Introduction to VC - Chapter 4

The Term sheet is critical. What’s in it usually determines the final deal structure. Don’t think of it as a letter of intent. Think of it as a blueprint for your future relationship with your investor.

• Economic terms: Will ultimately determine the investor’s return on a liquidity event

• Control terms: Mechanisms that allow investors to exercise control or veto decisions in your business

• Will the founder ever sell his company?

• Is the founder hiding any risks from me?

• Will the founder follow my strategic advice?

• How easily will the founder leave the company if he finds a better offer?

• Will they drop me if things go bad?

• How safe is my own position in the company?

• How much will they interfere with my business?

• Will they add the promised value?

The big problem: Both parties do not have all information and might even have hidden intentions!

New institutional economics explain why term sheets exist:

• 2-sided interaction

• div. of interest

• Time dimension

• Info. asymmetry

Limited Rationality

• Limited intellectual capacity

• Information is not or only in abundance available

Opprtunism

• Illegitimate Behavior

• Illegal Behavior

Dependency

• The action of the better informed party determines pay-off of the less informed party

Stocks

• Type of stock

• founder stock

• employee stock

• stock price

Stock rights

• dividend rights

• Conversion rights

• pre-emption rights

• voting rights

Contract

• Confidentiality

• Exclusitivity

• Enforceability

Exit

• Exit

• Liquidation prefereces

Protection

• Vesting

• Ratchets

• Anti-dilution

• Drag-along/Tag-along

• Protective provision

• Redemption

Other

• Conditions precedent

• Board representation

• Non-competition agreement

• Transaction and monitoring fees

Common stock

• A security that represents ownership in a corporation

Preferred stock

• A security that has a higher claim on the assets and earings than common stock

• Generally, dividends must be paid out before dividends to common stockholders are paid out before dividends to common stockholders are paid

Stock options

• Right to buy stock at a defined time (range) for a price (range)

Convertiable Loan

• Loan which can be paid back by the company in a defined time (range) or can be converted by the lender

price for each stock

• Price per share: Keep in mind the kind of stock and the attached rights

• Valuation: Pre-Money or Post-Money: Make sure you and the investor negotiate over the same assumptions!

• Full Dilution: This refers to the employee or option pool - However, the size of the pool also affects the effective valuation

• Warrants: A right for investors to buy a certain number of shares at a pre-defined price for a certain period of time

—>All these terms can lead to an effectively lower valuation! Always keep in mind what a term’s effect on value can be!

All terms can lead to an

Cap Table

• The Capitalization Table is a good tool to keep an overview - especially when studying the effects of further terms

• Issuing a certain amount of stock over a fixed period of time

• Mostly used to bind the receiving partoes to the company for a longer period

• Vesting period for stock/options typically 4 years

The time before the first stock will be vested

A typical right to protect the investor from founders and key employees to leave the company early

• The vesting term mostly affects the founders, but can be applicable to employees as well

• Often an accelerated vesting is negotiated (e.g. 25% of shares will be vested immediately upon completion of the deal)

• Determines how the proceeds in a liquidity event are shared among the owners of the company

• Protects investors from losing money in case of a drop in valuation and ensures a minimum return for the fund

• Liquidation preferences of 1x to 3x the investment are not uncommon, often invalid after certain minimum cash multiples

• The Preference: Determines who wil get what amount before participation

• The Participation: Determines how the proceeds of a liquidity event are split between shareholders after the preference

Anti-dilution rights protect the VC from a number of costs arising from new players entering the game!

Upside Scenario: New investors invest at higher valuation

• Effects: Loss of control, but higher value

• Anti-dilution: Let’s the old VC buy new shares to keep share of ownership

Downside Scenario: New investor invests at lower valuation

• Effects: Loss of control and lower value

• Anti-dilution: VC will be compensated for loss of value and can buy/convert new shares at a price of a predetermined method

The old investor can buy as much stock as necessary to keep the original share of ownership. The price per share will be the same as the new investor pays.

Calculation of the price takes into account the relation of old and new shares. Narrow- and broad-based approaches differentiate between different stock types.

• In an upside scenario the VC wants to avoid a loss of ownership —>he can buy shares from the entrepreneur to keep his ownership

• In a downside scenario the VC wants to avoid a decreasing value of his stock —>he can get stock from the entrepreneur to reflect his initial investment