BlogHer|bet '11 Entrepreneurism Track: The Term Sheet
Welcome to the BlogHer | bet ’11 liveblog of the Entrepreneurism Track: The Term Sheet panel.
Presenters: Diane Savage, Jan Reed and Lori Yoller
Moderator: Kim Polese
>> KIM POLESE: I was part of the original Java team at Sun, launched Java, and then left and founded a company called Marimba with three of my colleagues. I ended up taking that public and selling it to BMC in 2004 and then was the CEO of OpenSource start-up company. I recently sold that and now I’m chairman of yet another start up. So I am officially a serial entrepreneur.
On our panel we have actually a wonderful wealth of experience in both the start-up area, finance, and law. So let me get started without any further adieu with some introductions. Starting on the far side of the panel we have Diane Savage. Diane is with Cooley Goddard. She was a partner at Cooley Goddard from ’94 to 2000 and founded the Technology Transaction Group there. Formerly she was general counsel at Adobe so she’s been inside of companies as well as working at one of the largest law firms in the valley. She advises early stage companies and she also teaches business law at Stanford.
Jan Reed, next in line here is the principal at the Silicon Valley Financial Group and co-founder of that organization. She has 20 years of experience in financial management and helps advise early stage companies on the finance side of things. She was formerly CFO at Delix and also VP of finance at Vividence. So again, deep start-up experience as well here.
And then Lori Yoller has over 25 years of experience helping entrepreneurs and emerging companies both as a co-founder, an executive, an advisor, an investor, and a board member. So you’ve been on all sides of the equation. She’s currently with Growth Point Partners and she helps advise early stage companies both on the funding side as well as later stage transactions. She was formerly the chief development officer at Intellectual Ventures and co-founder of Precision IO, a start-up company and also the former I think VP of marketing at Packet Design. Do I have that right? A very successful company in the valley.
So again, tremendous breadth of experience here on the panel. What we thought we might do is start out with a little bit of war stories and then we’ll merge right into buzzword Bingo. So if you ever wondered what a liquidated preference was or a tranche or a participating preferred, well you’re going to find out today and also what we have here is a tool that I think will be very helpful. So on each one of your tables you’ve got a packet from Cooley Goddard. If you open that, you’ll find a sample term sheet. Diane and Jan did a tremendous job, and Lori of putting this together and giving you sort of an overview of what a typical term sheet would look like. We’ll go into again all of the buzzwords, demystify the term sheet, and basically help you understand what the ingredients are of putting together a great term sheet.
One of the things that I think is often not well understood is that valuation is often the focus but probably the least important element of a term sheet. Much more important are the terms in the term sheet. Every single term in the term sheet matters. So that’s why we’re going to take the time today to actually go into detail to define what those terms are and what the impact of those terms can be for a founder of a company. Understanding the terms in the term sheet can mean the difference between walking away with 20% of a company, or 2%, or .2%. It really, really matters. So that’s why we’re going to take the time to go into some depth.
Also very important in the whole equation here are the people that you’re working with on the other side of the table. So we’ll talk a little about that too. But why don’t we start off with some war stories because I think that will help put into perspective some of the potential pitfalls and also opportunities in putting together a good term sheet for you as a co-founder of a company. Diane, we’ll start with you and talk a little about what you’ve seen out there.
>> DIANE SAVAGE: Well I was just talking about when we talked before getting together here today we talked a little bit about war stories and one thing that I really see frequently when I’m working with founders, and remember I taught at Stanford Business School. I taught business law to graduate students for 10 years so I represented a number of graduate business school students who ultimately formed companies.
I think the thing that really surprised me was people were afraid. Some of my clients would be presented with term sheets by venture capitalists and they were afraid to admit they didn’t know what everything in that term sheet meant. I actually saw situations where clients would come back to me having shaken hands on a term sheet and they gave it to me and as we started to walk through it they really didn’t fully understand the term sheet they had. They knew the numbers.
This goes back to what Kim said. They were looking for and it kind of goes back to what Lisa said earlier today, it kind of went back to well I got the valuation I wanted. But what they really didn’t understand was there were other terms and conditions in that term sheet that were so important to them that really they didn’t wind up with the deal that they probably would have struck had they understood it completely.
Again somebody earlier today said that almost everything in a term sheet is either about valuation or control. I think Heidi said that when she was talking about the deck. It’s very true. I mean there are so many things that go on in a term sheet so you might say okay I have 60% of the company and I got the valuation that I want. I the founders have 60% of the company. We got the valuation we want.
Yeah right, but if you’re really not paying attention to other terms like what does the board look like? What does your board of directors look like? Are there super majority votes that are required in any circumstances? What are the protective provisions in the agreement?
There are many provisions typically that require the preferred to vote separately as a series and that can block an action that otherwise you might be able to control because you had a majority of the stock. What voting agreements are you being asked to agree to as a part of the term sheet?
So effectively control may have passed to the other side even though you wind up with 60% of the stock. It’s just important to understand that before you shake hands on a deal.
>> KIM POLESE: Jan.
>> JAN REED: I think I would just mirror a lot of things that Diane was saying and some of the things, probably the most common thing that I see with entrepreneurs I work with is they may have an understanding of the percentage ownership of the company that they have like hey I’ve got 30% ownership of the company and they’re extrapolating that to the exit and assuming that in an exit situation they’ll be able to receive 30% of the proceeds. It really depends. It really does depend on the terms.
You might be able to do that on the same terms if the valuation is high enough. If it’s not, you may not receive that. You might get 10%. You might get 5%. You might get 30%. But I think just really understanding that and to echo Diane’s point as well, it’s perfectly fine to have that conversation with the VC as you’re walking through those term sheets, certainly with your attorney you should.
You should go out and get legal counsel on that term sheet. It’s perfectly fine to have that conversation with the VC as well to truly understand what does this mean in an exit.
>> KIM POLESE: Great. Thank you Jan. Thank you.
>> LORI YOLLER: For me I kind of came into this and learning this kicking and screaming because I was a computer science major undergrad and then I learned everything I needed to in business and so I figured okay, I get the technology and I get the business. You hire a lawyer to do the legal stuff. I don’t need to know everything about everything. Give me a break. How many more books do I have to read in the evening to understand everything about everything and so I thought okay, I kind of get its valuation and board seats and control and that’s enough. My lawyer will do the rest.
But then I found when I was going into negotiations things sometimes would go very wrong and the two lawyers would be butting heads across the table and I did not have the sophistication to know which one was being a total pain or if my lawyer was the one who was out of line and I did not understand what the industry norms were to be able to either tell my attorney to be quiet or to agree with my attorney when they were saying the attorney on the other side of the table was being a jerk and that we should walk away.
So it became really important for me to be able to speak the language of my attorney and if I had had Diane my entire career I would have been just fine because she would have explained everything to me and life would have been good. But, I have worked with lots of attorneys and some of them in hindsight were terrible because they would take a term sheet and put red all over it and cross out just about everything and so we were being terrible on my side of the table and the other side was frustrated. At other times we signed up for agreements that we shouldn’t have.
And so both for licensing agreements, for partnerships, for term sheets, for any of the agreements you’re going to do you have to get really educated to be able to figure out what is the right balance? What are the industry norms? What am I trading off? If you have a great attorney who sits down with you and really understands your business and says here are the trade-offs we’re making. This is a business judgment. Let me tell you what I would do based on what I’m doing with some of my other clients and how they’ve handled this instead of just handing you back one that’s got red all over it and saying we’re going to stand firm on this whole thing, which is a bad sign in the first place.
So the wonderful thing is certainly if you are in Silicon Valley is there are all these amazing free education courses that your law firm probably puts on. Cooley has an amazing one that I still attend that’s a full day event that’s designed for CFOs to talk about just all the issues that are coming up and give an update in law. So I go at least once a week to some law firm that’s putting on a free education seminar because you cannot seem to learn enough about the law given how fast it changes. So that’s one thing I would add.
>> KIM POLESE: Great. Thank you. Thank you all of you. Why don’t we launch into the term sheet and then start maybe demystifying some of those terms. I think again it’ll become more clear the importance of each one of these terms as we get into the discussion. Congratulations. You just got your term sheet. Now the hard part starts. You have to basically figure out what it’s telling you and what terms might indicate your ownership and your control of the company. First question, what is the difference between common and preferred stock? There’s also something called founders preferred, what’s the difference between common and preferred and then founders preferred?
>> DIANE SAVAGE: Common and preferred stock is a vehicle that’s used to basically to make to justify a differential, a price differential between the stock and the price that your investor will pay for his or her stock, its stock and the stock that you as the founders and the employees of the company will pay for theirs. Preferred basically means just that. There is at least, at a minimum a preferred stock must have a liquidation preference. In other words, if your company went out of business the day after you got your investment, the first money would be paid back to the people who had invested in the preferred stock. So the liquidation preference is what defines the preferred stock but there are many other rights and privileges of the preferred stock that may also go along with it. This whole term sheet really is about the rights and preferences that go along with the preferred stock.
Founder’s preferred stock is a relatively new concept and the concept of founder’s preferred stock is that founders want some ability to achieve liquidity in a corporation perhaps before a situation where there’s a liquidity event like an IPO or a merger or other kind of acquisition event. The founder’s preferred stock, we have found there are a lot of discussions about it but we have not seen a lot of founder’s preferred stock deals done in the valley so far. There’s a lot of discussion about it. I don’t think, in order to do a founders preferred stock the founders really have to have a fair amount of leverage. The market still doesn’t provide most founders with the kind of leverage to be able to ask for and get a preferred stock. Do other people have a different experience here with founders preferred? Have you Kim had a different experience?
>> KIM: No actually I’ve never seen founder’s preferred in a term sheet that I’ve dealt with relatively recently.
>> DIANE SAVAGE: Right so, if you go online and you Google that, you’ll find just a ton of articles about it and people ask us about it all the time but really we have not seen that those deals have been done very often. Yes?
>> FEMALE: Question from audience (off microphone.)
>> DIANE SAVAGE: You’ll see in this term sheet there’s reference to a right of first refusal and a right of co-sale on the founders stock. Those are ways that the investors are trying to say to the extent that you are able to legally sell your stock before a liquidity event, first we want you to offer it to us before you can go elsewhere. Secondly, if you do sell it, we want to be able to tag along and sell a proportionate amount of our stock. So there are typically a number of different ways besides the securities laws in which your stock will be tied up.
>> KIM POLESE: Great. Again, feel free to ask questions as we go through the discussion so thank you for that one. Second maybe buzzword here is liquidation preference. You touched on that Diane but maybe we can talk a little bit more and again examples are always good about the impact of liquidation preference and what liquidation preference is.
>> JAN REED: I’ll talk a little bit about liquidation preference. Typically you’re going to see and please jump in any time. In liquidation preference you usually see an uncapped liquidation preference. So you have a liquidation preference that’s fully participating and another liquidation preference that’s participating with a cap.
The liquidation preference essentially means as Diane said the investors that have that preferred stock have liquidation preference and they are paid first before anyone else is. So in an exit scenario you have shareholders have liquidation say the value of that liquidation preference is eight million dollars and your company is sold for 20 million dollars. They’ll get eight million dollars first. So out of the 20, the eight million dollars is paid to them first. That leaves you with 12 million dollars. If you have a 60% ownership in the company and the preferred has 40% ownership in the company, you’ll get 60% of that remaining 12. That’s why sometimes you don’t always get 60% ownership.
>> FEMALE: What’s the participating piece?
>> JAN REED: The participating piece means that you can participate fully or you can participate with a cap. If you participate fully it means that if you have preferred shares, you get that eight million dollars first regardless and then you get to participate along with the common shareholders in the percentage you own of the company.
If it’s capped, then that participation may be capped at a certain amount. If your liquidation preference is eight million dollars and the capped participation is two times liquidation preference, that’s how you might usually see it worded, then you can participate at that 40% of the remaining value of the company up to 16 million dollars. Then that’s all you get as a preferred shareholder.
What’s interesting with the math there is that the higher the valuation, there comes a tipping point where it makes sense for the preferred shares to convert to common because then you’d be able to get at least 40% of the total valuation of the company. So that’s when the preferred may convert to common.
>> LORI YOLLER: Something that’s good to do to really bring this home is liquidation is all about who gets paid first in an exit and how much and to kind of put a scenario saying okay let’s say my company gets sold for 50 million dollars in five years. What’s going to happen? What does this actually mean in terms of what my cofounders get, what I get, what my team might get, and what the investors get? Really lay it out for yourself because otherwise it gets very confusing.
>> KIM POLESE: And there’s also you often hear about a one x or a two x or a three x liquidation preference. That goes back to the point that Jan made. Two x would be like the eight times two is 16 basically. Explain if you would one x, two x, three x, how that might work.
>> JAN REED: In liquidation preference and usually when they talk about one times or two times liquidation preference, I’ll try to do it without writing on the board. Let me give an example here off the top of my head. If the preferred shares are preferred share price is maybe one dollar. We’ll call it one dollar preferred share price. At a one times liquidation preference, you get one dollar for every share. It’s one times what you put in.
At two times liquidation preference, it’s two dollars for every share that you put in. So you put in one million dollars, your liquidation preference is two times, you’re essentially guaranteed two times that out. So you put in a million dollars at one dollar a share, you’re going to get two million dollars out guaranteed. Well, if the exit is at least two million dollars. Let me put it that way. If it’s not that, it gets a little bit more interesting just from a financial perspective I guess.
>> KIM POLESE: And in this case the you is the investor.
>> JAN REED: Right.
>> KIM POLESE: And so this is one of those terms that can really be a killer as an entrepreneur because if you have a two x or if your investor has a two x or a three x participating right or preferred participating right, you end up basically often times walking away with nothing or next to nothing. So that particular term can be a killer.
>> JAN REED: Depending on valuation.
>> KIM POLESE: Depending on valuation.
>> JAN REED: But the larger the valuation, the more it becomes the simpler it becomes actually. The larger the valuation the simpler it becomes because the whole point of preferred is to essentially address the risk. It addresses the risk that those investors are accepting when they put that money into your company and that’s the whole point of the preferred. As the risk starts to go away and as the value of your company starts to grow, a lot of the complications of this start to fall off the table.
>> LORI YOLLER: The only other thing I would add is it goes back to what is the norm at the time though. You can say well gosh why would anyone ever accept a three times participating preferred? That’s insane. But after the .com bubble bursts, that was the norm. So you just need to know is this the industry
>> FEMALE: We saw five x.
>> LORI YOLLER: Yeah, yeah. Somebody else saw up to 10 x. So you can say well I’m not going to do that. That doesn’t sound good but if it’s what all the standard term sheets are going out with at the time, you need to know again what is reasonable and what’s not and what your negotiating position is.
>> KIM POLESE: Exactly. So another very important term or element of a term sheet is dilution and anti-dilution protection. Oh I’m sorry. Did we miss a question?
>> FEMALE: So what is standard now?
>> KIM POLESE: What is standard right now in terms of liquidation preference or terms in this area?
>> LORI YOLLER: I’d say anything from one x to three x. Typically if its more than one x it is a capped. It doesn’t continue to participate.
>> KIM POLESE: Yeah. Anybody else have a different experience?
>> DIANE SAVAGE: I’ve seen one x with a cap at two, non-participating in the last few that I’ve seen.
>> KIM POLESE: Good, thank you for the question. Anti-dilution protection. What is anti-dilution protection and why is it important both for the investor and for the founder?
>> DIANE SAVAGE: Well the non-mathematical answer to that which is the one that I can give, Jan can give the mathematical or one of you can give the mathematical one. Anti-dilution protection is what an investor says I’m buying stock in your company and I’m putting a 10 million dollar valuation on your company. I’m paying a dollar a share for the stock. I’m okay with that but what happens if in the next financing round the valuation falls and instead of it being a 10 million dollar valuation it’s a five million dollar valuation and people are paying 50 cents a share for the stock? I’m not going to be very happy about that so I want some protection in that scenario.
The protection can range from a ratchet which basically says if, and these are terms that are going to be thrown around, a ratchet basically says if in the next round somebody buys your stock at 50 cents a share instead of a buck a share, I want my stock to convert into common stock at that rate. So for every dollar that I put in the company now I get two shares instead of one. Right?
To some sort of an anti-dilution formula weighted at a dilution formula that says based on the size of that next offering there will be some adjustment in terms of what my conversion rate is but it won’t be a ratchet. I won’t get automatically a ratchet down to the 50 cents a share but there’ll be some proportional adjustment. That can be broad based weighted average formula anti-dilution or an hour based weighted average formula anti-dilution. But those are really important to understand whether or not you’re being asked to give them a ratchet or some sort of formula instead.
Of course from your perspective the best thing is proportional anti-dilution protection which means there is not anti-dilution protection except if there’s a stock split. That’s not typical anymore.
>> KIM POLESE: You mentioned broad based verses narrow based. What does that mean?
>> DIANE SAVAGE: It’s just a different adjustment, a mathematical adjustment. Jan.
>> JAN REED: I think that and there’s so many terms here too that I think the most important thing to remember without like bombarding you with a lot of math either quite honestly is that just to make sure that you ask the question and that you understand, you ask the question what happens with this term sheet if the next series is a lower valuation than the series today? What happens to my shares? What happens to your shares? What happens to my ownership? If that’s the only piece you take out of this section, just take that question with you because that’s really what you need to have answered and whether you really understand what a ratchet is or what these different anti-dilution provisions are specifically, you don’t really need to know that but you need to be able to know enough to ask the question. Make sure you get an answer that’s satisfactory, that you really understand that answer. If you don’t, ask again. It’s okay. It’s okay to make sure you really understand what the impact of this is in each one of the scenarios. In an exit scenario, in an ex-funding round scenario. Just make sure you understand that.
>> DIANE SAVAGE: And it is important to understand a ratchet is not, it can be asked for. It’s not typical. Typically if you agree to a ratchet, it should be for a specific reason around something very specific. Sometimes when an investor is breaching to get to your valuation that goes back to is valuation the most important thing. Is somehow breaching to get to your valuation or is willing to give you a valuation based on your representation to that investor that you’re going to meet certain milestones then perhaps if a financing has to occur because you didn’t make that milestone in a timely fashion and it is a diluted financing. Maybe you can agree to a ratchet. Maybe you would agree to a ratchet but you would not want to generally agree to a ratchet. Think about the world that we live in today where today your company may have a ten million dollar valuation and a year from now that valuation may have gone down but it has nothing to do with you or the inherent value of your business, it has to do with the economy, right. So a ratchet is a very draconian remedy. It’s not one that you want to lightly give.
>> KIM POLESE: Question, yes.
>> FEMALE: In view of the term sheet, how much of the discussion occurs in English and how much of it in legalese?
>> LORI YOLLER: Well one of the things I wanted to say is it’s very, most of the time lawyers will not be present especially in a series A financing during the term sheet discussion. That’s one of the reasons why you’re not going to say to the venture capitalist, by the way I’m going to call Diane right now and she’ll talk to you about this. Right. Your venture capitalist wants to have that conversation with you so you need to be educated and you need to understand what these terms mean before you walk in that room. Now you may be able to lead – Mike, you were going to say something?
>> MIKE: The easiest thing is to have somebody model it so that you look at scenarios and say what happens. Then you don’t have to specifically understand the formulas, you understand the impact of the formula. That’s the most important thing. If you sell a company for this under the preferred terms, what do I get? What do they get? And have four different outcomes so that you understand kind of how it moves from one outcome to another. The same thing with the ratchet or series. What if I get another round, a low valuation, what does that mean? You can model it out or you can have your attorneys model it or ask the venture firm to model it. You have the right to know what it means.
>> FEMALE: So if I may. When I did my first mission with Mike, I asked Diane to teach me everything she could in a couple hour sessions. I was learning series A and B. Then I had Jan build me an excel model so that I could enter the variables while we were having the various conversations so I could track what various scenarios meant. So, indeed, to exactly your point, it’s not as though I could have designed all those formulas myself on the spot. But I had a very clear picture of what each variable meant and, of course, I was building a coalition of different board members, right, because I already had series A and B people so I had multiple phone calls. You really want those tools. You really I think you cannot over invest in legal and financial advice. Boards don’t always agree with that but I
>> KIM POLESE: I agree with that. Yes.
>> FEMALE: I just had a question sort of about the protocol of actually the meeting. When you walk in there is that just the negotiating time right then and you sort of have to make a decision on the spot or can you sort of walk away and think about it and figure out your questions and make sure that you truly understand what’s being said? Do VC’s take lightly to you asking them what a ratchet means or are they like who is this person? Why don’t they know this before walking in the door? I mean I’ve never been in front of a VC before. I expect at some point I will be. Certainly this is all new to me.
>> KIM POLESE: So maybe a good way of framing that is so you just made a presentation. You’ve gone through, you went to the partners. It went great. They love it. They want to move forward so they’ve told you we want to move forward now. What happens next? They produce a term sheet typically, almost always. And then what happens? And there’s a valuation.
>> JAN REED: And also you’ll receive that term sheet typically in an email. It’s not that you finish your presentation, they’ll say hang on a second. Here you go. Sign here.
>> LORI YOLLER: I’ve seen clients who have been called in, I’ve seen clients who have been called in by a fund and brought to a meeting and said here are the terms that we’d like to, we want to make an offer to you. Here’s the valuation. Here are the terms. We’d like you to decide today. You can leave but we’d like you to decide today. So in that situation, I have had clients put in that situation who have decided and like I said shook hands on that deal without fully understanding it.
>> KIM POLESE: Right. So you get a term sheet in an email let’s say.
>> LORI YOLLER: Typically.
>> KIM POLESE: And hopefully avoid that issue.
>> LORI YOLLER: But I think in that situation what Mike is saying is you can certainly have a conversation with the VC’s there and kind of walk through scenarios. Or there’s nothing that says, they know that you’re more than likely going to want to take some time to look at the term sheet and to discuss it. There’s no reason why you should feel forced to make a decision in that room but I think sometimes pressure is applied.
>> DEBBIE SAVAGE: Pressure definitely is applied and to your point, it puts you in a stronger position to say I’ve got to think about this partly because you don’t look desperate. It’s like oh my god, thank god I’ve got a term sheet, I’d better sign right now. It’s the only one I’m going to see.
>> JAN REED: Honestly, I mean, I think
>> DEBBIE SAVAGE: You want them thinking you’ve got a few other term sheets that you’re thinking about.
>> JAN REED: I think it’s also just bad business practice as well for something that important to not say I really need to think about it. I just need to sleep on it. I mean that’s reasonable. Don’t you think that’s reasonable?
>> DEBBIE SAVAGE: Having to consult with my attorney is not such a bad answer either.
>> JAN REED: Exactly. I mean it is very reasonable and you should. You should consult with your attorney if it’s just the term sheet, you should consult with them. Absolutely. You shouldn’t do it on your own. It’s not good.
>> KIM POLESE: Thank you for the question. Any other questions on this particular topic? There’s one other buzzword that we’ve heard a lot regarding anti-dilution which is weighted average formula anti-dilution. Not to get too technical but what does that mean sort of in basic terms?
>> JAN REED: So, I’m trying to think of a simple example here. Diane, do you want to take that one?
>> DIANE SAVAGE: Well a simple, I had to get a lawyer because I couldn’t do that.
>> JAN REED: Yeah. Go ahead Mike.
>> MIKE: Broad based anti-dilution and narrow based anti-dilution each have a formula. The only thing you really have to know is the worst thing for you is a ratchet.
>> KIM POLESE: Good, that’s a good point.
>> MIKE: The good thing for you is a broad based.
>> KIM POLESE: A broad based, right.
>> MIKE: Broad based might be 10% dilution where a ratchet could be 40%. It depends on the circumstances. They’re just some formulas and so weighted average is the formula that’s used to calculate those things.
>> DEBBIE SAVAGE: So it’s going to take you in a
>> MIKE: You left off a formula.
>> DEBBIE SAVAGE: Right and a diluted financing, if like I said a ratchet is if the next round pay is 50 cents a share and you paid a dollar and the valuation is cut by half, then automatically you convert two for one. In a broad based weighted average formula anti-dilution, your new, instead of converting dollar for dollar, one for one, you’re going to covert at something between 50 cents and a dollar, right. So it’s going to be some fraction formula for conversion so that’s all you really need to know. You can do the math. We have the formulas and people can work them out for you. One is based on fully diluted, right and the other one is based on
>> LORI YOLLER: Outstanding.
>> KIM POLESE: Its how many units you have.
>> DEBBIE SAVAGE: Right.
>> LORI YOLLER: Yeah.
>> MIKE: It’s a messy formula.
>> DEBBIE SAVAGE: It’s messy but it matters. Yeah.
>> KIM POLESE: You had a question.
>> DEBBIE SAVAGE: Yeah.
>> FEMALE: Does the same apply to, say, 500k at 7% and then Microsoft 240 million from 1.6%. Are there provisions when it goes the other way? The valuation goes up?
>> LORI YOLLER: That’s conversion.
>> JAN REED: Yeah, so if the valuation gets to a certain point, the preferred would usually convert to common because, well it depends. If it’s a capped participating, they would eventually convert to common. If it’s not capped, they would probably never convert to common because in the earlier example at the very beginning of our session, that eight million dollars preferred, you get the eight regardless. You just get the eight carved out at the beginning and then you participate in the rest. So you wouldn’t necessarily convert. I mean there’s a lot of terms in terms of going IPO and at certain valuations a preferred does convert. If you want to touch on why that
>> KIM POLESE: Thank you. So another term you often hear is co-sale rights. Can you talk a little about that, what that means?
>> LORI YOLLER: Co-sale rights I think I mentioned it earlier occur if a founder typically it’s if a founder wants to sell their shares before there’s been a liquidity event for the venture investor, the venture investor basically wants to be able to tag along and instead of the founder selling all of their shares, some proportionate amount based on how much each of them own of a company that investor has the right to sell to the buyer, to this willing buyer that has been found by the founder. So it’s just a restriction on your ability as a founder to sell shares. It makes it hard to negotiate a deal when you have a co-sale right associated with it. Not impossible but hard.
>> KIM POLESE: And what’s a drag along rate? You often hear about that too. Drag along right.
>> LORI YOLLER: Well drag along rights just again there are different forms of voting rights, voting agreements. A drag along basically means if we the investors in our infinite wisdom have made a decision to sell a company, we’re going to drag you along. You’ve got to vote. You’ve got to vote like us. So whereas you might in many situations in the event of a merger, different classes of stock, the common stock and the preferred stock gets separate votes. In this situation, you have a separate vote but you’ve committed ahead of time that you’ll do the same thing that the preferred investors have agreed is in their best interest.
>> KIM POLESE: So it’s part of what’s called a voting agreement in a term sheet.
>> LORI YOLLER: Yeah.
>> FEMALE: (Question from the audience) I have a quick question about and you might have heard this already but are there actually any I don’t want to say illegal but unscrupulous or red flag things that say, I mean not everybody is going to be a [INDISCERNIBLE 37:08.] Not every VC fund is always as well known as the other ones and maybe you get one that’s local or not as well known. You get a term sheet from them, is there some penny ante or low rank, some term that should give you a clue about the firm that you’re working with?
>> KIM POLESE: So red flags, when should you be on guard?
>> LORI YOLLER: I think a lot of firms have a certain set of terms that they typically put in. And you do see different things from east coast firms sometimes than west coast firms and different ones from European firms, different term sheets from strategic investors which are back in vogue and many of the large companies now have venture funds. And so they’re all typically if they’re of any size going to have a typical term sheet and they may have typical terms that they move forward so I wouldn’t say a red flag necessarily because one thing that’s important is to look at it in its entirety, right because some may have.
I will say there have been venture firms that I’ve worked with that will put a very high valuation that they know is going to be higher than what you might get from others to lock you into a period of exclusivity because once you sign this, you are not supposed to be talking to other investors typically. And then in due diligence they will uncover all these things that cause them to lower their valuation. So I will say there are some firms that will do that but it’s not a red flag necessarily you’d find in the term sheet. It’s knowing the reputation and the credibility of the firm and the partners in the firm that should inform you of that rather than something in particular that shows up in the term sheet.
>> DEBBIE SAVAGE: If you were in the session this morning on the deck, was it Heidi, somebody said you need to do your due diligence on the venture investors that you’re working with just as they’re going to do due diligence on you. I think that’s really important. You do need to make sure you understand who you are dealing with. The best way to do that is to call some of the companies that they’ve invested in.
>> FEMALE: So like lawsuits are, I’m making up what a red flag would be to a partner in terms of: Oh yes they’ve got term sheets and I am suspicious and creating a scenario where you’ve got a term sheet. It doesn’t quite look right to you. You double check and you realize: Oh this firm has been sued for quite a few --
>> DEBBIE SAVAGE: No, I don’t think that that’s the kind of thing that would come out. I think it would be more kind of along the lines of what was discussed earlier this morning which is are those, I don’t think there’s going to be a lot of red flags in a term sheet personally. I think what Lori talked about is kind of the most likely scenario but just who are you dealing with? How helpful are they going to be to you when the going gets rough? What kind of board members did they make? Did they really add the kind of value that you were anticipating you were going to get because most of the time when you deal with a venture investor, you’re dealing with them not just for the money but also because they have domain expertise and experience that you hope they’ll be ready, willing, and able to share with you. So it’s just making sure that you kick the tires about them as much as they kick the tires about you, especially if they’re a fund that is lesser known.
>> LORI YOLLER: And it’s the individual within the firm not just the whole firm.
>> FEMALE: Yes.
>> LORI YOLLER: So you are checking the reputation of that individual just like they’re checking your reputation.
>> JAN REED: Right. And the most important questions to ask I think are what was the behavior when the times were tough? So if you can talk to the companies, I think they even mentioned that in their earlier session as well, see if you can talk to the companies who maybe it wasn’t a successful exit and you can find out just sort of what the behavior with that experience was for those entrepreneurs. It can be very telling.
>> KIM POLESE: That’s right and even at a great venture firm at one of the top firms in the valley you can have a partner who is difficult to deal with and it’s important to know that and to choose really prioritize I’d say the partner over the firm when you’re looking at both of those considerations.
Let’s talk a little about the equity that a founder typically would have and sort of scenarios to think through. How much stock should a founder have post series A. That was one of the questions Diane that you posed. Now that’s one of those questions also that there’s no right answer but I think it’s something that you want to at least have thought through going into the discussions and we see all sorts of different experiences that founders have. So how much stock should a founder have post series A?
>> JAN REED: Boy that’s a tough question. It depends. It really does depend. It depends on how far along that company is. It really depends on how much risk has been removed toward your end goal if there’s little to no risk that’s been removed yet then you may not retain as much ownership after the series A. If there are more risks that have been removed at the time you get the series A then the likelihood is you’ll have more retention of ownership in the company.
>> FEMALE: Jan, what’s a risk?
>> JAN REED: A risk. That’s a really good question. All kinds of things. So risk of market. Risk in terms of team. So if you have three-quarters of your team built out but not the whole team built out yet, your key hires, that’s certainly a big risk. What’s that?
>> FEMALE: Product.
>> JAN REED: Product risk. That’s another one. Technology risk along with that. So those are all pieces of it.
>> DEBBIE SAVAGE: For example if you have a product in the market you’re starting to see traction. It’s clear you’ve got a winning model. There’s a lot of risk that’s been removed. So and that will make a huge impact in the valuation and also the terms.
>> JAN REED: So just even if you do have that product, if you’re not at the point you have a repeatable sales process yet, that’s another huge milestone to get to is repeatable sales. A developed product, not just beta product. Proof of concept. I mean there’s sort of some major milestones and once you hit each one of those major milestones, your value goes up as well. So even in thinking about after series A when you go out and look for your series B, it’s really important to think about the valuation of your company at each one of those major events.
So you do go out and ask for that first A round to really have a true understanding of what that money is going to get you in terms of how much further along in milestones, how many more milestones are you going to hit with that money. That’s only going to increase the valuation of your company in the next round when you go through this whole thing again.
>> LORI YOLLER: And many of these online businesses there’s business model risk too. Are you going to use advertising, subscriptions, couponing, selling goods? You may want to spend some time experimenting with all of those to figure out which ones work the best. So there you’ve still got business model risk which is natural in the early stage because you should be experimenting but it’s very important to be clear on here are the areas where there’s risk. Here’s the areas where I’ve de-risked this in my opinion and communicating.
>> KIM POLESE: So back to the, oh we have a question.
>> FEMALE: I’m sorry. I know this sounds very naïve, who determines that level of risk? Who sets that forth and says is it the entrepreneur themselves or is it the VC that’s coming forward saying we think you can handle this level or we want you to step through this level?
>> JAN REED: I think it’s important to understand what you believe the risks are and communicate that to the VC. If they don’t believe it, they will let you know. But I think that’s, you really do need to understand what your vision is, be able to clearly articulate what that vision is, and then be able to understand what are the risks, and what are the things you need to do to get there. That’s going to tell you what your risks are.
>> FEMALE: What the points of negotiation are.
>> LORI YOLLER: Yeah, what you often hear in feedback is we feel you have too much technology risk at this point or we feel you have too much market adoption risk so come back after you’ve got customers or we feel there’s too much product risk so come back when you’ve got a better prototype. They’ll often communicate which risks they’re willing to take at which points and which risks they’re not.
>> KIM POLESE: Yes.
>> FEMALE: So we didn’t answer the question though.
>> KIM POLESE: Right. So let’s go back to that.
>> LORI YOLLER: Which one?
>> KIM POLESE: The question how much equity? What kind of ownership should a founder have post series A?
>> LORI YOLLER: It’s interesting because Kim and I were just speaking on another similar panel and the guy making the presentation said in round numbers he’s seeing four to six million going into A rounds for 30 to 40%. This is what the investor is putting in is four to six million for 30 to 40% of the company. In B rounds six to 15 million going in for 20 to 50% of the company. Then he said in angel rounds they were seeing anywhere between 50k and 1.5 million for 10 to 25% of the company. But again, those are averages, round numbers so you’re going to see a lot of variation but that was what he had gathered some data and said that’s what he had been seeing specifically for consumer internet companies recently.
>> FEMALE: What happens if you don’t like that? I mean I know
>> LORI YOLLER: You want to keep 90%.
>> DEBBIE SAVAGE: Well one thing you can do is work to remove as much risk as possible before you go out and raise your series A. Just an example of that is when I co-founded Marimba with my colleagues, we actually were getting, it was kind of an extraordinary time because the internet boom was just happening but we were getting called from VC’s who wanted to fund us. And we didn’t want to take the money because we realized there’s huge risks. We haven’t even figured out what our business model is yet let alone built a product or gotten customers. Let’s do that and we actually took the first 10 months and did that. And then we returned the calls. At that point we could go in and we had a much higher valuation. We had removed so much risk that we were able to be in a position of control to the degree that you do have control in that scenario, far greater than we were 10 months earlier.
>> LORI YOLLER: It’s also a really important question though because I deal with some entrepreneurs and I’m seeing more and more of them saying okay, I went out and got some angel funding but I’m still totally in control of my company and I didn’t give them board seats and I say well if you’re going to go big, you might want to consider getting more sophisticated investors and more sophisticated board and some venture investments. Often entrepreneurs are saying no, no, no, I’m not giving up control and I’m not giving up any of my shares. I’m going to keep running this for as long as I can and try to turn it profitable so I’m not going to bring in them yet. There’s a big tradeoff there but these conversations are happening more and more. I don’t want to give away 50% of my company so I’m not going to go down that path. Pros and cons because having a phenomenal board member who has a whole portfolio of similar companies that they can then share ideas and kind of help you along could be incredibly valuable. But it’s a big tradeoff.
>> DEBBIE SAVAGE: You’re right.
>> KIM POLESE: Yes.
>> FEMALE: Do VC’s often operate in what you were saying is the norm for today in terms of term sheets. I know they’re in the business to make money off of you so do they always try to put everything in there they can and then it gets whittled out or do they try to be reasonable with what’s going on in today’s current market.
>> JAN REED: Do you mean do they try to give you a nasty gram to see if you remove all the stuff?
>> LORI YOLLER: I’d say many of the larger and more well known funds especially at the A financing have what we would call pretty soft terms, pretty favorable terms. So it’s counter intuitive but the larger and more well known funds tend to be less obsessed with the terms than the smaller funds. I think that’s, Jan and I were talking about this earlier, that’s because they really understand that having a lot of control and a lot of hooks into a company that is totally unsuccessful doesn’t get them much. And so it’s much more about building success and building the partnership than it is what these terms and conditions are.
>> DEBBIE SAVAGE: That’s right and there’s also a reputational risk for the venture firms as well. They want to be known as being reasonable to deal with.
>> LORI YOLLER: Right.
>> JAN REED: Exactly. And I mean they really, it isn’t an adversarial relationship. I mean there is a negotiation that takes place and it’s understood even as I don’t want to serve, invoke the gender thing here, but I think that sometimes the entrepreneurs idea of who are men tend to have less issues with doing the negotiation and not letting it become personal than some of the women. So sometimes you have to sort of let go of that and say it’s a term sheet. It’s a negotiation. It’s not an adversarial relationship. Those are two entirely different things. This is a negotiation. It’s a business deal. You need to have a legal document for that but they’re really there to be your partner and they really can, most of the VC’s I deal with are such a huge value they can bring to your company in terms of introductions, in terms of their depth and breadth of knowledge in your space. It is big. There’s ownership you give up for that but there’s benefit for that in terms of removing some of that risk.
>> KIM POLESE: Right. Very well said. Another element of that partnership is they want you to have skin in the game and to be in there for the long haul. So vesting is often a very standard provision of a term sheet and of an agreement that you make as a founder of a company. So most deals have a four year vest. That’s very typical. Three or four year vest is what I’ve seen and that means that basically every year you get 25, if it’s a four year vest you get 25% of your stock earned now that you actually have the right to buy and own. It’s typically a stock option or it could be founders stock. So maybe talk a little about that if you would Diane and Jan and Lori. Vesting and sort of what a typical structure would be. Founder’s stock, options, investing.
>> JAN REED: Vesting is typically four years. There usually are triggers on that vesting as well so in the event of an acquisition, an exit that happens before your four years vesting you usually typically would see especially for founders and sometimes for key employees as well, so your VP of sales, maybe your CTO as well may have acceleration so when an event happens that vesting would accelerate and you would be fully vested at that point in time because it just motivates you so.
>> KIM POLESE: More buzzwords. It could be a double trigger or a single trigger vesting acceleration and so single trigger means that in the event of an acquisition you automatically vest in either the rest of your stock or some additional percentage of your stock. Double trigger means that in the event of an acquisition that is either preceded or followed within some period of time by your being terminated without cause other than the acquisition, that acceleration would occur. A double trigger is more typical than a single trigger.
>> JAN REED: The reason for that is at an exit typically in a lot of these M and A scenarios there’s something called an earn out. I think the next session you’re going to talk a little bit more about exits but so this is a lead up to that but in the earn out portion you’re usually as a key employee of the company, you usually would be required to hang in there during that earn out period and maybe it’s one more year. There are typically certain metrics you may have to meet. Maybe it’s in terms of revenue. Maybe in terms of customer generation. There are different metrics that they’ll identify that are usually closely aligned with why they bought your company to begin with. They want to make sure you’re able to hit those targets. And then you’d receive the rest of your payout at the end of that earn-out. And so that’s the reason they want you to have skin in the game in terms of continuing to vest in that stock during that period of time. So that’s the reason.
>> LORI YOLLER: And really important, I spend most of my time working on exits and helping small companies find their best strategic partner and buyer and they definitely across the board they’re typically buying the company for that team, that extraordinary team who probably isn’t making 100 million dollars in revenue. They’re just starting. They’ve launched to the market. They’re getting some great traction. They’re doing well in revenues and are growing revenues but they’re buying it for the team so if everybody gets accelerated vested on acquisition you’re not very attractive for the acquirer and it makes it a lot harder for them to acquire your company. And that is the most likely exit for many companies especially in the consumer internet space. You don’t see as many IPO’s in that space right now. So very important to think about that. You don’t want everyone in the company to accelerate their vesting on acquisition.
>> KIM POLESE: Another buzzword you might hear associated with that that’s sort of less positive is handcuffs. You get the idea. I know we’re going to be running into the end of the session. I want to make sure we’ve answered questions. I’ve got a couple more that I can pose but Lisa how are we doing on time? How much time do we have?
>> LISA: We might have time for one more question. We might need to wrap up so people can get to the next panel.
>> KIM POLESE: Okay. Well here’s one. Often times these days particularly with angel rounds you have something called a convertible note that often then becomes a term sheet or an equity deal in a series A. So let’s just touch on that briefly. What does that mean and how does that work for a founder?
>> LORI YOLLER: And maybe how angel term sheets are typically structured these days.
>> DEBBIE SAVAGE: Well a lot of times in an angel investment the angels don’t really want to value your company. We were talking earlier about how much of your company you give away in a series A round. Well that all relates to valuation and at the end of the day, your lead venture capital investor is typically going to value your company. They’re going to say this is what we think its worth and we’re going to buy 30% or 40% of your company because of this valuation we’ve put on it.
Angels frequently don’t have the experience or the expertise or the desire to engage in that valuation process and so they may say instead of setting a value and buying a preferred stock they may say we’ll lend you a certain amount of money and that will be on a convertible note and that note will convert at the next round, the venture round that we know is coming. This is when you’ve painted a picture that says you will be doing subsequent venture rounds. It’ll convert at whatever the rate is, whatever the valuation is of that round plus we’re going to get something extra, some additional coverage, some additional shares, some additional kicker for our early investment. So that’s, we increasingly see that angel rounds where there is an anticipated venture round is done on a note and the nice thing about that is they’re really quick and easy to do in terms of the financial, the legal documents. It’s a very low cost way to get early stage funding into the company.
>> KIM POLESE: That’s right and often what you’ll see is a discount to those series A so it’s sort of a sweet nerve for the angel is to get a 10 or 20% discount on the series A price.
>> LISA: We might need to
>> KIM POLESE: We have to wrap it up.
>> LISA: Actually it’s after.
>> KIM POLESE: Okay. Well thank you. Great questions and a wonderful panel. Thank you.
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