Tales From The Trenches – Venture Capital Term Sheets 101 (Part2)
Seed-Stage Financing Instruments
Following are attributes of the key financing instruments used in the various stages of venture capital:
Convertible Note –A form of short-term debt that converts into equity, typically in conjunction with a future financing round.
Convertible notes used to “bridge” a startup that has previously raised equity capital to the next equity round or to an M&A exit can come with onerous additional terms, such as a liquidation preference with an embedded multiple of the principal amount, a secured interest in case of liquidation, and all sorts of control rights.
Conversion Event –In return for their investment, the investor receives a contractual right to convert their investment money into shares in the company upon the occurrence of a conversion event. There are two main types of conversion events: a qualifying round and an exit event.
Conversion Price – When a conversion event occurs, the investor receives the number of shares equal to their initial investment divided by the conversion price. The conversion price at a qualifying round is generally the price per share at the time of the qualifying round multiplied by a discount.
Valuation Cap–A pre-agreed valuation of the company. If a valuation cap is included at a qualifying round, the investor will either receive the number of shares calculated by the round price or by reference to the valuation cap, whichever is higher.
Termination–A SAFE does not usually have an expiration or maturity date. It is drafted to terminate at the time of the conversion of the investment into shares or when the company pays the investor back in full.
Convertible notes and SAFEs were invented to be very quick instruments that wouldn’t be outstanding for a long time and historically would be converted to a Series A within a year or two. Recent trends are showing that companies are staying in the seed stage for a longer and longer time, running leaner and leaner, and pivoting. We are more frequently encountering the problem where convertible notes remain outstanding, and mature. Or a conversion trigger has hit, but no one has exercised it. We are seeing discussions or e-mails exchanged on the topic, but there is no official notice. It can be a mess. It is vitally important to have a strong counsel team to stay on top of maturity dates, discount rates and caps on conversions (and other terms of these instruments) to ensure the company is not stepping on legal land mines, and understands the impact.
Equity Round Term Sheets
The National Venture Capital Association, or NVCA, has recently issued a suite of new model legal documents to be used in venture capital financings, including a new model venture capital term sheet, with explanatory footnotes and links to background material. While written from the perspective of the investors, not the entrepreneur, with much variation in the marketplace, following is a synopsis of key terms:
Pre-Money Valuation– The value of the company before cash is invested.
Post-Money Valuation– Pre-money valuation + total new investment = post-money valuation.
Subsequent Closings – The period of time after your initial closing when you can take additional investment, up to your round size. Usually, the subsequent closing period is 90 days so that you could raise additional money to match the size of the round, but the period can be extended to have plenty of time to finish up the round.
Option Pool – An amount of equity reserved for future hires. This amount can be between 4-6% to 15%, depending on the company’s hiring plan and stage. The option pool is usually included in pre-money capitalization. This way, the pool only dilutes existing investors.
Board Structure – Body of elected or appointed members who oversee the activities of a company. Board seats and board control are among the most important points to be conciliated in negotiating a term sheet. There are varying opinions on how to go about building a company’s board of directors, including the participation of observers and advisors.
Voting Rights – Preferred stockholders will spell out their rights to vote on specified corporate actions, particularly board composition.
Information Rights – The rights for investors to receive updated information on the company. They typically specify rights to updated financial information, rights to inspect the company’s books and records, and so on.
Liquidation Preference – Primarily a down-side protection for investors in the event of a less than desirable liquidity event (sale, merger, bankruptcy, etc.) that returns money to preferred shareholders before common shareholders.
Participation – Enables investors to see a return on their dollar-for-dollar investment defined by the liquidation preference in addition to participating in the distribution of remaining proceeds based on their ownership percentage.
Anti-Dilution – Provision used to protect investors in the event a company issues equity at a lower valuation than in previous financing rounds. Exceptions to anti-dilution adjustments should be specified for stock options issued out of an equity incentive plan, in an acquisition, or special situations such as shares to be issued to third party service providers or in joint ventures. There are variations of the anti-dilution mechanism, sometimes referred to as “broad based weighted average” adjustments (these put all investors on the same footing) or “narrow” adjustments (these can be extra punitive on management teams). A strong counsel team will ensure that the anti-dilution provisions specified make sense for your situation, and do not produce unintended results.
Pay-to-Play – Ensures that investors must contribute a certain amount in later rounds or suffer penalties, such as forced full or partial conversion to common stock, losing previously negotiated liquidation preferences, anti-dilution protections and control rights. A “pay-to-play” can help a company that has hit upon hard times to recapitalize, though if any investor requires a carve-out from such a provision, it can make other investors uneasy.
Warrants – A security that gives investors the right to buy stock at a certain price within a specified timeframe. These are often used to refer to economic incentives to reward investors for achievement of performance metrics.
Co-Sale and ROFR– Investors’ right to sell stock to the same buyer, at the same price and same percentage, that a founder or other major holder sells to.
Dividends–Can be structured similarly to liquidation preferences; you either have them or you don’t. The standard in the market is a dividend on preferred stock that doesn’t participate in a vote, it’s not cumulative and it doesn’t accrue unless it’s declared.
Cost of Counsel –It used to be said that 1% of the capital raise is a typical cost of counsel, but in reality, the amount of legal work is often not commensurate with the stage and the amount of capital being raised. The July 2020 update from the NVCA provides typical fee ranges as follows:
Seed Round should cost $20k
Series A Round should cost $30k
Series B Round should cost $40k.
Of course, costs will escalate above these amounts when using firms based in Silicon Valley, New York and Boston, and especially when there is “deferred legal maintenance” happening concurrently with the fundraise (e.g., corporate cleanup for companies who have operated without counsel), or other changes, such as to the company’s governance or leadership, M&A, recapitalization, restructuring of prior rounds of notes or SAFEs, increases to the equity incentive plan or adoption of management carve-out plans, to name a few.
Late Stage Terms
Ratchets–A term whereby an investor’s prior investment is adjusted (usually upward) upon the occurrence of a specified event. A typical “ratchet” scenario occurs to enable an earlier investor to be issued additional shares upon a later investor purchasing shares at a lower price. A ratchet is often the mechanism used to ensure anti-dilution protection but can also be used to adjust value for other events. Anti-dilution ratchets can be based on a “broad based weighted average” of the cap table, or they can be “narrow,” based only the price paid by new investors.
Ratchets are normally tied to companies that are post-revenue. In practice, when we are talking about Silicon Valley based technology and life science venture capital, investors typically align themselves with companies to achieve scale, size, market position, growth and exit as quickly as possible, with any profits generated along the way reinvested into growth. Profitability has not been the principal metric of achievement, and as such, all venture capital is deemed “growth capital,” and ratchets are used to put all investors in the same boat. In “Silicon Valley style” deals, ratchets are usually specified to be based on a broad based weighted average of the cap table. Most often, we see these minimal “broad based weighted average” ratchets waived in down rounds as a condition of new investment. Rarely in the United States do we see narrow or other ratchets requested in venture capital deals, much less tied to any financial or performance metrics.
Look out for ratchets in term sheets from non-US investors, where a tech startup is confused with a mature business, and an equity ratchet is used to protect against failure to achieve minimum performance indicators, or to compensate an investor with upside for the growth that their capital enables.
Carve-outs– This refers to a plan that is exempt from the liquidation preferences specified for the preferred stock holders in the charter, and “carves-out” an amount of proceeds from a sale transaction, usually to the management team, because the common stock is under water, or capital will not flow down to the management team that holds common stock in the “waterfall” of proceeds upon a sale. A carve-out refers to some plan to incentivize the management team to achieve a result that they would not otherwise receive through the waterfall of proceeds distributed in a company exit transaction. Carve-outs often appear in later stage deals when the company is distressed and needs an extension of equity or debt capital to get to exit. Or it’s a last-mile valuation that is designed to put a stake in the ground before the company goes public. If it’s a distressed round and new money is coming in with a demand of a 3x liquidation preference, or another demand that somehow lowers the probability of capital flowing down to the common stock upon sale, management will tell the new investors and the historical investors that management needs an incentive to ensure that they also participate in the company’s success. In cases like this, management will request a minimum amount of capital or percentage of proceeds upon a company exit. A management carve-out plan can also be offered by a new investor to management and squeeze the prior investors. Typically, the specific members of management that can participate in the carve-out plan are not determined until the exit, leaving little comfort to management who could be terminated in the immediate term. Some negotiation can occur as to whether management should be vest into the carve-out plan over time (or immediately), or whether they should have skin-in-the-game to continue providing services to the company all the way until exit.
Side letters and collaboration agreements are typically requested by corporate venturing groups or strategic investors who participate in a single round of financing, often concurrent with or as a condition to some business relationship. These investors do not always care about pro-rata investing rights, board seats or governance rights, and are usually focused on creating strategic value for their parent company (without losing money).
It is important to remember that strategic investors are not typically investing for direct financial gain. Even if a startup company has a fantastic return (e.g. a 10x return on invested capital of $5M), shareholders in a publicly traded industrial conglomerate, on whose behalf a strategic investor or corporate venturing group is investing, will probably not even take notice. Often times, the primary business purpose of a strategic investor or a corporate venturing groups is to enable innovation for their corporate parent, get information, understand the market, and to have the option to work with the startups’ business groups. All this turbocharges their multibillion-dollar business or enables a strategy that they are thinking of pursuing years down the road.
A collaboration agreement may be embedded within a side letter or spelled out in a separate document with a strategic investor. In such types of agreements, a strategic investor may want certain exclusive rights, such as a right of first refusal (in order to do a partnership with the company), right of first offer (to be able to acquire you if you get an acquisition offer from outside or restrict your collaboration with competitors), or a term to non-compete.
Many of these terms are a horror for a traditional VC. But there are ways to address these issues so that the new corporate venture investor is comfortable, and the existing investors don’t feel as if there is a cap on company value.
Side letters are also used by smart investors investing at early stages. They might use a SAFE or convertible note to document their investment on a standard form, but they will use a separate side letter or agreement to request specific rights, such as pro-rata investment rights, a board advisory seat, board observer rights, protective provisions (e.g., an MFN) or other terms. If a majority of the holders of a class of SAFEs or convertible notes can amend an instrument, a side letter can protect an investor from the will of the majority.
Summing it all up…
Whether you are an entrepreneur seeking to access venture capital, or an investor looking for the next big thing, the pandemic has underlined a new urgency to innovating your business to compete in the new normal. The pendulum of market terms has clearly swung in favor of investors and new segments of business models and investors are evolving rapidly. Before you raise your next round or write a term sheet, you should have expert legal advisors to guide you on the path.