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Updata Partners

 

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Clearstone Venture Partners

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When you hear the comment that this term sheet / shareholder agreement is an industry standard you should be very cautious. There are no standards. The phrase means that there are clauses that even the VC feels a bit uncomfortable presenting (or don't think that you will approve them).

You have a piece of paper or a spreadsheet that shows how much you own of your company, normally called a capitalization table. You may have common stock. You may have options. When you take a venture round, the capitalization table neither represents your ownership nor the allocation of shareholder value. Most of the terms that create the Preferred Stock for venture capitalists chip away at the value of common stock and options, so much so that, after a few rounds of investments, the value of common and options are largely worthless. Let's take a look at why and what can be done.

There are the obvious "big" preferred terms that eat away at shareholder value in most liquidity events, such as promising to re-pay the investment first through a "liquidation preference" and then allowing the venture investors to "participate" in the remaining value allocation. Another classic term is to place founder equity in escrow and force the founder to earn it back over years. Then, there are the slew of other terms that reallocate smaller chunks of value, such as cumulative dividends, redemption rights, ratchets, right of first refusals, and expense reimbursements. Finally, there are the many uncertain outcomes, such as allocating escrow to a preference waterfall, that force last minute negotiations where the preferred shareholders have control in many liquidity situations.

Here are some tips for a management team to retain value AND ownership through the process:

(1) Encourage competitive bidding among interested investors

(2) Raise more money than you need and limit the number of investment rounds to two

(3) Eliminate all secondary terms from term sheets and investment agreements

(4) Control a majority of the board under all circumstances

(5) Insist on executed employment contracts with equity and cash guarantees on liquidity

(6) Add mandatory preferred approval of liquidity offers at pre-defined prices

If other people have tips. add them below. It is about time that the capitlization table represents reality!

This is basic advice, applicable to any sales situation and a mistake people often make. If you are meeting a potential client (or investor) first make sure they are interested in your product (your company) and agree to go out again (meet again) and provide more background on yourself (your materials) before trying to to sneak into the bedroom and score (discuss terms). Often times terms come up early, I'd recommend saying "first lets see if we click before talking specifics" and drag it out a bit... a meeting or two .... before talking numbers. This way, you know there is an actual interest, potentially leading to a term sheet before entering any type of negotiation which can cause the whole thing to go sour if there is a disagreement. However, if you already are all over each other, you're more likely to settle the disagreement then storm away unhappy. This holds true for selling anything. First gain interest, then sell. Many people just jump the gun and try to sell before knowing if they customer wants anything and while it can work, it changes the tide of leverage.

This advice is applicable in most negotiations, but it is particularly important to heed in venture capital: don't accept your first offer.

Venture capitalists are betting that they can pressure you to take the terms that they offer, and there are countless stories told by venture capitalists about how they duped CEOs with below-market valuations, excessive control provisions, and aggressive economic terms. I have heard venture capitalists laugh out loud when mentioning a company name and sat on a call where a VC actually whispered the pre-money valuation that was below $1 MM, referring to it as "unbelievable."

Practically speaking, why would any venture capitalist make you a good offer in the first pass of terms" If anything, they will make the lowest reasonable offer and then aggressively pressure you to take it with only minor changes. The good news is that, once a venture capitalist has decided to invest, you now have the negotiating leverage.

Members, read on for some very specific advice...

Liquidation preferences are a key term in the definition of preferred stock (it's generally acknowledged to be the second most important economic term). Earlier, I wrote about this and other terms in a post on negotiating a term sheet, but here I want to give some specific examples to illustrate why this is such an important term.

You probably already know this, but it's worth repeating that liquidation preference refers to the procedure for paying investors off in a sale or winding up of the company. It typically includes two components: a preference (which is an amount that gets paid before others) and participation (the ability to "double dip"). Many folks have written on preferences in terms of definitions, so instead I'm going to give some simple examples.

For simplicity sake, imagine a VC has $10MM invested in one class of preferred stock in a company, owns 40% and the company is sold for $50MM. Here’s how the three different scenarios in my previous post work (in a specific example):

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:

[Sadly I couldn't get the table to format here. You can see the matrix on my blog at http://www.altgate.com/]

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:

So, most VC's will draw out the period between initial diligence and offering a term sheet. It's just part of the game. Every day that goes by is another day to judge your success or failure. However, when you get your first term sheet from a lead, it normally has a cascading effect to get other funds that you are talking with to move, either to be a follow-on investor to the first lead or to issue their own terms.

Members, read on for some tips and tricks to get that first sheet...

Most of term sheets added here have founder share vesting, but not mine. Here are a few good tips. First, you should negotiate hard on the number of years and the cliff. Nothing is "standard" with these deals. Second, try to get the VC to grant you "credit" for time served since company inception. Time served happens frequently with hot deals. Third, buy your initial shares with real money to justify your negotiating position. You are in a stronger position to reduce of eliminate the vesting if you have skin in the game.

Today Wilson Sonsini is launching an online term sheet generator. It's actually really cool and quite helpful in understanding the key terms. I actually got a sneak peak a few weeks ago and wrote a review here.

There is some similarity between this and the elections, so it's a good time to discuss this.

What does "Voting as a single class" means for you (and other small investors) " and don't get it wrong, you may be a big shareholder today, but you must think like the small shareholder you will be down the road.

Here is an example of how a VC with 20% of the shares can force a decision on all the other shareholders and investors, most of which are against that decision.

The lead VC has 20% of the shares (5% B shares+ 15% C Shares)
The lead VC wants to force a decision, the rest of the shareholders are 80:20 against it.

There are 30% series C shares and 20% series B shares. the rest are common and options (who don't vote).

The holders of the C shares vote first, the decision, forced by the lead VC wins (although 40% of the C shares are against). but all of them are now "voting together as a single class", e.g. casting all their votes in favor of the decision.

The holders of the B shares do the same, they are against the decision (80:20) they "vote together as a single class" against the lead VC.

Then there is a second vote. The "holders of the preferred shares", although most of the holders of the preferred shares are against, and although all the B shares votes are against the decision. All "the holders of the preferred shares" are now forced to vote for the decision.

Now all the preferred shares vote together for the decision, although most of the holders of shares and most of the investors were against it.

The VC, with it's 20% of shares, against the will of most of the other investors and most of the shareholders can force a decision.

Try and use the smaller VCs to remove this from the investment agreements.
They will tell you this is only inserted to simplify things, they will describe situations where some retired employee can influence the decisions and so on. Remeber, this is just another mechanism to give power to the biggest shareholder (who, in the long run, is not you).

Somehow when you see that little clause on the term sheet about an 8% dividend for the preferred shares, it doesn't seem that big of a deal at the time. But to put it in perspective, let's take a typical "success" story and see how that dividend affects the deal.

Imagine a scenario where a startup raises $14.5MM in 4 rounds (seed plus A, B and C) and that each round has the 8% compounding dividend paid on exit. Further, let's imagine the company sells for $75MM. Here's the cash flow:

[Once again, a table doesn't format here. Does anyone know how to insert a table using Textile or something similar" In the meantime you can go to http://www.altgate.com/ to see the table.]