YOU GOT THE TERM SHEET NOW WHAT?

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1 YOU GOT THE TERM SHEET NOW WHAT? The purpose of this guide is to give entrepreneurs a high level overview of the angel and venture capital fundraising process. It is our hope that this overview will help improve the efficiency and ultimate success of the process by helping set reasonable expectations as to how the fundraising process works, from the initial discussions with investors through to the closing of the deal. I. Initial Presentation and Discussions The venture capital and angel investor fundraising process will generally start with the investor asking the entrepreneur to make a presentation to the investor about the company. This is the initial opportunity for the entrepreneur to tell the investor the company s story. You should focus on establishing a compelling narrative for your company s story, as well as on how the company is or intends to execute on the plan. It is that combination of a compelling story plus execution that will drive the initial discussions and help the company and prospective investors develop a sense of the company s valuation. Venture and angel investors want to see a big problem with a big market, so your presentation should define the problem and market size, and demonstrate how your product/service addresses that problem in a way that can succeed in the competitive market. Showing the investors the product, even a prototype or demo if you are very early stage, beats telling them about it any day. Expect the initial presentation meeting to run about thirty minutes to 1 hour, with the initial minutes being your pitch to the investors, and the remainder being time for the investors to ask tough questions slides in your pitch deck should be sufficient to tell a compelling story. Slides should be concise and never too busy. The bullet points should introduce your further explanation; never read your slides. Be prepared to discuss the key assumptions that drive your model, as well as the details of your competition and your competitive advantage. Expect that your investors, particularly if they are professional venture capital investors, will be highly informed about technology generally and about your market and competition. Don t let them know more than you do, or something you don t. Be very prepared. Typical Pitch Components (1) Brief Intro to the Company and the Overall Idea: who you are, what you do, who your customer is, and how you make money. You should be able to nail this in one sentence. (2) Your Story: define the big problem you are solving, and the size of the market opportunity. Identify how, if at all, your competition solves the problem today. (3) Your Team: who makes up your team, including any major board members/advisors, any successful exits your team members have had. The key is to convince the investor that there is a strong and committed team in place that can get the company to the next level. Many investors are more willing to put money behind a proven team than an unproven idea.

2 (4) Your Solution: convey how you will solve this big problem and why your team and your solution have a competitive advantage over the way the problem is solved today, and is ripe for repeatable success and scale. Describe your technology and why it will beat the competition. (5) Your Competition: define your competition, their relative strengths and weaknesses, their leadership, their investors. Continue to focus on why you can beat them, but don t downplay their relative strengths. (6) Your Business Model: How will you make (big!) money in a repeatable way with strategic barriers to entry that allow you to maintain your competitive edge. (7) What You Need to Succeed: This is the ask. Ask for the amount you need to execute and move your story to the next chapter/milestone. Most investors prefer that you ask for a specific amount rather than a range, e.g., we are seeking to raise $3 million rather than we are looking to raise $3 million to $5 million. Be ready to support your ask numbers with detailed financial data and projections. II. Term Sheet Negotiation and Finalization Once an investor, or multiple investors, has decided they want to make an investment in your company, they will present you with a term sheet. Other times, particularly if you are seeking angel capital, you and your advisors may have the opportunity to develop your own terms. The term sheet will set forth the fundamental terms on which the investor proposes to invest in your company. With the exception of confidentiality and no shop provisions, in which the company and founders agree that for some set time (e.g., six weeks) they will not negotiate a term sheet with another investor, the term sheet is typically non-binding. Term sheet negotiation is a chance for the entrepreneur and investor to discuss the terms on which they would be willing to enter into an investment relationship, without absolutely committing to each other. While there are many terms in a term sheet, the majority of these terms can be divided into three categories: economics/financial, control/governance and exit. In the economics/financial category, the key terms are the valuation/price per share and the liquidation preference. Venture capitalists use a post-money valuation when discussing valuation and price, so when a VC says they ll put in $5 million at a $20 million valuation, they mean they a post-investment valuation of $20 million (or a pre-investment valuation of $15 million). So in that case, the VC s $5 million investment buys 25% of a $20 company on a postmoney basis. This calculation is done on a fully-diluted basis, and investors will generally want the company s option pool computed on a pre-money basis, meaning that the option pool dilutes the founders but not the investors.

3 Another critical economic term is the liquidation preference. The liquidation preference really has two components, the actual preference and participation with the common stock. The actual preference means the amount that a venture investor will receive ahead of any other series of stock in a liquidation event such as a merger, acquisition, change of control, sale of all or substantially all of the company s assets, or a liquidation or dissolution. For example, if an investor has a 1X liquidation preference, it means that in a liquidation event (typically a sale of the company or its assets), the investor will get its investment amount back from the proceeds of the liquidity event before any other series of stock receives any proceeds. If the preference were 2X, the investor would get two times its initial investment amount back prior to any other class or series of stock receiving any sale proceeds. The participation component of the liquidation preference deals with whether, after receiving its liquidation preference, the preferred stock will then participate along with the common stock in receiving the remainder of the sale proceeds. There are three types of participation: full (where the preferred stock participates with the common stock with respect to all proceeds); capped (where the preferred stock shares the proceeds with the common stock until the preferred investors has received a certain defined multiple, e.g., 2X its original investment amount, after which the common stock gets the remaining proceeds); and no participation (where the preferred stock has only the liquidation preference but does not share in any remaining proceeds with the common stock). It is important to note that the preferred stockholders must choose between taking the liquidation preference amount (including any participation) or converting into common stock and sharing in the liquidation proceeds alongside the common stock. The preferred stock does not get both the liquidation preference and what it would get if it converted to common stock. In addition to these economic terms, venture capital investors typically put in place certain control/governance provisions to allow them to monitor their investment and control certain activities and decisions of the company, in an effort to help the investor achieve its desired return on investment within its investment horizon. The most common control terms are the right to designate one or more board members, and to put in place certain protective provisions defining certain actions the company cannot do without the investor s consent. Typical examples of these actions requiring investor consent are: sell the company, authorize the creation or issuance of new stock; change the terms of the preferred stock issued to the VC; amend the company s certificate of incorporation or bylaws; declare or pay a dividend; or incur debt beyond a defined level. Exit terms relate to the ways in which an investor can exit the investment. Customary exit rights include redemption rights, where the investor has the right to require the company to buy back its shares at a predetermined price (or formula) after a set number of years (usually if the company is not performing well enough quickly enough and the investor can t get a more favorable exit); registration rights, which allow the investor to demand that the company register the investors shares for sale in a public offering (demand registration rights) or register investor shares if the company registers any shares for sale in a public offering (piggyback registration rights); tag along rights, which allow the investor to sell their shares if the founders or company sell shares; and drag along rights, which allow the investor to require the founders

4 to sell their shares in a stock sale that meets certain requirements and which the board and investors approve. It is important for the entrepreneur and its counsel to be familiar with these economic, control and exit concepts and know how (and whether) to negotiate these provisions in the term sheet. For instance, investor redemption rights will typically change significantly as the company completes subsequent rounds of financing, so there is little value to the company negotiating redemption rights in an early stage round. Similarly, registration rights will change as subsequent investors fund the company, so companies should not focus on negotiating these rights in an early financing. Estimated timing from initial draft term sheet to signed term sheet: 1-3 weeks III. Due Diligence After the term sheet is signed, the next phase in the fundraising process is for the investor to perform due diligence on the company. This process generally takes anywhere from days, depending on the stage of the company and the amount of the financing, and is the investor s opportunity to kick the tires, to look into all aspects of the company s operations. There are many instances where investors will perform substantial business due diligence prior to formal legal due diligence. This can be a very important stage of the investment, many investors viewing it as a reality check on the investor presentation. Thereafter, the investor will begin the legal due diligence process by sending, either directly or through the investor s attorney, a Due Diligence Request Checklist. This due diligence checklist sets forth a number of items the investor wants to review related to the company s business, legal and financial operations. Investors will generally provide feedback to the company periodically during the due diligence process, as the investor reviews the due diligence materials and asks follow up questions or requests additional information. Due diligence can be time-consuming and frustrating, for both the investor and the company, but it is a critical part of the investment process, as no serious investor is going to commit a substantial amount of money without understanding the company. The company can make the diligence process go smoother, and often more successfully (resulting in a closed deal at the term sheet valuation), by having all of its corporate records and housekeeping matters in good order from the date of the company s formation. It s often a good idea for the company to designate a due diligence gatekeeper who will be the sole or primary person responsible for dealing with the investor on due diligence matters. It is also very helpful if the company can provide all of the information requested in the initial checklist in one shot, rather than sending over in piecemeal fashion. Another key is for the company to deal with any known problems or messy issues up front. Every deal and every company has a snake in the woodpile, and it is better for the entrepreneur to address yours proactively up front, rather than have the investor discover it during diligence (or worse, right before or after closing).

5 Once the investor is satisfied with the due diligence, it is ready to negotiate and finalize the deal documents and fund the transaction. IV. Standard Deal Documents The signed term sheet sets the stage for negotiation of the financing deal documents, which will reflect and expand upon the terms in the term sheet. The customary transaction documents in a typical Series A preferred stock financing are as follows: A. Amended and Restated Certificate of Incorporation The Amended and Restated Certificate of Incorporation is one of the fundamental legal documents in a typical venture financing, as it sets forth the characteristics and rights of the preferred stock the investor is purchasing. The Amended and Restated Certificate states the number of shares of common and preferred stock the company is authorized to issue, as well as the characteristics and rights of those shares. For instance, the Amended Certificate will state what the liquidation preference of the preferred stock is, whether the preferred stock has a dividend preference over the common stock (i.e., the company cannot pay a dividend on the common shares until a set dividend amount is paid to the preferred stockholders), and will contain any anti-dilution protections in favor of the preferred stock. Antidilution provisions adjust the prices at which the preferred stock is convertible into common stock in the event of certain actions or events such as a stock split or stock dividend, or if the company issues additional preferred stock shares for less than the conversion price (usually the price per share the investor paid). The Certificate of Incorporation will also address other rights of the investor s stock, such as the right of the holders of preferred stock to convert their stock into common stock, the right of the holders of preferred stock to designate one or more members of the Board of Directors, and will generally set forth certain protective provisions requiring the investors consent prior to taking certain company actions. B. Stock Purchase Agreement The Stock Purchase Agreement establishes the fundamental terms of the sale of the preferred stock to the investor, including the number of shares to be sold, the type of security to be sold (e.g., Series A Preferred Stock), the purchase price per share, the number of shares to be purchased, and the essential closing conditions and anticipated closing date of the transaction. The company (and sometimes the founders) will be required to make extensive representations and warranties regarding the company s business, financial and legal condition, including the outstanding equity the company has issued ownership of the company s intellectual property, and certain other fundamental matters about the company. A Schedule of Exceptions to the representations and warranties will also be included. (See Section V, below) The Stock Purchase Agreement will also contain certain representations and warranties of the purchasers, essentially establishing that the purchasers are accredited investors under the

6 securities laws and having them acknowledge they are purchasing restricted stock in a private company for which there may not be a liquid market. C. Investor Rights Agreement The Investor Rights Agreement sets forth the investors preemptive rights and registration rights. This Agreement will typically provide that the investors, or at least a defined category of major investors holding a certain number of shares, have the preemptive right to invest in any future financing the company may undertake. This preemptive right allows the investors the opportunity to maintain their proportionate ownership percentage in the company in the event the company issues additional shares in a subsequent financing round. The Investor Rights Agreement will generally also contain the investors registration rights, which, as discussed above, are essentially rights of the investors to sell their stock in a public offering by requiring the company to register, in accordance with applicable securities laws, the investors shares of common stock into which the investors preferred stock is convertible. D. Voting Agreement The Voting Agreement sets forth the agreement of the investors and certain key holders of the company s common stock (usually the founders) regarding the size of the company s board of directors, as well as the investors right to designate one or more members of the board. A typical board composition for a company raising its Series A preferred stock round would be five board members, with the investors having the right to designate two directors, the key holders having the right to designate two directors (one of whom is usually the company s CEO), and the fifth director being an independent director not affiliated with the company or the investors who is designated by a majority of the key holders and a majority of the investors. The Voting Agreement will often also contain a drag-along provision, which provides that if a certain percentage of the investors, directors and key holders approve a sale of the company which meets certain requirements, then the company and the company s stockholders agree to vote in favor of such sale and take all necessary steps to consummate such sale. E. Right of First Refusal and Co-Sale Agreement The investors will typically have a right of refusal to purchase any shares of common stock the founders desire to sell, and this right of refusal is generally set forth in a Right of First Refusal and Co-Sale Agreement. In most situations, the company will have the right of first refusal to purchase such shares, and the investors will have a secondary right of refusal to purchase any remaining shares the company does not wish to purchase. If the company declines to exercise its right to purchase, the agreement also gives the investors the right to sell a proportionate number of their shares of stock to the buyer who is purchasing the founder s stock, the rationale being that the investors should have the right to get some liquidity if a founder is going to sell some of her stock.

7 F. Ancillary Documents In addition to the fundamental financing transaction documents described above, there will generally be several ancillary documents signed as part of closing the deal. The company s board of directors and shareholders will sign consent resolutions authorizing the company to enter into the financing transaction and sell the stock to the investors. The company will also often enter into an indemnification agreement with the investor members of the board of directors, and sometimes with the company s officers, in which the company agrees to indemnify the investor board members from any liability the directors may face as a result of third party claims arising from the directors service on the company s board, except to the extent the liability arises from the director s gross negligence or willful misconduct. In many financings, the company s counsel will be required to sign and deliver to the investors a legal opinion affirming, among other things, that the company is authorized to enter into the transaction documents, has duly authorized, executed and delivered the documents, stating the company s authorized shares of stock by class, and opining on certain other matters about the company and the transaction. While there are several opinions in any legal opinion for a venture-backed financing that are relatively standard, legal opinions are often heavily negotiated and can add to the overall cost of the transaction, so for smaller investments the company and its counsel should push back on the requirement to provide a legal opinion, particularly since the investors can assess many of the matters to be opined upon through the investors own due diligence. V. Schedule of Exceptions As mentioned earlier, the company (and sometimes the founders) will make certain representations and warranties in the Stock Purchase Agreement about the company, it s financial, legal and business condition. It is essential that the company review the representations and warranties in the Stock Purchase Agreement carefully with company counsel, and be sure to set out any exceptions to the representations on the Schedule of Exceptions to the Stock Purchase Agreement. It is better for the company to disclose these exceptions to the investor than try to hide them and hope against hope that the investor never finds out. Most sophisticated angel and venture investors understand the complexities of running a business and can weigh the risks and effect of any given exception to a representation in the context of the overall transaction. Completion of the Schedule of Exceptions is one of the major tasks undertaken by management and requires significant effort and communication with counsel. The effort should be undertaken as early as possible in the process. VI. Employment Agreements, Invention Assignments and Stock Vesting Venture investors want assurance that the founders and key employees will stick around and help drive the company to the next milestone, so they will generally require that the founders and key employees enter into employment agreements with company. These employment agreements will contain customary restrictive covenants including confidentiality,

8 non-solicitation of customers, non-solicitation of employees, and non-competition. The agreements will also cover what happens to the employee s stock if the employee is terminated or resigns, with the key moving parts of negotiations focusing on how a termination for cause is defined and what constitutes a resignation not for good reason, as those are the circumstances in which the agreement will prove most onerous to the employee with respect to the company s stock repurchase rights. The investors will also require that all employees, contractors and consultants enter into proprietary information and inventions agreements prior to the closing of the funding, to ensure that the company owns all intellectual property utilized in the company s product or service. It is imperative that the company have these in place for all employees, contractors and consultants who had any part in developing the company s intellectual property, as the investors will not close the transaction without being absolutely certain that the company owns the intellectual property. Venture investors will also likely impose some vesting requirement on the founders stock prior to closing on the investment. Starting the business is just the initial step for the company, so the company and the investors will need the founders to remain with the company and contribute to the company s continued development and success. One way to incentivize founders to stay with the company is to require that the founders stock vest over time, usually over a four-year period, with 25% vesting after one year of service and the remaining 75% vesting monthly or quarterly over the remaining three years. Many founders are surprised at the idea that the stock issued to them at inception will reverse vest based upon this concept. Investors, however, have a legitimate interest in retaining management and preventing an early departure of a contributor who owns a substantial percentage of the company s stock. Founders often impose their own vesting requirements when they start the company, and venture capitalists will often credit founders with vesting of 10-25% of their stock at the closing of the deal, in recognition of the founder s historical contributions to the company. VII. Final Closing Day Items During the process, there will be numerous communications with counsel about the negotiation of the documents and the Schedule of Exceptions. Once all due diligence is completed and the investment documents have been negotiated and finalized, you are ready to close the transaction. The company and the investors will sign the investment documents, and the company will generally be required to provide the investors with a Secretary s Certificate certifying that the company has provided true and correct copies of the company s organizational documents to the investors and that the person signing the investment documents on behalf of the company has the authority to do so, and a Compliance Certificate stating that the company s representations and warranties in the Stock Purchase Agreement are true and correct and the company has satisfied all conditions to closing in the Stock Purchase Agreement. If a legal opinion was required, company counsel will deliver its signed legal opinion to the investors. When all of the investment documents and the Secretary s Certificate, Compliance Certificate and company counsel legal opinion are signed and delivered, the company s counsel will file the Certificate of Incorporation with the Secretary of State of the state in which the company is incorporated, and the investors will wire the investment funds to the company. When the Certificate is filed and the funds are wired, the transaction is officially closed. After

9 the closing, the company and its counsel will attend to certain post-closing items, such as issuing stock certificates to the investors and filing the necessary documents with the SEC (typically a Form D filing) and any blue sky filings with state securities divisions in states in which the investors are located. You just closed a successful financing round with a sophisticated angel or venture capital investor. Go pop the champagne and toast a successful closing and then go right back to your desk and work like you have never worked before to build a successful company with a repeatable, scalable business model. You can bet your competition is.

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