Mastering Private Equity. Prahl Michael

      Box 2.2

      VENTURE CAPITAL TERM SHEETS

      Term sheets serve as the main negotiation tool in VC fundraising and, once agreed upon, set out the rights and obligations of investors in a round’s newly created preferred share class. The provisions of the term sheet are then formalized in a share subscription agreement, and in an amended or redrafted shareholders’ agreement plus articles of association of the target company.36

      First-time entrepreneurs are well advised to carefully review the terms under negotiation before signing a term sheet, especially as earlier investment rounds set the ground rules for future fundraising, potentially complicating that process. Guidance from an experienced entrepreneur or a friendly venture partner can help overcome the knowledge gap between start-up founders and seasoned VC investors.

      The provisions in a term sheet can be divided into economic terms and control terms.

      Economic Terms

      Economic terms set out the price of shares, the investment amount and the rights and obligations of the newly created preferred share class.

      SHARE PRICE AND VALUATION: The first part of the term sheet defines the offer made by the VC in a given round, including the valuation of the company (pre-money), amount of invested capital, number of shares to be issued and price per share. The type of securities to be issued for this round, for example “series B preferred stock,” is clearly defined.

      LIQUIDATION PREFERENCE: This clause gives preferred shareholders preference over any distributions received in case of a defined liquidity event, be it an acquisition by a strategic buyer, a merger, an initial public offering (IPO) or the liquidation of the company. Preferred shareholders receive their invested capital back first (and at times a multiple thereof) before any distributions are made to common shareholders. In the case of “participating preferred shares,” preferred shareholders will share the balance of the exit proceeds after the liquidation preference has been satisfied pro rata with common shareholders, on an as-converted basis.

      EMPLOYEE STOCK OWNERSHIP PLAN (ESOP): An ESOP sets aside a percentage of shares in the start-up that can be granted to non-founding employees in the form of stock options to attract, reward and retain first-rate talent. A term sheet will stipulate a vesting schedule for these options – a clearly defined timeline for the options to convert into shares – it will also allow the board to force a forfeit of these options under certain circumstances. In addition, the term sheet will clearly define the number of shares reserved for the ESOP, and the strike price, timing and expiration date of the options. Given that ESOPs are a source of dilution for all existing shareholders, both the size and timing of an ESOP need to be carefully considered when planning to raise external funding. Many VCs will require an ESOP of 20 % of the outstanding shares before closing a round.

      ANTI-DILUTION: This provision protects earlier investors in the event of a “down-round” (i.e., a round of funding raised at a lower valuation than the previous round). With anti-dilution provision in place, the conversion price of the preferred share class will be adjusted downwards to the level of the new valuation; as a result, shareholders who invested at a higher valuation in earlier rounds will receive additional shares to maintain their ownership stake in the start-up and avoid dilution.

      Common shareholders do not have such protective provisions and will be diluted. Anti-dilution clauses come in various degrees of severity, and founders are well advised to be aware of their impact.

      CONVERSION RIGHTS: Preferred shareholders may convert at any time to common stock at their sole discretion; the conversion rate – at the outset usually 1:1 of preferred to common – is clearly defined in this clause. Investors will generally be converted from preferred to common shareholders at clearly defined trigger events, typically just prior to a sale or merger. In the event of an IPO, conversion of the preferred stock is usually automatic.

      Control Terms

      Despite being minority shareholders, venture investors typically request certain control rights to monitor the development of the start-up and influence important decisions.

      BOARD REPRESENTATION: VCs will expect to be represented on the board of directors of the investee company. Whether it is one or two board seats with the respective votes or merely an “observer right” depends very much on the dynamics during negotiations. (An in-demand company courted by several venture investors may be able to negotiate lesser representation as a condition of investment.) Founders are well advised to have a clear board plan – defining the number of seats available to venture investors and those assigned to independent directors – before raising their first external round.

      PROTECTIVE PROVISIONS: Venture investors usually receive voting rights on an “as-converted” basis equal to that of common shareholders. In addition certain actions may require the consent of the VC or approval of at least 50 % of the preferred shareholders. These actions may include alterations of the certificate of incorporation, which would adversely change the rights, privileges and powers of the preferred shareholder, or approval of any sale of assets or mergers, or any changes to the number of preferred shares issued. Veto rights may apply with regards to specific events such as an IPO, new equity financing or increase in the ESOP and can extend to governance matters such as the right to approve the appointment of senior executives.

      DRAG-ALONG/TAG-ALONG PROVISIONS: A drag-along provision gives the majority shareholder the right to force other shareholders to sell their shares in a third-party transaction. This provision enables the majority shareholder to sell out and achieve a clean break at exit. A tag-along provision provides minority shareholders with the right to sell their shares in conjunction with the majority shareholder in a third-party transaction, participating in any liquidity event pro rata.

      TRANSFER RIGHTS AND NEW ISSUE RESTRICTIONS: The term sheet typically includes preemptive rights for share transfers and new issues, stating that the existing shareholders shall be offered any shares first in the case of an existing shareholder wanting to sell out.

      INFORMATION RIGHTS: This provision clearly states which operational and financial information must be provided to preferred shareholders and when; the requested information usually includes at a minimum unaudited monthly and annual financial statements.