Written by Dan DeWolf
When a venture capital firm is interested in a company it will meet with the management team numerous times to understand fully the business model and to learn more about the management. At some point in the process, the venture capital firm will decide that the investment is worth pursuing and will present a Term Sheet to the company. The Term Sheet (which is a nonbinding letter of intent) sets forth the basic terms and premises upon which the venture capital firm would be willing to invest.
The Term Sheet does not address all of the issues and matters that may arise in the course of preparing a definitive investment or purchase agreement, but rather is intended as an outline of the material terms of the understanding regarding the proposed investment by the venture capital firm. Although not legally binding as to most provisions, the Term Sheet serves as the road map for the lawyers to draft the documents that will be binding on the parties. In the course of the final negotiations for the definitive documentation, the parties will often refer back to the Term Sheet for guidance. Accordingly, it is important that the Term Sheet be clear and that the most important terms and conditions to the investment be spelled out. One may ask why bother with a written Term Sheet if most of the provisions are nonbinding and subject to final documentation? The short answer is, as Samuel Goldwyn once said, a verbal agreement isn't worth the paper it is written on!
One of the key issues of negotiation will be the valuation of the company. That is to say, how much equity will the venture capital firm obtain for its investment in the company? Or, to look at it from the flip side, how much dilution will the current owners of the company experience when the venture capital firm invests? To help answer these questions, the venture capital firm will try and estimate what the company may be worth in five years. This is accomplished by considering reasonable assumptions as to revenue growth and expenses as well as basing the values against comparables of publicly traded businesses with similar business models or within similar business sectors. The venture capital firm is generally looking to obtain an eight- to 10-times' return on its investment over a five year holding period. For example, if a venture capital firm thinks it can sell a business for $100 million in five years, it may be willing to invest based on a post investment valuation of $12 million. The venture capital firm assumes that only about a third of its investments will be truly successful so that if it is able to obtain an eight- to ten-times' return on its winners, the winning investments will balance out the rest of the portfolio in which it may lose money or only generate small returns. Ultimately, on a portfolio basis, the venture capital firm is looking for returns north of 15%, and 20% returns or greater across its entire portfolio would be a very successful fund for a venture capital firm. Like a baseball player, if a venture capital firm gets a "hit" on one out of three investments, it would be hitting over 300 and would be considered a great success.
In addition to focusing on valuation, the venture capital firm is looking to own enough of the equity of the company so that it has a meaningful stake. Typically this will range from 15% to 25% of the equity ownership of a company. For example, if a venture capital firm is looking to invest $2 million into a company in return for 20% of the company, the valuation of the company after the investment would be $10 million. This valuation is called the "post-money" value of the company. You obtain the post-money valuation by multiplying the number of shares outstanding immediately after the investor invests, by the most recent per share price paid by the investors. The "pre-money valuation" is the value of the company immediately prior to such investment. This pre-money valuation is calculated by multiplying the total number of shares outstanding prior to the investment, by the per share price to be paid by the new investors. In the instant example, where the venture capital firm is looking to invest $2 million for 20% of the company, the post-money valuation would be $10 million and the pre-money valuation would be $8 million. If the stock were sold to the investors at $1 per share there would be 10 million shares outstanding after the investment was completed.
One point of contention on valuation is whether the shares reserved for the employee stock option pool should be included when making these calculations. The venture capital firm will almost always insist that the stock option pool be included. For example, if 25% of the equity is reserved for future issuance to employees in the stock option pool and the venture capital firm is investing $2 million for 20% of the company, and assuming that the stock is purchased at $1 per share, then at completion of the investment, the venture capital firm would own 2 million shares and 2.5 million shares would be reserved in the stock option pool. Only 5.5 million shares (not 8 million shares) would remain with the rest of the prior investors. The post-money valuation remains at $10 million.
From the entrepreneur side, the discussion not only involves valuation and dilution, but also how much cash does he or she need in order to reach either (i) a milestone where additional capital can be raised at a stepped-up valuation or (ii) cash flow break-even on an operational basis. If the entrepreneur raises too little money, he or she will risk needing to raise more capital later at a point in time when he or she will have very little leverage in the negotiation. If he or she raises too much capital, he or she will suffer more dilution of his or her ownership than is necessary. Generally, however, it is better for the entrepreneur to be willing to suffer a bit more dilution and to raise a little extra capital in order to enable the company some additional runway for success. Owning less of a successful enterprise is clearly preferable to owning more of an enterprise that is undercapitalized and doomed to fail.
After there is an agreement as to the valuation, the next issue will be the type of securities to be issued. The venture capital firm will generally insist on securities that are senior to the Common Stock. The venture capital firm wants to be able to have seniority as to a return of its capital in the event of a sale or liquidation (a "preference") and the right to certain "protective provisions" so that it can maintain some control over how the company is operated and whom may become a shareholder. Generally, the venture capital firm will be looking to receive Preferred Stock. However, if the investor is an individual such as an angel investor, he or she may want the enterprise to be formed as a limited liability company ("LLC") for pass through tax purposes and thus they would invest in some form of "Senior Membership Interest," which would have similar attributes to Preferred Stock.
The venture capital firm will want a preference as to its capital if the company is sold or liquidated. There are generally two types of preferences: a liquidating or ordinary preference (also known as a nonparticipating preference) and a participating preference. Under an ordinary preference, if a company is sold or liquidated, the venture capital firm would have a choice of receiving back its invested capital — that is its preference — or taking its pro rata share of the proceeds from the liquidation or sale by converting the Preferred Stock into Common Stock. The rationale behind the liquidation preference is that it is meant to be downside protection for the investor. By having a preference, the investor is more likely to at least get its capital back and will be entitled to its capital back before anyone else shares in the proceeds. If the sale or liquidation proceeds are large enough, however, the venture capital firm would opt to convert its Preferred Stock into Common Stock and to take its pro rata percentage ownership share instead. Thus the downside for the investor is protected while preserving the upside. Sometimes the venture capital firm will insist on a multiple return of its capital (such as two or three times) as the preference. Multiples of the liquidation preference can be problematic however, because the large preferences created may ultimately be a disincentive to attracting top management and employees who will not want their equity and options sitting junior behind the large preference of the investors in the event of a sale of the company.
A participating preference provides the venture capital firm with both downside protection and potential upside gain without having to make any calculations as to whether to convert to Common Stock if there is a sale or liquidation. Under a participating preference, the venture capital firm receives back its capital first and, additionally, is then able to participate as a Common Stockholder in its pro rata share as to the remaining proceeds. This is the best of all worlds for the investor and why some entrepreneurs call a participating preference a "double dip." Often, as a compromise between the company and the venture capital firm, the parties will agree to a participating preference but with a cap as to its participation at two or three times its capital invested. With a participating preference with a cap, the venture capital firm could choose to take its participating preference (where it would receive its capital back first and then its participation as a shareholder subject to the cap), or if the proceeds from a sale are large enough, it can opt to convert to Common Stock immediately and forego its preference and take its pro rata share of the proceeds without the limitation of a cap.
The venture capital firm will also want a preference as to dividends. By attaching a set dividend rate to the Preferred Stock the venture capital firm can add extra returns to its investment. The dividend is often cumulative, which means it accrues each year even though it is not paid. Additionally, the venture capital firm may request that the dividend be paid in kind (known as a PIK). This means that the dividend is paid in more shares of Preferred Stock or Common Stock. This can be helpful for a company that is concerned about its cash position and at the same time will add to the ultimate returns of the venture capital firm.
Most venture capital firms will also want to focus on the protective provisions. The protective provisions are terms that will be written into the company's charter that expressly state that the consent of some percentage (typically a majority) of the holders of the Preferred Stock is required in order for the company to take certain actions. These provisions are often subject to much negotiation, although it is difficult for a company to argue persuasively against any provision that protects the holders of the Preferred Stock as to seniority and preferences. The typical protective provisions are likely to require consent for the following actions:
- Merger or sale of the company or sale of substantially all of the assets of the company.
- A modification of the rights, preferences, or privileges of the Preferred Shares.
- An increase in the number of authorized Preferred Shares.
- The creation of any class of shares senior to or on parity with the Preferred Shares.
- The issuance of any securities that convert into Common Stock at a price per share less than the purchase price for the Preferred Stock.
- The reclassification of outstanding capital shares of the company.
- The modification of the company's charter or bylaws, if such action would materially alter the rights of the Preferred Shares.
- The incurring of any debt outside the ordinary course of business.
- The filing for bankruptcy protection or an assignment for the benefit of creditors.
One other area of much discussion in Term Sheets is price protection for the venture capital firm. What the venture capital firm does not want to do is invest in a company and later have other investors invest at a lesser price. In order to protect against this scenario, the venture capital firm will want some provision relating to price protection. The two types of price protection are called "full ratchet" and "weighted average." Under full ratchet, the price per share purchased originally by the venture capital firm is adjusted to an amount as if it had paid the lesser price originally and, accordingly, the venture capital firm will receive additional shares. Under weighted average price protection, the venture capital firm's shares are adjusted to match an average of the price per share paid to the company weighted with respect to the number of shares issued. Companies will invariably argue vigorously for weighted average and most venture capital firms are willing to give on this point. That said, companies should be aware that the protective provisions usually give the venture capital firm a blocking right as to the issuance of additional Preferred Shares and as a result the venture capital firm can later block the issuance of Preferred Shares at a lower price if it does not have its own shares re-priced to that lower valuation. As such, perhaps the venture capital firms are not being so generous when they "give in" on the weighted average type of price protection.
Another issue that is discussed in the Term Sheet is the composition of the board of directors. Many venture capital firms will prefer a smaller board of directors so that a core group of professionals can move quickly to make decisions. Often, venture capital firms will desire control of the board, but unless the venture capital firm owns 50% or more of the company, this is clearly a reach by the venture capitalists. Typically, the parties will agree to a board that consists of some members from the company and some members from the investor groups and one or more independent directors to be mutually agreed upon. The independent directors are particularly helpful if the company anticipates the need for additional rounds of financings. The independent directors can act as a balance between the varying interests of the investors and the management. Sometimes where there are a limited number of board seats available, certain investors may be granted "observer rights." What this means is that a person may attend the board meetings but has no right to vote. This use of the board observer is often helpful where a company is trying to assemble a group of investors for a large financing and every investor wants a seat on the board. Most corporate governance experts recommend an odd number of directors so as to avoid any potential deadlocks in voting. That said, I have rarely seen a board act if there was not a consensus or a decisively clear majority. If a board is down to deciding major decisions by the difference of one vote, it is probably a dysfunctional board and the company is likely to be in trouble. Good directors are able to work together towards a consensus in a bipartisan way. Boards of directors that resemble the US Congress are doomed to fail.
One final issue in the Term Sheet worth discussing is known as the "Standstill Provision." Basically what this provision says is that the company will not look to raise any capital from any other party until the venture capital firm completes its due diligence. It is in the interest of the venture capital firm to lock up the company for as long as possible to enable the venture capital firm to make a thorough investigation of the company. During the due diligence phase, the venture capital firm may learn of things about the company so as to want to renegotiate the purchase price. Clearly it is in the venture capital firm's interest to provide as long an exclusivity period as possible; and just as clearly it is in the company's interest to limit the time frame of this period and move quickly to a final deal.