World Business

In this two-part series, columnist Tom Taulli defines key terms and sketches used up common pitfalls for entrepreneurs negotiating a term sheet through venture capitalists

by Tom Taulli

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A term sheet is a document prepared by venture capitalists that sets forth the key provisions of a proposed investment. The decoy for the entrepreneur is to focus mainly on the overall valuation of the transaction. But this can be baneful. Keep in mind that a term sheet has a variety of protective clauses for the VC that be possible to significantly reduce the valuation for the entrepreneur. As a result, it’s imperative to have one thoroughbred attorney negotiate a term sheet with you.

To induce a sense of the business process, imagine yourself in the following scenario. After months of pitching VCs, you finally get a terminus sheet on this account that your Series A round of funding (for a company we’ll call ABC Corp.). The amount is for $5 the masses, and the post-money valuation (BusinessWeek.com, 8/8/08) comes to $10 million. The term sheet is only seven pages, but it is complicated and even mysterious. You can find a sample term sheet at the National Venture Capital Association’s Web site and see some real-life examples at TheFunded.com.

A term sheet is a expressing conditions offer. The VC behest perform further due diligence and negotiate clew contracts, such as employment agreements, the option custom, registration rights, shareholder agreements, and so onward, before you see the clean the deal. The process can easily take several months.

What are the clew terms and common potential stuff of term sheets? Let’s take a look:

Preferred Stock. When a assemblage is created, the founders will get common shares, which represent ownership in the presume. These are also referred to considered in the state of founder’s shares. VCs don’t want these shares; instead, they want preferred stock. These securities be obliged a multifariousness of protections—such as settlement preferences and voting rights—that provide VCs through downside protection and control. However, there is virtually no mode to get rid of the preferred stock. Although, you can certainly procure some of the underlying protections (which we will talk about below).

Liquidation Preferences. VCs have a broad definition of "liquidation," what one. includes an acquisition, bankruptcy, and the sale of a great quantity of a company’s assets. For the most part, a VC wants to get as plenteous capital back on such events. As the name implies, a liquidation preference means that a VC gets the first money to the end of a deal.

Consider this example: ABC Corp. has a 1X liquidation preference in the expression sheet. This means that—upon liquidation—the investor will receive up to $5 million. In other words, whether the company sells since simply $5 million, then the VC will possess completely the money. Interestingly enough, there are 2X and 3X preferences (and even higher, depending put on the riskiness of the company). But this is uncommon and definitely worth negotiating over.

What if ABC Corp. sells for, say, $7 million? What happens to the additional $2 million?

Well, if there is participating preferred stock, then the VC will get every extreme $1 the masses (which is based on the percentage of ownership). In fact, this is often referred to as "double dipping." This would obviously have existence a tough outcome for founders, so I suggest you negotiate away the participation feature. And, if this doesn’t work, you be possible to attempt to put a limit upon the participation (maybe nay added than 3X the VC’s investment).

Dividends. This is an annual return on the preferred stock, which have power to range from 5% to 15% (payable in either house or coin, which is usually at the option of the company). Of point of compass, you should try to pass during the term of the take down amount. If the preferred is cumulative, it means dividends that are not paid pleasure be added up. If this happens athwart five or six years, the impact can be substantial, so try to negotiate a condition that makes the dividends noncumulative.

Reverse Vesting. When entrepreneurs learn about this concept, the reaction is usually conflict or anger. With reverse vesting, the founders set aside their common shares and then earn them over vacant time (the standard is four years). Simply express, VCs want to contribute sure the founders stay encompassing.

But there are ways to mute the impact of rescind vesting. First, you can do all that in one lies to get present vesting for a portion of the shares (say a quarter or a third). After all, you have before that time put a lot of work into the association. Next, you can shorten the vesting period (perhaps to two or three years).

Drag-Along Rights. This means that minority shareholders new wine agree to a sale or liquidation of a company. For the principally part, this is triggered when the proceeds are less than the discharge preference, which appliance that the founders will get nothing.

Yes, this sounds harsh. Then again, this is a situation where the company didn’t live up to its expectations. So why should the founders get a return? Essentially, that’s the main process of reasoning from VCs. A drag-along right is normally tough to negotiate away. Save your energy according to other terms, such as liquidation preferences and reverse vesting.

As you be able to see, there are great number nuances to a term sheet. And we’re only about half-way through the main provisions of a standard rendition. While the clauses sound innoxious and somewhat dull, they can nonetheless have a big impact on your return. In my next column, I’ll take a look at the remaining clauses of term sheets.