MaGIC Startup Academy Launch : Day 3 How To Negotiate A Term Sheet

Venture Financing
How to negotiate a term sheet
C. Jeffrey Char
J-Seed Ventures, Inc.

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Securities research analyst
Corporate finance attorney
Serial entrepreneur
Venture capitalist

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J-Seed Ventures Inc.
Venture incubator
Founded in 2000
Self-funded
9 portfolio companies currently

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We start businesses that
address real market needs
with innovative business
models and technologies.
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Advice for Raising Capital
 Mistakes are costly – plan ahead
 Don’t raise too early – OPM is for scaling
 Binding vs. non-binding
 Valuations – higher is not always better
 Find an experienced lawyer

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Common Stock vs. Preferred Stock
 Common Stock
 Statutory definition
 Founders
 Preferred Stock
 Articles of Incorporation
 Investors

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Negotiating A Term Sheet
Preferred Stock Rights
Preferred Stock Restrictions
Contractual Rights
 Liquidation Preference
 Anti-Dilution Protection
 Protective Provisions
 Investor Redemption Rights
 Conversion Rights
 Voting Rights
 Automatic Conversion
 Company Redemption Rights
 Board Representation
 Maintain Ownership
 Information Rights
 Registration Rights
 Employee Equity

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Contractual Rights
 Voting Rights
 Employee Equity

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Liquidation Preference
Issue Normal Provision
Only investment returned, or
participate with common after
investment returned
Occurs on true liquidation
or on sale of company
Liquidation preference increases
over time
Senior liquidation right, or in
proportion to invested capital
(“pari passu”)
Participate with common unless
fully diluted payout is 3x to 5x
investment price
Merger deemed liquidation
Not unusual
In proportion to invested capital

Liquidation Preferences Compared
Mobile Tech, Inc. Capital Structure
Class Price Per Share Shares $ Paid In
Common $0.01 6,000,000 $ 60,000
Preferred $1.00 4,000,000 $ 4,000,000
No Liquidation Money Back and Money Back and
Company Sale Price Preference Money Back Only Participate to 3x Cap Fully Participating
$5 Million Common
Preferred
$10 Million Common
Preferred
$20 Million Common
Preferred
$40 Million Common
Preferred
$ Million
Total $ Per
Layout Share
$ 3 $ 0.50
$ 2 $ 0.50
$ 6 $ 1.00
$ 4 $ 1.00
$ 12 $ 2.00
$ 8 $ 2.00
$ 24 $ 4.00
$ 16 $ 4.00
$ Million
Total $ Per
Layout Share
$ 1 $ 0.16
$ 4 $ 1.00
$ 6 $ 1.00
$ 4 $ 1.00
$ 16 $12 $ 2.00
$ 4 *
$ 8 $ 2.00
$ 36 $ 24 $ 4.00
$ 4 * $ 16 $ 4.00
* Preferred converts to maximize returns
** Preferred receives less due to cap.
$ Million
Total $ Per
Layout Share
$ 0.6 $ 0.10
$ 4.4 $ 1.10
$ 3.6 $ 0.60
$ 6.4 $ 1.60
$ 9.6 $ 1.60
$10.4 $ 2.60
$ 24 $ 21 $ 4.00
$ 16 $ 19 $ 4.00
$ Million
Total $ Per
Layout Share
$ 0.6 $ 0.10
$ 4.4 $ 1.10
$ 3.6 $ 0.60
$ 6.4 $ 1.60
$ 9.6 $ 1.60
$ 10.4 $ 2.60
$ 21 $ 3.50
** $ 19 $ 4.75

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Anti-Dilution Protection
”Ratchet” (full, narrow or
broad base)
Size of employee incentive
pool
Broad base
15-25% of company
(including shares subject to
options and shares reserved
for future options)

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Pre-Money
Capitalization of JS Tech, Inc.
Number of Shares Original Purchase Valuation at Time
Type of Security Outstanding Price Per Share of Purchase
Common Stock 1,000,000 $0.10 $ 100,000
Options to Purchase Common 100,000 $0.10 N/A
Series A Preferred Stock 500,000 $1.00 $1,100,000
Series B Preferred Stock 400,000 $2.00 $3,200,000
New Issue:
Series C Preferred Stock 500,000 $1.50 $3,000,000

Anti-dilution operates by adjusting the
“Conversion Rate” of a series of preferred stock
Conversion Rate = Original Purchase Price (always the same)
Adjusted Conversion Price
• A decrease in the “Conversion Price” increases the Conversion Rate.
• The Conversion Price never exceeds the Original Purchase Price.
Formulas for Determining Adjusted Conversion Price of Series B
Full Ratchet: Narrow Base Broad Base
Weighted Average Weighted Average
C$
BPP
BPP A + B + ( ) A + B + CS + O + ( )
CPP A + B + C A + B + CS + O + C
BPP = Series B Purchase Price B = Series B shares outstanding
CPP = Series C Purchase Price C = Series C shares to be issued
C$ = Total amount paid for Series CS = Common Stock shares
A = Series A shares outstanding O = Option shares outstanding
C$
BPP

Example of Anti-Dilution(3)
Application of formulas to JS Tech, Inc. Series B Preferred Stock
JS Tech, Inc. Issues 500,000 Shares of Series C Preferred Stock at $1.50/Share
Full Ratchet: Narrow Base: Broad Base:
$750 $750
500 + 400 + $2.00 500 + 400 + 1,000 + 100 + $2.00
500 + 400 + 500 500 + 400 + 1,000 + 100 + 500
1,275,000 = .9107 2,375,000 = .95
1,400,000 2,500,000
$2.00 X .9107 = $1.82 (new CP) $2.00 x .95 = $1.90 (new CP)
$2.00 $2.00 $2.00
$1.50 $1.82 $1.90
= 1.33 (new rate) = 1.0989 (new rate) = 1.0526 (new rate)
400,000 Series B @ $1.33 400,000 Series B @ 1.0989 400,000 Series B @ 1.0526
convert to 532,000 Common convert to 439,560 Common convert to 421,040 Common

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Protective Provisions
Actions which require consent
Who must consent
 All investors or only new
investors
 Percentage required
 Preferred Series vote vs. Preferred
Class vote
 Sale of Company
 Senior securities
 Equivalent securities
 Change in rights
 Repurchases except on termination
 All investors
 3 of 5, or 4 of 7, largest investors
 Sale of Company and Repurchases -
Preferred as a class
 Others - Vote by series

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Investor Redemption Rights
Earliest demand date
Redemption price
When repurchased
Sinking fund
5 years
Cost plus 10%
Over 3 years
None - so legal limitations apply

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Conversion Rights
When investors can convert at
their option
Forced conversion by other
investors
At any time, partial or total
80% majority can force
remainder to convert

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Voting Rights
Vote number of Preferred
shares or as if converted to
Common
Classified Board of Directors
Vote on as-converted basis
Each series represented. In
Articles of Incorporation if
required by investors

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Contractual Rights
 Voting Rights
 Employee Equity

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Automatic Conversion
Earliest date
Minimum valuation
Minimum IPO deal size
IPO only, or also merger
Forced conversion by other
investors
3 years after investment
3-5 times investment value
$10-15 million
IPO only
80% of all investors can force
remainder to convert

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Company Redemption Rights
Earliest demand date
Redemption price
When redeemed
Opportunity to convert before
redemption
3-4 years after investment
Cost plus 10%
One-time purchase
Yes

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Contractual Rights
 Voting Rights
 Employee Equity

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Contractual Rights
Board Representation
Classified Board
Voting agreement and proxies
Company’s best efforts to elect
person nominated by Preferred
Observer rights
Termination
Each series represented.
Traditionally dominant, but recent
trend away from classified boards
Occasional
Most frequently used
Large investors
On IPO or if diluted to below 10%

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Contractual Rights
Maintain Ownership
Preemptive right or right to buy after
closing
Decision time period
Excluded transactions
Termination
 Time
 IPO/merger
 Failure to exercise rights
Preemptive right (“Right of First
Refusal”)
15 days
 Employees and consultants
 Acquisitions
 Bank lending
 Equipment financings
 Licenses
5 years
Yes
No

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Contractual Rights
Information Rights
Who receives rights
Type of information
Large investors (often $300,000-
$500,000 minimum)
 Annual audited within 90 days
 Monthly unaudited within
20-30 days
 Annual budget when presented
to/approved by Board

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Contractual Rights
Registration Rights
When investors can demand IPO
How many investors must demand
Participation in IPO
Demand rights after IPO
Lockup after IPO
3-5 years
Holders of over 40%
Cutbacks to zero
1 to 3 on Form S-1, annual on Form S-
3
180 days if directors, officers and 1%
holders sign

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Contractual Rights
Employee Equity
Buy-back on founders’ shares
Vesting of options
Co-sale rights
Reverse vesting over 4 years; cost
buy-back
4 years; 6 or 12 month delay after
employment starts
Investors can sell if founders sell

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Contractual Rights
Employee Equity
Reverse vesting of founder shares
1 2 3 4
100%
75%
50%
25%
years

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C. Jeffrey Char
J-Seed Ventures Inc.
Jeff@J-Seed.com
JSeedVentures
CJeffreyChar

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MaGIC Startup Academy Launch : Day 3 How To Negotiate A Term Sheet