The Venture Capital Financing Process: Term Sheet Negotiation. Presentation for entrepreneurs on the legal process of term sheet negotiation with Venture Capitalists.

1. © 2014 Valla & Associates, Inc., P.C.
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Majda Barazzutti
July 23, 2014

2. THE VENTURE CAPITAL
FINANCING PROCESS:
TERM SHEET NEGOTIATION
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ENTREPRENEURIAL JOURNEY

3. Financing is a Staged Process
 Common Stock
 Bootstrapping
 Friends and Family
 Angels: Equity, Warrants, Convertible Notes
 Series seed financing
 Series A Preferred (B, C, etc.)
 Liquidity Event
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4. Convertible Debt
 Bridge loan before financings
 Useful when the company does not have a
satisfactory valuation
 Risks of repayment feature
 No minimum capital but insolvency changes the
rules
 Better include a provision to force conversion
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5.  Warrants: option to purchase company shares
at a price within a set period
 “Kicker” to increase the potential investment
value
 Warrants increase in value as the value of the
underlying shares increase in relation to the
exercise price
 Usually issued with bridge financing
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Warrants

6. Alternatives: Strategic Investors
 Aims Differ
 Not Interested in Helping the Company Grow
 Conflict of Interest: greater returns from
commercial rights than growth
 Expertise
 Could affect future VC financings
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7. Venture Capital
 Identify the Right VC
 Due Diligence
 The Risk of “Finders”
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8.  Prior to Investing:
 Document Employees
 Founders Relationships
 Securities filings
 Confidentiality and Invention Agreements
 Prepare for VC’s due diligence
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“Clean Up”

9. Preferred Stock (Series)
 Why Preferred?
 Liquidation Preference
 Preserve a low common stock value for option grants
(ratio 1:4 to 1:8):
 Common Stock was bought at cheap price, $0.10
to founders.
 If Common were sold at same time at $5.00 to
VC, tax consequences for founders.
 No limits to Preferred/Common ratio
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10. Sample Term Sheet
 Binding Provisions:
 No Shop
 Confidentiality
 Applicable law
 ALL other provisions are not binding
 See examples: NVCA (http://www.nvca.org)
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11. A Typical Term Sheet
 Valuation/Number of Shares/Price
 Liquidation Preference
 Redemption
 Conversion
 Vesting of founders’ stock
 Antidilution
 Voting Rights
 Protective Provisions
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12. Valuation/Price
 Pre-money/Post-money valuation: Option pool shuffle
 How are your shares valued?
 8M pre-money valuation, 6M shares outstanding
 $8M pre-money ÷ 6M existing shares = $1.33/share, right?
 WRONG: The share price is $1.00
 WHY? Read the term sheet: “The $8 million pre-money
valuation includes an option pool equal to 20% of the post-
financing fully diluted capitalization.”
 $8M pre-money ÷ (6M existing shares+2M options )= $1/share.
 Pre-money valuation includes an unallocated option
pool for new employees -- lowering pre-money valuation
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13. Liquidation Preferences
 Liquidation Preference: 1x or more – 2x, 2x
 Participating Preferred:
 Straight/Non-participating 67%
 Full participating (double-dip) 19%
 Capped participating 14%
 Preferred has the option to convert into Common
 Interaction of various series: First pay B, then A, then
all; all participate equally, etc.
 “Deemed Liquidation”: good times and bad times
 Not an IPO
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14. Dividends
 No expectation of dividends, but:
 Cumulative Dividends: __ % cumulative dividend accrues over
time, whether or not the company declares it - PLUS participation
with Common Stock on an as-converted basis.
 Non-cumulative Dividends: “An amount equal to $[_____] per
share of Series A Preferred when, as and if declared by the
Board”
 PIK (payment-in-kind) dividends. Company option to pay
accrued and unpaid dividends in cash or in common shares
valued at fair market value.
 Usually payable on liquidation or redemption, not conversion
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15. Redemption
 Optional (Company call):
 Company can repurchase stock at original price (plus
dividends) if Investors don’t convert to Common after x years
 Mandatory (Investors Put)
 Investor can force Company to repurchase shares after x
years – beware of redemption premium
 Guaranteed exit path for VC if Company is “successful
enough”
 But, Company must have legally available funds
 22% of all VC financings in 2012, 35% in down rounds
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16. Conversion
 Preferred always has a conversion to Common feature,
but loses all preferred privileges
 Optional Conversion
 Automatic Conversion: IPO
 Conversion Ratio is initially 1:1, modified based on
anti-dilution provisions
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17. Anti-Dilution
 Protect investors if company issues equity at a lower
valuation than preferred
 Full Ratchet 3%
 Weighted Average: Broad Base: more favorable 92%
 Weighted Average: Narrow Base: less favorable to
company 4%
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18. Exclusions from Dilution
 Carve-outs from anti-dilution:
 Options grants to employees, consultants (negotiate
all or only authorized pool)
 Warrants to lenders (approved by majority vs.
unanimous board approval)
 Warrants to service providers, strategic partners
 Shares issued in mergers / acquisitions
 Exercises or conversions of current stock or grants
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19. Other Terms:
 Vesting of founders’ stock, acceleration
 Right of first refusal: new issuance and
transfers by founders
 Employee pool
 Co-sale agreement (drag along, tag along) :
force a sale
 Registration rights
 Board Control
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20. Other Terms:
 No-shop agreement
 Information rights
 Confidentiality
 Indemnification
 Counsel expenses up to ___
 Lock-up provisions
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21. Bottom Line
 (Almost) anything can be negotiated
 Pick your battles: Liquidation Preferences,
Protective Provisions, Board Control
 Make sure you understand what you’re signing
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22. Thank you
IN BOCCA AL LUPO!
Valla & Associates, Inc., P.C.
1990 N. California Blvd., Suite 1060
Walnut Creek, CA 94596
USA
E-mail: majda.barazzutti@vallalaw.com
Phone: +1 925 705 7623 Fax: +1 925 705 7629
www.vallalaw.com
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