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Term Sheet Issues

Board
While identifying prospective independent board members will help make VCs slightly more comfortable investing in your startup, they may still be concerned about getting an independent approved. Selecting independent board members is often done by a process of mutual approval, whereby both the directors representing the management team and the investors must approve them. This selection process is designed in spirit to ensure that the independent director does not favor one side or the other (they should remain independent of the influences of either party). Nobody wants the other side to have a ringer. Since independents must receive mutual approval be to be accepted, VCs are sometimes concerned that the management representation on the board will choose to block all of the proposed independents leaving the company with an even number of directors and no mechanisms for breaking ties in the future. While this doesn't happen if all parties are acting in good faith, being a good partner is not always a high priority for individuals. As a result, VCs may seek to insert penalties in the term sheet that incentive the management side of the board to select an independent director. These terms might include something as aggressive as the VCs taking control of the independent's board seat after a designated period of time until an independent is selected. In sum, it's important to VCs that your company selects an independent board members. Typically this comes about through a good faith effort by all of the parties. VCs that have had problems securing an independent director in the past, may look for mechanisms to ensure that the management team actively works to find and approve this person.

Valuation VCs have an unfair advantage when it comes to financings. They simply have more experience doing deals. A typical start-up company will do 2-4 venture capital financings before a successful exit (or, conversely, an ignomious ending). A typical serial entreprenur may lead 2-3 companies in their career before calling it quits (or checking themselves in to an insane asylum). Thus, the universe of financings that even the most experienced entrepreneurs get directly exposed to is typically 5-10 financings over a 15-20 year career. In contrast, the typical venture capitalist, either individually or across their partnership, will do 5-10 financings in any given year. Year in, year out, Thus, VCs and entrepreneurs are not operating on an equal playing field when it comes to negotiating financings and interpreting the impact of the terms involved. One area that has always struck me where this assymetrical relationship comes into sharp focus is when theres a discussion around the price of the deal. Entrepreneurs often mistakenly focus solely on the premoney valuation while VCs look at multiple knobs in the negotiation to drive to a set of terms that, in total, they find acceptable. And if they dont focus on the pre-money, they focus on their ownership position after the financing, irrespecive of the amount of capital that was raised.

In my partnership, weve come up with a new term (I think its new - I dont see it written or talked about much) called the promote to help communicate with entrepreneurs the real value behind a particular deal so get them to step back from concentrating only on the pre-money valuation or post-money ownership. What is the promote? First, let me take a step back and define a few terms. In the world of VC-backed financings, there are multiple terms that impact the ultimate price of the deal. The first, and most focused on, is something called the pre-money valuation. That is, what is the company worth prior to the money being invested? This pre-money valuation is own known in shorthand as the pre and you will hear entrepreneurs and VCs discussing other company finances using this term (You were able to raise money at a $9 pre? I had to struggle to get to $6 pre and I have a prototype and real customers! Life isnt fair.) But the pre-money isnt the only term that defines price, the amount of capital raised and the post-money plays a part as well. The post-money is the pre-money plus the invested capital. That is, if a company raises $4 million at a pre-money valuation of $6 million, then the post-money is $10 million. The investors who provided the $4 million own 40% of the company and the management team owns 60%. Another term that impacts the price is the size of the option pool. Most VCs invest in companies that need to hire additional management team members and sales and marketing and technical talent to build the business. These new hires typically receive stock options, and the issuance of those stock options dilute the other investors. In anticipation of those hiring needs, many VCs will require that an option pool with unallocated stock options be created prior to the money coming in, thereby forming a stock option budget for new hires that will not require further dilution after the investment. In our $4 million invested in a $6 million pre-money valuation example above (known in VC-speak shorthand as 4 on 6), if the VCs insist on an unallocated stock option pool of 20%, then the investors still own 40%, there is a 20% unallocated stock option pool at the discretion of the board, and a 40% stake is owned by the management team. In other words, the existing management team/founders have given up 20% points of their ownership in order to go towards future hires. This relationship between option pool size and price isnt always understood by entrepreneurs, but is wellunderstood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a 6 on 7 deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a 6 on 9 deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did 30% so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, Jeff their price was better. My company is worth more than $7 million. At the time, I wasnt facile enough with the nuances myself to argue against his faulty logic. Thats why we instituted a policy at Flybridge to talk about the promote for the founding team more than the pre. The promote, as we have called it, is the founding teams ownership percentage multiplied by the postmoney valuation. It represents the $ value in the ownership that the founding team is carrying forward after the financing is done. In my example of the 6 on 7 deal with the 20% option pool, the founding team owns 34% of a company with a $13 million post-money valuation. In other words, they have a $4.4 million promote in exchange for their founding contributions. Note that in the 6 on 9 deal, the founding team had a nearly identical promote: 30% of a $15 million post-money valuation, or $4.5 million. In other words, my offer wasnt different than the competing offer, it just had a smaller pre and a smaller option pool. Entrepreneurs negotiating with VCs should spend time making sure they understand all of the aspects of the deal, but particularly the elements of price - the pre-money, the post-money, the option pool - and do

the simple math to calculate the promote. There are many other elements of the deal that affect price (participation, dividends) and control (board composition, protective provisions), but make sure you think hard about the value youre carrying forward, not just the price tag you think the VC is giving your company in the pre. Startup Valuation - The VC Method 20 Sep 2006 Anyone from the valley will agree there is a certain buzz in the air right now - a buzz very reminiscent of the late 90s. Not only does it remind us of the good times, but also of the dangers of getting caught up in the hype. It seems everyone is all too aware of this becoming another bubble - and everyone, including myself, seems to be cautious about valuing new startups using bubble era metrics. So how should one value a startup? Its obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price. This post is a bit of an educational piece for those who wonder how VCs typically value a startup. The method I describe below, is one of the most widely used (often called the VC method). At the very least, this method provides a ballpark figure to start with, which can then be adjusted according to a variety of external factors. For more details on the VC Method, see HBS Note 9-288-006. In describing this method I will start with a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing. Terminal Value The first thing we need to calculate is a terminal value for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit. We need to somehow come up with a value for the company at that point in time. The easiest way to do this is to look at a comparable company. For example, if a company in the same or similar industry was recently acquired or went public, this value can be used as a proxy for the terminal value of the company we are trying to value. Another, perhaps more common method, is to look at price/earnings (PE) ratios for companies in the industry, and use this along with expected earnings in the terminal year as shown in the business plan (suitably discounted to adjust for EEE - Entrepreneurs Enthusiasm Error :) Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoos industry are trading at PE ratios of around 15. This means Infelidoos expected terminal value is $3M x 15 = $45M. Note: this terminal value is best case - assuming everything goes right. We will account for the fact that everything doesnt always go right in the discount rate (see below). The Venture Capitalists Required ROI Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later). This means in year 5 the VCs investment must be worth (1 + 0.50)5 x $2M = $15.2M. [That's just (1 + IRR)years x Investment]

So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%. Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M. The Discount Rate Above we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:

The risk-free rate Premium for market risk Premium for illiquidity Premium for value added by VC (compensation) Premium for fudge factor (past experience)

Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:

Seed stage: 80%+ Startup: 50-70% First-Stage: 40-60% Second-Stage: 30-50% Bridge/Mezzanine: 20-35% Public Expectations: 15-25%

Multi-Stage Financing The above example was overly simple because we assumed a single financing was enough to take the company to the point where it became self-sustaining. In reality companies will generally take several rounds of financing, and each round dilutes the ownership of existing shareholders. Additionally, option pools need to be reserved for future employees. This affects the percentage ownership each investor will have in the terminal year, and thus we must factor this dilution into the calculations. In essence, we calculate the share of the pie each investor must have in the terminal year, based on when they make their investment and their required discount rate (using the process outlined above in each case). Then, we take dilution into account when calculating the ownership percentage the investor must take now (current ownership %) in order to achive this terminal percentage ownership (final ownership %). To make this conversion, use the formula: current ownership % = (final ownership %)/(retention %) Retention refers to the amount of ownership that a VC retains, taking into account future dilution. If there are no subsequent financing rounds then the retention is 100%. If there are subsequent rounds then it is some smaller number. To calculate the retention %, add up the sizes of final percentage ownerships of subsequent investors (the size of their slice of the final pie), and subtract this from 1. E.g. if there are three investors, and their final shares of the pie must be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%) = 85%. Similarly investor 2s retention is 95% and investor 3s is 100%. Note: This is further complicated in the case where an investor also participates in subsequent rounds (which is very often the case). A simple formula wont really help here, and youll have to model the scenario using a spreadsheet.

After adjusting for dilution, we know the ownership stake an investor must take in the company now in exchange for her investment, which implicity places a valuation on the company.

Misc By the time I was in the 9th grade, I had been playing chess for a few years (as in I knew the rules) but I didn't play seriously and more often than not I lost. Then one day at the library (remember, pre-internet) I happened to find a book on chess. So I read the book and almost overnight I became one of the chess "stars" in high school. In one of the funnier incidents, I started playing chess during lunch hour and was "hustling" money which on one occasion resulted in a kid pulling a knife on me after I relieved him of a few bucks. True story. What was it in that book that allowed me to take advantage of the situation? Well, there was a lot of basic stuff, some general rules and even some strategy, however, the most useful bit of information, initially, was a table on the relative value of pieces. You know, a pawn is worth 1, a knight/bishop 3, rook 5, a queen 9 and the king "infinite" unless it's the endgame then it's more like a 4. Experienced players have a "feel" for this from many games played and they can also break the "rules" by, for example, sacrificing a queen for a rook to get better position. But these are all things learned from experience and best not tried by a novice. If you are new to the game, you have no idea. When you are starting out, having some rules of thumb can make all the difference between winning and getting hustled. What does this have to do with negotiating term sheets? Well, I think a lot of newbies get hustled when negotiating term sheets because they don't know the relative importance of the various terms. Have you heard the joke about the VC who says, "I'll let you pick the pre money valuation if I get to pick the terms?" My goal here is to provide a framework that gives relative value of various terms on a term sheet and allows you to compare them on two dimensions: economics and control (or as my friend Noam Wasserman likes to say, "rich" versus "king"). In the same way that a chess grand master doesn't need rules of thumb from someone else, if you're a seasoned negotiator of term sheets then this is probably equally useless. And no, this is not based on any academic or scientific study. It's based on my own experience and, more importantly, that of a few other experts like Dave Kimelberg (Softbank's GC). In my view there are 12 important terms on a typical Series A / B term sheet. Yes there are other terms and yes sometimes they are important, but if you go with the thesis of keep it simple, then 12 is the magic number. In terms of rating, the rich/king differentiation is important as different people are after different things so depending upon your motivation you may be inclined to pay more attention to one column than the other. So without further adieu, below is a table showing them as well as the relative importance:

Term 1. Investment / price 2. Board of directors 3. Option pool refresh

Rich 10 10 8 -

King

4. Preemptive rights 5. Andi-dilution protection 6. Registration rights 7. Drag along rights 8. Right of first refusal / co-sale 9. Dividend right 10. Liquidation preference 11. Protective provisions 12. Redemption

1 5 1 1 5 5 7 1

3 1 5 8 -

Here a 10 means it is really important to get as favorable a result as possible on this term, a 1 means it is not so important and a "-" means it doesn't apply (i.e. a zero). The cool thing about having something like this is you can use it as a tool to compare term sheets (provided you can determine how favorable or unfavorable each individual term is...more on that below). The next part of this post is to provide a range of typical results for each term which will give you a means to rank each term in each term sheet with a "1,3 or 5" where 1 is "unfavorable", 3 is "fair" and 5 is "favorable." If you aren't already familiar with the terms in a term sheet, you should check out the model term sheet (basically a template) put together by the National Venture Capital Association. They have other model agreements too, but you will see with the term sheet that they include various options, some discussed here. Below is a scale for each of the 12 key terms across the two dimensions: 1. Investment/price. I think there are two ways you can rank price. One is to rate it relative to your expectation and another is to rate it relative to similar companies (in terms of stage, geography, sector, etc.). If you don't have comparables, you can fairly easily get them, for example Dow Jones puts out a quarterly survey of VC deal terms which includes pre-money valuation (send me an email if you want a copy). If you're less than 80% of your benchmark, that's probably unfavorable, if you are within +/- 20% than that's fair and if you're over 120%, then it's favorable.

2. Board of directors. This term comes down to simple math. If you give up and don't have control of the board, that's unfavorable, if it's tied, call it fair and if you control it, that is quite favorable. BTW, the reason I didn't rate the board control a "10" on the "king" scale is because even when you give up control, your board members are bound by fiduciary obligations to the firm, i.e. they can't do whatever they want.

3. Option pool refresh. Often time this will show up as a separate term in the term sheet, however it is actually just another bite at the apple in terms of price. Traditionally there is a refresh pre-deal so that after the round the company can execute on its hiring plan without needing to expand the pool for 12-18 months. You will have to develop your hiring budget if you haven't already. Given that benchmark and your hiring equity budget, I'd say less than 12 months is favorable, 12-18 months is fair and more than 18 months is unfavorable.

4. Preemptive rights. As you know, preemptive rights give your investor the right to invest in future rounds. This is of moderate economic value, however you are giving up some control of future financings. There is remarkably little variation in how this term gets negotiated, probably because

of its relatively low importance in the grand scheme. I'm told the only area that gets negotiated is whether the investor has an "overallotment right" whereby they can take a portion or all of the pro rata of another investor in the same series who didn't participate. That said, unless something unusual is in your term sheet, it's probably a 1 for rich and 3 for king.

5. Anti-dilution protection. Anti-dilution is a pretty important economic term. In terms of the range of possibilities, no anti-dilution would be a 5, broad-based weighted average would be a 3 and fullratchet would be a 1. I think the vast majority of deals end up as broad-based weighted average. Very few deals avoid it altogether, but it can be done, particularly in later stage or very hot deals.

6. Registration rights. Reg rights have some economic value and in theory you do give up some control, but in reality they're close to worthless. You can push on these and most investors will give in when pressed. You can negotiate when the right kicks in and cutbacks. But bear in mind that investors will love it if you waste time negotiating this because it is not an important term. Unless something unusual is going on, I'd rate this a 1 on both dimensions.

7. Drag along rights. Most deals include drag along rights and like many of the other terms, the key is in the voting thresholds. I rated this a 1/5 on the rich/king scale. In terms of economics the issue is with regard to a sale of the company where the preferred stock, because of special rights, is indifferent to a deal that would be better for Common. However, the bigger issue is on the control side of the equation where you could get dragged into a sale that you don't want to do. So in terms of rating both the economic and control sides, I would say that if the thresholds are such that a single investor can unilateral drag along, that's a 1, if it takes 2 or more investors that's a 3 and if it takes investors plus either a neutral party or Common (you) then it's a 5.

8. Right of first refusal / co-sale. I rated this a 5 because this is essentially a "lock-up" on the founders stock which seriously affects liquidity and thus value. It doesn't really affect control issues. If you read the actual section of the stock purchase agreement that describes this term it's several pages of bureaucratic procedures for a sale that in the real world you can't imagine ever occurring (which they don't). As a result, the only real counter party for selling common stock is the other investors or the company with the investors approval and they're all quite likely to low ball. Unfortunately, I've never heard of avoiding this term completely, so in terms of how to rate it, I'd say that if you can negotiate a right to sell some portion (say 20% on an annual basis) you're at a 5 otherwise if it's a standard lockup then you're at 3.

9. Dividend right. I rate this a 5 on the economic scale. In terms of the range, there is no dividend which is a 5, then there is a simple interest dividend which I'd say is a 3 and a 1 would be a compounding dividend. For some reason, the dividend rate has been 8% ever since I've seen term sheets. You can negotiate the rate, but the bigger battle is whether you pay a dividend and how the rate compounds.

10. Liquidation preference. This is a very important economic term that doesn't have any importance in terms of control. The issue here is during a sale, how do investors get paid out. I'd say about 1/3 of deals have a preference at 1X but no participation, another 1/3 have a preference with a cap and participation and the balance a preference with no cap plus participation and that's pretty much how I'd rate it, i.e. 5 for 1X preference/no participation, 3 if with a cap in the 2-4X range and 1 if with no cap and participation. 11. Protective provisions. This is very important from a control perspective but not so economically. While there are a ton of these protective provisions, the key ones relate to sale/merger of the company and future rounds of financing. As with other control rights, the key is in the voting thresholds so I'd assess this the same as 7 (drag along rights). 12. Redemption. Finally, we get to number twelve, redemption rights. This is an almost worthless economic right. I've never seen or heard of this being exercised and most investors will acquiesce if you push on this. Unless you see something unusual, I'd rate this a 3. Ultimately the individual rating combined with the overall importance of each term will allow you to create a weighted average total for each term sheet on both the rich and king dimensions. While you wouldn't want to make a decision to take an investment on this alone, it will give you a basic idea of where the strengths and weaknesses of particular term sheets lie. It also gives some tips for negotiating. For example, you don't want to waste your time negotiating redemption rights and attorney's fees and instead, you want to go to the core of what's important to you on the rich/king scale.

Price Calculated as investment/post-money valuation, the price is the percentage of ownership given to the investor. Pre-money valuation is the value of the company today. Post-money valuation is the pre-money valuation plus the amount invested. Board Whether you have ten angels or just one investing in this startup, a seat on the board needs to be reserved for you or a representative of your company. Define Equity You must specify whether you will accept common equity or if you will demand preferred convertible shares. Common equity is typical in first round investing, but if you expect more, that must be clarified. Tranches In an effort to reduce the investment risk, many investors will provide money in stages or tranches based on defined milestones. This puts more pressure on company founders to perform and you keep your money longer. Anti-Dilution Protection This clause can be vital in protecting your investment as it maintains the conversion price of stock, keeping it from being reduced to a price equal to the price per share paid in a later down round. Right of First Refusal To keep a tighter grasp on those investing in the company, you may want the right to purchase shares held by other angels in the deal before they are sold to an outside party. This clause will allow you to consolidate ownership. Liquidation Preferences This clause should always be present to prevent the entrepreneur from selling early at a loss to the investor. The term communicates that the angel wants the option to get his investment back or negotiate ownership, whichever is more. [2]

Co-Sale Rights This term enables investors to avoid missing out on opportunities to liquidate their shares. The founders or a sub-set of the companys shareholders cant secretly find buyers willing to pay a high price for their shares and engage in the transaction without giving their VCs the right to participate.

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