Attorney
Recommendation: Writing and Negotiating Term Sheets with a View toward Success
by Peter M.
Rosenblum,Partner, Foley Hoag LLP
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:
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
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.
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.He may be reached at PMR@foleyhoag.com .