Venture Capital Term Sheets: The Good, The Bad & The Ugly


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Term-by-term teardown of venture capital equity and bridge note term sheets for startups and entrepreneurs. What to look for and what to avoid.

Published in: Business, Economy & Finance

Venture Capital Term Sheets: The Good, The Bad & The Ugly

  2. 2. Page 2 Startup Capital Ventures Capital-Efficient Investing In The Enterprise
  3. 3. Agenda Basics Ownership Control Convertible Debt Page 3Startup Capital Ventures
  4. 4. First Principles Get an experienced startup attorney! •  The term sheet is just the beginning… Subsequent investment rounds will want the provisions that the Series A gets at minimum Don’t leave provisions up to subsequent rounds Leverage industry-standard termsheet builders NVCA: option=com_content&view=article&id=108&Itemid=136 Wilson-Sonsini: Orrick: Startup Capital Ventures Page 4
  5. 5. Investors Care About Ownership & Control When Things Go Well... •  Pricing •  Dividends •  Participation •  Conversion Rights •  ROFO (not ROFL…) When Things Don’t… •  Voting Rights •  Protective Provisions •  Liquidation Preference •  Antidilution •  Drag Along •  ROFR •  Pay To Play Page 5Startup Capital Ventures
  6. 6. On Valuation: Push-Me / Pull-You or The 60 / 40 Rule Startup Capital Ventures Page 6 In early stages, you can “push” your company’s value •  Capital requirement: I call this the 60/40 rule: Your “ask” can be $2M or $4M but the “money” may take 40% either way – so ask for more not less •  Avoid overvaluations which cause down-rounds later When your company has revenues, the market will starts to “pull” your value •  Financial metrics such as gross & net margins, time to EBITDA become important •  Financing market becomes more efficient due to comparable deals •  Valuations become calculable
  7. 7. Agenda Basics Ownership Control Convertible Debt Page 7Startup Capital Ventures
  8. 8. “Three On Four” Series A Amount Raised: $3,000,000 including $250,000 from the conversion of principal and interest on bridge notes. Pre-Money Valuation: The Original Purchase Price is based upon a fully-diluted pre-money valuation of $4,000,000 and a fully‑diluted post-money valuation of $7,000,000 including an employee pool representing 17% of the fully‑diluted post-money capitalization. Price Per Share: $0.20 per share based on the capitalization of the Company set forth below. (the “Original Purchase Price”). Startup Capital Ventures Page 8
  9. 9. “Three On Four” (really?) Page 9Startup Capital Ventures
  10. 10. Pricing: Good, Bad & Ugly The good: straightforward pricing fully funded at closing The bad: tranched deal based on milestones The ugly: Founders diluted below 40% Startup Capital Ventures Page 10
  11. 11. Dividends Pay Investors Cost Of Capital In A “1X” Exit The Too Good: No dividends (a subsequent round to may ask for them so address this now) The Good: The Series A Preferred will carry an annual X % cumulative dividend payable in-kind in equivalent value of stock upon a liquidation or redemption. For any other dividends or distributions, participation with Common Stock on an as-converted basis. The bad: Egregious interest rate > 7% The ugly: Mandatory cash-pay annual dividend Page 11Startup Capital Ventures
  12. 12. Antidilution Protects Investors Against Down-Rounds The Good: The holders of the Series A shall be entitled to anti-dilution protection according to a broad-based, weighted-average formula, but in no event shall the holders of the Series A Preferred have less favorable anti-dilution protection than that enjoyed by any future class of Preferred Stock The too good: None (but future rounds will want it so set a good precedent & get it over with) The bad: narrow-based weighted average (excludes common, etc.) The ugly: Full ratchet where holders of such shares never get diluted in – but everyone else does (In the long run rarely succeeds) Page 12Startup Capital Ventures
  13. 13. Liquidation Preference & Participation: Investors Get Their $ Back Before You The Good: First pay one times the Original Purchase Price plus accrued dividends on each share of Preferred. The balance of any proceeds shall be distributed pro rata to holders of Common Stock. (Investors get their $ out first in a < 1X exit, otherwise convert to common) The (Normative) OK LPF + Participating Preferred: First pay one times the Original Purchase Price plus accrued dividends on each share of Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis. The Bad LPF + Capped Participating Preferred: First pay (2 or 3) times the Original Purchase Price plus accrued dividends on each share of Preferred. Thereafter, Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Preferred receive an aggregate of X times the Original Purchase Price. It rarely gets Ugly here. Startup Capital Ventures Page 13
  14. 14. Conversion Rights (The Good Bit) (Normal) Automatic Conversion: Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a underwritten public offering with a price of X times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $XM (a “QPO”), or (ii) upon the written consent of the holders of a majority of the Series A Preferred or (iii) after a date of DD/MM/YY if no other conversion provision has been triggered Optional Conversion: The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described under “Anti-dilution Provisions.” Page 14Startup Capital Ventures
  15. 15. ROFO Ensures Existing Investors Can Maintain % Ownership In Subsequent Rounds It Is What It Is: All [Major] Investors shall have a pro rata right, based on their percentage equity ownership in the Company (fully diluted), to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet. In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares. Page 15Startup Capital Ventures
  16. 16. Agenda Basics Ownership Control Convertible Debt Page 16Startup Capital Ventures
  17. 17. Voting Rights / Board Makeup The good: The Series A nominates two Directors, the CEO will be a Director, one Director to be nominated by vote of Common Stock, and one independent Director as elected by a majority of all stock classes voting together The bad: The Preferred shareholders nominate two Directors, the CEO shall be a Director, one Director to be nominated by vote of Common Stock, and one independent Director as nominated by Preferred The ugly: usually happens when a shareholder vote is called & the Preferred controls Page 17Startup Capital Ventures
  18. 18. Protective Provisions: What Part Of “No” Don’t You Understand? So long as X% shares of Series A Preferred are outstanding in addition to any other vote or approval required under the Company’s Charter or By-laws, the Company will not, without the written consent of the holders of at least X% of the Company’s Series A Preferred, either directly or by amendment, merger, consolidation, or otherwise: (i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any merger or consolidation or any other Deemed Liquidation Event; (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred]; (iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred; (iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/ services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of the Series A Director(s)]; or (v) create or authorize the creation of any debt security; (vi) create or hold capital stock in any subsidiary that is not a wholly-owned subsidiary or dispose of any subsidiary stock or all or substantially all of any subsidiary assets; or (vii) increase or decrease the size of the Board of Directors Page 18Startup Capital Ventures
  19. 19. ROFR Maintains Control Within Existing Investor Group Company first and Investors second (to the extent assigned by the Board of Directors,) will have a Right Of First Refusal to acquire any shares of capital stock of the Company proposed to be transferred by Founders or others, with a right of oversubscription for Investors of shares unsubscribed by the other Investors. Before any such person may sell Common Stock, he/she will give the Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors. Page 19Startup Capital Ventures
  20. 20. Pay To Play: When Things Are Ugly For Everyone Ugly for founders: Things have not gone well, most are probably fired The VCs are challenging each other: On any subsequent [usually down] round all Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the Investors. All shares of Series A Preferred of any Investor failing to do so will automatically lose anti-dilution rights, lose right to participate in future rounds, convert to Common Stock and lose their right to a Board seat if applicable. The happy ending: P2P is usually followed by issuing new stock to then-current management Page 20Startup Capital Ventures
  21. 21. Drag-Along Rights: Investors Can Force An Exit Usually means the company lost the plot… Holders of Preferred Stock and the Founders shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred and which is approved by [the Board of Directors] [and the holders of a majority of the outstanding shares of Preferred Stock, on an as- converted basis (the “Electing Holders”)] Page 21Startup Capital Ventures
  22. 22. Agenda Basics Ownership Control Convertible Debt Page 22Startup Capital Ventures
  23. 23. K.I.S.S. If it’s over three pages you are paying your lawyer too much… Forcing a (speculative) cap price presents challenges •  If the cap is low the company has little incentive to exceed milestones, and future investors can be upset at bridge round investors and find dilutive workarounds •  If the cap is high it can signal missed milestones making future investors wonder about the company –  Sometimes caps are absurdly high making the term a throwaway – why bother? Page 23Startup Capital Ventures
  24. 24. By Now You Should Recognize These Terms… Amount to be Raised: Up to $###,###. Type of Security: Unsecured convertible promissory notes (the “Notes”) and warrants. Closing Date: The Initial Closing of the sale of the Notes is scheduled to occur on Month 30, 20XX (the “Initial Closing”). Subsequent sales may occur within 180 days of the Initial Closing, subject to approval by the Company, but in no cases on or after a Qualified Financing or Liquidation Event. Interest Rate: Interest will accrue on the principal amount of the Notes at the rate of 5% per annum, to be paid-in-kind (PIK) in the value of the applicable class of stock at the time of conversion. Page 24Startup Capital Ventures
  25. 25. Warrants: Tax-Advantaged, Non- Voting Discount For Early Investors If can: Investors will receive XX% warrant coverage, consisting of warrants to purchase the equity securities issued in the Qualified Financing at the price per share of the equity securities issued. If can, but try wait: Investors will receive an additional YY% warrant coverage (for a total of ZZ% warrant coverage) if the Qualified Financing occurs after 180 days from date of Initial Closing. If no can: If a Qualified Financing does not occur on or before one year from the date of Initial Closing, then the warrants shall be exercisable for Common Stock of the company at the then-current price per share at that time. Term: The warrants shall be exercisable for seven (7) years. The right to exercise the warrants shall terminate upon a Liquidation Event in which Warrants will have a “net exercise” provision. Startup Capital Ventures Page 25
  26. 26. Maturity & Conversion: The Meat In The Sandwich Maturity: Earliest to occur of (i) one year from Initial Closing (ii) the closing of a Qualified Financing or (iii) a “Liquidation Event” as defined by either (a) an Initial Public Offering (IPO), (b.) the sale of substantially all of Company’s stock or assets, or (c.) the initiation of U.S.B.C. Chapter 11 or any other type of bankruptcy proceeding. Conversion: Automatically converts to shares of the equity securities issued upon a Qualified Financing (to be not less than $X.X million inclusive of bridge conversion, with at least $X00,000 from an outside institutional investor) (the “Qualified Financing”). In the event that no Qualified Financing occurs before maturity, either (a. the bad) the note holder shall have the option to, or (b.the good ) the notes shall automatically, convert into Common Stock of the company at the then-current price of common stock per share. Page 26Startup Capital Ventures
  27. 27. “Meat’s Not Meat ‘Til It’s In The Pan” Painting: Charles RussellStartup Capital Ventures Page 27
  28. 28. Capital-Efficient Investing In The Enterprise Startup Capital Ventures Page 28