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FINANCE

Anatomy of a Venture Financing Term Sheet

Contributed by:

Vivek Boray and Anil Advani

vivek@inventuslaw.com
anil@inventuslaw.com
inventuslaw.com

This article is not legal advice and is provided for general information purposes only.

Valuation

  • Valuation will determine the percentage of the Company to be sold for the specific $ investment and consequently how much the founders and other shareholders will get diluted
  • Pre-Money Valuation + New Investment = Post Money Valuation
  • Post Money Valuation is based on “fully diluted capitalization”; i.e., denominator would include all the outstanding stock and all rights, warrants, and options to acquire stock, AND, typically, assuming conversion of all outstanding promissory notes, SAFE and other similar instruments. SAFE refers to a “simple agreement for future equity”, which was first championed by the Y Combinator accelerator and has become the standard instrument used for early stage investing in the Silicon Valley.

Liquidation Preference

  • “Downside protection” for the investors: in the event of a liquidation, Preferred

Investors get paid BEFORE holders of Common Stock, generally the founders, employees, advisors, and consultants]

  • As long as it is 1x non-participating (e.g. investors either receive 1x their investment amount back, or they convert to common stock and take their pro rata return), the company and founders should be fine. Watch out for “fully participating” liquidation preference. In that scenario, Investors get 1x off the top AND participate fully on their pro rata ownership. For example, if the original investment was $4MM and represents 25% of the fully diluted capitalization of the company and company is sold for $50MM, then under 1x non-participating, the investors would convert to common and take 25% of $50MM=$12.5MM, if it’s 1x fully participating/participating, the investors would get $4MM off the top, and then 25% of the $46MM=$11.5MM for a total return of $15.5MM thus limiting the amount that the founders would receive.

Voting Rights:

  • Board Seats. Majority of the board members make decisions; Shareholder Agreements can provide investors with the right to nominate board seats.
  • Control of the Board is a key part of control of the company and business.
  • Protective Provisions. Veto rights that investors have over certain actions to be undertaken by the Company, even though the investors may not own a majority of the outstanding shares in the Company. Need to keep this list limited to only material actions such as sale of the company, issuing a new class of preferred stock, licensing away company IP, etc.
  • Board Observer. This refers to have access to board materials and to attend board meetings. Companies need to keep to a very limited number to avoid having large board meetings, which can be difficult to manage. As such, board observers should be used only as needed.

Exit Rights

  • Drag Along Rights: Investors have a right to force a sale of the company. This should be triggered only after a certain time (e.g. 7 years); or require separate common stock approval or perhaps state a required minimum sales figure.
  • Redemption Rights: Investors have a right to force the company to buy their shares at the then-fair market value. This should be triggered only after a certain time (.e.g 7 years).

Dividends

  • Distribution to shareholders; typically, not a big issue as long as it is “non-cumulative” and subject to board approval. Non-cumulative refers to the investors not having the right to claim a dividend unless it has been declared by the board, whereas cumulative means requires a dividend to be paid and doesn’t leave it to the discretion of the board.
  • Typically, between 5-8% per annum.

Founder Related Matters:

  • Right of First Refusal: In the event a founder is going to sell his/her shares to a third-party buyer, the existing investors have the right to purchase their pro rata portion of those shares, at the same price.
  • Co-Sale Rights (a.k.a. tag along rights). In the event a founder is going to sell his/her shares to a third-party buyer, the existing investors have the right to sell their pro rata portion of their shares, at the same price.
  • Founder Lock–In. Many investors require founders to be locked in from selling their shares for a specified period of time, even the vested portion of the shares, in order to ensure founder retention. Such clauses must be carefully negotiated, including appropriate carve-outs such as transfers for estate planning purposes and sale upon acquisition.
  • Founder Vesting. Typically, 4-year vesting, on a monthly-basis, starting from the time founders started providing full time services to the Company. Founders should negotiate appropriate “acceleration” terms to protect themselves in the event they are terminated by the incoming investors.
  • Founder Representations and Indemnity. Founders should do their best to resist such clauses as the consequences can be severe.
  • Founder Employment Terms. Founders should get a written employment agreement after the initial round of venture funding. Need to negotiate terms like non-compete and other restrictions carefully.

Participation Rights

  • Investors’ right to purchase new shares to be issued by the Company.
  • Need to limit this right to “major investors”
  • Need to limit this right to only their “pro rata” shareholdings
  • Watch out! Sometimes this is crafted as a right of first offer, where the Company is required to go to existing investors first before being able to explore investment opportunities with outside investors. Such clauses may prove cumbersome and the cause of unwanted delays during periods of urgent need for financing.

Information Rights

  • Investors’ right to receive certain financial information
  • Need to limit this right to “major investors”
  • Need to limit to what is possible without too much burden on the company and management. For example, should not agree to audited financials, unless the company is already going to be producing these anyway.
  • Watch out! Should carve out for “confidentiality”, and where investors may have “competitive investments”
  • Some visitation right (i.e. the right to visit the company), is acceptable if limited to major investors.

Registration Rights:

  • Standard Registration Rights are ok. Registration Rights refer to the ability of the investors force the company register the stock for public sale or for the investors to join in a proposed public offering of the company’s stock.
  • These rights are highly unlikely to ever be triggered.
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