14 Deadly Conditions of VC Term Sheets
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The term sheet is the most important document to negotiate with your investors. However, the excitement that comes from the arrival of the term sheet often serves as a distraction from the finer details — details that can cost you dearly in the future. For more on these terms, read more on our blog: https://timiacapital.com/blog/14-vc-terms-that-can-ruin-your-startup/
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14 Deadly Conditions of VC Term Sheets
- 1. October 2021 14 Deadly Conditions of VC Term Sheets
- 2. Expert Panel Join the conversation using #VCterms Mark Bakker VP Marketing TIMIA Capital @markbakker Andrea Blobel Pérez Marketing Associate TIMIA Capital Mike Walkinshaw CEO TIMIA Capital @talk_to_walk
- 3. Agenda ● Audience Poll ● VC Terms to Watch Out For ● Audience Q&A Join the conversation using #VCterms
- 4. Before We Get Started Join the conversation using #VCterms You’ll be sent an email with the webinar recording in a few days. Ask us questions! We’ll have a Q&A session at the end. Get involved! Answer the interactive polls throughout the webinar. Look for resources in the chat box during the webinar. Talk to us and your peers! Join the conversation on social using the hashtag #VCterms
- 5. Poll Join the conversation using #VCterms What Size is Your Company? ● <$1M ARR ● $1-5M ARR ● >$5M ARR
- 6. Poll Join the conversation using #VCterms What Terms Should We Cover? ● Board Seats ● Liquidation Preference of Preferred Stock ● Participating Preferred Stock ● Warrants ● Veto Rights ● Anti-Dilution Protection ● Right to Participate in Future Financings ● Stock Option Issues ● Redemption Rights ● Insurance Obligations ● Right of First Refusal ● Co-Sale Rights ● Drag-Along Rights ● Expenses of the Venture Investors
- 7. Join the conversation using #VCterms #1: Participating Preferred Stock Also referred to as a “double-dip” — this is a very expensive one-word add on to VC terms.
- 8. Join the conversation using #VCterms What could go wrong? ● Your exit sale price of the company is $30 million ● VCs invested $3 million in preferred stock at a 1X liquidation preference with participation ● The first $3 million goes to the VC to satisfy the 1X liquidation preference ● The remaining $27 million is split 50-50 (assuming VC owns 50% of shares) ● Founders/common shareholders receive $13.5 million and the VC would receive a total of $16.5 million.
- 9. Join the conversation using #VCterms What you can do ● Argue that it will hurt the Series A investors down the road ● If you’re forced to accept the term, negotiate for the participating feature to go away if the VCs receive back some multiple (e.g., 3x)
- 10. Join the conversation using #VCterms #2: Liquidation Preference of Preferred Stock Do you really know what this means or how it may affect the flow of cash when you sell your company?
- 11. Join the conversation using #VCterms What could go wrong? ● When the VC first invests, at a small amount, this liquidation preference may not seem so bad ● After multiple rounds of VC investment layered on top of each other, it is very common for common shareholders to be buried below $50M of liquidation preferences ● If your company doesn’t grow as expected, and you need to sell for a lower price, 100% of proceeds could go to the VC and 0% to management!
- 12. Join the conversation using #VCterms ● Hire a good advisor ● Negotiate an "either/or" — the VC should be forced to choose whether to get their money back via liquidation preference or go pro rata with the investors as a whole ● Execute on your startup’s plans, gain traction, and seek funding when you’re in a better negotiating position What you can do
- 13. Join the conversation using #VCterms #3: Board Seats It’s just a chair, right?
- 14. Join the conversation using #VCterms What could go wrong? ● Board seat allocation is aligned with share ownership ● In the beginning, investors may own 25% of the company’s stock and have 20 to 40% of the seats on the board ● In future investment rounds, they can own the majority of the stock and take majority control of the board ● Be careful of board seats combined with Veto or Voting Rights
- 15. Join the conversation using #VCterms What you can do Find a way to negotiate that the VC takes board observer rights in lieu of board seats.
- 16. Join the conversation using #VCterms #4: Warrants Option to purchase a certain number of shares (common or preferred) at a future date at a fixed price.
- 17. Join the conversation using #VCterms What could go wrong? ● Often used in early stage deals ● Sometimes in later-stage deals or strategic rounds to provide upside potential value to investors ● Unlike stock options, warrants tend to provide an option to purchase the most recent class of shares — at the founder’s expense
- 18. Join the conversation using #VCterms What you can do ● There’s not much you can do to escape warrants in VC ● Understand the value of a warrant when you grant it (i.e. Term, Strike Price, etc.) ● Seek out alternative growth capital to avoid warrants
- 19. Join the conversation using #VCterms #5: Veto Rights VCs may invoke veto rights in several scenarios
- 20. Join the conversation using #VCterms What could go wrong? VCs could stipulate blocking rights on a sale of the company OR on changing the direction of your business should you need to pivot.
- 21. Join the conversation using #VCterms What you can do Argue that sale veto right should not apply where the VC receives a minimum return on its investment (often 3x-5x).
- 22. Join the conversation using #VCterms #6: Stock Option Issue Do you really know what this means or how it may affect the flow of cash when you sell your company?
- 23. Join the conversation using #VCterms What could go wrong? ● Any increase in the option pool will come at your expense ● It will reduce your percentage ownership of the company
- 24. Join the conversation using #VCterms What you can do Produce a grounds-up budget for future options, estimating the options that will be needed for future hires until the next round of financing.
- 25. Join the conversation using #VCterms #7: Right of First Refusal aka ROFR
- 26. Join the conversation using #VCterms What could go wrong? ● Allow the company and investors to keep the founders’ shares within the existing shareholder base ● Prospective buyers will be less inclined to put effort into due diligence if an ROFR exists ● Deterrent to a founder attempting to sell her stock
- 27. Join the conversation using #VCterms What you can do Negotiate exceptions from the right of first refusal, for transfers to family members or trusts for estate planning purposes, and/or for the sale of small (5%-15%) stakes.
- 28. Join the conversation using #VCterms #8: Anti-Dilution Protection Founders will want to avoid the more severe full ratchet anti-dilution clause
- 29. Join the conversation using #VCterms What could go wrong? ● Reduced conversion price ● Inversed increase of conversion rate of early investors ● The more shares issued, the lower the price of shares and the greater adjustment to early preferred shares
- 30. Join the conversation using #VCterms What you can do Avoid full ratchet anti- dilution/death-spiral clauses
- 31. Join the conversation using #VCterms #9: Drag-Along Rights #10: Co-Sale Rights The right to force shareholders to participate/share in a sale of the company/shares
- 32. Join the conversation using #VCterms What could go wrong? Drag-along rights eliminate the current minority shareholders through the sale of 100% of a company's securities to a potential buyer. If you become a minority shareholder due to multiple equity rounds, you will have no say in the sale of your company.
- 33. Join the conversation using #VCterms What you can do 1. Watch out for majority and minority distinctions in the small print. 2. Negotiate tag-along rights instead — these offer the minority shareholders the option to sell but do not mandate an obligation. 3. Avoid over-dilution in the first place!
- 34. Join the conversation using #VCterms #11: Redemption Rights Option to purchase a certain number of shares (common or preferred) at a future date at a fixed price.
- 35. Join the conversation using #VCterms What could go wrong? ● Investor can force founders to take massive amounts of cash from the business. ● “MAC” redemption rights allow investors to do so if the company experiences a change to its business, operations, financial position or prospects. ● Enforcement provisions allow investors to elect a majority of the Board of Directors until the redemption price is paid.
- 36. Join the conversation using #VCterms What you can do 1. Push back to knock them out completely. 2. If they must be included, negotiated that a long term before execution (at least 5 years) and don’t allow enforcement provisions. 3. Limit the redemption price to align with initial investment.
- 37. Join the conversation using #VCterms #11: Right to Participate in Future Financings aka pro-rata participation rights
- 38. Join the conversation using #VCterms #12: Insurance Obligations Liability and life insurance on the key founders.
- 39. Join the conversation using #VCterms #14: Expenses of the Venture Investors A commitment to reimburse the reasonable legal fees of the investors plus any due diligence or out-of- pocket costs incurred.
- 40. Join the conversation using #VCterms Key Takeaways ● Never gloss over a term sheet ● Seek legal advice ● Map out potential consequences of each term in several scenarios (sale, IPO, etc.) ● Seemingly insignificant terms can have a dramatic impact on common shareholder returns ● This list is not exhaustive, check out our blog for more
- 41. Join the conversation using #VCterms Consider non-dilutive finance to avoid VC terms & pitfalls ● Upfront cash injection of $500k - $5million ● Flexible repayment plans ● No board seats taken ● Retained control and ownership of the company ● Fixed interest rate, transparent structure, optional balloon ● No warrants and no harsh covenants
- 42. It’s Your Company Keep It That Way
- 43. Join the conversation using #VCterms “The minute I found TIMIA, I felt like I found my tribe. From the language on the website, to the application process and how I interacted with the team, it was obvious that you guys were a different animal. I really appreciated TIMIA’s software-centric, modern way of doing business.” Mark Godley CEO | LeadGenius
- 44. Q&A Join the conversation using #VCterms Mark Bakker VP Marketing TIMIA Capital @markbakker Andrea Blobel Pérez Marketing Associate TIMIA Capital Mike Walkinshaw CEO TIMIA Capital @talk_to_walk
- 45. Thank You!
Hinweis der Redaktion
- Andrea starts with a question Mark and Andrea to introduce themselves very briefly. As founders, we often get excited by the arrival of a VC term sheet and are tempted to gloss over the finer details—details that can cost us greatly in the future. While there are many terms that matter, we’re going to quickly run through seven most common terms that can come back to bite you later. Let’s dive in...
- Before we getting started I want to go over a few housekeeping items: The on-demand link to this webinar will be sent by email in a few days time so please feel free to share it with colleagues You will be muted for the duration of the webinar but you can submit questions in the chat. There’ll be a Q&A session at the end so please submit questions throughout the webinar using the Q&A box and we’ll get to as many as we can in the time allowed. We also have interactive polling throughout so make sure to get involved when you can. Look to the resource widget for our latest resources including some blog posts on this topic! And finally we encourage you to tweet with us using the hashtag #VCterms to keep the conversation going online.
- Mark Participating preferred stock is a frequent request from VCs. This is also referred to as a “double-dip” because the VC first gets paid their liquidation preference and then also gets paid a pro-rata percentage of the remaining exit proceeds. This is a very expensive one-word add on to VC terms.
- It is best demonstrated by an example to show how costly this can be… If your exit sale price of the company is $30 million, and the VCs had invested $3 million in preferred stock at a 1X liquidation preference with participation: The first $3 million goes to the preferred holders to satisfy the 1X liquidation preference, and the remaining $27 million is split 50-50 (assuming the preferred and common shares owned equal percentages of the company). So, in total, the founders/common would receive $13.5 million and the preferred would receive a total of $16.5 million. If the preferred is non-participating, the $30 million in proceeds would be split 50-50 and the founders/common would receive $15 million from the sale. This is assuming the VC owns 50% of the company.
- Founders can try to resist participating preferred on the theory that it will hurt the Series A investors down the road if later financings also incorporate that term. If founders are forced to accept participation, they can often negotiate for the participating feature to go away if the VCs have received back some multiple (for example, 3x) of their investment. NOTE: Participation should be limited in cases where the company is truly liquidated (not sold at reasonable market sale). It is NOT standard practice and should be pushed back on.
- Mark VCs often insist on a liquidation preference to protect their investment in downside scenarios. The term “2X liquidation preference with participation” is commonly used—but do you really know what that means or how that may affect the flow of cash when you sell your company?” A liquidation preference refers to the amount of money the VC (as the preferred investor) will be entitled to receive on the sale of the company or other liquidation event before any proceeds are shared with the common stock. So what can go wrong for founders?
- The liquidation preference is typically expressed as a multiple of the original invested capital, usually at 1x. So in the event of a sale of the company, the investor will be entitled to receive back $1 for every $1 invested, before any other shareholders get paid. In situations where the company is particularly risky or the investment climate has turned adverse, investors may insist on a 1.5x, 2x, or 3x liquidation preference. When the VC first invests, at a small amount, this liquidation preference may not seem so bad However, after multiple rounds of VC investment layered on top of each other, it is very common for common shareholders to be buried below $50M of liquidation preferences. This means that if your company is sold for $49M, common shareholders get 0% of the proceeds on exit. If your company does not grow as expected, and you need to sell for a smaller number...$10M... you can find yourself in a position where 100% of the proceeds go to the VC and $0 to management. Why put all the effort in putting a company through a sale if there is nothing in it for the mgmt team?
- Hire a good advisor — someone with experience who knows the landscape and the players. Participations should be negotiated as an "either / or". In other words, the VC should be forced to choose whether to get their money back via an LP or go pro rata with the investors as a whole. NOT both. Execute on your startup’s plans, hit key milestones and benchmarks and build a great product. If you do that, everything else falls in place. Consider non-dilutive capital to get you there.
- Andrea VCs will often want the right to appoint a designated number of directors to monitor their investment and have a say in how the business is run. What is a sin is giving up Board control to a minority investor. So a 20% investor gets 3 board seats out of 7 = 42% Combine board seats, and Veto / Voting Rights Agreements - suddenly you’ve lost control of your company.
- Board seat allocation is aligned with share ownership. That means, in the beginning, investors may own 25% of your company’s stock and have 20-40% of the seats on the board. However, in future investment rounds, they can own the majority of your stock and take majority control of the board—effectively leaving you out of key decisions in the direction of your company. What is a sin is giving up Board control to a minority investor. So a 20% investor gets 3 board seats out of 7 = 42% Combine board seats, and Veto / Voting Rights Agreements - suddenly you’ve lost control of your company.
- Founders may be able to negotiate that the VC takes board observer rights in lieu of board seats. Talk to your lawyer or advisor and see how you can find a way out of this.
- Andrea Warrants represent an option to purchase a certain number of shares (common or preferred) at a future date at a fixed price, which can be the price of the current round of financing or set at a premium to the current price per share.
- Warrants tend to be used in earlier-stage deals to compensate an investor helping you to raise startup financing (in lieu of or in addition to cash). Warrants can also be used in later-stage deals or strategic rounds to provide upside potential value to investors to encourage participation in a round of financing. Unlike stock options, warrants tend to provide an option to purchase the most recent class of shares (rather than common shares). Warrants can also be issued to third parties while stock options are limited to employees, directors, consultants and advisors engaged in the business.
- It can be difficult to negotiate out of warrants as they are so common in the VC world Understand the value of a warrant when you grant it. Term, Strike Price etc. There is a lot on the internet to help. They can often seem like a giveaway but they are not.
- ANDREA VCs will typically insist on protective provisions or veto rights on certain actions by the company that could adversely affect their investment or their projected return. VCs may invoke veto rights in scenarios such as: The amendment of the company’s charter or bylaws to change the rights of the preferred, or to increase or decrease the authorized number of shares of preferred or common stock The creation of any new series or class of shares senior to or on parity with the preferred Redeeming or acquiring any shares of common, except from employees, consultants, or other service providers of the company, on terms approved by the Board The sale or liquidation of the company Incurring debt over a specified dollar amount Payment of dividends Increasing the size of the company’s board
- The most sensitive of these veto rights is the one granting the venture investors a blocking right on an exit. They could also stop you changing the direction of your business should you need to pivot.
- Similar to participating preferred stock, founders can mitigate this veto right by arguing that it should not apply in situations where the VC receives a minimum return on its investment (often 3x-5x).
- VCs want to ensure that your company has a stock option pool for future equity grants This is typically 10% to 20% of the company’s capitalization, with later-stage companies having smaller pools The options are used to attract and retain employees, advisors, and board members.
- VCs will almost always insist that this option pool be included as part of the pre-money valuation of the company, and it is standard to do so. However, founders should realize that any increase in the option pool will come at their expense, reducing their percentage ownership of the company.
- If the size of the pool becomes an issue in the term sheet negotiation, it is a good idea for the founder to produce a grounds-up budget for future options, estimating the options that will be needed for future hires until the next round of financing.
- It is common for investors to have a right of first refusal (ROFR) on any stock to be sold by the founders.
- ROFR restricts you and others from selling their shares. ROFR will usually require the founders to first offer the shares to the company, and then to the investors (on the same terms as on the proposed sale) before they can be sold. Why? This mere existence of this right is a deterrent to a founder attempting to sell her stock, as a prospective buyer will be less inclined to put effort into due diligence if an ROFR exists. Such a right will allow the company and the investors the opportunity to keep the founders’ shares within the existing shareholder base. But think it through carefully.
- Founders are usually able to negotiate exceptions from the right of first refusal, for transfers to family members or trusts for estate planning purposes, and, less often, for the sale of small (5%-15%) stakes.
- VCs often obtain protection against the company issuing stock at a valuation lower than the valuation represented by their investment.
- The most common is weighted average anti-dilution protection, which reduces the conversion price, inversely increasing the conversion rate of the preferred stock held by earlier investors if lower-priced stock is sold by the company. With weighted average anti-dilution, the more shares that are issued, and the lower the price of the shares, the greater the adjustment to the earlier preferred.
- Founders will want to avoid the more severe full ratchet anti-dilution clause, which reduces the conversion price of the existing preferred to match the price of the new stock (no matter how many shares are issued). This term is commonly referred to as a “death spiral” term, as it leads to a near endless amount of dilution. Investors will typically agree to specifically exempt from anti-dilution protection certain types of equity issuances, such as incentive equity for employees and other service providers, equity issued in acquiring other companies, and equity issued in connection with bank financings, real estate, and equipment leases, etc. These rights are very rarely exercised, rather they are used as a bargaining chip in negotiations when follow-on rounds are done at lower valuations, usually to punish the founders/common shareholders for perceived under-performance.
- Drag-along rights give the company the right to force all shareholders to participate in and vote for a sale of the company if the sale has been approved by specified groups.
- For a Series A financing, the drag-along is typically triggered if approved by the board, holders of a majority of the common stock, and holders of a majority of the preferred stock. In later-stage deals, drag-alongs may be structured to give the venture investors alone the right to invoke the drag-along right. It is also common for investors to have a right of first refusal (ROFR) on any stock to be sold by the founders.
- While drag-along rights themselves may be clearly detailed in an agreement, differentiation between majority and minority may be something to watch out for.
- Occasionally, VCs request a provision allowing them to cash out of their investment through a redemption feature (assuming the company has the cash).
- Series A investors will not typically push for a redemption feature, knowing that such a provision may show up in future rounds of financings to the detriment of the Series A investors. However, you should still watch out for them. Specifically, MAC redemption rights allow investors to take back their cash if there is an adverse change in business direction—a common scenario with startups! Investors will even sometimes try to add enforcement provisions to give their redemption rights some teeth. For example, the investors may require that if the company defaults (cannot pay the redemption price in cash), then the investors will have the right to elect a majority of the Board of Directors until the redemption price is paid in full and/or the Company will be required to pay the redemption price via the issuance of promissory notes. Again, the founders should push back hard.
- First, founders should push back to knock them out entirely. If the investors insist on redemption rights, only agree if those rights cannot be exercised until at least five years after the closing. Founders should also try to limit the redemption price to an amount that is equal to the investment — and push back hard on any cumulative dividends.
- We are going to zoom through the next four terms in the interest of time so we can get to your Q&A. Keep the questions coming by the way! Back to #11 VCs will normally receive a right to purchase more stock in connection with future equity issuances to maintain their percentage interest in the company. These participation rights are usually reserved for major investors who own a certain amount of stock and typically terminate on a public offering. As with anti-dilution protection, these rights are typically designed to apply only to true financings and are drafted to exclude employee equity, equity issued in acquisitions, or kickers issued to lenders, landlords, or equipment lessors.
- The company may be obligated to maintain directors’ and officers’ liability insurance, covering the officers and directors of the company in connection with litigation with respect to duties they are performing for the company. The term sheet will specify the dollar amount of coverage (often $2 million to $10 million). Venture investors occasionally also require the company to acquire and maintain life insurance policies on the lives of the key founders that will provide the company with cash in the event a founder dies. This insurance policy is usually used to redeem the preferred shares of the VC investor.
- Term sheets will typically include a commitment from the company to reimburse the reasonable legal fees of the investors plus any due diligence or out-of-pocket costs incurred, payable at the closing of the transaction. This obligation is typically “capped” at a specific dollar amount, but if the deal takes longer or requires more legal work than was expected, the cap is often revised to take that into account. Typically, VCs also include fees such as quarterly board meeting fees to be paid to the VC fund.
- Never, EVER gloss over a term sheet—seek legal advice and ensure you understand every term included. Map out the potential consequences of each term in several scenarios (i.e., future funding rounds or an exit event). Even small, seemingly insignificant terms in a term sheet may have a dramatic impact on the returns to common shareholders down the line—even if the company is moderately successful. This list is not exhaustive, check out TIMIA’s blog for more terms to watch for.
- Andrea
- Andrea starts with a question Mark and Andrea to introduce themselves very briefly. As founders, we often get excited by the arrival of a VC term sheet and are tempted to gloss over the finer details—details that can cost us greatly in the future. While there are many terms that matter, we’re going to quickly run through seven most common terms that can come back to bite you later. Let’s dive in...