Recently I read Venture Deals from Brad Feld and Jason Mendelson. The book gives a very interesting perspective over the VC-Entrepreneur relationship. Following some notes related to the chapters describing the term sheet used by the authors at their VC firm Foundry Group (a copy of the term sheet is available at the following link).
The first 5 points refer to the economics of the deal, the other ones refers to the control of the company:
- Price: the share price is the key indicator that describes the economics of the deal. The company value can be the premoney or the post money value. The new investor will buy the shares at a price, that will be derived from the number of shares issued including the option poll, and the premoney valuation
- Liquidation preference: define shares priorities in a liquidation event. A certain multiple of the original investment is returned to the investor before the common stock receives any consideration. If this multiple is 2X, the investor with preferred shares will first receive 2 times the initial investment. The common stock holders will follow. If there is also a participating clause the “preferred” investor will participate also in the proceeds over his multiplied investment. The effect of this clause is increasing the preferred stock price value over the common post money value. In some cases the participation is capped when a certain multiple is reached
- Pay-to-play: is a provision for down rounds, that incentive the investor to keep participating pro-rata in future financing rounds in order to not have their preferred stock converted in common stocks
- Vesting: the industry standard is 1 year cliff and monthly vesting for a total of 4 years. Unvested stocks typically disappear into the ether when someone leaves the company. The options get reallocated in the employee’s poll. The vesting can be accelerated by a single or double trigger. Double trigger is the most common: first trigger is an acquisition, the second is being fired by the acquiring company
- Antidilution: is a down round protection that permits to early investors to convert their purchased stock price to a lower one, with the effect to increase the number of shares they own. The antidilution can be weighed average or full ratchet. In the full ratchet world the adjusted conversion rate uses the lowest conversion price of any late stock sale. In the weighted average the adjusted conversion rate is calculated considering the price of the current and past rounds. The exact adjustment depends in whether the formula is broad-base or narrow-base. The full ratchet is more convenient for the investor
- Board of directors: most VCs will own less than 50% of company equity, but they will ask to have a board seat. The board is where strategy originates and for an investor with a long-medium perspective is fundamental to participate in the strategic decision. Day by day operations are instead a task for the management team
- Protective provisions: are veto rights on certain actions like increasing the number of stocks. Is important for an easier management of the company that the investors at different stages are aligned on this provisions to avoid to have classes of stock with different terms
- Drag-along agreement: this term gives to a subset of the investors the ability to force all the other investors to do a sale of the company
- Conversion: refer to the right of the preferred shareholders to convert their stake into common stock at any time
Following a list of other terms that don’t matter too much, or are important only in a downside scenario:
- Redemption rights: is a downside protection for a VC that want an exit path from the company
- Right of first refusal: define the rights that an investor has to buy shares in a future financing. This is also knows as a pro rata right. Often this right is given to the major investor. For this reason is important to define who is a major investor
- Restriction on sales: this right is also known as right of first refusal on sale of common stock
- Co-Sale agreement: is the possibility to sell shares in a pro rata basis when the founders sell their stocks
- No-Shop agreement: is a way for the VC to avoid that the founder starts other negotiations with other potential investors. Is important to define the time frame of validity of the agreement (usually 45-60 days)
- Indemnification: this clause states that the company will indemnify investors and board members to the maximum extent possible by law
- Assignment: is a clause that permits some flexibility to a VC to transfer stocks between partners of the fund. Is important that the transfer will maintain the same rules of the stocks
The book does a great job to facilitate the understanding of the terms sheet language. Anyway the authors make very clear that for these types of negotiations is always important to have the support of a qualified professional. A financing round can be done for 5000$-15000$ if is an early stage situation, and 25000$-40000$ in later stages. It is critical to have on your side someone with experience in multiple deals, and with a clear understanding on the financing cycle of companies. The errors in terms sheet get amplified in the successive rounds, so is fundamental to have a good start. An interesting article on this topic has been recently published on the Mark Suster blog: Here are More Signs that LA Tech is Moving to the Next Level.
Which is you experience with term sheets? Which 3 terms you think are the most critical?