Venture Capital Term SheetsNC State University | April 7, 2009

Glen E. Caplan

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Sources of Capital

Self Funding

Angel

Venture Capitalists (VCs)

Corporate Investment (Strategic Investment)

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Capital Structure of Typical Start Up

Founders: Common Stock(Vesting over time)

Employees: Common Stock Options(With vesting over 4 years)

Investors: Convertible Preferred Stock

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Angel Investors = High Net WorthIndividuals with High Risk Appetite

Early stage preferenceUsually “one and done”

Terms offered by company rather than investors

Less sophisticated on terms and value

Less “value-added”

Endangered species?

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How to Approach Angels

Individuals (network)Other successful entrepreneurs

Organized Groups (TIG, Atlantis, PAN, CAP, CHAP)

One signature for all dealings

Follow-on investments possible

Better preparation for institutional rounds

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Venture Capital Requirements

25-30% Internal Rate of Return

Market Size / Position

Management Team “Bet on Jockeys, not Horses”

Clear Exit Strategy

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Current Venture Capital Environment

Plenty of Capital in the System?$28 billion committed in 2008 (21% decline)

Investors More Cautious with Deals

Potential Exits Uncertain and Delayed

Valuations Declining Have We Bottomed Out?

Terms Heavily Negotiated

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4 Principles of Term Sheets

Valuation

Exit Strategy

Down-Side Protection

Control4

3

2

1

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Principles of Term Sheets

1 Valuation

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Valuation Calculation

Post-Money (shares)Pre-Money (shares)

Capitalization

2,000,0000Outstanding Preferred Stock

2,000,0002,000,000Outstanding Common Stock

200,000200,000Reserved Stock Options

100,000100,000Outstanding Stock Options

$8.6 milliion$4.6 millionSeries A Preferred Purchase Price = $2.00 per share)

Valuation:

4,300,0002,300,000

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Principles of Term Sheets

Exit Strategy2

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Acquisition

Liquidation Preference

Multiple of Liquidation PreferencePreferred gets multiple times investment back before Common gets any money

Participating PreferredPreferred gets investment back first, remaining proceeds shared between Common and Preferred pro-rata

Limited or Capped ParticipationPreferred gets investment back first, remaining proceeds shared between Common and Preferred until Preferred reaches a multiple of investment (usually 2x – 5x) and remainder goes to Common

Non-Participating PreferredPreferred gets investment back first, remaining proceeds go to Common

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Effect of Liquidation Preference

Hi-Tec, Inc. has 2,000,000 shares of Series A Preferred outstanding that was purchased for $1.00 per share and 2,000,000 shares of Common Stock outstanding.

It has just been acquired for $15M. How is the money divided?

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Effect of Liquidation Prefere nce

4x Multiple of Liquidation Preference with Full Participation:

1. Preferred receives 4x liquidation preference ($8M). 2. The remaining $7 million is split pro rata between the

Common and Preferred ($3.5 million each).

3.5 millionCommon

11.5 millionPreferred

Total return

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Effect of Liquidation Preference, cont.

1x Liquidation PreferenceParticipation Capped at 4x:

1. Preferred receives liquidation preference ($2M). 2. The remaining $13M is split pro rata between the

Common and Preferred until Preferred receives $8M (i.e. $6 million each).

3. The remaining $1M goes to the Common Stock holders.

7 millionCommon

8 millionPreferredTotal return

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Effect of Liquidation Preference

Non-Participating Preferred:

1. Preferred receives liquidation preference ($2M).

2. The remaining $13M goes to the Common, but because the Common holders will receive more than the Preferred holders, the Preferred holders will convert into Common and all holders will be treated equally.

7.5 millionCommon

7.5 millionPreferred

Total return

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Liquidation Preference Summary

Current Trends

Multiple Liquidation Preferences15% of financings

1x – 2x = 70% (down from 80% in Q407)2x – 3x = 20%>3x = 10% (up from 0% in Q407)

Participating Preferred57% of financings

51% were uncapped (up from 41% in Q407)Source: Fenwick & West LLP – Trends in Terms of

Venture Financings in the San Francisco Bay Area (Fourth Quarter 2008)

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IPO

Registration RightsDemand Rights

S-3 Rights

Piggy Back Rights

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Principles of Term Sheets

Down-Side Protection3

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Down-Side Protection

Anti-Dilution Protection

Ratchet (Largest adjustment)

Conversion price of Preferred adjusted down to price of dilutive issuance

Broad based weighted average (Least adjustment)

Conversion price of Preferred adjusted down based on a weighted average of outstanding securities, including options and warrants

Narrow based weighted average (Medium adjustment)

Conversion price of Preferred adjusted down based on a weighted average of outstanding capital stock – does not include options and warrants

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Down-Side Protection

Don’t Forget Exclusions

Option pool of limited size

Mergers / acquisitions

Warrants for banks / leasing companies

Strategic transactions

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Anti-Dilution Calculation

Facts:

Hi-Tec, Inc. has:

3,000,000 shares of Common Stock,

5,000,000 shares of Series A Preferred Stock

Options to purchase 2,000,000 shares of Common Stock outstanding.

The Series A Preferred Stock was sold at $1.00 per share.

Hi-Tec, Inc. now would like to issue 4,000,000 shares of Series B Preferred Stock at $0.50 per share.

How is Series A Preferred Stock affected?

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Anti-Dilution Calculation, cont.

Ratchet:Series A initially converts to Common on a 1:1 ratio based on

its purchase price $1.00/$1.00.

After the issuance of Series B, the conversion price is ratcheted down to $0.50.

The new conversion ratio is calculated as follows: $1.00/$0.50 (or 1:2). So, for every 1 share of Series A converted, the holder will receive 2 shares of Common.

So, the 5,000,000 shares of Series A will convert into 10,000,000 shares of Common Stock.

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Anti-Dilution Calculation, cont.

Broad-Based Weighted Average:

Formula: (all outstanding securities) x Conversion Price + Amount RaisedAll outstanding securities + New Securities Issued

Calculation: (3,000,000 + 5,000,000 + 2,000,000) x $1.00 + $2,000,000 = 0.85714283,000,000 + 5,000,000 + 2,000,000 + 4,000,000

Conversion Ratio: $1.00 ÷ $0.8571428 = 1.166

So, the 5,000,000 shares of Series A will convert into 5,833,333 shares of Common Stock.

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Anti-Dilution Calculation, cont.

Narrow-Based Weighted Average:

Formula: (Common + Preferred) x Conversion Price + Amount RaisedCommon + Preferred + New Securities Issued

Calculation: (3,000,000 + 5,000,000) x $1.00 + $2,000,000 = 0.83333333,000,000 + 5,000,000 + 4,000,000

Conversion Ratio: $1.00 ÷ $0.8333333 = 1.2

So, the 5,000,000 shares of Series A will convert into 6,000,000 shares of Common Stock.

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Down-Side Protection - Summary

Current Trends

Ratchet = 2%

Weighted Average = 98%

No Anti-Dilution Protection = 0%

Source: Fenwick & West LLP – Trends in Terms of Venture Financings in the San Francisco Bay Area (Fourth Quarter 2008)

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A Tale of Two Term SheetsTwo companies financed under exactly the same conditions

Initial Capitalization3,000,000 founders shares2,000,000 shares initially reserved for options

Series A FinancingRaises $5M at a $5M pre-money valuation

Series B FinancingRaises $2M at a $5.5M pre-money valuation (and adds 1M shares to option pool)

Series C FinancingRaises $21M at a $63M pre-money valuation (and adds 1M shares to option pool) at a $84M post-money valuation

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Key Financing Terms

Company ANarrow-based weighted average anti-dilution protection

Participating Preferred capped at 4x Liquidation Preference

Company BRatchet Anti-Dilution

4x Participating Preferred with no cap

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Cap Tables Following Last Financing

Company A Company B

5,666,666Series C

4,000,000Series B

Common Ownership: 13.24%

5,000,000(6,000,000)Series A

4,000,000Options

3,000,000Common

7,000,000Series C

4,000,000Series B

Common Ownership: 10.71%

5,000,000(10,000,000)Series A

4,000,000Options

3,000,000Common

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Payout Scenarios

$40M acquisition?Company A: $1.6 million (or 4%)Company B: -0-

$100 million acquisition?Company A: Approximately $10.5 million (or 10.5%)Company B: -0-

$200 million acquisition?Company A: Approximately $23.7 million (or 11.85%)Company B: Approximately $9.4 million (or 4.7%)

$500 million acquisition?Company A: Approximately $66.2 million (or 13.24%)Company B: Approximately $41.6 million (or 8.32%)

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Down-Side Protection - Redemption

Forced liquidity: Zombie companies

Timing: 5-7 years

Amount (all at once or percentage)

Forced exercise during certain period or “any time” after target date

Statutory limits on share repurchase

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Principles of Term Sheets

Control4

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Control

Board of Directors

Key RightsAppoint and fire officersSet policy/Make major decisionsIssue options

Number of directorsInvestors: Election of BOD members by “series” or “class” vote

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Control

Protective Provisions

Must obtain approval of the Preferred to:

Authorize additional shares of stock

Create a new series of stock with equal or greater rights

Complete a merger/sale of assets

Change the size of Board of Directors

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Control

Typical Additional Investor Rights

Information Rights

Co-Sale Rights

First Refusal Rights

Preemptive Rights

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Hutchison Law Group

Serving the Southeast’s life science and technology communities.

Represent companies of all sizes, with a strong focus on emerging growth companies from inception through exit.

Serve clients along the Southeast corridor from Maryland to Florida.

Extraordinary depth and experience in law, technology and business.

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Glen CaplanHutchison Law Groupgcaplan@hutchlaw.com919.829.4303www.linkedin.com/in/glencaplan

Questions?(and hopefully answers)