Term Sheet Basics


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

Term Sheet Basics

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