Term Sheets & Valuations COPY

Question 1

Is a term sheet legally binding?

Answer 1

No. Most have an exclusiveity cause but there’s not much teeth to it as both sides retain an “out”.

Question 2

What documents are added or modified as a result of the term sheet?

Answer 2

Purchase & Sale Agreement is added, and the charter or articles of incorporation (operating agreement) are modified in line with the terms.

Question 3

What share class are Angels usually buying?

Answer 3

Common. They buy common at the early stage, primarily because of simplicity and not slowing down business through unecessary negotiation.

Question 4

Typical venture fund terms

Answer 4

5 years w/ 2 year extension, or 10 years w/ 1-2 year extension.

Question 5

What is the milestone section?

Answer 5

Investor sets clear rules or targets that stages the infusion of capital to reduce risk.

Question 6

How do you calculate pre-money valuation?

Answer 6

Existing shares outstanding including warrants and options x price per share offered.

Question 7

How do you calculate post-money valuation?

Answer 7

Existing shares outstanding * price per share offered + new invested capital.

Question 8

What is the philosophical difference between pre and post money valuation?

Answer 8

Pre-money is the comparable valuation increase (if it is an upround) for existing investments to the previous round. T Example, if investors originally invested at a 1M post money valuation, and now the business is worth 2M pre-money, they are up 2x on their price per share independent of post-money valuation.

Question 9

What is the composition of an attractive board to investors?

Answer 9

Independence, not related to founders. Investors (even if from separate groups) maintaining a majority,

Question 10

What are the key areas of a term sheet entrepreneurs should pay attention to?

Answer 10

Price per share
Corporate governance
Options
Valuation

Question 11

What is the best approach to getting investors for an entrepreneur?

Answer 11

Talk to as many as possible! Getting a syndicate of VC investors makes future fundraising easier, and can generally benefit the business network.

Question 12

What are milestones that can adjust the value of the company?

Answer 12

In some situations, if the company performs below 50-75% of a target, the value of shares issued in the previous round can be adjusted proportionally to dilute other investors and/or founders. These milestones should note GAAP or other acct. standards.

Question 13

If pricing is fair or even aggressive, what will VC’s focus on?

Answer 13

Downside risk! Liquidation preference etc.

Question 14

What are the concerns with information rights for founders and entrepreneurs?

Answer 14

If they are too onerous and take too much time away from the business.

Question 15

Why is it best to beware of strategic partners that become investors?

Answer 15

They may require rights to influence or block future sales or acquisitions that may benefit them, and too much dependence on a strategic partner may limit choices and independence down the road.

Question 16

What is the typical change in rights in later rounds for vs. investors?

Answer 16

Later rounds at a minimum share the same rights and typically have more influence and rights.

Question 17

What is Total Common Equivalent?

Answer 17

Fully diluted shares, treating all preferred, common, and options equally.

Question 18

What is a cumulative vs. non-cumulative preferred dividend?

Answer 18

Cumulative is a dividend that accrues whether or not it is paid for the year. Non-Cumulative does not accrue.

Question 19

What are the different terms (investor friendly, middle, company friendly) for Dividend Provisions?

Answer 19

Investor friendly - Cumulative 15% preferred rate
Middle - Non-cumulative 8% rate, participate in common if dividend paid
Company - Non-cumulative 8% preferred rate

Question 20

What is the most important factor in liquidation preference?

Answer 20

The multiple the preferred gets in a liquidation scenario.

Question 21

What are the different terms (investor friendly, middle, company friendly) for Liquidation Preference?

Answer 21

Investor friendly - 3x return in liquidation plus accrued dividends before common, then participation in common on as converted basis
Middle - Return of original investment plus accrued dividends before common
Company - Preferred gets original purchase price, then remaining is distributed amongst common

Question 22

What is a redemption clause?

Answer 22

Protects investors from companies that become “living dead” serving only to pay employees salaries.

Question 23

What are the different terms (investor friendly, middle, company friendly) for Redemption Clause?

Answer 23

Investor friendly - Investor can redeem 1/3 of investment on 3rd anniversary, 1/2 at 5th anniversary, remaining at 6th anniversary at 3x purchase price.
Middle - 3 equal annual installments on 5th anniversary at original purchase price plus declared and unpaid dividends.
Company - none

Question 24

What is a conversion clause?

Answer 24

Allows preferred investors to convert to common at a liquidity event so they generate a return that is greater than the multiple mandated in the liquidation preference.
Ok giving up preferred rights if a transaction would yield a higher return.

Question 25

Standard conversion clause

Answer 25

Preferred investor shall have the right to convert to common at any time at a 1:1 ratio.

Question 26

What are the different terms (investor friendly, middle, company friendly) for Conversion Clauses?

Answer 26

Investor friendly - Automatically converted if 2/3 of preferred vote for it or firmly underwritten ipo where preferred gets 3x minimum, 40M valuation min
Middle - Automatically converted if 2/3 of preferred vote for it or firmly underwritten ipo where preferred gets 2x minimum, 25M valuation min
Company - Same as middle but with lower total non-IPO valuation threshold, maybe $5M

Question 27

What does a dilution clause do?

Answer 27

Most important tool for investors to make sure subsequent financing rounds will not dilute the value of their investments below the price they paid in a prior round.

Question 28

What are the different terms (investor friendly, middle, company friendly) for Anti-dilution provision?

Answer 28

Investor friendly - Full ratchet, price per share adjusts to any new lower price immediately.
Middle - Weighted average adjustment
Company - Proportional adjustment for stock splits, dividends, etc.

Question 29

What are protective provisions?

Answer 29

Typically they give a share class certain powers not available to all share classes. A standard protective provision is to require a majority of a share class to vote for additional issuance.

Question 30

What are investor friendly, middle of the road, and company friendly protective provisions typically granted to a specific share class?

Answer 30

Invetor Friendly - 2/3 majority of preferred vote for MnA, redemptions of common shares, IPO’s, additional share issuance, changes to the board, changes to certificate of incorporation, dividend declaration
Middle of the road - 50% majority of preferred vote for MnA, redemptions of common shares, IPO’s, additional share issuance, changes to the board, changes to certificate of incorporation, dividend declaration
Company Friendly - 50% majority of preferred required for actions that changes rights and privelages of preferred, or reduces the number of authorized preferred

Question 31

What are investor friendly, middle of the road, and company friendly protective provisions in the Board Composition section?

Answer 31

Invetor Friendly - Preferred class gets a majority vote through a board majority
Middle of the road - Investors and Founders split, with one additional independent member
Company friendly - Founders retain majority of the board

Question 32

What are special board approval items?

Answer 32

Specific decisions that would require a board vote. Could include - Employment agreements, comp programs, annual budgets, real estate leases or large capex.

Question 33

What are information rights?

Answer 33

Define what access is given to investors by the company.

Question 34

What are investor friendly, middle of the road, and company friendly provsions in the Information Rights section?

Answer 34

Investor Friendly - Annual audited, quarterly unaudited, and monthly books.
Middle of the road - Annual audited, quarterly unaudited, and monthly books as long as shareholders own 25% of original purchase.
Company friendly - Annual audited, quarterly unaudited.

Question 35

What is something to remember with Information Rights if the investors are requiring audit capabilities?

Answer 35

May not reflect the specific situation, but may be a general policy of the investment firm.

Question 36

What are registration rights?

Answer 36

Determine to what extent and how preferred and common will participate in a public offering or registration in advance of a public offering.

Question 37

What is a right of first refusal clause?

Answer 37

Gives investors the right to control future sales of common or preferred, to restrict the sales or participate pro-rata.

Question 38

What are investor friendly, middle of the road, and company friendly provsions in the Right of First Refusal section?

Answer 38

Investor Friendly - First right of refusal over all new shares
Middle of the road - As long as investors own 1/8th of original purchase, first right of refusal over new shares, any pro rata shares not taken by an investor must be offered to all other investors first.
Company friendly - As long as investors own 1/8th of original purchase, first right of refusal over new shares

Question 39

What is a Conditions Precedent?

Answer 39

Section that outlines the steps to completion of a deal, including signed purchase agreement and operating agreement modification.

Question 40

What are investor friendly, middle of the road, and company friendly provsions in the Purchase Agreement section?

Answer 40

Investor Friendly - Contains required reps and warranties by the founders, registration rights only waived with 2/3 majority of preferred
Company Friendly - Less strict reps and warranties by the founders, registration rights only waived with 50% majority of preferred

Question 41

What are all the documents involved in a share sale?

Answer 41

Purchase Agreement - Provides for the terms of the purchase contemplated in the term sheet
Investor Security - Details security the investor purchases. Includes liquidation rights, voting rights, dividends etc.
Registration Rights - Allows investor to force registration of securities under applicable law
Stockholders Agreement - (operating agreement)

Question 42

What is the importance of the Employee Matters section?

Answer 42

Management is KEY to investments. This section typically restricts management from cashing out before other securities. Typically incorporated early by Angels or early stage, no need to revise later. Includes option pool and other compensation matters.

Question 43

Who bears the cost of cousel to the lead investor?

Answer 43

Typically the cost of counsel for the lead investor is born by the company.

Question 44

What are the considerations for considering valuations?

Answer 44

Company is a sum of it’s parts, some of the parts may have different values.
Future capital needs must be anticipated. Future rounds of unanticipated fundraising will be approached with significant suspicion from new investors.
The more adept an entrepreneur is at finding appropriate comparables the more aligned expectations will be for future events.

Question 45

What are standard Gross IRR returns for Venture?

Answer 45

Require 50% IRR returns, equating to around 30% IRR returns for investors.

Question 46

Why can a management fee have such an impact?

Answer 46

2% management fee over a 10 year period of a 100M fund is 20M, or a 20% hurdle depressing returns over time.

Question 47

What is the best position for entreprenuer compensation negotiations?

Answer 47

Options based on targets or hurdles agreed to by everyone.

Question 48

How do you conduct a valuation?

Answer 48

Consider exit scenario, and fundraising rounds required to get there, and work backwards to your required IRR.

Question 49

What control should the investors go for?

Answer 49

Enough to make sure the business plan is being successfully executed.