Term Sheet Basics For Venture Capital In Today’s Economy

August 30, 2012

So you want to raise money from outside investors? Remember that old adage: “No free lunch”? Well, in outside funding the rule applies more than anywhere else. Best to ask yourself, “Have you considered what strings are attached?”

External equity, debt or some combination are viable means of financing your growing business and taking the venture to new levels. That’s what Venture Capitalists (VCs) can help you achieve. But never forget that VCs have financial goals of their own. Before you sign the term sheet, you had better understand the fine print. This article is intended as a primer to term sheet basics.

Outside funding offers many advantages to growing businesses, such as working capital to fuel faster growth and stronger capitalization to lower future lending costs. However, taking outside money changes the way you manage your company in ways that as an entrepreneur you may not like. You probably won’t work for yourself any more; there will be a Board to report to. You’ll have fiduciary responsibilities to your shareholders, and, depending on how your financing is structured, potentially wider reporting requirements which could include audited financial statements for compliance with financing covenants or SEC requirements. Before you seek capital, it is important to understand the ins and outs of a term sheet, so you can make informed decisions about your future operations. This knowledge will not only enhance your stature and credibility with funding sources, but will help you safeguard your business vision.

IT’S NOT ABOUT THE MONEY…

When surveyed about the benefit of working with VCs, only 12% of the entrepreneurs mentioned the money.

Most Appreciated VCs Contributions

Financial Advice 44%
Corporate Strategy & Direction 43%
Sounding board for ideas 41%
Challenging status quo 32%
Contacts or market information 26%
Management recruitment 10%
Marketing strategy 7%
Money 12%

At the top of the list of most appreciated VC contributions is Financial Advice with Corporate Strategy and Direction running a very close second. As veterans of venture deals clearly know, smart money means a firm that partners in the success of the venture. The partner you want is one who can sit on your board, make key introductions, provide sound advice and support you when the times get tough, because at some point in the venture that is what you will need most.

…BUT CONSIDER THE TRADE-OFFS

Venture Capitalists have financial goals of their own, and in their term sheets they protect their ownership percentages through a variety of mechanisms such as preemptive rights, anti-dilution protection, and price protection. These provisions will protect VC’s by limiting your financing options in the future.

Preemptive rights

Preemptive rights enable the investors to maintain their percentage ownership in the company by purchasing a pro-rata share of stock sold in future financing rounds.

Anti-dilution Protection

Anti-dilution protection adjusts the investors’ ownership percentages if the company initiates a stock split, stock dividend, or recapitalization.

Price Protection

Price protection adjusts the conversion price at which the preferred stock can be converted into common stock if the company issues common stock or stock convertible into common stock at a price below the current conversion price of the preferred stock (i.e., the VC’s will be issued more shares of common stock upon the conversion of the preferred stock). This protects the VC’s from risk if the pre-money valuation turns out to have been too high.

In addition to these general types of provisions, the following are specific terms and clauses that an entrepreneur should understand when reviewing a proposed term sheet.

Anti-dilution The right of current shareholders to maintain their fractional ownership of a company by buying a proportional number of shares of any future issue of common stock.
Earn-out An arrangement in which the sellers of a business may receive additional future payments for the business based on the economic performance of the sold business (or the buyer, including the sold business) after the sale.
Exclusivity The right of a strategic investor to have exclusive rights to a product or technology.
Liquidation Preference The right to receive a specific value or multiple of the investment before other investors, if the business is liquidated.
Lock-ups An interval during which an investment may not be sold. In the case of an IPO, employees may not sell their shares for a period time determined by the underwriter, usually lasting 180 days.
Ratchet or Clawback A mechanism to prevent dilution. An anti-dilution clause is a contract clause that protects an investor from a reduction in percentage ownership in a company due to the future issuance of additional shares by the company to other entities.
Right of First Refusal A contractual right, frequently granted to venture capitalists, to purchase shares held by other shareholders before such shares may be sold to a third party. A venture capitalist may participate in a first round of investment in a start up company and request a right of first refusal in any following rounds of investment.
Reporting Requirements The right to define the standards against which companies report
Representation on the Board of Directors. The control over major decisions is vested in the company’s board of directors. The financial investor may wish to participate in such decisions. Such participation will be more substantial than merely exercising the right (held by any shareholder) to review all books and records of the company and have reasonable access to management personnel to become better informed about decisions. Typically, the financial investor achieves some control over major decisions by securing the right to appoint one or more members of the company’s board of directors.
Tag-Along and Drag-Along “Tag-along” rights allow an investor to participate in another shareholder’s sale of interests. Non-management investors and minority investors find this right to be very valuable in that the founders are not allowed to exit alone. A “drag-along” right entitles the investor to force certain other shareholders (usually the founders) to be dragged along in a sale by the investor to a third party. This might enable the investor to sell control without owning control.
Washout Round A financing round whereby previous investors, the founders, and management suffer significant dilution. Usually as a result of a washout round, the new investor through majority ownership gains control of the company.
Wipeout Bridge A short-term financing that has onerous features; if the company does not secure additional long-term financing within a certain timeframe, the bridge investor gains ownership control of the company.

The decision to work with a VC is an important one; it will shape the future of your company for many years. By understanding the goals of the VC’s, entrepreneurs–with the assistance of experienced legal counsel— will be in a better position to negotiate an investment structure that meets the goals of both the VC’s and management. When considering an outside investment, the question should not be how much a percentage of total shares the entrepreneur retains, but rather, how much his ownership will be worth at the end of the day.

Disclaimer: The foregoing is intended only as primer that may be useful in the initial evaluation of various business options. This information is not offered, or intended as legal advice. It is, in no way, a replacement for consultation with experienced counsel.

Demystifying the VC term sheet: Drag-along provisions (venturebeat.com)
Seed Funding – Some New Considerations (startupnorth.ca)
Demystifying the VC term sheet: Dividends (venturebeat.com)
Do you have what VC’s are looking for? (marsdd.com)
Demystifying the VC term sheet: Protective Provisions (venturebeat.com)

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A. Dinsdale - Managing Editor

Editor at Smart Business Advice

My professional experience has been close to 20 years as a small business owner, consultant, writer/editor, Real Estate Manager, AutoCAD draftsman, community volunteer, and teacher. Small Businesses and Entrepreneurship is an interest of mine. I am the managing editor of this site - Small Business Advice For Today's Economy! - (www.small-businessadvice.com) which is a web destination tailored to the small business owner, where innovative and competitive businesses provide information about their B2B services and products. The site is also a portal for the latest small business news worldwide.