Monday, November 3, 2014

Private Equity Term Sheet Tutorial

We have covered a number of financing vehicles that are commonly used by startups at the seed stage; namely the convertible note, safe investment, and to a lesser extent promissory notes.   Companies that have progressed beyond their seed investment and are ready to raise a venture round will do so by issuing preferred stock.

This is because all startup investors require protection, privileges, and control not afforded by common stock.  These assurances are made part of a preferred class of stock issued by the company under mutually agreed terms between the investor and startup.
If it is the startup’s first venture round, the shares will be termed Series A Preferred Stock.  The next round would be Series B, then Series C, etc.  Every VC fund has a preferred equity term sheet template that is modified as needed for the specific startup situation.  In practice, these terms have become somewhat standard in the industry.  The process of raising capital is as much about building a relationship as it is about getting cash to grow.  A lot of discussions happen before a VC presents a term sheet to an entrepreneur.  But when the major terms have been agreed to, a VC fund will extend their list of preferred stock terms in a “term sheet” to the company.
The term sheet is like a letter of intent and typically 5 to 8 pages.  It describes the nature of the investment, the amount of control the investor will have, what happens if the company shuts down, how more stock can be acquired, conversion or sale of stock, and additional protective provisions.  The terms under which a VC fund invests in a company are  discussed during the fund raising process but things do not progress to the term sheet stage unless there is general consensus on price, board composition, liquidation issues, and anti-dilution.  The term sheet is used to agree on the investment process, time frame, and structure of the underlying security to be issued.  Term sheets are signed by the company and investor with the intent to conclude final due diligence, legal paper work, and funding within typically 30 to 45 days.
The term sheet is not the binding legal agreement that memorializes the transfer / purchase of stock and additional provisions in the term sheet.  Rather, the term sheet spawns legal paperwork in several areas that does memorialize the terms.  Once signed, a preferred equity term sheet will at least require an update to the company Articles of Incorporation and will also cause the creation of several other agreements including Stock Purchase Agreement, Investor Rights Agreement, and Shareholders Agreement.  Different law firms have different ways of implementing the terms and some will also add specific agreements for key terms such as a Right of First Refusal Agreement and Voting Rights Agreement.  The point is that the term sheet leads to a set of closing documents that implement the clauses in the term sheet.  Collectively these are anywhere from 1.5 to 2 inches of paperwork generated by the company’s law firm and reviewed for accuracy by the investor’s law firm and investors.
Generally speaking as a company grows and issues follow on rounds of preferred equity (Series A, Series B, Series C, etc…) the terms of each subsequent offering pile onto the terms of the previous round.  In some cases follow on round terms are “pari-passu” (i.e., equal footing) to prior rounds and in other cases not.  It depends on the specific situation, company progress, and investor involved.  This can make Series C, D and E rounds more complicated as terms pile on.  But, in the case of a Series A and even Series B, terms tend to be pretty common and straight forward.
Still, it can be hard for first time entrepreneurs to try and figure out what a term sheet looks like, what terms are standard, and what are the key points to focus on.  Serial entrepreneurs are more facile at this as are CEO’s that have raised several rounds and are experienced on what to expect.  We work with a lot of first time entrepreneurs and therefore put together this tutorial to prepare entrepreneurs so they can get going with the discussions without feeling apprehensive.  There is a lot of information available on the web that discusses details and differences of terms noted below.  So, we didn’t list a definition for each term.  Instead, this tutorial walks through the major categories in the preferred equity term sheet and talks a bit about the primary term areas of price, board composition, liquidation, and anti-dilution.  Ninety percent of Series A and B term sheet discussions revolve around these terms.
1. Price:  Preferred investments are priced rounds.  That is to say that a value will be placed on the company and shares of that preferred round.  Pricing terms include the valuation of the company prior to the investment, the price per share of the preferred shares, the amount of preferred shares to be issued, and who will the preferred shares be issued to.  Pricing discussions will also produce a capitalization table that will list the total fully diluted shares and who will own what at the end of the investment.  For example, a Series B term sheet will list the founder shares, employee stock plan, common share holders, Series A preferred holders, and Series B preferred holders.
2. Board composition:  The board of a company collectively decides on major company issues such as strategy, expenditures, budget, financing, and issuance of additional stock.  Most Series A and B investors will want a board seat so they can manage their investment and represent their ownership interests.  Board members vote on major company issues.  Votes are typically weighted based on company ownership.  For example, a Series A investor owning 20% of the company post investment will have a vote that equates to a 20% say.  There’s a lot written about good balanced board composition.  A common approach looks like two co-founders representing the common share holders, an independent board member, and one board member representing each class of preferred (i.e., a Series A board member, a Series B board member, etc.).  It is not uncommon for later stage board members to be board observers.  Board observers participate in board meetings and have access to much of the same information as board members but do not have voting rights.  Where this line is drawn is individual to the company but commonly happens at Series C and later.
3. Liquidation Preference:  In case a company needs to shut down the remaining assets are distributed to the shareholders.  This is commonly done in rank order where debt holders have first claim, then preferred share holders, and common being the last to collect.  Preferred share holders will ask for a liquidation preference that defines where they rank and how much they can collect.  Investors will ask for at least a 1X liquidation preference.  This means they will have a right to receive 100% of their investment back.  It is common for liquidation preference to be negotiated at 1.5X and can go up to 2X.
4. Anti-dilution Provisions:  This is the last major area of discussion.  As part of a preferred round an investment is made at a dollar per share for a certain percentage of the company.  Investors are very sensitive to this percentage and require corrections should dilution happen.  Dilution can happen in two ways: issuance of more stock, an expansion of the employee stock plan, or a drop in valuation that provides other investors an opportunity to acquire a percentage of the company at a lower price than prior investors.  In either case, investors will ask for anti-dilution protection.  Several methodologies are used (broad based weighted average, narrow based weighted average, and full ratchet).  Broad-based weighted average is the most common.
Once a hand shake agreement has been reach on these major deal points and both parties are still enthusiastic about the investment relationship, the VC fund will present a term sheet to the company for signature.  Signing the term sheet initiates the final due diligence and legal paper work.  Due diligence is lead by an investor from the VC fund.  The legal paper work is generated by the startup’s law firm.  Once due diligence is completed and legal paper work is signed off, funds are wired from the VC fund to the startup company’s bank account.  At that point the round has closed.   The overall process is summarized in the private equity process / work flow graphic below.

“We’ve looked at private equity terms sheets for a number of transactions,” says Marc Theeuwes, former venture capital investor.  “There is a loose consistency in how they are organized and conceptually the terms can be grouped into four key areas: the security, investor rights, shareholder rights, and protection.”
The four main private equity term sheet areas are:  (1) the parties, type of security, and price, (2) what rights do the investors receive, (3) what rights do the share holders receive, and (4) what protections are included.  These term sheet areas align generally with the legal documents that are generated to memorialize the investment including:   Articles of Incorporation, Stock Purchase Agreement, Shareholder Rights Agreement, and Investor Rights Agreement.  The term sheet is very useful because it ensures that all the important issues are called out, discussed, and negotiated prior to costly legal activities.
The four main categories are listed below.  While not always called out in this order or groupings, they are related by function and intent, and are common in most preferred equity term sheets.
1. Offering / Purchase / Process Terms:  The top section often termed preferred equity or offering terms will list the nature of the transaction, parties involved, and core terms of the security.
This section includes the Issuer (Startup),  type of security (e.g., Series A Preferred), Investor (VC fund, funds, other investors), Amount of Financing (e.g., $5M), Purchase Price ($0.5000 per share), Pre-money valuation (e.g., $8M), Post-money valuation (e.g., $13M), Capitalization (referring to a cap table showing ownership at close).  This section also calls out Liquidation Preference, Dividends, Conversion (automatic, optional), and Anti-dilution adjustments.  Additional terms can include warrants and interest rates (if any).  These terms are transferred from the term sheet into a Stock Purchase Agreement and the updated company Articles of Incorporation.
The term sheet also contains terms specific to the process and close of the investment.  These commonly include Close date (target date to complete the financing round), No Shop / Exclusivity (agreement to not seek venture funding during the round closing), Expenses (agreement by company to pay for legal cost of closing), and Confidentiality (agreement to keep the round and information confidential).   These terms are also incorporated into the Stock Purchase Agreement.
2. Share Holder Rights:  Share holder rights contains terms that cover transfer of stock, board composition, and voting.  The term sheet will call out specific terms on pro-rata, right of first refusal, co-sale rights, drag along right, pre-emptive rights, redemption rights, board composition and voting, and rights upon acquisitions (usually reserved for strategic investors).  These terms are typically transferred from the term sheet into the Shareholders Agreement.
3. Investor Rights:  These terms define rights of the investor, provisions on transfer of shares, and certain protective provisions.  The term sheet spells out Information Rights (access to information on a timely basis), Right of First Offer (ability to acquire more shares), D&O Insurance (agreement to issue Directors and Officers liability insurance), and Common stock vesting (agreement on common stock vesting policy).  Also included in the investor rights area is a broad set of terms called Registration Rights.  This common group of terms details how the company will register the shares so that the investor can sell them (most commonly at an IPO). This group includes definitions for Registrable Securities, Demand Registration, Piggyback Registration Rights, Registration on Form S 3, Registration Expenses, Assignment of Registration Rights, Lock-up Agreement, and Termination of Registration Rights.  These terms are transferred from the term sheet into the Investor Rights Agreement.
4. Protective provisions:  Protective provisions are a group of terms that limit the ability of the company to take actions which may adversely affect the investors and provides investors with some control and veto abilities.  These provisions state that the company cannot proceed with certain actions without the majority vote of the preferred share holders voting as a group.  The most common actions called out are:  transactions (i.e., Sale of the Company’s assets, Acquisition with cap, IPO), raising capital, altering any rights of preferred stock, changing the number of preferred shares (issuing more or reverse split), issuing securities with preference or parity over the preferred, changes to board (members or number of members), amending articles of incorporation with material affect on preferred, approval of company budget, operational plans, and debt and credit policy. These are transferred from the term sheet into the updated Articles of Incorporation.
In summary the term sheet details the parties involved, type and price of the security, what rights do the investors receive, what rights do the share holders receive, and what protections are included.  These are the four primary categories of terms common to preferred equity term sheets and are summarized in the preferred equity term sheet summary table below.