This article was originally published in the ACEF Newsletter.
A good term sheet sets up the business for success. While we do include a variety of terms that may be useful at various times, everyone needs to recognize that the principal reason for a term sheet is to outline the participants’ understanding, not necessarily to set up a plan to enforce in court every right at every time.
When it comes time to negotiate terms, I encourage angel investors and entrepreneurs to keep these points in mind:
- How is everyone going to make money from the deal?
- How do you want to do the next round of financing because there will almost certainly be another round?
- What is your exit strategy?
Success and prosperity is a good theme; there are ways to draft the documents along those lines.
For purposes of this discussion, I will exclude valuation as a separate topic, recognizing its extreme importance and complexity and that it is more a business than legal issue.
Standard Documents
Early stage deals need a term sheet that is credible but doesn’t get in the way of future financing by having terms that can’t be waived or will be unpalatable to future investors. I like to start with a standard, middle of the road set of documents that are fairly standard in the venture capital community.
This sets a tone, and I find that sometimes the VCs will simply add their deal-specific terms to the documents as written. If the terms look like what the VCs are expecting, they will tend to do minor amending and then their deal will move forward. Even when they want to negotiate or change some of the terms, we don’t have to go back to square one.
Board Provisions
The ability to set strategy and move the company in the proper direction is a very important thing. The terms that define the composition of the board of directors are among the most strategically important conditions of the deal and should be based on significant dialogue between the company and the angel investors.
For all but the smallest deals, it probably isn’t appropriate to allow the founders and existing management team to control the board. This does not necessarily mean that the angels control the board, just that the founders and management cannot overwhelm them.
On smaller rounds (say, $250,000 and under), angels might take one seat or an observer position; for larger rounds they should seek significant angel representation on the board. An effective angel group is not just contributing money; they also provide perspective, expertise, and assistance. The place where that is most easily expressed and applied is at the board level.
My preference is to have a five-person board with two angels; the CEO; one other representative of the common stock, and then an independent member from the industry who can add perspective.
Preferred Stock
Other than for very small deals, I recommend preferred stock and tend to avoid any form of convertible debt. Using a debt instrument postpones the time that that the company can show any stockholders equity and leaves the company with an insolvent balance sheet from day one, which can create a variety of legal issues at unfortunate times, as the law treats an insolvent company differently than it treats a solvent one. An unintended and difficult consequence is that every time a third party views the company’s balance sheet, all they see is debt because there is no equity. This will discourage risk-adverse third parties.
Preferred stock is useful for all of the usual reasons that people choose preferred over common. There is also a more subtle reason. If the angel investors buy common stock, that will set the company’s stock option price at that level—usually too high. If they take a preferred stock, there will be opportunities for better option pricing.
In terms of the preferred stock itself, the question is: how is it preferred? I like it to look like a middle of the road Series A preferred. It doesn’t cost more to use a standard form as opposed to tinkering, and, as mentioned, I believe there can be a real advantage to standard terms when you reach subsequent rounds.
We do like to put in a provision allowing two-thirds of the preferred stock (or other majority) to waive provisions that would otherwise favor the preferred. The idea is that if you have to do something quickly, you have a way to do it. If someone is unavailable to vote (for example, they might be having surgery or be visiting Antarctica), or if one or two small holders are adverse, it will not frustrate necessary corporate action. We want documents to be protective but not to get in the way of making money for the company and all of its stockholders.
Employee Option Pool
Assume that the pre-money valuation of a particular deal is $1 million and that the angels are putting up $500,000. If there is no option pool, the angels receive equity reflecting one-third of the $1.5 million post-money valuation.
Now suppose you want to create a 10 percent (or larger) option pool for managers and employees (not founders)—a very important thing to do if you want to attract the right talent to the enterprise. What percent of the company do the angels get now?
The angels will prefer that the option pool comes out of the founders’ shares. If this approach is followed, the angels will retain one-third of the stock, while the founders’ percentage of ownership drops from two-thirds to 56 2/3 percent because 10 percent of the founders’ shares go into the option pool.
The founders might respond by asserting that if the company had made all of its key hires and allocated the option pool to them, the company would have a higher valuation.
Split responsibility for the pool reflects the company reality. The founders then negotiate for responsibility for the pool to be split in proportion to allocated pre-money valuation—producing 30 percent of the equity going to the angels, 60 percent to the founders, and 10 percent to the pool.
How this finally settles out depends on who has the most bargaining power.
Here’s why the allocation of the pool is important. If you think of a company going public at a $100 million pre-money valuation, every one percent is worth $1 million to someone. By the time a company has an IPO, even if the initial capitalization is diluted by four to one, the 10 percent which is retained by the angels from the founders is worth about $2.5 million—which is real money and worth negotiation.
In the next round with the VCs, there may be a substantial fight over the same issues. Many VCs view the option pool as the responsibility of the management team and the angel group, and they won’t take responsibility for any part of it. Consistency in approach may help, but then again the VCs may not care about what went before.
Anti-dilution Terms
For most term sheets, angels are better served with weighted-average than full-ratchet anti-dilution .Even though full-ratchet terms may appear more beneficial by effectivelyadjusting the price of previously issued shares to the price of a new issuance, they set a precedent for the VCs and may produce very undesirable results in future rounds.
Investments in certain industries (biotech comes to mind) lend themselves particularly to a full-ratchet approach.
Liquidation Preferences, Cumulative Dividends, Warrants, Registration, and Conversion Rights
I’m not a big fan of cumulative dividends, warrants, or participating preferred stock that has liquidation preference and then participates with common stock on a share per share basis. When I include any of these terms in a deal, I keep in mind that I’m setting a baseline for subsequent rounds.
The VCs are going to ask for whatever the angels have (and more) and any participating preferred the VCs have will drain away a substantial amount of money from the founders and angels. Cumulative dividends are seldom, if ever, paid. Practically speaking, angels will only receive them to the extent that the VCs decide not to require that the angels give them up.
The same goes for warrants. If they survive, they complicate the balance sheet, and VCs often ask for additional consideration to permit the warrants to remain outstanding. That said, business considerations may suggest that cumulative dividends and warrants are important for future positioning of the investment.
Registration rights raise a variety of complex issues, but also should receive a practical approach. The important registration rights are piggy back (granting the investor the right to register unregistered stock when either the company or another investor initiates a registration) and so-called S-3 registration rights (which allow use of a short-form registration on Form S-3 after the company is already public).
In over 30 years of practice, I think I’ve only done one demand registration (where the investors can initiate the registration process) that was not an S-3 registration.
Protective Covenants
Protective covenants become more important depending on board composition. They matter more if angels don’t have a significant role on the board. I try to think of the protective covenants in two groups.
The first category consists of actions which relate to the operations of the company, such as changes to the stock option pool, incurrence of debt, and certain kinds of licensing. These should require only a vote of the board including angel directors to authorize them. Once the board has spoken, why appeal to the stockholders?
The second category includes actions which fundamentally affect the angels’ investment and should go back to them for authorization—for example amendments to the charter or bylaws or mergers and acquisitions.
The term sheet also should have tag-along rights which are integrated with the basic rights of first refusal in the documents. Tag-along rights (also called co-sale rights) allow the angels to sell their shares if the management team is selling. If management has the right to sell shares, then you want the passive investors to be able to participate, too.
The deal should also provide for drag-along rights, which compel people to sell their shares if a specified group decides the company should be sold and prevent an attempt by minority stockholders from obstructing the sale.
Such rights can be a particularly good idea in angel deals because frequently there is a large group of people investing and some of them develop a very close relationship with the company founders. You need the drag-along rights to be able to profit from the success of the company, and you don’t want one or two hold-outs on the founder or angel side to be able to halt a deal that is advantageous.
This goes back to my original themes of future financing, success, and exit. When a good exit shows up, you want to be able to grab hold and run with it.
Sometimes founders will worry that drag-along rights will allow someone to steal the company. One way to address this concern is to require a reasonably high threshold of approval to trigger the drag-along rights.
For example, if the board (which has a fiduciary duty) and some reasonably substantial percentage of the stockholders (perhaps 75 percent of the total or two-thirds of each class) vote “yes,” then everyone has to go along.
An anti-circumvention clause, a charter provision that says the company and other investors will not undertake a merger or any other transaction which would have the effect of depriving investors of their rights, is designed to prevent a cram-down without consent and can be useful. It doesn’t necessarily have to go into the term sheet but can be part of the deal documents.
Vesting
Many times the founders will argue that they should be fully vested in their equity in the company when the deal closes because of all the work they’ve done before the closing. However, from an investor’s point of view, the day the deal closes is day one and there is considerable work to be done for the founders to earn their shares and justify the claims that induced the investment. A variety of compromises are possible.
I frequently see management with 20 to 25 percent of their equity vested at closing and the balance vesting over four years. Many investors favor a one-year cliff and then monthly or quarterly vesting after that.
I resist acceleration of vesting because of an IPO or sale of the company for a number of reasons. Equity is typically provided to founders and management to assure that they will remain with the company for a period of time. Performance triggers to vesting can be used but raise a host of other independent issues. In fact, the time of an IPO is precisely the time when continuing “golden handcuffs” is most important. Public investors and underwriters want to make certain that management remains in place after their investment.
Many sophisticated acquirers feel the same way about a post-sale period and penalize companies and their selling stockholders if there is acceleration of vesting at the time of sale. Indeed, there is no guarantee that a sale is a “success” and mandatory acceleration might be providing a reward for failure. Finally, there are a number of venture capitalists who have policies precluding so-called single trigger acceleration, and this could become an issue in a later round.
Termination for Cause
Termination for cause and the definition of “cause” seem to have become flash points in negotiations in recent years, if not at the term sheet phase then in the negotiations of basic documents. In the real world after all the lawyers get done, almost no one admits that they have been fired for cause. That being said, there is no reason not to have a good, tight definition of cause in a transaction.
At a minimum, it will shape negotiations on termination, but it also will set forth the company’s expectations of its employees. The way we typically handle this issue in negotiation is to ask the CEO to take off the CEO’s employee hat and consider how he or she as CEO wants to manage these issues with every other person employed by the company. Most CEOs get it after that.
Conclusion: There is no perfect term sheet, just as there is no perfect deal.
The term sheet is simply a manifestation of the deal prepared against the background of expectations of both parties. A lot of the terms have to be worked out on a person-to-person basis to achieve the basic business understanding that underpins the deal and shapes the parties’ future relationship. I’m one of those lawyers who think that the best documents are the ones that I draft, that people sign, and that never come out of the drawer.
Peter Rosenblum, a partner at Foley Hoag, LLP, counsels clients in diverse industries concerning business and regulatory matters, financing strategies and structuring of corporate transactions. He is actively involved in the firm’s corporate and corporate finance practices, with an emphasis on public and private offerings of debt and equity, mergers and acquisitions, joint ventures and venture capital. Rosenblum has broad experience structuring and executing mergers and acquisitions for public and private clients. He represents numerous registered investment advisors and managers of private investment funds and hedge funds, both onshore and offshore.