Term Sheet Negotiations

© 2014 Valla & Associates, Inc., P.C. www.vallalaw.com 1

Majda Barazzutti

July 23, 2014

THE VENTURE CAPITALFINANCING PROCESS:

TERM SHEET NEGOTIATION


ENTREPRENEURIAL JOURNEY

Financing is a Staged Process Common Stock

Bootstrapping Friends and Family Angels: Equity, Warrants, Convertible Notes

Series seed financing Series A Preferred (B, C, etc.) Liquidity Event


Convertible Debt Bridge loan before financings Useful when the company does not have

a satisfactory valuation Risks of repayment feature No minimum capital but insolvency

changes the rules Better include a provision to force

conversion


Warrants: option to purchase company shares at a price within a set period

“Kicker” to increase the potential investment value

Warrants increase in value as the value of the underlying shares increase in relation to the exercise price

Usually issued with bridge financing


Warrants

Alternatives: Strategic Investors

Aims Differ Not Interested in Helping the Company

Grow Conflict of Interest: greater returns from

commercial rights than growth Expertise Could affect future VC financings


Venture Capital Identify the Right VC Due Diligence The Risk of “Finders”


Prior to Investing: Document Employees Founders Relationships Securities filings Confidentiality and Invention

Agreements Prepare for VC’s due diligence


“Clean Up”

Preferred Stock (Series) Why Preferred?

Liquidation Preference Preserve a low common stock value for option

grants (ratio 1:4 to 1:8): Common Stock was bought at cheap

price, $0.10 to founders. If Common were sold at same time at

$5.00 to VC, tax consequences for founders.

No limits to Preferred/Common ratio


Sample Term Sheet Binding Provisions:

No Shop Confidentiality Applicable law

ALL other provisions are not binding

See examples: NVCA (http://www.nvca.org)


http://www.nvca.org/

A Typical Term Sheet Valuation/Number of Shares/Price Liquidation Preference Redemption Conversion Vesting of founders’ stock Antidilution Voting Rights Protective Provisions


Valuation/Price Pre-money/Post-money valuation: Option pool shuffle How are your shares valued?

8M pre-money valuation, 6M shares outstanding $8M pre-money ÷ 6M existing shares = $1.33/share, right?

WRONG: The share price is $1.00 WHY? Read the term sheet: “The $8 million pre-money

valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”

$8M pre-money ÷ (6M existing shares+2M options )= $1/share.

Pre-money valuation includes an unallocated option pool for new employees -- lowering pre-money valuation


Liquidation Preferences Liquidation Preference: 1x or more – 2x, 2x Participating Preferred:

Straight/Non-participating 67% Full participating (double-dip)

19% Capped participating

14% Preferred has the option to convert into

Common Interaction of various series: First pay B, then

A, then all; all participate equally, etc. “Deemed Liquidation”: good times and bad

times Not an IPO


Dividends No expectation of dividends, but: Cumulative Dividends: __ % cumulative dividend accrues

over time, whether or not the company declares it - PLUS participation with Common Stock on an as-converted basis.

Non-cumulative Dividends: “An amount equal to $[_____] per share of Series A Preferred when, as and if declared by the Board”

PIK (payment-in-kind) dividends. Company option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

Usually payable on liquidation or redemption, not conversion


Redemption Optional (Company call):

Company can repurchase stock at original price (plus dividends) if Investors don’t convert to Common after x years

Mandatory (Investors Put) Investor can force Company to repurchase shares

after x years – beware of redemption premium Guaranteed exit path for VC if Company is

“successful enough” But, Company must have legally available funds

22% of all VC financings in 2012, 35% in down rounds


Conversion Preferred always has a conversion to Common

feature, but loses all preferred privileges Optional Conversion Automatic Conversion: IPO Conversion Ratio is initially 1:1, modified based

on anti-dilution provisions


Anti-Dilution Protect investors if company issues equity at a

lower valuation than preferred Full Ratchet 3% Weighted Average: Broad Base: more favorable

92% Weighted Average: Narrow Base: less favorable to

company4%


Exclusions from Dilution Carve-outs from anti-dilution:

Options grants to employees, consultants (negotiate all or only authorized pool)

Warrants to lenders (approved by majority vs. unanimous board approval)

Warrants to service providers, strategic partners

Shares issued in mergers / acquisitions Exercises or conversions of current stock or

grants


Other Terms: Vesting of founders’ stock, acceleration Right of first refusal: new issuance and

transfers by founders Employee pool Co-sale agreement (drag along, tag

along) : force a sale Registration rights Board Control


Other Terms: No-shop agreement Information rights Confidentiality Indemnification Counsel expenses up to ___ Lock-up provisions


Bottom Line (Almost) anything can be negotiated Pick your battles: Liquidation

Preferences, Protective Provisions, Board Control

Make sure you understand what you’re signing


Thank you

IN BOCCA AL LUPO!Valla & Associates, Inc., P.C.

1990 N. California Blvd., Suite 1060 Walnut Creek, CA 94596

USAE-mail: [email protected]

Phone: +1 925 705 7623 Fax: +1 925 705 7629www.vallalaw.com


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Term Sheet Negotiations