Category: Term Sheets
Jeff Bussgang from Flybridge has today’s great VC post titled In VC deals, Price Doesn’t Matter – But The "Promote" Does. While I personally dislike the phrase “promote” to describe the concept Jeff is describing (I think “founders post-deal ownership value” – or FPDOV – is a much better phrase, although I realize “promote” is catchier.)
If you are an entrepreneur negotiating a VC financing, you should read this post carefully. Jeff does an excellent job explaining one of the key ways that VCs outnegotiate entrepreneurs while making the entrepreneur feel good about the outcome.
Today, our friends at Techstars posted their model forms of seed financing documents.
There are five primary documents in the set:
Of course, these are just example documents so all legal disclaimers about usage apply (e.g. “do with them what you want, but we take no responsibility for your actions.”) That said, I think these are a great starting point for anyone doing an early stage financing.
Q: Can you please explain what sort of adjustments you should expect to the price that a VC promises in a term sheet between the signing of the term sheet and signing of a final stock purchase agreement (SPA)?
A: (Jason) To answer your question, we first need to determine what the definition of "price" is.
I don’t care what price per share I pay. It’s an irrelevant number. What’s relevant is the pre-money valuation. That, along with my investment will determine what percentage of the company that I own post investment. For more on this, see this prior post.
If the question is "how often do I see the pre-money valuation change from term sheet to SPA" that answer is almost never. Only in rare cases of something material happening to the company, I tend to think "a deal is a deal." If something that bad happens to warrant a price change, it’s probably more likely that the entire deal falls apart.
The only other situation that could potentially change the valuation / price is if something is found in diligence that wasn’t known to the VC at the time of term sheet. For instance, if founders have deferred salaries or have debt that need to be paid back and a large chunk on the financing is going to be immediately used, this too might change the economics.
If you define price as the "price per share" (not having anything to do with valuation), then I would tell you that I think EVERY deal that I’ve been involved with has had a price adjustment during this period. The price per share is based on the outstanding equity of the company and rarely does this get 100% figured out until right before closing.
Q: Thank you very much for your term sheet series. Not being that familiar with "specific" term sheets, I have heard something about VC terms that effectively allow the VC to fire the founder(s) and in the process relieve them of their shares since they had then left the company before liquidity. I have read a previous Ask the VC post about the ‘moral’ and ‘reputation’ reasons that VC’s will not do this.
However I am more interested in the legal binds and would like to know if these sort of terms are something that is standard/negotiable in various term sheets.
A: (Jason). There is certainly nothing in a standard term sheet that specifically addresses this. I’ve seen founder / CEO termination clauses in term sheets that effectively say "if X, Y and Z doesn’t happen, you are fired." I’ve always found these to be egregious and worse yet, sets up the VC and founder / CEO to be enemies, not collaborators trying to help the company be successful.
As for different mechanics that a VC might use to remove a founder / CEO / founders, etc.:
1. Board control – if the VC has board control, or the ability to elect a majority of the board, terminating founders and / or executives is fairly simple;
2. Voting rights – be careful that there aren’t any non-standard control provisions in the voting rights that allow the VCs to vote people "off the island."
As far as acquiring the terminated party’s shares, I’ve never seen a VC with a contractual right to be able to do this. I’ve seen some documents which gives the shares back to the company, but never the VC.
And shares going back to the company is rare as well, so long as we are talking shares that have vested under a option plan or are not subject to some sort of repurchase. Those shares should be free and clear the property of the terminated party.
Q: Is it customary for an equity investor to have a veto right over future investments that are at parity or senior to that series? Do you see it often? Do you ever see it limited by the percentage ownership (e.g. if the series becomes a less than 10% shareholder, the veto right goes away)?
A: (Jason) It is customary. In fact, most times the previous investor gets a veto right on all equity financings, senior or junior and in some cases even debt issuances. This is one of the “standard” terms that Brad and I blogged about in our term sheet series regarding the protective provisions section of financing documents. As for a limitation, yes, it’s not unusual for the term to go away if X% of the preferred outstanding at the time the provision is adopted remains outstanding. What is X? I’ve seen anywhere from 25-75%. 50% seems to be non-controversial.
Note also that beside the veto right, the prior investors will also have a right of first refusal to participate in whatever financing you are contemplated. Here’s our prior post on the subject. So while they can say “no” to a financing, they can also say “yes” and either participate or not.
None of this is “as bad as it sounds.” Remember, the VCs are going to want money to come into the company, if appropriate. Without it, the company (and their investment) will not be worth much. When it typically gets to be a problem is when a company raises several different rounds of capital and each series of stock has a separate veto right, instead of an aggregate veto right across all preferred. There have been situations where a new / contemplated financing round is good for some of the prior investors and bad for others. In this case, separate veto rights can, indeed, cause a problem.
Q: We have an interested Angel for an investment in our startup LLC. We have a strong lawyer for support. We’d like to submit a draft Term Sheet to, as you say in your blog, “control the paper”. Everything I find online about Angel Term Sheets contemplates shares, which presumes a corporation (vs. an LLC). We expect to give secondary (non-voting) membership as well as putting the investor on an Advisory Board. Can you point to resources that are more appropriate to an LLC structure?
A: (Brad) Your lawyer should be able to quickly crank this out. There’s nothing special about it – just slightly different language given the notion of “members” vs. “shareholders” and the difference in how members rights are allocated / delineated. I don’t know of any generic forms online, but if your lawyer doesn’t have this in a boilerplate form, I’d recommend you revisit the notion that you have “a strong lawyer for support.”
Q: Can you explain what supra pro-rata is? It seems to be showing up in some VC term sheets now. What’s the impact on the entrepreneur? How hard should one try to negotiate it out? If a VC insists on this term, should the entrepreneur walk away?
A: (Jason) First of all, for those of you who want a refresher on pro rata rights, see our prior post on it here. As for what is “supra pro-rata” it is a multiple of a 1X pro rata right. So, if I own 10% of the preferred, I normally will have the right to buy 10% of any future securities issued by the company. With a supra pro-rata right it is normally 1.5, 2 or 3X. In our example, a 2X supra pro rata right would allow me to buy 20% of the next round.
This isn’t a very common term, unless you are dealing with very early / seed stage financings. You’ll see in some cases where a VC seed funds a deal with a small amount of money. It is normally the intention of the VC to lead the first real venture round, but in order to protect itself (in case the entrepreneurs decide to take funding from someone else), the VC will ask for a supra pro rata right. Although the seed deal doesn’t represent a lot of money, it does represent a lot of the VCs time, so they want to make sure that they can stay in the deal.
If your financing is a “regular” full blown round, then I would say this is a rare term.
As for my advice on “walking away,” there are very few terms that I consider “walk” terms. If you need the money and don’t have other options, get the money.
(Because I know that I’ll get the question, if I was on the entrepreneur side, I’d walk from poor valuation, overly aggressive liquidation preferences, over bearing board and voting controls and VC board members who expect compensation to join your board).
Last week I attended a dinner put on by Ed Zimmerman and the fine folks at Lowenstein Sandler. Ed has been an active participant in the NVCA model documents initiative and I’ve gotten to know him through the years as someone who is passionate about what he does, which among other things, is law and collecting wine.
With all of the questions that we get regarding term sheets, I thought some of you might enjoy Ed’s take on what makes the “perfect term sheet” which served doubly as our dinner menu the other evening.
Q: Have you experienced a company which grows along nicely, but does not offer a liquidity event? In the funding agreement, there is a clause for redemption rights. Is this used so that the VC can get out of the investment?
A: (Jason). Yes, we’ve experienced companies growing nicely without liquidity events. And yes, we usually request redemption rights in our deals. That being said, we’ve not exercised them.
(For a primer on redemption rights, see our prior post)
So why ask for them? Theoretically, one can come up with a situation where a fund is late in life (funds are usually 10-12 years in term), you have a nice company, but no liquidity. In this event, it’s nice to have an “out” to get liquidity, or to have some leverage to have some control on the situation. That being said, redemption rights are pretty benign. They look scary, but I would hazard to guess that few VCs, if any, have ever actually used them.
I’d equate redemption rights similarly to registration rights: VCs rarely use them, but if you need them and didn’t ask for them, you are a chump.