Negotiating Venture Capital Term Sheets
Larry Kane, Partner, Orrick April 21, 2015 1
Terms for Venture Financing: •Series A as a precedent for future rounds •Institutional Venture Round versus Angel Round •Pick your VC Carefully– you will be partners on the business going forward •Pre-Financing Strategy (No Legal Risks) Proper Organization and Documents IP Documents (CIAA, Assignments of IP, Patents) Stock Options with 409A Stock Issuances to Advisors Series Seed/CN Securities Law Filings EXECUTED DOCUMENTS
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Terms for Venture Capital Financing: Principal Term Sheet Purposes: • • • • •
Guides to Drafting• Even if not binding- parties will look to term sheet Sets the Valuation (Pricing) • Participating Preferred Alters the Valuation Management of the Company Going Forward Investors Rights Exclusivity Period/Timing From Signing to Close – expect 3 to 5 weeks from signing of term sheet to closing No shop – Need to give your self flexibility to Raise Cash to get to Next Financing if Deal Does not Close Diligence Period Drafting Period (Who Drafts) Costs – Company pays legal fees for investors plus your fees Expect company fees to be 2x to 3x investor fees (depends on how clean the company is and how many angel investors, etc). Investor may need to call capital which may take 15 days Offshore Investors may need a few weeks to get government and banking approval
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Terms for Venture Capital Financing: Venture Capital Terms •Pricing/Valuation Initial Valuation and Capitalization Liquidation Preference Dividends Anti-dilution Protection Rights to Participate
•Management Controls Board Rights Protective Provisions
•Liquidity Events Registration Rights Co-Sale/Rights of First Refusal Drag Along Rights
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Terms for Venture Capital Financing: Type of Security Convertible Preferred Stock (not Common Stock) •Convertible Preferred Stock •Senior to Common Stock
Converts into Common upon certain events
Receives Dividends [if and when declared] – very rare
Protective Rights
•Convertible Note, Series Seed and Convertible Equity
Angel/Small Rounds – generally less than $1.0 million
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Terms for Venture Capital Financing: Round Size and Valuation • Amount Raised More investment = more dilution (sometimes easier to raise more) What does your company plan to do with the money raised? Keep Flexible
•Pre-Money Valuation • Are Convertible Notes Pre-Money?
• Pro- Forma Capitalization
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Terms for Venture Capital Financing: Valuation/Capitalization Structure •Valuation is Generally based on Fully-Diluted Shares Outstanding Shares Convertible Securities (options, warrants) Not pure authorized shares Watch for dilutive shares being added to pre-money shares
•Generally Need to Include: Founders Stock (vesting often required) Advisors/Partners Available Employee Stock Pool (10-20% after deal) Convertible Equity/Notes
•Warrants/Stock Granted to Third Parties
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Terms for Venture Capital Financing: Pro-Forma Example Assume $7.0m pre-money valuation and $3.0m of new cash for a $10.0m post-money valuation with a 20% option pool: Post-Money Cap Table: Founders
50.0%
Option Pool
20.0%
New Investors
30.0%
Total:
100%
What about Convertible Securities and discounts? PAY ATTENTION TO VOTING PERCENTAGES VOTING = CONTROL
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Terms for Venture Capital Financing: Return on Investment/Power boosting the Investor Returns • Dividends Cumulative vs. non-cumulative dividends Generally, non-cumulative dividends are never paid as they are payable only “when and if declared by the Board of Directors” East Coast VCs with Private Equity Background look to Cumulative Dividends Generally set around 8.0% per annum – can be used in redemption provisions Cumulative may be treated as debt for accounting • Liquidation Preference -Paid on Sale of Company “Preference” = preferred stock’s down side protection. “Participation” = changes the valuation Cap on participation = making lemonade out of lemon
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Terms for Venture Capital Financing: Return on Investment - Redemption • Redemption – not overly common but at leas 5 years May force sale of the Company like Drag Along Return is often similar to liquidation preference but with a hurdle Timing for redemption – the further out the better Triggers for calling a redemption – the more difficult the better
Installments – the more the merrier as it may not require sale of the company
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Terms for Venture Capital Financing: Conversion • Optional Conversion Preferred stock is convertible into common stock at any time.
• Anti-dilution Provisions -if you sell stock at a lower price in the future Full ratchet vs. weighted average anti-dilution adjustment Broad based vs. narrow based weighted average anti-dilution adjustment Some variable in the weighted average formula Exceptions for Non-Financing Offerings
Stock Options (watch for caps)
JV and Commercial Agreement
• Mandatory Conversion Triggers for mandatory conversion – IPO or vote by the preferred stock Percent preferred vote necessary to trigger conversion
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Terms for Venture Capital Financing: Control Mechanisms & Board Composition • Voting Rights • Generally votes with Common
• Board Composition (Voting Agreement) Generally expect 5 person board with 2 from VC; 2 from founders one of which is CEO and one independent Preferred stock votes with common stock on an as-converted basis Board seat designation rights of preferred stock Expect a CEO board seat Expect Independent director board seat (how determined) Under Delaware law, certain Directors can have more than one vote
• Board Observer Rights
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Terms for Venture Capital Financing: Control Mechanisms & Protective Provisions • Investor vote required for Key Decisions: • Pay Attention: Board versus Shareholder Approval: Authorize/Issue new Preferred Stock Amending the terms of the existing Preferred Stock Grant options beyond a certain limit Amend the charter Sell the Company – exit events No Additional Debt Change in the Business Key Hires Acquisitions
• Be careful on the percentages and multiple investors holding separate vetoes • Remember, these terms can slow the management of a company. 13
Terms for Venture Capital Financing: Liquidity Events • Drag Along: Investors can force Common Stockholders to participate in a sale of the Company Triggers for activating the drag along Conditions for enforcing the drag along Preferred and Common have different exit outcomes: oRequire High Percentage of Approval at Shareholder and Board level o
• Pay to Play Requires Investors to Keep Investing or conversion into Common Triggers for activating the pay to play Consequences for failure to pay
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Terms for Venture Capital Financing: Investor Rights: Investor Rights • Registration Rights Common Rights – Don’t spend too much time on this Demand registration = forcing function for your company to go public S-3 registration = short form registration for eligible issuers Piggyback registration = investors tagging along company registration Lock-up = absolutely necessary for company to retain underwriters
• Information Rights Reserved for “Major Investors” Financial statements – annual, quarterly, monthly; audited vs. unaudited
budget
cap table
Visitation rights – conditions for exclusion
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Terms for Venture Capital Financing: Investor Rights (Continued) • Preemptive Right (Right to Participate) Common right for investors to maintain ownership Standard Right for “Major Investors” Calculation of pro rata share Excepted company issuances Accredited Investors Lose if they don’t exercise?
• Negative Covenants Ordinary course of business items vs. extraordinary events Dollar threshold
• Affirmative Covenants Non-compete, non-solicit, non-disclosure and inventions assignment Board matters Option vesting Key person and D&O insurance 16
Terms for Venture Capital Financing: Transfer Restrictions • Right of First Refusal and Co-Sale on Sale of Stock of Founders and Existing Stockholders Restricted parties Participants Excepted transfers
• “Reverse vesting” / vesting resets Customary Terms for Founders- best to have in place prior to deal 4 year vesting with credit for time served with double trigger on change of control and acceleration on termination without cause
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Terms for Venture Capital Financing: Exclusivity and Other Terms • Closing Conditions
All Consultants/Employees Sign CIAA
Employment/Vesting Agreements with Founders (structures exit of Founder)
Legal Opinion
Shareholders all signing voting and ROFR Agreement
Amendment of Charter
Representations True and Correct
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Terms for Venture Capital Financing: What About Strategic Investors? •
Great For Market Valuation or Acknowledgement
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Often Tied to Strategic Business Deal / Active Business Purpose
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Beware of Access to Confidential Information and Conflicts of Interest
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Thank You!
CONTACT Larry Kane Partner, Orrick’s Technologies Companies Group
[email protected] (415) 773-5827
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