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Published on October 1, 2007

Author: sabanci

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Understanding and Negotiating Term Sheets :  Understanding and Negotiating Term Sheets Ted Bernhard September 12, 2006 Overview of the Discussion:  Overview of the Discussion What is a term sheet? Highlight most significant issues Definition Underlying Goal of the Provision Alternatives Recent Market Trends Negotiating tips Typical Mistakes made in Negotiating Specific Tips for Success What is a Term sheet?:  What is a Term sheet? An indication of two parties wanting to try to come to an agreement sometime in the future Goals: Articulate the basic provisions and terms of a potential deal that can be used to draft the actual definitive legal agreements Sometimes lock down the negotiations between the Company and Investors for a period of time Risks: Company relies on a term sheet before it should. (Expression of intent – not a deal until the money is the bank!) VC’s risk getting sued by a disgruntled entrepreneur if deal doesn’t come together See Sample Term Sheet from National Venture Capital Association Matching the “Terms” to the Actual Legal Documents :  Matching the “Terms” to the Actual Legal Documents Term Sheet Ettiquette – Who issues a term sheet?:  Term Sheet Ettiquette – Who issues a term sheet? Like everything else, it’s a function of relative negotiating power Varies by type of financing: Venture Capital Financing – the VC’s will deliver it to Company Angel Financing – Often Company will prepare standard terms and circulate an offering document and invite people to participate only on those terms. Things to be careful of between Term Sheet Signing and Closing :  Things to be careful of between Term Sheet Signing and Closing Expiration Date (may have to negotiate and decide very rapidly) “No Shop” Provisions Confidentiality Due Diligence (likely to become more intense) It’s not a deal yet! Important Term Sheet Issues :  Important Term Sheet Issues Type of Security General Terms (why not so important) Anti-dilution (why not so important) Liquidation Preference (why it’s REALLY important) Voting/Supermajority Provisions Board Structure and Board Members Employment related Agreements Other terms with which to be familiar: Drag Along Pay to Play Choice of Security – Common Stock:  Choice of Security – Common Stock When used: seed and very early stage rounds Advantages: All for one and one for all (everyone treated equally) Simplicity (keep those legal costs down!) Low barrier to educate people about them Disadvantages: VC’s probably have to justify why they are violating common expectations of Preferred Stock to their LPs Can seriously mess up your stock option pricing (FMV or greater) Likely to be unfair upon liquidation in the near term Choice of Security – Convertible Debt:  Choice of Security – Convertible Debt Convertible Debt + Warrants: When used: bridge financing or by angels Watch out for: bridge to somewhere? You do have to repay at a fixed time or lose your company Warrants that accumulate over time Advantages: Additional Security for Investors with upside equity participation You don’t have to set a price for your shares and can maintain flexibility with stock incentive plan and future investment Interesting to note that PWC Moneytree doesn’t even include debt financings as “rounds.” Angels seem to love these types of deals. Common warrant coverage ratio is 25% up to 50% in extreme circumstances Choice of Security – Convertible Preferred Stock:  Choice of Security – Convertible Preferred Stock When used: The standard venture capital financing security Advantages: Equity investment not debt Special Voting rights for investors Preferences to investors Allows for maintaining low pricing for common stock options Familiarity by Investors and their LPs Sets a value for Company Disadvantages: Company can be structured in a way that puts investor shareholders interests at conflict with founders and employees who hold common. Choice of Security:  Choice of Security Typical Negotiating Mistakes: Trying to convince a VC to take an angel-style deal or vice versa Treating the advice from any single person as “the” way to do it Making yourself an LLC or a Partnership. VC’s do not like and are often prohibited from investing in an LLC because of the attributes passed through to their own LPs. General Terms (Price, Shares, Valuation):  General Terms (Price, Shares, Valuation) Recent Market Trends: Up rounds now exceeding down rounds for last two years Most recent data shows 45% increase price increase for valuations over prior rounds in Q4 05, the largest since survey began See attached Fenwick and West Report with detailed analysis Most common Negotiating Mistakes: Getting too hung up on valuation – it’s just supply and demand Failing to properly take into account who bears the dilution from the option pool Failure to contemplate long term fundraising plan Anti-Dilution:  Anti-Dilution Definition: Provisions designed to compensate current investors in the event of a future “down” round of financing Underlying Goal: Protect Investor from the economic dilution resulting from future down rounds of financing Different Alternatives: Full Ratchet Weighted Average None Very unusual: Lock in a particular investor at a fixed percentage Mechanically this can be done by altering the conversion ratio Anti-Dilution Provisions:  Anti-Dilution Provisions Recent Market Trends: Anti-dilution provisions Q ’05: Full Ratchet: 9% Weighted Average: 85% None: 6% Source: Fenwick & West Typical Negotiating Mistakes: Spending too much time and effort on this Failure to take into account additional complexity these provisions add Accepting a full ratchet for any reason Liquidation Preference:  Liquidation Preference Definition: The priority scheme of how money that gets paid upon liquidation to certain groups of shareholders Liquidation includes a Merger or acquisition! Underlying Philosophy: 1. He who puts up real cash gets cash back before others who didn’t. 2. LIFO – he who puts in real cash most recently gets his money back first. Variations: Single or Multiple Preferences Participation or non-participation Capped or non-capped Liquidation Preferences:  Liquidation Preferences Recent Market Trends: Liquidation Preferences Q4 ‘05 Percentage of Deals having a liquidation preference: 41% Percentage of Deals having multiple liquidation preferences: 24% Percentage of Deals with a particular multiple: 1-2X – 67%; 2x-3x – 33%; 3x –0% Percentage of Deals having participating preferred: 64% Percentage of Deals with uncapped participation: 50% Source: Fenwick and West Typical Mistakes made in Negotiating: Failure to contemplate the “sideways” exit scenario Failure to contemplate the cumulative affect of adding the preferences on top of each other. Structuring the deal in a way that in encourages reckless behavior on founders and executives part Remember that while “double dipping” may be the norm now, it is still double dipping. Voting Rights:  Voting Rights Recent Market Trends: In almost all preferred stock deals these days – fairly standard list of items requiring supermajority(see attached) Shareholders agreement is typical in all but the earliest stage rounds Typical Negotiating Mistakes: Treating this laundry list as “boilerplate” and just signing off on it Effectively signing away right to influence on future transactions Locking in veto power to specific voting blocks Typical Items requiring special consent:  Typical Items requiring special consent Protective Provisions: Without the approval of the holders of at least a majority of the Series A, the Company will not take any action that (i) effects a sale of all or substantially all of the Company’s assets or which results in the holders of the Company’s capital stock prior to the transaction owning less than 50% of the voting power of the Company’s capital stock after the transaction, (ii) alters or changes the rights, preferences or privileges of the Series A Preferred so as to materially and adversely affect such shares, (iii) increases or decreases the number of authorized shares of Preferred Stock or increases the number of shares reserved under the company’s option or stock plans, (iv) authorizes the issuance of securities having a preference over or on a par with the Series A Preferred, (v) redeems shares (excluding Common Stock repurchased at the lower of fair market value or cost upon termination of an officer, employee or director or consultant pursuant to a restricted stock purchase agreement), (vi) changes the number of directors, (vii) amends the Articles of Incorporation or Bylaws of the Company so as to materially and adversely affect the rights of the holders of the Series A Preferred or, (viii) authorizes payment of any dividends, distributions or similar action, or (ix) authorizes any secured borrowing or any borrowing or guarantee by the Company of an amount or obligation in excess of $500,000 on a cumulative basis. Board Structure and Members:  Board Structure and Members Most Recent Trends: Increasing Number of Independent Board Members, independent chair More active participation and oversight being demanded Best practices influenced by Sarbanes Oxley Typical Negotiation Mistakes Trying to keep all founders on the board Adding too many board members, too soon. Employment-Related Agreements :  Employment-Related Agreements In a technology company, the people are the most significant asset. Common Employment Agreements: Employment Agreement Options vs. Restricted Stock Vesting Provisions Intellectual Property Assignment Confidentiality Non-solicitation Non-Compete Board Seats for Founders Employment-Related Agreements :  Employment-Related Agreements Most Recent Trends 15-20% of Outstanding Equity Set aside for option pool 3-4 year vesting Deferred compensation and option accounting rules impact structure of compensation Typical Negotiation Mistakes Making IP related documentation (I.e. non-competes) so oppressive that you can’t attract quality employees Failure to adequately motivate employees Number of shares Vesting Failure to articulate who bears the dilution of the Incentive Pool Not setting up your capitalization table to make the options look attractive Other Provisions: Drag Along rights:  Other Provisions: Drag Along rights Definition: Require minority shareholders to voluntarily cast their vote in favor of that which is approved by the majority, regardless of how they would like to vote. Goal: Prevent obstructionist minority shareholders from killing an acquisition or merger. Other Provisions: Pay to Play:  Other Provisions: Pay to Play Definition: Provisions that strip previous investors of certain rights if they do not participate up to their pro-rata share in a later round Purpose: Penalize funds for not “doing their share” to keep a company afloat when times are tough Seeing less since funds getting larger, deeper pockets and not as many down rounds where people don’t want to participate. Only found in 16% of all deals Things to Remember as You Negotiate:  Things to Remember as You Negotiate It’s a gigantic balancing act between all of the moving parts and -- prioritize what you care most about Intellect doesn’t carry the day -- It’s a free market (this is capitalism in it’s purest form!). Get multiple term sheets Don’t get fixated on valuation. Things to Remember as You Negotiate, pt. 2:  Things to Remember as You Negotiate, pt. 2 It really is not zero sum – the moment the deal is done, you all have aligned interests in making the company succeed (or else the term sheet is structured wrong). Don’t get emotional Don’t get intimidated – the fact that you got a term sheet at all from a VC is something to be happy about Get advice from others who have been through it before If you like the people who are going to be investors, just “get the deal done.” Final Thoughts…:  Final Thoughts… Term sheet negotiation should not be painful! Behavior is during this process is a really good indicator of what is to come in the “partnership.” As a VC, my partner and I walked away from deals where we had “agreed” on the terms just because of the way the entrepreneur behaved towards the negotiation and us and what it made us envision what our “marriage” to the entrepreneur for the next 10 years would be like. Do your own due diligence on the investors and watch their behavior during the process Thank You:  Thank You Ted Bernhard Stoel Rives LLP 900 SW 5th Avenue Suite 2600 Portland, OR 97204-1268 Telephone 503-224-3380 Direct Dial 503 294-9202 Fax 503-220-2480 E-mail tbernhard@stoel.com www.stoel.com http://energyventuresnw.blogspot.com/

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