13 Apr Capital-raising term sheets for angels and venture capitalists
Editor’s note: Matt Storms is writing a series of articles on raising capital from investors. This installment focuses on the term sheet.
Most of the time when raising equity capital, the offering terms are summarized in what is referred to as a term sheet. When dealing with angel investors, it is typical for the company to produce the initial term sheet.
Sometimes prospective angel investors will want to negotiate the initial term sheet, especially if one of the prospective investors has taken on the role of lead investor. For a variety of reasons, companies need to be careful not to fall into the trap of negotiating with each prospective investor.
Elements of an angel-deal term sheet
In a financing with angel investors, the terms of the deal are often rather straight forward. Typically, the security being offered is either common stock or a “stripped down” preferred stock, meaning preferred stock that has a basic liquidation preference but few other rights. The angel term sheet will typically contain at least the following:
• A description of the security being sold.
• The price for the security.
• The company pre-money valuation.
• The minimum (if any) and maximum amount to be sold.
• Basic information about the issuing company (e.g., whether it is a corporation or limited liability company, the state of incorporation/organization).
• The current cap table.
• Any applicable security transfer restrictions.
The term sheet can also contain other provisions that address issues such as board representation, veto rights over certain types of transactions or conduct, co-sale or tag-along rights, drag-along rights, dividends, put rights, piggyback registration rights, and anti-dilution provisions.
Once the term sheet is “finalized” for the deal with angel investors, it often becomes an important element of the issuing company’s private placement memorandum.
Venture capitalists (VCs)
When dealing with VCs, in almost every case, it is the VC who prepares the initial term sheet. Unless the deal is very small, VCs commonly invest in small groups (e.g., two or three firms), with one VC acting as lead. The lead VC will typically present the term sheet, and the company will have a relatively short time period to accept it (in an attempt to prevent the company from “shopping” the deal).
Elements of a VC term sheet
VC term sheets are complex. This last fall I was a guest lecturer for a University of Wisconsin MBA class in which the subject matter was VC term sheets. I was amazed at how difficult it was to summarize in an hour (beyond just a cursory level) the key elements and variations in VC term sheets. Below is a list of issues that are often included or addressed in a VC term sheet. This list is an addition to the items listed above for an angel term sheet.
• The conditions to closing the investment.
• Closing date.
• Identity of investors.
• Dividends (the percentage and whether they are cumulative or noncumulative).
• Liquidation preference (e.g., amount and whether the security is participating preferred stock or non-participating preferred stock).
• Board representation (e.g., single board representative or control).
• Protective provisions.
• Conversion rights.
• Anti-dilution provisions (weighted average or full ratchet).
• Pay-to-play provisions (assuming more than one VC is participating).
• Redemption/put rights.
• VC legal expenses (shifting costs over to the company).
• Demand registration, S3 registration, and piggy-back registration rights.
• Management and information rights.
• Participation or pre-emptive rights.
• Employee stock option requirements and limitations.
• Tag-along and drag-along rights.
• Confidentiality/no shop requirements.
The above list is far from being an exhaustive list. Upon acceptance of the term sheet, the VC’s lawyer typically steps into the process (if he or she had not already done so at the diligence or initial term-sheet stage). The VC’s lawyer typically produces the initial drafts of the investment documents.
Sometimes a company seeks only a small financing to cover current cash flow needs until a larger financing, public offering, sale of the company, or other event gives rise to a sufficient revenue stream for the company. In those types of situations, companies often seek what is referred to as a “bridge financing.”
While there are a variety of different structures for bridge financings, a common bridge financing involves a convertible note. The typical term sheet for this type of bridge financing is somewhat similar to an angel financing term sheet. However, the note is typically converted into the security that is offered as part of the next financing or, if there is no next financing within a specified period, an existing class or series of stock. As an inducement, the convertible notes often have either a high interest rate, or what is referred to as “warrant coverage,” which entitles the holder to purchase additional common stock above and beyond what the convertible note is converted into.
A very good resource for a detailed form term sheet is the National Venture Capital Association website. The NVCA term sheet form can be downloaded. The form contains many good explanations of the various provisions in a VC term sheet. However, as you might have guessed with the authors of the form (VCs and their lawyers), the NVCA term sheet is drafted in a way that is generally more favorable to the VC than it is for the company or its founders.
I am a member of the American Bar Association Venture Capital and Private Equity Committee. Currently, we are in the process of providing additional commentary to the NVCA term sheet form. We intend to provide alternatives and additional provisions that are more company and founder friendly. Once we do, I plan to write a follow-up article on our end product. So, stay tuned!
Previous articles by Matt Storms
• Matt Storms: Translating the language of capital-raising
• Matt Storms: Securities compliance is part of raising capital
• Matt Storms: Raising capital through placement agents
• Due diligence and corporate clean-up
• Matt Storms: The mechanics of raising capital for your business
• Sarbanes-Oxley for the Rest of Us
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