Term Sheet Basics

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2014/05/07 by lingdecklee

[The following are something I learned from Startup Leadership Program]

term-sheets-101-286x300

The Players

  • The Entrepreneur or Founder
  • The Venture Capitalist
  • The Angel Investor
  • The Lawyer

The Term Sheet

  • A document usually prepared by a VC to express interest in investing in a company, and the proposed terms.
  • A blueprint for founder’s future relationship with investors.
  • Common “deal points” include risk, return, control and duration.

Equity Investment in a Company

  • When a company is created, the founders receive common stock.
  • When VCs invest in companies, they purchase preferred stock.
  • Separate financings are designated as a Series identified by a letter, such as Series A, Series B, etc.

Valuation of a Company

  • Price Per Share x Number of Shares
  • Premoney valuation + investment amount = Postmoney valuation

Valuation Calculation Example

  • Term sheet provides that Investors will invest $3M at a $3M pre-money valuation and require a 15% post-money option pool
  • There are 5M shares outstanding
  • Warrants to purchase 1M shares
  • What do we need to calculate?
    • Number of shares to be issued to investors
    • Number of shares to be in option pool
    • Price per share to sell shares to investors
  • What do we know?
    • We know the investors are going to own 50% of the fully diluted post closing shares
    • $3M pre-money investment + $3M investment = Post money valuation of $6M
    • Investors % = Investment/Post-money valuation
    • $3M/$6M = 50%
  • What else do we know?
    • We know the option pool is going to be 15% of the fully diluted post closing share amount
  • So…if the investor will own 50% and the option pool will be 15%, then the 6M shares outstanding on a fully diluted basis (5M shares and warrants for 1M shares) will equal 35% of the post closing fully diluted shares.
  • Now we can calculate the total fully diluted share amount outstanding post-closing (6M/.35)

Valuation: Post Closing Cap Table

Holders                          Number of Shares     Percentage


Pre-money (Founders)     6,000,000                35%

Investors                       8,571,429                 50%

Option Pool                    2,571,429                 15%

Totals                            17,142,858               100%

Price

  • $20 per share for 150,000 shares (the Original Purchase Price).  The Original Purchase Price represents a fully diluted premoney valuation of $5 million and a fully diluted postmoney valuation of $8 million.  Fully diluted assumes the conversion of all outstanding preferred stock of the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Company’s existing option pool by [X] shares prior to this financing.

Liquidation Preference

  • Liquidity Events: Sale of the company or the majority of the company’s assets
  • Liquidation preference is important when the company is sold for less than the amount invested by the shareholders.
    • Example: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [X] times the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
  • Preference and Participation
    • Full participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.
    • Capped participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis, provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends.  Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.
    • No participation
  • Example: 5 million investment in a 10 million premoney valuation company: Series A Preferred owns 33% and the Founder owns 67%. Company about to be acquired for 30 million:
    • 1X Preference; no participation
    • 1X Preference; full participation
    • 1X Preference; participation with a 3X cap

Board of Directors

  • The size of the Company’s Board of Directors shall be set at [X].  The Board shall initially be comprised of _____, as the Investor representatives[s] _____, _____, and _____.  At each meeting for the election of directors, the holders of the Series A Preferred, voting as a separate class, shall be entitled to elect [X] member[s] of the Company’s Board of Directors which director shall be designated by Investor, the holders of Common Stock, voting as a separate class, shall be entitled to elect [X] member[s], and the remaining directors will be [Option 1: mutually agreed upon by the Common and Preferred, voting together as a single class] [or Option 2: chosen by the mutual consent of the Board of Directors].

Drag-Along Agreement

  • The [holders of the Common Stock] or [Founders] and Series A Preferred shall enter into a drag-along agreement whereby if a majority of the holders of Series A Preferred agree to a sale or liquidation of the Company, the holders of the remaining Series A Preferred and Common Stock shall consent to and raise no objections to such sale.

Conversion

  • The holders of the Series A Preferred shall have the right to convert the Series A Preferred, at any time, into shares of Common Stock.  The initial conversion rate shall be 1:1, subject to adjustment as provided below.

Redemption at Option of Investors

  • At the election of the holders of at least a majority of the Series A Preferred, the company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing.  Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.

Adverse Change Redemption

  • Should the Company experience a material adverse change to its prospects, business, or financial position, the holders of at least a majority of the Series A Preferred shall have the option to commit the Company to immediately redeem the outstanding Series A Preferred.  Such redemption shall be at a purchase price equal to the Original Purchase Price plus declared and unpaid dividends.

Protective Provisions

  • For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or through any merger, recapitalization, or similar event, that:
    • alters or changes the rights, preferences, or privileges of the Series A Preferred
    • increases or decreases the authorized number of shares of Common or Preferred Stock
    • creates (by reclassification or otherwise) any new class or series of shares having rights, preferences, or privileges senior to or on a parity with the Series A Preferred
    • results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services
    • results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold
    • amends or waives any provision of the Company’s certificate of Incorporation or Bylaws
    • increases or decreases the authorized size of the Company’s Board of Directors
    • results in the payment or declaration of any dividend on any shares of Common or Preferred Stock
    • results in issuance of debt in excess of $100,000.

Right of First Refusal

  • Investors who purchase at least ___ shares of Series A Preferred (a “Major Investor”) shall have the right in the event the Company proposes to offer equity securities to any person, other than the shares (i) reserved as employee shares described under “Employee Pool” below; (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement, or debt financing form a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their right of first refusal, to purchase [X] times their pro rata portion of such shares.  Any securities not subscribed for by any eligible Investor may be reallocated among the other eligible Investors.  Such right of first refusal will terminate upon a Qualified IPO.

Voting Rights

  • The Series A Preferred will vote together with the Common Stock and not as a separate class except as specifically provided herein or as otherwise required by law.  The Common Stock may be increased or decreased by the vote of holders of a majority of the Common Stock and Series A Preferred voting together on an as-if-converted basis, and without a separate class vote.  Each share of Series A Preferred shall have a number of votes equal to the number of shares of Common Stock then issuable upon conversion of such share of Series A Preferred.

Restrictions on Sales

  • The Company’s Bylaws shall contain a right of first refusal on all transfers of Common Stock, subject to normal exception.  If the Company elects not to exercise its right, the Company shall assign its right to the Investors.

Co-Sale Agreement

  • The shares of the Company’s securities held by the Founders shall be made subject to a co-sale agreement (with certain reasonable exceptions) with the Investors such that the Founders may not sell, transfer, or exchange their stock unless each Investor has an opportunity to participate in the sale on a pro rata basis.  This right of co-sale shall not apply to and shall terminate upon a Qualified IPO.
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