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Session 11: Term Sheet Fundamentals
This document summarizes key terms related to venture capital term sheets. It discusses the purpose of a term sheet, common instruments used in financings like preferred shares and convertible notes, liquidation preferences, rights that investors obtain like affirmative rights and board seats, founder vesting schedules, and other terms like anti-dilution, valuation methods for convertible notes, and more. The document provides examples to illustrate concepts like liquidation preferences and anti-dilution calculations.
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Session 11: Term Sheet Fundamentals
- 1. Term Sheet FundamentalsMay 2020 Backing Ventures in Deep Tech creating 10x differentiated businesses Samik Rakshit Head of Fund Operations, pi Ventures Twitter: @samik_rakshit
- 2. The Funding Process Pitchto Investors Convinced? Term Sheet Negotiation concluded? Due Diligence - Financial DD - Legal DD SHA/ SSA Ok? Detailed Terms concluded? Can Issues be fixed? ClosureDrop Yes No No Re-negotiate No No Yes Yes No Yes Parallel process Yes
- 3. What is TermSheet? Written document having the key terms and conditions of a potential deal Deal between Founders & Investor/s Dividing the upside and risk between the parties Non- binding agreement. Binding to the extent of Non-shop & Confidentiality Gives road map for lawyers to draft Definitive agreements
- 4. Instruments Promoters own Equity/ Commonshares Investors own Preferred shares (most common way of investment) Convertible/ Optionally Convertible (Redeemable) Participating/ Non-participating Cumulative / Non-cumulative Compulsory Convertible Notes/ Debts (CCN/D) Preference shares
- 5. Liquidation Waterfall Equity shares Preference shares Remaining debts Govt. dues Unsecured Creditors (CCD/N) Wages& Unpaid dues Secured Creditor Liquidation cost
- 6. Eg. ₹10cr Ser Ainvestment at ₹30cr pre-money. Company ends up selling for ₹100cr. Particulars Principal return Additional Participation Total Remarks (if any) 1X Non- participating Greater of ₹10cr or ₹25cr (25% X ₹100cr) - ₹25cr Greater of pro-rata return or principal return 1X Participating with 3X Cap ₹10cr ₹20cr (25% of remaining proceeds of ₹90cr upto 3X of total investment) ₹30cr Limiting returns to 3X of Investment 2X Participating ₹20cr ₹20cr (25% of ₹80cr) ₹40cr 25% of the remaining proceeds (₹100cr - ₹20cr) Liquidation Preference Variants Non - Participating (1X Non- Participating) Capped Participating (1X Participating with 3X Cap) Uncapped Participating (2X Participating)
- 7. Eg. ₹10cr Ser Ainvestment at ₹30cr pre-money. Company ends up selling for ₹100cr. Particulars Principal return Additional Participation Total Remarks (if any) 1X Non- participating Greater of ₹10cr or ₹25cr (25% X ₹100cr) - ₹25cr Greater of pro-rata return or principal return 1X Participating with 3X Cap ₹10cr ₹20cr (25% of remaining proceeds of ₹90cr upto 3X of total investment) ₹30cr Limiting returns to 3X of Investment 2X Participating ₹20cr ₹20cr (25% of ₹80cr) ₹40cr 25% of the remaining proceeds (₹100cr - ₹20cr) Liquidation Preference Variants Non - Participating (1X Non- Participating) Capped Participating (1X Participating with 3X Cap) Uncapped Participating (2X Participating)
- 8. Affirmative Rights/ BoardRights What? Economic Rights Operational Rights How? Hard negotiations Protective provisions Thresholds
- 9. Affirmative Rights/ BoardRights What? Economic Rights Operational Rights How? Hard negotiations Protective provisions Thresholds Change VC terms Creation of more stock Amendment of AoA/ MoA Issue senior rights stock Change in BoD composition M&A Business pivot Economic Rights (examples) Operational Rights (examples) Appoint/ remove auditors Incur Opex beyond threshold Related party transactions Approve annual budgets Change in business projectionsIncur Capex beyond threshold
- 10. Affirmative Rights/ BoardRights What? Economic Rights Operational Rights How? Hard negotiations Protective provisions Thresholds Change VC terms Creation of more stock Amendment of AoA/ MoA Issue senior rights stock Change in BoD composition M&A Business pivot Economic Rights (examples) Operational Rights (examples) Appoint/ remove auditors Incur Opex beyond threshold Related party transactions Approve annual budgets Change in business projectionsIncur Capex beyond threshold Voting & Conversion Preference shares on a “as if converted basis” have voting rights.
- 11. Other Rights Drag Rights Investorscan force the sale of the company under certain conditions Pre-emptive/ pro rata rights Gives the existing investors the right to participate in subsequent rounds ROFR/ ROFO Preferred Stock holders get the first right to participate Tag along/ co-sale rights Management agrees not to sell their shares without giving investors a right for pro-rata participation in sale Note: Drag-along and tag-along rights typically end at an IPO, as they get replaced by security laws for public markets.
- 12. Founder Vesting Typical Foundervesting curve 4 years vesting with 1 year cliff. Post the cliff the shares are vested in periodic intervals Pre-vesting of Founder Vesting at certain times 6.25%
- 13. Founder Vesting Typical Foundervesting curve 4 years vesting with 1 year cliff. Post the cliff the shares are vested in periodic intervals Pre-vesting of Founder Vesting at certain times 6.25% Cliff Y1 Y2 Y3 Y4 Closing date 25% vesting 50% vesting 75% vesting 100% vesting 31.25% 37.5% 43.75% 50% 56.25% 62.5% 68.75% 81.25% 87.5% 93.75% 100% 75% Say a Founder had 40% shares as at Closing date. So after 18 months the founder will vest 15% shares (37.5% of 40% shares)
- 14. Founders Agreement Equity Vesting FounderLock-in Non - compete IP assignment Exit Terms Scenario Vested Shares Unvested Shares Resignation Remains with Founder Lapse Retirement Remains with Founder Lapse Death/ Incapacitation Remains with Founder Accelerated Vesting Leave for Cause Lapse Lapse M&A Gets bought by the company/ Acquirer Depends on Acquisition terms Exit (typical) Terms
- 15. Founders Agreement Equity Vesting FounderLock-in Non - compete IP assignment Exit Terms Scenario Vested Shares Unvested Shares Resignation Remains with Founder Lapse Retirement Remains with Founder Lapse Death/ Incapacitation Remains with Founder Accelerated Vesting Leave for Cause Lapse Lapse M&A Gets bought by the company/ Acquirer Depends on Acquisition terms Vesting during M&A - depends on acquisition terms Exit (typical) Terms Options No accelerated vesting Accelerated vesting Single Trigger Double Trigger Merger of company Acquiring company fires the concerned person
- 16. Anti-Dilution Protect Investors indown round investment Broad based - Fully diluted - Current Outstanding + Convertibles Weighted AverageFull Ratchet Narrow based - Current outstanding shares (equity + pref) Anti-dilution Weighted Average formula NCP = OCP X ((CSO + CSP)/ (CSO + CSAP)) NCP = New Conversion Price OCP = Old Conversion Price CSO = Shares outstanding immediately prior to the new issue CSP = Shares purchased if the round was not a down round (previous round pricing) CSAP = Shares actually purchased because the round is down
- 17. Anti-Dilution - Example Chronologyof events 1. Outstanding shares with company is 600,000 2. Seed round - Investor 1 puts in $400k for 40% 3. Series A round - Investor 2 like to put in $500k for 50% Solution: Price for Seed Round per share = $1 Price for Series A round per share = $0.50 Full Ratchet:- Particulars # shares %age Total value Founders 6,00,000 60% $6,00,000 Investor 1 4,00,000 40% $4,00,000 Total 10,00,000 100% $10,00,000 CAP table post Seed Round Weighted Average:- Particulars # shares %age Total value Founders 6,00,000 60% $6,00,000 Investor 1 4,00,000 40% $4,00,000 Total 10,00,000 100% $10,00,000 CAP table post Seed Round Full Ratchet Weighted Average Particulars # shares %age Total value Founders 6,00,000 10.00% $1,00,000 Investor 1 4,00,000 Anti-dilution (Full Ratchet) 20,00,010 sub-total Investor 1 24,00,010 40.00% $4,00,000 $0.17 Investor 2 30,00,012 50.00% $5,00,000 Total 60,00,022 100% $10,00,000 CAP table post Series A Round (after multiple iterations) Particulars # shares %age Total value Founders 6,00,000 25.38% $1,00,000 Investor 1 4,00,000 Anti-dilution (Weighted Avg) 1,81,818 sub-total Investor 1 5,81,818 24.62% $4,00,000 $0.69 Investor 2 11,81,818 50.00% $5,00,000 Total 23,63,636 100% $10,00,000 CAP table post Series A Round (after multiple iterations)
- 18. Convertible Note Defer thevaluation till next round of financing Key Parameters Max Valuation Cap Discount Lower Cap 3 Methods of Conversion: Conversion Method Calculation Impact on Founders Impact on CCD Investors Impact on VC Pre-Money Pre-money valuation of company is fixed Best Worst Worst Percentage-Ownership %age ownership of VC is fixed Worst Best Best Dollars-invested Post-money includes nominal value of CCD Middle Middle Middle
- 19. Few More Terms Valuation Postmoney valuation = pre-money valuation + Investment in the round Tranching Staggering the same round of investment. Usually milestone based investment. ESOP Part of the capital structure allocated for employees Clawback Chance to reclaim money or stock options already given to a founder or employee Legal & Due Diligence fees Mostly all investors put the burden of legal fees on the entrepreneur. Can negotiate some overall caps
- 20. For more information,write to samik@piventures.in *Thanks to Prof Shivaram from IIT Mumbai for the phrase J AI HIND*