Global Innovation Labs Founders Bootcamp - Demystifying term sheets

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Global Innovation Labs Founders Bootcamp - Demystifying term sheets

  1. 1. Demystifying Term Sheets<br />Alan D. Lucas <br />CMC Consulting Boston, Inc.<br />
  2. 2. Term Sheets <br />It’s all about deciding control, ownership & economic power <br />and <br />sets the tone of your investor relationship <br />
  3. 3. Term Sheet Definitions<br />Guts of the business deal<br />NOT a “legal” document<br />Investors template <br />
  4. 4. Term Sheet Definitions<br />Common Stock<br />Founders and Employees<br />Voting rights<br />Options and restricted stock<br />Preferred Stock<br />Investors stock <br />“preferred” because of better rights and protections than common stock<br />Exact definition of preferred rights (preferences) is key focus of negotiation <br />
  5. 5. Term Sheet Definitions<br />Valuation <br />“Pre-money”- value before financing<br />“Post-money”- pre-money plus financing<br />
  6. 6. Term Sheet Definitions<br />Participating preferred<br />If the company is sold, the preferred is paid the liquidation preference, then paid again as if it had converted to common<br />Non-participating preferred<br />Redeemable preferred<br />After 5 years, the preferred investor can demand repayment<br />Cumulative dividends<br />If the dividends are not paid in one year, they are added to the dividends owed in the next year.<br />
  7. 7. Control, Ownership & Power <br />Key Terms to Negotiate<br />Vesting of founders shares (3-5 years)<br />Upfront; Cliff; quarterly; monthly <br />Quit/fired, buyback vested & loss of unvested shares <br />Accelerated vesting – (change of control) <br />Option Pool 15-20% (for future hires) <br />common shares & dilutive to founders (keep as low as possible)<br />Preferred Stock Rights <br />Participation at liquidation <br />Anti-Dilution Protection <br />Board of Directors 4-6 members post A Round<br />% Based on investor ownership <br />Who will have majority 2-2-1 (who is the independent & how chosen) <br />
  8. 8. Preferred Stock<br />Investors never give up their right to participate in upside<br />Investors will always have alternative forms of payout, guaranteeing them (at least) the better of: <br />Astraight liquidation preference or <br />Pro rata share on as-converted basis<br />
  9. 9. Preferred Stock<br />Participation Preferred Stock <br />Rights that investors stock gets upon “liquidation” (M&A; sale of assets, IPO)<br />“Liquidation preference”: Investor get 100% of original money back + dividend before Common<br />“Participating preferred” permits investor to share the leftovers “pro rata” with Common <br />
  10. 10. Preferred Stock<br />Participation Preferred Stock – Variants <br />None: Investors get no “double dip;” only their liquidation preference: “straight preferred”<br />Multiple Liquidation Participating Preferred: Very nasty and coming back<br />Full Participation: Investors share PRO RATA with Common, without limit<br />Capped Participation: Investors share Pro Rata with Common but only UNTIL ~2-5X return received<br />Irrelevant in grand slam; matters only in poor outcome <br />
  11. 11. Multiple Preferred Liquidation<br />Investors take a multiple of their liquidation preference out before Common<br />Uncommon<br />Devastating in middling and poor outcomes <br />
  12. 12. Preferred Stock<br />Anti-DilutionProtection<br />Investors protection in event of “down round” so that A Round investors“conversion ratio” is equal to subsequent investors’<br />
  13. 13. Preferred Stock<br />Anti-Dilution Protection <br />Full Ratchet: “if only one new share is issued” in B round, all A round investors entitled to B round’s conversion ratio. A round is effectively re-priced to B round’s (lower) price.<br />Weighted Average: Less harsh; takes into account the true dilutive effect of the subsequent down round.<br />
  14. 14. Valuation - Know The Pricing of Other Deals<br />Consider a number of qualitative factors<br />management, size of market, etc.<br />Track pre-money values in series A deals<br />Create competition and negotiate <br />When a company is raising equity capital<br />It can’t avoid ownership dilution<br />It tries to avoid value dilution<br />
  15. 15. Valuation <br />Forecast a future value assuming success<br />Example<br />If the company hits its plan, it will be worth $60 million in 5 years based on a multiple of revenues<br />Determine a required rate of return<br />Figure out how much of the future value the investor needs to own in order to achieve the targeted return<br />
  16. 16. Targeted Rates of Return<br />
  17. 17. Valuation Determines The Return<br />
  18. 18. Single Stage Investment<br />Invest $2,500<br />Required return 50%<br />Target future value is $19,000<br />Sell company for $60,000<br />Target ownership<br />$19,000 / $60,000 = 32%<br />Post money value<br />$2,500 / 32% = $7,900<br />Pre money value<br />$7,900 - $2,500 = $5,400<br />
  19. 19. Example<br />Assume 1million shares outstanding & $2.5 million is raised at $5.00 per share<br />Pre-money value is $5 million<br />1,000 shares x $5 = $5,000 (pre-money)<br />500 shares sold x $5 = $2,500 (raised) <br />Post-money value <br />$5,000 + $2,500 = $7,500 <br />
  20. 20. Business Is Sold for $10,000<br />Investor 33%<br />1X Preferred No participation<br />LP is $2,500<br />Conversion value is $10,000 x 33% = $3,333<br />Proceeds to remaining common shareholders $10,000 - $3,333 = $6,667<br />Investor 33%<br />1X Preferred Participation<br />LP is $2,500 <br />Proceeds after payout of LP $10,000 - $2,500 = $7,500<br />Participation is $7,500 x 33% $2,475 + $2,500 = $4,975<br />Proceeds to remaining common shareholders $10,000 - $4,975 = $5,025<br />
  21. 21. Business Is Sold for $10,000<br />Investor 33%<br />1X Limited Preferred <br />No participation<br />LP is $2,500<br />Conversion value is $10,000 x 33% = $3,333<br />Proceeds to remaining common shareholders $10,000 - $3,333 = $6,667<br />Investor 33%<br />2X Limited Preferred <br />Participation<br />LP is $5,000 <br />Proceeds after payout of LP $10,000 - $5,000 = $5,000<br />Participation is $5,000 x 33% $1,667 + $5,000 = $,6,667<br />Proceeds to remaining common shareholders $5,000 - $1,667 = $3,333<br />
  22. 22. Convertible Debt<br />The investor receives<br />A note paying a stated interest rate of X%, converted at a into preferred units of membership interest at a X% discount to the Company’s future equity round pricing<br />
  23. 23. Demystifying Term Sheets<br />It’s all about the relationships <br />Between investors and founders<br />Investors and syndicates <br />Creating competition among investors is to the company's benefit<br />Trust and comfort level are surprisingly big drivers <br />
  24. 24. Alan D. Lucas<br />617-834-2829 <br />alan@alandlucas.com<br />

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