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Term Sheet

1. Definition.

A Term Sheet is preliminary, non-binding agreement on the terms that the company has agreed to regarding the proposed investment. In our case, the term sheet is negotiated by one of the Twin Cities Angels' members who is a prospective sponsor or leads due diligence of your company.

2. General concepts.

VCs and other sophisticated investors have developed "standard" terms for financings, summarizing what is contemplated and what is prohibited (most of the time many of those events never surface). We rarely encounter anyone who does not agree to the terms once they understand their intent. Unfortunately, expressing these fairly simple terms usually takes many pages of legalese, which can appear overwhelming. To companies without experience in VC financings, the "standard" term sheet may give the appearance that the investor is trying to take advantage of the company, leaving it in an "inferior" position. However, you should realize that VCs and the Twin Cities Angels accept being in the "inferior" position to "new money" (i.e., investors in subsequent financing rounds). In other words, later rounds of financing will receive the same kind of preferences over Twin Cities Angels as Twin Cities Angels get over the company in the current round. So we do not ask for something we are not willing to accept ourselves. The key provisions that we expect in a Term Sheet are fairly standard and have been used by VCs for many years:

3. Preferred Shares (vs Common Shares).

Allows the investor to have certain rights and protections as spelled out in the agreements. Typical preferential provisions are described below.

4. Liquidation preference.

One of the key "preferences" is in liquidation (which includes sale or acquisition of the company) and generally provides that the investors will recover at least their principal (i.e., invested amount) before management gets any part of the distribution from the sale or acquisition. Without a liquidation preference investors can do badly while Common shareholders do well. For example, if the investors put in $1 million for a third of the company, and the company is liquidated/sold three months later for $2.4 million, in the absence of a liquidation preference the investors would get $800K (and lose 20% of their investment) while the founders would pocket $1.6 million. The liquidation preference protects the investors from such outcomes.

5. Participatory preferred.

Provides investors a return on their investment in case of liquidation (sale or acquisition). The investors first get their principal returned (before any distribution to Common shareholders), and then the investors get pro rata distribution with Common shareholders until some threshold is reached. In the above example, even if the investors got their money back the founders would still pocket $1.4 million. A typical Participatory Preferred would provide that investors first get their investment back, with nominal interest, and then their Preferred shares are converted into Common, where they "participate" pro rata as other Common shareholders.

6. Anti-dilution (basic).

This term adjusts the conversion rate of Preferred into Common (which normally starts at 1:1) to compensate for Common stock-splits, stock dividends, reverse splits, etc.

7. Anti-dilution (from future financings).

Protects investors when a future financing is done at a lower share price than the investors' share price. There are various flavors of this anti-dilution; Twin Cities Angels usually uses a weighted average which partially compensates for the lower price. For these calculations, you should always think in terms of price/share (and not company valuation). The price/share is the true measure of value to the investor; whereas the company valuation can go up while the share price goes up, remains the same or drops. Investors can be "washed out" of their stock position if there is no anti-dilution provision. For example, if there were no anti-dilution and the management and founders still control the company (i.e., have more than 50% voting shares) they can get rid of investors by doing a "washout" round (say 1 cent/share, when investors had come in at $2/share) that dilutes investors out of the picture; then grant new options to management to bring them back to a dominant position. One way to look at this form of anti-dilution is that it makes management responsible for meeting plan, and to suffer the consequences for serious under-performance. Most good entrepreneurs accept these terms if they do not manage the company well enough so that additional money has to be raised at a LOWER price per share, they will be additionally diluted. That seems fair, from both sides of the table.

8. Anti-dilution weighted-average formula and terms.

PCPnew = ((FDpre x PCPcurr) + IC)/FDpost

  • PCPnew is the new Preferred Conversion Price (i.e., after adjustment for dilution
  • FDpre is equal to the number of full-dilution shares immediately before the funding event in question
  • PCPcurr is the Preferred Conversion Price (immediately before the closing of the funding event in question)
  • IC is the Immediate Cash to be received at the closing of the funding event in question (i.e., expressly excluding any cash that might be received in the future from warrants, options, etc.)
  • FDpost is equal to the number of full dilution shares immediately after the closing of the funding event in question.
  • Full dilution counts all shares that would be issued if all overt and contingent were to take place (e.g., exercise of options and warrants, conversion of preferred shares, exchange of debt for equity, etc)

9. Trigger for anti-dilution provision.

This anti-dilution provision triggers if a given financing is to be done at a lower price/share than the current conversion-price for the preferred shares in question. Note that some anti-dilution provisions only trigger if the price/share equals or exceeds the current preferred conversion price, and ignore options and warrants. To see why this is flawed, consider this example: The current conversion price for preferred is $1/share; the company sells shares at $2/share with each share including 5-year warrants to purchase 100 shares at $2/share. Such a funding would fail to trigger some anti-dilution provisions, but effectively "washout" the preferred investors. The trigger should include only the cash to be immediately received, but include full dilution shares from the funding in question. In other words, the imputed price/share of the funding should be computed using only the cash to be received immediately but divided by full dilution shares (eg assuming that all future options and warrants are exercised, but excluding any cash from option/warrant exercise).

10. Trigger for anti-dilution formula.

EPP = IC/(FDpost – FDpre)

  • EPP is the Effective Purchase Price
  • IC , FDpost and FDpre are as defined in point 8 above.

11. Board seats or some other forms of voting control.

This is done to keep management from acting against the interest of investors (e.g., changing the terms of the Preferred stock after the fact or issuing shares to wash out investors). Typically a vote of the Preferred is required to increase the authorized shares.

12. Registration rights.

There are times that management will create a good success but not want to provide liquidity for the investors. Investors can find themselves locked in, where management gets great salaries and bonuses while investors get nothing (e.g., dividends). In some cases they would never get a return. Registration rights are rarely invoked, especially since the advent of Rule 144 (which allows holders of unregistered shares to sell as if they were registered after two years of holding period, of course providing the company has done an IPO).

13. Escrow and schedule for disbursements.

For shares of founders or current key executives whose shares are not already within a vesting program. In order to protect investors (and other founders) from early departure of key executives who have substantial percentage of shares, an escrow is setup and shares released over time, similar to option grants and vesting for new employees.

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