If you have successfully sold your business concept to a venture capitalist, the next step will be the term sheet. This is basically the offer letter stating how much the VC will buy, at what price, and under what terms. Term sheets can be incredibly simple, one to two page documents or incredibly complex and lengthy.
If you receive an incredibly complex and lengthy term-sheet, reconsider that VC as a potential investor. If this is the first document you are getting from them, imagine how complex the actual investor rights and subscription agreements will be. This will mean an expensive legal bill which, by the way, will be sent to you.
Basics of the offer:
Closing date – an estimated date upon which they expect to have the legal work wrapped up and you will receive your money.
Investors – who will be joining the party. You may have more than one venture capital firm invest in your company (especially at later stages).
Amount raised – how much they will be giving you. Price per share – what they plan on paying you per share.
Pre-money valuation – what they deem your company is worth without their money. Capitalization – this is often split into pre- and post-valuation terms. It states how many shares there are outstanding prior to the investment and how many shares will be outstanding after the investment.
Basics of the terms:
Dividends – the stock that the venture capitalist will want will either be preferred or participating-preferred. At some point when your company is successful, the VCs will want to convert their stock to common stock – for sales purposes. They want to make sure that they have the same dividend rights that common stockholders have. In some cases, they want to have dividend rights that the common stockholders don’t have (nice, huh?). This will also be listed here – try to negotiate away from cumulative dividends as this is an unpaid dividend that accumulates to the preferred shareholder and is payable upon liquidation or redemption. It’s a way to give a higher valuation to you feel good, but actually get more of your company without putting in any more money.
Liquidation preference – This is what happens when you either (1) liquidate the company or (2) sell it/IPO. In general, you would think that the VC owns 40% of your company, they would get 40% of the profit. Well, if they have straight preferred, this is true, but they have come up with a special construct to make sure they get a little bit more: participating preferred. See the example below for an explanation.
Liquidation Preference Example:
In the old days, VCs would invest $5 million in a company worth $5 million pre-investment and get 50% of the company of preferred shares.
At the time of sale, the VCs would get money back in this way:
1. Sale price: $7 million. VC’s get their $5 million back, the founders get $2 million. (This is the preferred part – they get their money back before the common shareholders get a payout.)
2. Sale price: $10 million. VCs convert to common and the VCs get half and the founders get half (each $5 million).
In this case the company has to be sold for over $10 million for the VCs to make any return.
In the days of the internet boom… VCs realized they were throwing their money behind some pretty crappy stuff, thus some clever MBA financial engineer introduced the participating preferred shares. Same example: VCs invest $5 million in a company worth $5 million pre-investment and get 50% of the company of preferred shares. However, the participating part means they get their money back before the rest is split up according to ownership.
1. Sale price: $7 million. VC’s get their $5 million back, then the founders and the VCs split the remaining $2 million 50/50. In this case, founders get $1 million.
2. Sale price: $10 million. VC’s get their $5 million back, then the founders and the VCs split the remaining $5 million 50/50. Founders get $2.5 million.
In this case the company has to be sold for over $5 million for the VCs to make any return – a much lower hurdle.
The multiplier part is the amount the VCs want to get back before any gets split between the shareholders. In the above case, if the investment was 1.5x participating return, the VCs would require $7.5 million be paid to them first, then the remaining amount would be split between the VCs and the founders.
Voting rights – this lays out how the VC is allowed to vote his shares. Usually, they set it up so that even if they have a minority share, they have the majority of the votes when it comes to anything important (“protective provisions”).
Protective Provisions – the VC wants to make sure that they can protect their investment. They will want the right to be able to say whether they sell the company or not, whether there is any conversion to common, add board members, borrow money, etc.
Anti-dilution Provisions – another tool for the VC to protect his investment. Let’s say the VC owns 40% worth $4M and you own 60% worth $6M. You need to raise more money ($4M), but you can only find a pre-money valuation of $8M. If dilution was allowed, the end result would be VC2 gets 33.3%, your share would be reduced to 40%, VC1’s share would be reduced to 26.6%. If anti-dilution provisions are in place, the end result would be VC2 gets 33.3%, your share would be reduced to 26.6%, VC1’s share would stay at 40%. Ouch.
Redemption Rights – what happens if your company becomes one of the living dead. If you build a decent company and you’re making a nice living, but the company is not growing at a rate that will attract a buyer or make possible an IPO,the VC is eventually going to want his money back. This gives them the right to get it back (plus any dividends accrued). This usually kicks in after the fifth year and is payable over a few years.
Representations and Warrantees – the escape clause. They will say that you have represented certain things to them, such as revenue growth, customers, etc. After you have signed the term sheet, they will comb through your books and records and if they don’t like what they see, they will back out.
Conditions to closing – another escape clause. This should note that the offer is made predicated on beliefs that may change after they look after you books. It also contains some legalese about meeting appropriate filing and legal requirements.
This pretty much covers the basics of the easy term-sheet. A more extensive term-sheet is likely to contain the investor rights terms which continues on in the protective vein, making sure that the VC has the first shot of their shares being sold if the company goes public, that the company (not the VC) pays for the registration of shares, what sort of information rights the VC has, whether the VC has the right to participate in future rounds, what requires investor approval, and any required non-disclosure and non-compete provisions.
The term-sheet will also most likely contain an expiration date and a no-shop provision to ensure that you are unable to find another term-sheet to have as a comparison. You goal in this case is to have several potential investors who all give you term-sheets at the same time.
Your job is to negotiate your deal to your best advantage. Do not spend too much time worrying about the valuation, but instead pay attention to the control provisions and negotiate those.