Understanding Private Equity Term Sheets

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1 Understanding Private Equity Term Sheets Presented to: GROW FL and FLCAN By Terence F. Brennan (407)

2 TERM SHEET FUNDAMENTALS 1 2 Valuation Management Rights 3 Return on Investment 4 Dilution Protection

3 Valuation

4 Classes of Equity in Term Sheets Common Stock: Attributes are general voting and profit sharing rights Common Stock Options: Offers the right to purchase common stock Convertible Preferred Stock: Attributes are preferential rights, distribution priorities and redemption rights

5 Key Terms Pre-Money Valuation Establishes Investor Return Calculation Investment Amount Consists of Cash/Convertible Debt/Assumed Debt Post-Money Valuation Pre-Money Valuation + Investment Amount

6 Example Value Percentage Pre-Money Valuation $6,000,000 60% + Investment Amount $4,000,000 40% = Post-Money Valuation $10,000, % Investor Advances $4.0 million to purchase 40% equity interest based on post-money valuation

7 Determination of Investor Price Per Share Fully Diluted Shares Pre-Money Capitalization % Fully Diluted Ownership Common Stock 2,000, % Preferred Stock % Outstanding Stock Options 250, % Reserved Stock Options 750, % TOTALS: 3,000, % Price Per Share = Pre-Money Valuation Fully Diluted Shares Price Per Share = $6,000,000 3,000,000 Price Per Share = $2.00

8 Determination of Investor Price Per Share Fully Diluted Shares Post-Deal Capitalization % Fully Diluted Ownership Common Stock 2,000, % Preferred Stock 2,000, % Outstanding Stock Options 250, % Reserved Stock Options 750, % TOTALS: 5,000, % No. of Investor Shares = Investment Amount Price Per Share Investor Shares = $4,000,000 $2.00 Investor Shares = 2,000,000

9 Option Pool Investor Typically Insists on Option Pool to Incentivize Employees Dilution is borne by Initial Investors 15% is customary es

10 Management Rights

11 Investor Appointed Directors Term Sheet Always Gives Investor the Right to Elect One or More Directors Investor Directors Exert Control By Approving or Rejecting Management Proposals for: Loans Acquisitions, Divestitures, Issuance of Stock and Options

12 Typical Investor Protection Usually Two-Thirds of Investors Must Approve: Amending Articles of Incorporation Issuance of Shares (to prevent dilution) Merger/sale of assets Reclassification or Reorganization of Entity Authorize a dividend or redemption

13 Typical Additional Investor Rights Information Rights Regular financial reporting; Inspection of records Preemptive Rights Participate pro-rata in additional stock issuance to preserve equity percentage First Refusal and Co-Sale Ability to block/participate in stock transfers

14 Investor s Exit Protections REGISTRATION RIGHTS Investor will require registration rights to take advantage of public market exit for investment Will require Company to register, and pay for, one or more IPO s. Company will want to defer as long as possible and limit number of registrations 3-5 years from closing Typically 3-5 years post-deal DRAG-ALONG RIGHTS Investor will require the common shareholders to consent to the terms of the sale of the Company Company should try to impose criteria for drag along right re return to early stage investors, percentage for founders in new company, and minimum purchase price.

15 Redemption Redemption rights provide investors with rights to salvage their investments in nonperforming target companies Term Sheet requires that Company must redeem investor shares Investor can exercise in three, or, more preferably for Company, five years Redemption means that investors are bailing on Company and will cause cash drain on an already struggling company Amount Redeemed Investor Purchase Price, usually in annual installments Pricing: Investor will want Purchase Price plus accrued dividends. Company should avoid multiples of redemption price, and should try to limit it to FMV per share which will be lower than PP

16 Liquidation Preference: Investor s Insurance LIQUIDATION PREFERENCE: BASIC ELEMENTS In a dissolution, sale, merger or other event: (i) Preferred Stock receives a return of its investment-or preference amount - before Common Stock receives any proceeds In aggressive term sheets, preference amount can be 2 or 3x the Investment Amount (ii) Investor also usually receives preference amount equal to its equity percentage before Common Stock holders receive any proceeds (iii) Remaining proceeds shared between Common Stock and Preferred Stock, pro-rata. This is known as Participating Preferred.

17 Liquidation Preference: Alternate Forms Capped Participation Preferred Stock receives Preference Amount Proceeds are then allocated between Common Stock and Preferred Stock, pro-rata, until the Investor receives a multiple of Investment Amount Non-Participating Preferred Preferred Stock receives greater of Preferred Amount OR proceeds allocated on between Common Stock and Preferred Stock

18 Effect of Liquidation Preference Common Stock (Founders) Sample Capitalization Fully Diluted Shares % Fully Diluted Ownership 2,000, % Preferred Stock (VC) 2,000, % Stock Options (Employees) 1,000, % TOTALS: 5,000, % Investment Amount = $4,000,000 Sale Price = $25,000,000

19 Example of Liquidation Preference Common Stock (Founders) 3x Liquidation Preference with Full Participation Amount of Proceeds % of Proceeds $5,200, % Preferred Stock (VC) $17,200, % Stock Options (Employees) $2,600, % TOTALS: $25,000, % Preferred Stock Receives 3x Investment Amount ($12m) first Remaining $13m is split pro rata among Common Stock and Preferred Stock

20 Second Example of Liquidation Preference Common Stock (Founders) 1x Liquidation Preference with 3x Capped Participation Amount of Proceeds % of Proceeds $8,666, % Preferred Stock (VC) $12,000, % Stock Options (Employees) $4,333, % TOTALS: $25,000, % Preferred Stock Receives 1x Investment Amount ($4m) first Remaining $21m is split pro rata among Common Stock and Preferred Stock BUT, Preferred Stock stops participating at 3x Investment Amount ($12m) Remaining proceeds distributed to Common Stock

21 Detailed Worksheet for Liquidation Preference $25m - $4m Preference Amount=$ 21m $21m x.40 Preferred= $8.4m Investor takes only $8M due to 3X limitation $21m 8 = $13m Common Used Shares = 2M Option Shares =1M $13m x.33 = $4.158m for Option Holders $13m x.66= $8.58m for Common Shareholders $12m + $ $8.58=$24,738,000 $25,000,000 - $24,738,000= $262, $262,000 x.66 =$172, $262,000 x.33 = $86, $8.58M + $172,920 = $8,752, $4.158M + $86,460.00= $4,244, $4,244, for Option Holders $8,752, for Common Shareholders = $12,997, es

22 Dilution Protection

23 Dilution Protection Dilution Protection is based on adjustments to Conversion Price Conversion Price is price at which Preferred Shares are converted to Common Stock Conversion Rate = Purchase Price Conversion Price Initially, Conversion Price = Purchase Price (1:1 ratio) Dilution Protection occurs if Company sells shares at price per share lower than Purchase Price. If so, Conversion Price is adjusted Following adjustment, each share of Preferred Stock is convertible into more than 1 share of Common Stock

24 Anti-Dilution Tools Full Ratchet (Worst for the Company) Conversion Price adjusted to equal PPS of the down round offering Broad-based weighted average (Best for the Company) Conversion Price adjusted down based on a weighted average of all outstanding securities, including options and warrants. Reduces conversion PPS, but not as much as Full Ratchet Narrow-based weighted average (Compromise Position) Conversion Price adjusted down based on a weighted average of outstanding capital stock, but does not include options and warrants

25 Anti-Dilution Example Impact on Series A Conversion Rate Fully Diluted Shares % Fully Diluted Ownership Common Stock 2,000, % Series A Preferred Stock 2,000, % Stock Options 1,000, % TOTALS: 5,000, % Series A Price Per Share: $2.00 ($10m post-money valuation) Proposed Series B Price Per Share: $1.00 ($5m pre-money valuation) (Pre Money Valuation/diluted shares = $1B round purchase price) Proposed Series B Investment Amount: $4,000,000= 4,000,000shares Post Money Valuation $9,000,000

26 Anti-Dilution Example Full Ratchet Anti-Dilution Protection Outstanding Shares Conversion and Common Shares % Fully Diluted Ownership Common Stock 2,000,000 2,000, % Series A 2,000,000 4,000, % Series B 4,000,000 4,000, % Stock Options 1,000,000 1,000, % TOTALS: 9,000,000 11,000, % * Diluted by Down Round and Conversion Effect Formula: Series A Conversion Price = Series B Price Per Share Calculation: Series A Conversion Price = $1.00 Series A Conversion Ratio: $2.00 $1.00 = 2.00

27 Exclusions from Conversion Adjustments Exclusions are for certain stock issuances that don t trigger adjustments. Including: Issuances from the option pool Shares issued in mergers/acquisitions Warrants issued incident to leasing and loan agreements Stock issuances as incentive awards

28 A Tale of Two Termsheets Initial Capitalization 3,000,000 founders shares 2,000,000 shares initially reserved for options Series B Financing Raises $2M at a $5.5M premoney valuation Adds 1,000,000 shares to option pool *See worksheet on next slide Series A Financing Raises $5M at a $5M premoney valuation Series C Financing Raises $21M at a $63M pre-money valuation Adds 1,000,000 shares to option pool

29 *Dilution Example If 5m issued shares at Pre-Money Value of $5.5m; then the B Round Purchase Price Per Share =$1.10 yielding 1,818,183 convertible B shares with a total Post Money Value of $7.5m Of the 7,818,183 total issued and reserved shares, 3 million are nonvoting options. This means that there are 4,818,183 issued and outstanding voting shares; and that the B round investor has voting control of 37.7% of the Company

30 Questions? Terence. F. Brennan Brennan Legal Group PLLC (407)

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