Reviewing Investor Term Sheets: What You Need to Know

1. Reviewing Investor Term Sheets:  What You Need to Know Radhika Raman & Kady Bruce Boston University School of Law Startup Law Clinic

2. What is a term sheet?

3. Is a term sheet legally binding?

4. Exclusivity • Common for the only binding part of a term sheet to be a restriction that you don’t talk with other investors for some period of time after you sign the term sheet. • Reasonable because the VC is going to be paying lawyers to draft documents and perform due diligence on your company. • Be sure the time period is not too long – 30 to 45 days is plenty of time to finalize a VC investment in almost all cases.

5. Types of early stage financing deals

6. Convertible notes

7. Series A – Convertible Preferred Stock • What is convertible preferred stock? • Convertible = includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date. • Preferred = Sits behind debt (even convertible debt), ahead of common stock on dividends, distributions, liquidation, and redemption. • Value of convertible preferred stock is ultimately based on common stock’s performance. • When should I use convertible preferred stock? • If you can negotiate a substantial valuation at the seed round. • If you don't mind the extra legal expense of this transaction over a convertible note round. • Caution – the investor will own a part of your company, and may want to exercise control via board seats, veto power, forced sale, etc.

8. Valuation

9. Pop Quiz! Pre-money valuation An investor comes to you and says, “I’ll invest $5 million at a pre-money valuation of $10 million.” • What percentage of your company would the investor own after investing? A: 33% B: 50% C: Stop quizzing me.

10. Calculating Ownership % An investor comes to you and says, “I’ll invest $5 million at a pre-money valuation of $10 million.” A. 33% INVESTOR OWNERSHIP % = INVESTMENT AMOUNT ________________________________ PRE-MONEY VALUATION + INVESTMENT AMOUNT

11. By the Numbers: Shares vs. Percentage • Remember: the number of shares you hold only tells half the story. • Warren Buffet – owns 350,000 shares of Berkshire Hathaway = 33.1% of company (1,060,000 total shares in company) • Google – 350,000 shares of Google = 0.1% of company (324,890,000) • An investor might ask: “If my money is buying me shares, then how many shares do I get, and what percentage of the company will I own right after my investment?” • Know your numbers! • Be careful of optics – for Warren Buffet, 33.1% of company sounds a lot better, for Google, 350,000 shares sounds a lot better.

12. Liquidation preference

13. Types of liquidation preference

14. Types of liquidation preference II

15. Liquidation preference hypothetical • $5 million Series A investment at $20 million pre-money valuation (investors own 20%). • Company is sold for $40 million with no additional shares issued post-investment.

16. 3 Examples: No Liquidation Multiplier

17. What will the term sheet say? In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows: • Alternative 1 (Non-Participating Preferred Stock): “First pay the Original Purchase Price on each share of Series A Preferred. Thereafter, the balance of any proceeds shall be distributed pro rata to holders of Common Stock.” • Alternative 2 (Participating Preferred Stock with Cap): “First pay the Original Purchase Price on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis until the holders of Series A Preferred receive an aggregate of [two] times the Original Purchase Price.” • Alternative 3 (Participating Preferred Stock): “First pay the Original Purchase Price on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock on an as-converted basis.”

18. Board of directors • Important! Have discussion with VC about board makeup. Be on the same page. Bigger isn’t always better. • Control of the Board can also affect the thinking on other issues, such as vesting. • Usually a preferred stock investor requires one or more board seats • Typical post-investment = three person board with one investor representative and two founders as representatives of the common stock. • Can have one+ independent directors (directors that don’t hold equity and don’t have any other material interest in company). • Can have a “board observer” rather than a board seat. • Rule of thumb for early-stage boards = investor’s and common holder’s representation on board should reflect the relative control of the cap table.

19. Protective provisions

20. Founder vesting • Review and understand from the founder’s perspective. • Important things to understand are: • (i) When does vesting commence? • (ii) Does vesting accelerate upon termination without cause? • (iii) Does vesting accelerate (in whole or in part) upon a change of control or upon a termination of employment without cause within some period of time after (and sometimes before) a change of control (so-called “double trigger” acceleration)?

21. Antidilution protection

22. The option pool shuffle Investors may try to add option pool into pre-money valuation • What you hear: “I’m willing to invest $2 million on an $8 million pre-money valuation.” • BUT, the term sheet might say, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.” • Both are accurate, but the option pool lowers your effective valuation! • What the investor is really saying: “Your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call the sum your $8M ‘pre-money valuation’.” $6M effective valuation + $2M new options + $2M cash = $10M post Fully-diluted = total number of outstanding shares remaining if all convertible securities were converted to common stock.

23. How can inclusion of an option pool change the per share price? Hypo: 6 million shares outstanding, $2 million investment • What you hear: “I’m willing to invest $2 million on an $8 million pre-money valuation.” $8M pre-money ÷ 6M existing shares = $1.33/share • Term sheet says: “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.” $8M pre ÷ (6M existing shares + 2M new options) = $1/share

24. Pop quiz! : Option pools

25. Option Pool Quiz Answered • Answer: Option 1 is better because the outstanding common stock is valued higher due to a smaller post-money option pool.

26. Other key terms

27. Example Term Sheet • https://nvca.org/resources/model-legal-documents/

28. Negotiating Tips

29. Thank You! Law Clinic at: https://sites.bu