionally, there are critical terms in every term sheet that can
greatly affect how much control of the company the founders must
give up following the closing, which include board provisions, and
protective voting rights. Make sure you understand each term and
how it can affect you and your company, and keep in mind that a
favorable valuation is only one ingredient of a good term sheet.
In a term sheet there is always a paragraph called an election
paragraph that details how the board of directors will be chosen.
The entrepreneur must be quite adamant about what the proper
balance should be between venture capitalists, company founders,
and outside representatives.
One example of how the board might be chosen is: two directors
chosen by the founders, two directors chosen by the venture
capitalist, and one chosen by mutual consent.
How you structure the selection of the person chosen by mutual
consent is very important i.e.; chosen with the consent of the board
with each member having one vote, chosen based on number of
shares held by founders or venture capitalists.
Venture capitalists often ask for the right to have another member
of their firm attend board meetings even if they only attend as an
In most term sheets venture capitalists will insist that one of the
founders board members be the CEO of the company. One thing
entrepreneurs must consider is that should the current CEO be
replaced so does the board seat. That may very well change the
founder’s position on the board.
The venture capitalists insist on receiving preferred shares of the
company for their investment. The founders on the other hand have
common stock shares.
Preferred stock has various "preferences" over common stock.
These preferences can include liquidation preferences, dividend
rights, redemption rights, conversion rights and voting rights.
When a company raises venture capital in a preferred stock financing,
it typically designates the shares of preferred stock sold in that
financing with a letter. The shares sold in the first financing are
usually designated "Series A", the second "Series B", the third
"Series C" and so forth. Shares of the same series all have the same
rights, but shares of different series can have very different rights.
All series of preferred stock will, of course, be "senior" to the
common stock simply by virtue of having a liquidation preference
Preferred Shares is the most typical form of security issued in
connection with a venture capital financing of an emerging growth
company. This is because of the many advantages that preferred
shares offer an investor - it can be converted into common shares,
and it has dividend and liquidation preference over common shares.
It also has anti-dilution protection, mandatory or optional
redemption schedules, and special voting rights and preferences.
Venture capitalists will normally require your principal shareholders
to become parties to a shareholders’ agreement as a condition to
closing on the investment. It is not uncommon for investors to
require that the shareholders’ agreement be unanimous (i.e. all
shareholders execute it). Any existing shareholders’ or buy/sell
agreements will also be carefully scrutinized and may need to be
amended or terminated as a condition to the investment.
The shareholders’ agreement will typically contain certain restrictions
on the transfer of your company's securities, voting provisions, rights
of first refusal and co-sale rights in the event of a sale of the founder's
securities, anti-dilution rights, and optional redemption rights for the
venture capital investors.
For example, the investors may want to reserve a right to purchase
additional shares of your preferred shares to preserve their
respective equity ownership in the company in the event that you
later issue another round of the preferred shares. This is often
accomplished with a contractual pre-emptive right as opposed to
such a right being contained in the corporate charter, which would
make these rights available to all holders of the preferred shares.
Venture capitalists will also often require key members of a
management team to execute certain agreements as a condition
to the investment. Normally, these agreements include: Employment
Agreements; Non-disclosure and Intellectual Property Assignment
Agreements; and, Share Repurchase Agreements.
These agreements will define each employee’s obligations, the
compensation package, the grounds for termination, the obligation
to preserve and protect the company's intellectual property, and
post-termination covenants, such as covenants not to compete or
to disclose confidential information.
Share repurchase agreements apply specifically to the company’s
key founders. Essentially, they operate like a “reverse option” where
the company retains the right to repurchase a declining number of
your founders shares if your employment is terminated before the
end of the share repurchase period.
The term sheet will include a bunch of requirements for the
entrepreneur to provide the venture capitalist regular reports on
how the company’s doing.
One of the worst terms is a ratchet requirement ·. This protects the
venture capitalist that has in their $3,000,000 investment. The
companies not reaching its goals, they’re out trying to raise
additional financing from other venture capitalists by trying to raise
a (B) round of financing and the new venture capitalists tell you that
the value they place on your company is not $10,000,000 but
The ratchet term states that the dollar value of the original venture
capitalist is not allowed to decrease. Now that the company is now
valued at $5,000,000 their $3, 000,000 investment is now worth 60%
of the company and you’re required to issue them enough shares to
get them there.
This term ratchet puts the entrepreneurs in a position where they
have to totally swing for the fences and take insane risks if they’re
ever going to see a penny; the notion of building a nice stable
growing business and cashing out a few years later for a solid
profit is just not on, because you won’t see any of it.
Another item in the term sheet that provides venture capitalists
more control is tranches. Following our example once again the
venture capitalist agrees in the term sheet to invest $3,000,000.
The term in the term sheet called tranches states that they are not
providing the entire $3, 000,000 up front the give you $750,000 at
closing, and if in six months you’ve reached certain milestones
which most times are revenue related: the give you another
$750,000, and they will give you the remaining $1,500,000 in six
months again depending on the company achieving its revenue
Entrepreneurs hate tranches with a passion, because most
successful companies have had changes in direction, which tend
to make former milestones irrelevant, and if you miss a target you’ve
probably been spending money to get there, so if the company
misses the revenue target their back is to the wall and their going
to have to renegotiate the terms just to keep their doors open and
most likely at a much lower valuation.
Always remember that venture capitalists do spend real money in
getting all the contracts and other legal work completed and they
don’t pay for it because you are required to pay for this out of the
funds they provide. Every entrepreneur finds this very irritating as
they feel the investment is to grow their business not pay the
venture capitalists legal bills.
VC's are not fans of entrepreneurs who raise capital and then turn
around and give themselves $200,000 salaries. Knowledgeable
entrepreneurs also usually don't do this since this is expensive,
dilutive capital they have raised. They are taking significant dilution
in order to gain incremental salary. If the deal is successful, every
early dollar will turn into $15-25 worth of foregone equity at the
exit! So, it is a bit of an IQ test from the VC's perspective.
Generally, the entrepreneur passes and takes a $60-100,000 salary
early on and moves this up once the company is more mature.
As a company grows, it takes on multiple rounds of investment. This
usually constitutes several "classes" of convertible preferred stock,
with each designated alphabetically (Series A, Series B, etc). The
founders and angel investors often have common stock which is
junior to the various preferred stock series.
Each new round usually has at least one, if not more, new investor's
to price the round and set the terms independently. The new class
of stock is usually senior in liquidation to the series before it. So, if
Company A raises $2M of Series A, $5M of Series B and $10M of
Series C, investors in Series C get their money first, Series B next
and then Series A. If there is enough left over, the common gets the
remaining unless it is participating preferred. This means the
preferred get their money out and then participate in the remainder
with common based on their % ownership in the company.
Different classes with different rights and seniority creates a broad
array of misaligned interests:
Acquisitions: If the Company gets and acquisition offer for $11M, the
Series C investors might push to sell if they have lost faith in the
business. They get their $10M back (and the Series B gets $1M).
However, the B and Series A would not want to sell since they get
little. If they have blocking rights, they will prevent the sale from
This happens when major decisions (sale, new capital, etc) must be
voted on individually by each class versus combined by everyone
(pari passu) "at the same time", . In the later case, the C would be
able to push through a combined vote since its $10M is greater than
the $7m from the other two classes combined (assuming simple
New Capital: When new rounds of capital are raised, all kinds of
games can begin. If the older investors are tapped out, the recent
investors are not overly excited about carrying the company for the
free riders. So, they throw in a pay to play. In this situation, old
investors have to invest their pro rata (% ownership of the preferred)
or their preferred stock gets pushed to common.
This means that even if you are a Series B investor, if you don't
invest your full amount, your Series B stock converts to common
and falls behind the remaining Series A, B and C stock. This is
particularly nasty if there has been a lot of money raised. Let's say
there is $20M in each of the classes and you are a Series C investor.
Before the new financing, you needed a $20M exit to get your money
back (C comes out first and was $20m in total).
If new money comes in (say $10m) and you don't invest your pro rata,
you get pushed to common and now need a $70m (minus your
investment) exit just to get your first dollar out (A,B &C are $20m
each and the new D is $10m). You then participate with everyone
based on your % owned in the company. If you invested $10m and
own 20%, then you would get your full money back $50M later. So,
before, you needed a $20m exit to get all of your capital out and after
the Series D came in, you need a $120M exit ($70m in preference
ahead of you and $50m for ownership).
It is for these reasons, that investors like to have blocking rights on
sales and financings. This means that they own enough of a Series
(or they and "aligned co-investors") that the Company needs their
approval to sell or raise. This prevents a pay-to-play from being
crammed down on them.
The name of the game for VC's is called "exits". An "exit" happens
when a VC sells its ownership in a portfolio company. Venture is
really a simple business. You make money by "exiting" a company
(either because the company gets sold or it has an IPO and the
shares can be sold) at a price higher than what you paid. That's the
Today Entrepreneurs are selling less of their companies to venture
investors in a strong market for promising start-ups, according to
the latest Dow Jones Venture Capital Deal Terms Report
The median share of companies sold to investors in first rounds has
declined to 38% from 50% two years ago. Company-unfriendly
provisions that gained notoriety after the tech bubble burst remained
relatively rare, affecting mostly companies whose business had
Three quarters of U.S. companies closing second rounds, which are
a strong indicator of the state of the venture industry, said their
valuations increased. And 80% of U.S. companies said they received
a term sheet from at least one potential new investor, indicating
healthy interest from company outsiders.
In most U.S. deals, investors settled for liquidation preferences equal
to the amount they invested. Only 20% of companies reported a
preference higher than 1x and most of those said it was 2x or less.
Company-unfriendly full-ratchet dilution protection appeared in 16%
of financings surveyed, most often in financings where the
company's valuation fell from its prior round.
Pay-to-pay provisions, aimed at keeping investment syndicates on
the same page if a company runs into trouble, are becoming less
common. Only 21% of U.S. respondents said their term sheet
included this clause, down from a high of 37% in the survey covering
April 2003 through March 2004. Under this provision, investors who
fail to participate in a subsequent round in which the company's
valuation falls, can have their preferred shares converted to
common stock or stripped of certain rights.
The market also found that founders and prior investors usually did
not sell shares to investors in the latest round, despite a longer wait
for liquidity. But with more founders bootstrapping companies before
seeking an initial venture financing, the rate was highest in first
rounds with 16% of those deals affording founders the opportunity
to sell some stock.
This tale of turmoil is both true and surprisingly common. The early
stages of a venture company are not unlike the heady, exciting days
of a new romance. The founder of a company, passionate about an
idea, consumed with making it happen, meets a VC who is interested
in investing. Their discussion focuses on the CEO’s strengths,
accomplishments, and dreams for the future. The founder envisions a
perfect marriage in which his or her sweat equity, technical expertise,
and/or market knowledge are valued by the VCs, as evidenced by a
large dollar investment and generous compensation. The deal is done,
the VCs join the board, and the founder assures the management
team that the board is fully aligned with the CEO’s vision for the
Well now that we have defined term sheets lets look at the items
you as lawyers should be concerned about representing your
clients best interests during these negotiations.
Understanding the Legal Documents you as Lawyers are
The actual executed legal documents described in the term sheet
must reflect the end result of the negotiation process between you
and the venture capitalist. These documents contain all of the legal
rights and obligations of the parties, and they generally include:
Share Purchase Agreement ("Subscription Agreement");
Employment and Confidentiality Agreements and Intellectual
Assignments, and Share Repurchase Agreements;
Warrant (where applicable), Debenture or Notes (where applicable);
Preferred Share Resolution (to amend the corporate charter) (where
Contingent Proxy, Legal Opinion of Company Counsel and a
Registration Rights Agreement.