THE TERM SHEET – THE PRICE OF GROWTH

 

If you are going to raise Venture Capital, you will hopefully be presented with a term sheet (sometimes called letters of intent). This delineates the terms on which the VC is willing to invest in your company. Besides cash flowing into your company, there can be many off term-sheet benefits associated with selling part of your company to a VC firm – for instance association of business & technology expertise, access to new networks, increased credibility of your business/business plan and potentials for later stage financing. However, the cash and associated benefits naturally comes with claims on company equity and depending on the amount of cash vs. the valuaton claims on how the company should be managed.

The term-sheet sets the economic and ownership basis of the investment. And while the investors most likely possess substatial experience with formulating and discussing various investment terms through their previous investment operations, you might be raising capital for the first time – here is given a short introduction into a few of what we believe are the key elements of a likely term sheet for you as an bio-entrepreneur to understand when arranging deal structures. Two sample term sheets (from NVCA and MBBP law firm) are included at the end of the post and can be highly recommended.

You and the other owners might not have too many additional options than the term sheet presented- it is naturally up to you and the rest of the company to determine if the terms (economic vs. benefits) are in accordance with your business goals. As in all other money transactions, supply and demand can be highly influential on your possibilities to negotiate on the terms – having several options should of course increase the zone of possible agreements seen from a founder’s perspective. Some of the most important goals of the term sheet are to set the grounds for:

  • Economic terms of the investment – (who owns what and on what terms). Valuation of the company, with the company capital structure after the investment (possible invested as tranches depending on fulfillment of tranches).
  • Control terms of the investment – (who determines/controls what).
  • Future investment/exit terms – (what happens if). For instance during company liquidation and follow-up investment events.

 

For you as a founder and owner (co-owner) of a company you will have to do the math of the term-sheet. You might end up finding that even though the company should be successful (sale, merger or the like) – depending on the values & terms, most money goes to the investors. This does of course not mean that no founders can get a fantastic return on their initiative/inventions/investment, but do the math.

 

WHO OWNS WHAT AND WHAT HAPPENS IF?

VALUATION

Naturally an important item with the pre-money valuation representing the value that the investor puts on the company before their investment. This value therefore also determines the percentage dilution existing owners will experience if accepting the offer. Note that most agreements will include a stock option pool set aside to existing/incoming management members, and that this most likely is to be implemented prior to closing of the investment. This in essence means that the future investors not will be diluted by the stock option pool whereas the existing founders/owners will. A simple example – with a pre-money valuation of 10$ and an investment of 10$ and an option pool of 15 % on a fully diluted basis: Founders (35%), Investor (50%) and Option Reserves (15%).

COMMON STOCK vs. PREFERRED STOCK

Although the above mentioned valuation example suggests a rather straight forward division of equity, the preferred ownership vehicle for most VC´s are realized through convertible preferred stocks. This is a fundamental difference from the common stock normally owned by founders (+management option pool) you should be aware of. On economic terms, the convertible preferred stocks can for instance be included to possess specific advantages in case of a sale, a merger or some other changes of control. Thus, the preferred stocks might possess specific participating preferred stock tools, anti-dilution rights and might have specific rights to cumulative dividends on their investment (see below for each item). These rights can have profound effects on the estimated future value of your founder shares. First of all, in most cases your shares must be expected to be rather illiquid and of less value than the preferred shares: the fact that you possess “only” common stock with less rights to any possible future capital gains made by the company in essence makes them of less value except under circumstances where the preferred stocks are transformed into common stocks (for instance at an IPO, sale, investment above a certain amount etc. as set out in the term-sheet).

PARTICIPATING PREFERRED STOCK

Holders of participating preferred stock will be paid back their initial investment (plus accumulated dividends) first before holders of common stock are entitled to any distribution. Moreover, they participate in the sharing of the remaining assets on a pro rata basis. Simple example: 10M $US have been invested into your company year x-6 on a pre-money valuation of 10M $US. The investment was made through acquisition of participating preferred stocks with cumulative dividends (8% for instance). In case of a successful exit (determined in the term-sheet) assets will be divided between founders and investors in the following scenario:

1. The investors will get their initial investment (10M $US) returned with compounded 8% annual dividends for the six years.
2. Founders (and option holders) will now dip into the remaining assets (and only the remaining) on a pro-rata basis (in this example 50:50).

ANTI-DILUTION RIGHTS

Provides the investor with some protection against scenarios that comprise later stage financing events valuated at a lower pre-money valuation than the last rounds post-money valuation. Thus, upon conversion of the preferred share into common share (again for instance a sale, IPO, investment >x amount etc.), this tool allows the preferred stock holders to receive a greater number of common stocks (and thereby higher ownership percentage or at least not lower) upon conversion than otherwise. The conversion price can be based on a weighted average or following something termed the full ratchet (ratcheted fully to the new lower share price occurring due to the new equity issuance). (See resources for further information´s).

 

WHO DETERMINES WHAT?

Importantly, the term sheet will most likely include expectations with respect to the board (number of seats, who decides on which person is the chairman etc., management, voting rights etc.). You have to make sure that the control you and your other founders are giving up is aligned with the investment. It might be valuable to include (if not in the initial proposal) possibilities for association of independent board members designated by the founders. Even though these will have no voting-rights they might be able to serve as important shock absorbers between the investors and the founders/managers in case of controversies. Especially if they have industry knowledge and experience.

TAG-ALONG RIGHTS

A minority interest security item. Gives a beneficiary the right to tag along on a sale of stock. The shareholder can therefore using his/her tag-along rights to force a potential purchaser of a specified group of stockholders’ stock to purchase his/her stock as well. A completely general item.

DRAG-ALONG RIGHTS

A control item to ensure that a minority shareholder cannot block a potential investment, sale or alike. The drag-along item provides majority shareholders the right to undertake a sale of the entire company, thus dragging minority shareholders along – probably completely fair in most/all circumstances.

FOUNDERS REPRESENTATION AND WARRANTIES

Although a VC Investment typically comes with no collateral, you should be aware of the fact that most VC investments will come with a requirement for founders (personally and the company) to ensure issues such as the validity of the presented due-diligence data, legal authority of the company etc. These requirements will incur some level of personal risk on the founders. Whether this is fair or not is for you to decide, but perhaps it could be limited to the initial investment (at spin-out/founding) or in the case that money are actually transferred to the founders as part of the investment. Please see an interesting discussion on this issue by Jonathan D. Gworek, from Morse, Barnes-Brown & Pendleton.

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SAMPLE TERM SHEETS

The sample term sheet from the National Venture Capital Association is highly recommended for an excellent introduction into typical term-sheet control items:

 Term sheet template from NVCA – www.nvca.org, see also our VC page.

 Term sheet template from MBBP law firm – www.mbbp.com.

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