The term sheet tango

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May 27, 2003 - In today's venture capital market, starting a technology-based company is—to ... seen a venture capitalist (VC)'s term sheet before, you need to ...
The term sheet tango

*** AUTHOR PROOF ***

Published online: 27 May 2003, doi:10.1038/bioent736

The term sheet tango Teri Willey & David Parsigian Teri F. Willey is managing partner at ARCH Development Partners ([email protected]) David Parsigian is attorney and counselor at law at Miller Canfield Paddock and Stone ([email protected])

By understanding the subtleties of term sheets, founders of companies receiving their first round of venture financing can avoid unwelcome surprises. In today's venture capital market, starting a technology-based company is—to say the least—challenging. After exerting the efforts necessary to develop a compelling business plan, secure necessary intellectual property rights and build the beginnings of a management team, it might seem like the offer of investment from a venture capital firm is the deserved icing on the cake. But there's still more work to do. If you've never seen a venture capitalist (VC)'s term sheet before, you need to understand not only what you're getting into, but how to make sure you and the VC have the same set of motivations. As markets go up and down, the look and feel of venture capital deals change. But there are a few constants. First, venture capital investors always invest in return for preferred stock, which has a variety of rights and preferences over the common stock that is typically issued to other stakeholders in the company, including founders, licensors of intellectual property and company employees. By purchasing preferred stock, venture capital investors are assuring that they have sufficient control over the company and will be the first to get money out of the sale of the company. Although this may seem unfair to a founder who has toiled without pay to get an idea off the ground, understand that the VC is (or should be) contributing both start-up expertise and industry contacts that the founders would require years to develop. Even more, the investor is contributing the tangible element without which the best of ideas will remain on the drawing board—money! Having put money at real risk, the VC will structure those preferred stock rights and preferences to assure the highest possibility of return on its investment. And three of those rights and preferences have a direct effect on the founders. Liquidation preference

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The term sheet tango

*** AUTHOR PROOF ***

Because every venture capital deal is ultimately about making money, the most important preference is to be assured of the first opportunity to recover an investment. Simply stated, if the company is sold, the VC investor will get the first dollars out of that deal. This means that the founders (and the other holders of common stock) must wait for their piece of the action until the investor's preference is fully paid. Accordingly, the amount of that preference can have a dramatic effect on the return to the founders. Let's see how this might work. Suppose the VC offers to purchase 40% of your company for $1 million in the form of 'Series A' preferred stock. Further suppose that the term sheet provides for a '2X' liquidation preference. Assume then that this is the only outside investment and that the company is sold sometime later for $10 million. The 'Series A liquidation preference' would consume $2 million (2 times the original investment) of the net proceeds from the sale before the common stockholders receive a farthing. But that's not all. Most venture capital investments are for 'participating preferred.' In our example, this means that not only does the VC investor get the first $2 million of proceeds, it also will be entitled to share with the common stockholders in the remaining $8 million, based on the number of shares owned by preferred and common stockholders. This means that the preferred stock investors will receive an additional $3.2 million (40% of the $8 million), leaving just $4.8 million for the rest of the stockholders. The bottom line is that the Series A investors get 52% of the proceeds of the sale, even though they only own 40% of the company. The challenge is always to ensure that investors and founders have the same incentives. In the face of a liquidation preference for the investors, one possibility is to structure a success fee for the founders that they receive in return for the company's reaching a specified value in a sale. Control Percentage of ownership does not always equate with control. The term sheet will usually include some 'protective provisions' that give investors veto power over decisions that have an effect on company value and investment return. For example, no sale or merger of the company will occur without the consent of the investors. Even less significant actions may require investor consent: for example, certain capital expenditures, incurrence of debt and decisions whether to license technology or remove a member of senior management. Even so, don't assume that you don't have influence over the investors in these decisions. The knowledge and day-to-day management of founders gives them credibility. Moreover, at least in the early stages, founders will be able to present their case about any decision as a member of the board of directors, sitting as an equal with the VC representative on the board.

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The term sheet tango

*** AUTHOR PROOF ***

Vesting of founder's shares It's often said that VCs don't invest in ideas; they invest in people. In fact, they invest in good ideas being driven by people with the knowledge, skill and determination to turn them into a profitable enterprise. Without those people, the company isn't worth much and an investment is pointless. So to be sure that the founders stick around to turn their dream into economic reality, the investor is going to force the founders to earn the stock that they already own in the company. As you review the term sheet, you'll find a provision that says that if you fail to stay with the company, the company may repurchase your founder's shares at the price you paid for them, with that repurchase right reduced over time. For example, say you come to the table with 400,000 founder's shares. Based upon a typical four-year vesting schedule with a one-year 'cliff' and monthly vesting thereafter, your ownership of the first 100,000 of those shares won't be assured until one year after the investment closes, and the remainder will cease to be subject to the repurchase price in equal monthly 'installments' over the next three years. I once had a founder weep as he read these vesting terms. I was proposing to take his stock away and he'd barely gotten over the insult of the pre-money valuation I'd proposed! Nonetheless, expect to see vesting of founders shares in the term sheet. Focus your energy on how to align interests by exploring the option of accelerating your vesting based on reaching milestones that add to the company's value. Just remember, once the deal is done, you and your investors will be sitting on the same side of the table, trying to grow a successful company. So as you sort out the terms of the investment, acknowledge where you have a common interest with your investor and focus the negotiation on the areas where your interests differ from those of the investor. If you can get those interests aligned, you'll have a good deal.

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