Term Sheets and Valuations

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I blogged a few months ago about the book Term Sheets and Valuations. Now, while one of our companies is negotiating a term sheet, I’m finding this resource very helpful.

The author is Alex Wilmerding, a VC for more than 10 years. He explains many of the sections that can be found in a typical term sheet from a venture capital firm or sophisticated angel investor. “A term sheet serves as an outline of a transaction, so there are usually 8-15 sections.”

He explains how each section can be written to favor the investor, the entrepreneur, or be balanced. (I actually tink that most of his “balanced” examples are actually quite investor-favorable!) He gives sample language for 16 possible sections of a term sheet.

Some of the issues he addresses include:

  • The need for a cap table in the term sheet (showing ownership before and after the transaction)
  • The desire for investors to permanently have board seats; and why they desire them
  • Dividend requirements, and the difference between cumulative and non-cumulative dividends
  • Liquidation preference and typical multiples
  • Redemption rights by which investors force a company to achieve liquidity or pay back their investment within a certain amount of time
  • Conversion and automatic conversion
  • Dilution protection: full ratchet vs. weighted average conversion
  • “Play or lose” provisions
  • Voting rights of various classes of stock
  • How investors can increase their control of a company by requiring board approval on many issues, such as compensation, debt financing, leases, stock option plans
  • Information Rights
  • Registration Rights
  • Right of First Refusal

One of the authors main points is that entrepreneurs should never start negotiating any single item with investors until they have a solid understanding of the deal in its entirety.

From my experience, it is very easy for sophisticated investors to slip in language into any one of the above sections which will completely skew the deal in their favor, at the expense of the entrepreneur or of all the common shareholders.

Sometimes investors insert terms that might sound harmless (like cumulative dividend rights or liquidation preferences with a multiple of 3 or 5) but these terms might end up giving the investor all the return of the entire deal and leave nothing for the entrepreneur and common shareholders.

Sometimes investors just like to handcuff entrepreneurs because they can. It doesn’t really give them any financial benefit, but it gives them more control.

CEOs should not only study books like Term Sheets and Valuations but they should seek counsel from experienced legal and financial professionals before negotiating and signing a deal that might jeopardize other shareholders.

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