2.06A Checklist: Preferred Equity Investment Term Sheet
Venture Capital Term Sheet Guidelines Checklist
* Preliminary Statements in the Term SheetNot all term sheets contain preliminary statements. Many will simply
recite each of the key terms of the parties' preliminary understandings. In
other instances, however, one or more preliminary statements will identify the
parties, and summarize the nature of their discussions to date and the fact that
they wish to set forth an outline of their plans going forward. To the extent
that the preliminary statements only recite the history of dealings and the
identity of the parties, the concepts of "pro-investor" or "pro-company" do not
apply. If, however, any material terms are imbedded in the preliminary
statements, they should be viewed through the same lenses that are applied in
the section discussions below.
* Structure of Investment/Type of Securities to Be Issued
The structure of the investment section is as important to the term sheet
as a skyscraper's foundational piers are to the integrity and quality of the
building itself. In most venture investment settings, investors will see to
structure their investments as "preferred stock" or "preferred equity interests"
that enjoy a priority in terms of return on investment over common stock or
common equity. The preferred equity is usually denominated in series (Series A,
Series B, etc.) tied to separate rounds of investment. This provides flexibility
so that the voting, economic, priority and other terms of securities can be
tailored to specific circumstances and to specific investors. The founders of
the company will usually own common equity. The venture investors will usually
own preferred equity, which may actually be a series of different types of
interests with different attributes. But one constant is that preferred equity
(as suggested by its name) always enjoys a series of protections and preferences
that common equity will note.
The underlying concept of preferred is that actual cash investments are
entitled to better treatment and standing than sweat equity investments.
Preferred provides a means of recognizing this accepted distinction as well as a
means of protecting what is typically a minority position for venture investors.
For example, preferred equity most often will retain a level of veto or
influence over many aspects of a company's operations, including:
* approval rights for borrowings,
* future financings,
* entry into new lines of business,
* sale of the company,
* issuance of new equity interests,
* entry into material contracts,
* executive hiring and firing,
* dilution,
* entry into noncompetition or other limiting agreements,
* board member nomination and voting,
* key board decisions,
* other major strategic decisions,
* how and when the company may be liquidated.
In some instances, future series of equity interests can have the same or
even superior rights as all previous preferred series of shares. So a Series B
or Series C equity might be equal to, superior to, or inferior to the original
Series A, depending, of course, upon all the circumstances and conditions
associated with the company, its markets, financial condition, and the financing
environment overall.
* Total Amount of Proposed Investment and Per Equity Interest Pricing This section is usually straightforward and non-controversial. It simply
sets forth the aggregate amount of money the investor proposes to invest and
price per interest it is paying (e.g., price per share if the company is a
corporation, or price per unit if it is an LLC or other non-stock issuing
entity).
* Pre- and Post-Money Capital Structure
The issuance of equity securities by definition changes the percentage
ownership levels of all equity holders (unless no new equity holders are
involved and all existing holders subscribe their current position). Therefore,
it is important for all parties, including the investor and the company, to
understand not only the ownership percentages prior to the pending investment
(referred to as "pre-money ownership") but also the ownership percentages after
the pending investment (referred to as "post-money ownership"). Accordingly,
this section of the term sheet will usually set out a pre-money and post-money
ownership calculation listing each equity holder and the percentages of the
company and each class of securities they own both before and after the
investment. It is important for both parties to test the calculations to ensure
that they have been performed correctly. It is also important that these
calculations be performed for all classes and series of equity securities (e.g.,
common, series A preferred, series B preferred, etc.). And last, the
calculations should be performed with respect to "total common equity
equivalents" or TCEE. To calculate the TCEE, one must add the number of common
equity, options and warrants, and any preferred equity that had been issued
prior to the proposed financing, together with the equity to be purchased as
part of the proposed financing. The TCEE assumes that preferred equity and
common, as well as options and warrants, are treated equally in valuing the
company. All parties should note that preferred equity can bear a dividend that
accrues and, in some cases, will be added to the original value of the equity.
This section of the term sheet should have line items for each of the following:
* Total Investment in Dollars
* Number of Units
* Purchase Price Per Unit
* Pre-Financing Capitalization
* Post-Financing Capitalization
* Equity Options Outstanding
* Preferred Equity
* Total Common Equivalent
* Total Enterprise Value
* Voting Rights
Voting rights provisions in the term sheet are usually straightforward
(other than the various supermajority and other protective features reviewed
separately below). In general, all classes of preferred equity and common will
vote together as a single class, except where otherwise provided by law. The
preferred equity is assigned the number of votes that it would have if it had
elected to convert into common. Therefore, prior to any vote, the parties must
apply the conversion feature and calculate the total number of common equity
units each preferred investor would be entitled to in order to calculate its
number of votes.
* Dividends and DistributionsAfter the structure of the securities to be issued, dividends and
distributions can have the greatest effect on ownership percentages over time.
Also, the relative distributions rights among classes can dramatically affect
the true value of those classes. Dividend and distribution provisions are one of the most powerful tools in
an investor's arsenal for protecting its investment in a company. Through these
provisions, an investor can ensure that it protects its investment and can get
out of an investment with the greatest prospect of a return in the event of
liquidation of the company, and a certainty that its original investment and its
deferred dividends and distributions trump all other equity investor returns. As with many sections of any term sheet, the dividend and distributions
section can be either pro-investor, pro-company or balanced. Factors that
influence in whose favor the provisions ultimately work are, among others, the
percent or stated return assumed for the investor's equity, whether the dividend
or distribution is cumulative or non-cumulative, or whether the distribution or
dividend for preferred stock is a preferred distribution over dividends or
distributions for any other equity classes that have rights to dividends.
Dividends and distributions can be cumulative or non-cumulative. If a dividend
or distribution is non-cumulative and the company does not declare a dividend or
distribution in a given year, or does not have the legal capacity or asset
resources to do so, then that dividend or distribution opportunity is
permanently forgone, and the company has no obligation ever to pay such dividend
or distribution. It is, in effect, a non-event. Cumulative dividends and
distributions work oppositely. Stated periodic returns are required (just as
would be the case with interest on a loan, for example), and to the extent a
dividend or distribution is not actually paid in a given year, then it accrues
and must be paid in the future. A pro-investor dividend and distribution provision in the term sheet would
ensure that the investor's equity (usually a series preferred) would be entitled
to receive cumulative dividends or distributions in preference to any dividend
on the common equity (or on any other class of equity) at a stated rate (often
the then prevailing prime rate plus six to eight points or a rate similar to
that charged by asset based lenders, though the market at any given time will
establish such return rates). The percentage will be multiplied by the dollar
amount of the original investment to establish the stated periodic mandatory
return. A pro-company provision could take several forms. It could have no
mandatory dividend or distribution. If it did have a mandatory dividend or
distribution, then it would be non-cumulative. And any dividend or distribution
would be set at a more modest return level of prime to prime plus two. A
balanced approach would be any blending of the pro-investor and pro-company
provisions in light of prevailing market conditions. Perhaps it is appropriate here to address the importance of market terms.
At any given point in time, the venture capital markets-as with any market-will
have prevailing terms. Some times a great deal of money will be chasing a
limited number of quality company investments. This creates competition among
the investors and therefore improved terms for the company. At other times, more
companies are seeking money than there are willing investors. In such markets,
investors have the upper hand and the prevailing market will be much more pro-
investor with respect to terms. In all markets, some investment opportunities
will be valued more highly than others because of the company's market niche,
track record, management team, or other factors. So, whether one is an investor,
a company seeking funding, or a third party advisor, it is important to
understand the prevailing market and where one's opportunity fits in that
market. This requires research, and often a subscription to a proprietary data
base. Not surprisingly, investors are not always interested in having the terms
of their investments publicized. Therefore, the research process may be more
burdensome than in other settings. But without an understanding of the market,
one cannot hope to negotiate a favorable or indeed even fair deal.
* Liquidation PreferenceLiquidation preferences are the blueprint to determining who gets what,
and in what amounts, at the time the company faces or elects a liquidation
event-a sale or other winding down of the company's business. Any class of
equity holder who enjoys a preference will receive the first fruits of
distribution after creditors are satisfied and will by definition come ahead of
all other classes of equity holders. The principal driver in the liquidation
preference provision of the term sheet is referred to as a multiple. This means
how much beyond the dollar amount of its original investment will the investor
be entitled to receive at the time of liquidation, above and beyond what common
equity holders are entitled to. Pro-investor liquidation provisions will usually
provide the investor (most commonly a holder of series preferred equity) a
multiple on the value of the initial investment, often ranging as high as three
to four times the original investment, depending upon market conditions.
Investors often will state the maxim that they seek "three to five in three to
five." This means they have made their investment decision based on financial
models that show a return of three to five times their original investment over
a period of three to five years. Thus a liquidation preference of this type
would mean that at the time of company liquidation, the investor must receive
the stated multiple of its investment in the company before any other class of
equity holder receives anything at all. Depending upon market conditions, many
private equity and venture investors seek minimum annual rates of return from
the low 20% range to the mid-30% range. In a pro-company provision, liquidation preferences would either be non-
existent or would be set at a much more modest level of original investment plus
any cumulative accrued and unpaid dividends or distributions. In other settings
and markets, the liquidation preference might be set at one and a half to two
times original investment and still be viewed as pro-company. Balanced
provisions would be somewhere between these extremes, again depending upon
specific market conditions and the company's relative attractiveness when
compared to other investment opportunities. In all instances, the term sheet
should make clear that a merger, acquisition, consolidation, sale of all or
substantially all of the assets of the company, or other business combination or
liquidation (in which the equity holders of the company do not own a majority of
the outstanding equity of the surviving entity) is treated as a liquidation
event. Any other special considerations related to a liquidation should also be
included in the definition of liquidation so that it is clear when the
preference comes into play. It is surprising how many times the investor and the
company find themselves in a disagreement over whether a potential transaction
triggers the liquidation preference. Special attention should be given to this
definition both in the term sheet and in the definitive documentation.
* Conversion Features
Conversion features are, by definition, pro-investor. A conversion feature
grants to the investor the right to convert its preferred equity into common
equity in advance of a transaction or liquidity event that offers a higher
return premium than the stated distribution and liquidation preferences. It is,
in effect, the mechanism by which an investor is able to capture the upside of
common equity without prematurely giving up the down side protections of its
preferred equity. Investors who are only purchasing preferred stock will often
give up their preferred rights if a transaction would yield a higher return. Investor elective conversion features, both in the initial term sheet and
in the definitive documentation, tend to be very simple. Often, the provision
will be only a few sentences, providing, in effect, that the investor shall have
the right at any time at its election to convert any or all of its preferred
equity into common on a one-for-one basis.
Automatic conversion features are by definition more complex. A pro-
investor automatic conversion feature would require all preferred holders to
convert into common upon the closing of a firm underwriting public offering
where the price per common equity unit is a multiple (often three to four times)
of the original investor investment, and where net proceeds of the offering meet
a stated minimum threshold (often $40-60 million). It would also likely have a
drag-along feature whereby the agreement of a super majority of preferred
holders (often stated as two-thirds) can require all preferred equity holders to
convert. A pro-company provision would reduce or eliminate the multiple and set
a much lower net proceeds threshold ($5-10 million). It would also lower the
drag-along threshold to a simple majority. A more balanced automatic conversion
feature would lie between these extremes on each of these three elements (e.g.,
drag-along percentage, multiple of original investment, and minimum net
proceeds).
* Redemption Features
The core group of venture investors is made up of limited duration funds
or other entities that expect to attain liquidity in the investment within a
defined range of years. In many instances, the investor's charter documents will
require that it liquidate its investments and distribute proceeds to its own
investors on or before a certain date. Rarely is this period longer than seven
years and it is much more common for the stated investment duration to be three
to five years. As a result, venture investors generally do not invest in a
company unless they have a reasonably clear exit or liquidity mechanism. A
redemption clause addresses this situation by expressly requiring redemption of
the investor's interest by the company if a liquidity event has not occurred
prior to that date. This clearly gives the company an incentive to move
aggressively toward a public markets liquidity event (e.g., an initial public
offering) or a private sale to a strategic or financial buyer. If neither of
these events occurs prior to the stated redemption date, then the company is
obligated to redeem the investor's interest by a certain date or within a window of time.
In a typical pro-investor redemption clause, the company would be required
to redeem some or all of the investor's equity position in the company by the
stated date. The redemption price in a pro-investor formulation is generally set
as a multiple of investment plus accrued and unpaid dividends or distributions.
For example, the company might be required to buy back not less than half of the
investor's position at the end of year three of the investment at a multiple of
two to three times the initial investment, plus any accrued and unpaid dividends
or distributions. The balance of the investment would usually be redeemed over
the next two years at investor favorable multiples. A pro-company provision,
ideally, would have no redemption feature, but in a market driven by external
investor demands for liquidity, this ideal is rarely achieved. A balanced
provision will obligate the company to a mandatory redemption scheme, but on a
timetable and at a price that is equitable to both sides and that does not
create undue strain or advantage to either side.
* Anti-Dilution Provisions and "Ratchet" Adjustments to Conversion Features
Almost every early stage company can expect to go through multiple rounds
of financing. And because both the company and its markets change over time, the
economic and other attributes of each round will differ. This raises the central
issue of whether and to what extent the percentage ownership interest of earlier
round investors will be diluted by subsequent investors. Anti-dilution
provisions are among the most powerful prophylactics for an investor, especially
in a declining economic situation (a "down round"), and therefore are considered
among the most important in any venture investor's negotiations with a target company.
One term that investors and companies alike must understand in dealing
with anti-dilution provisions is "ratchet." In a down round, the investor's
ideal outcome is to have his original investment's conversion feature re-priced
to the same, lower price being paid by the new investor for his equity in the
company. This maximum level of conversion feature protection is referred to as a
"full ratchet," because the old investment ratchets fully, not partially, down
to the newly established pricing. Such provisions can be extremely dilutive to
common equity holders, and therefore should be viewed as more important than
other provisions in the term sheet. A less pro-investor down round anti-dilution formulation is a "partial
ratchet." In this more balanced approach, the term sheet clause and definitive
agreements would provide that the conversion feature is adjusted on one of
several weighted bases. The most typical and balanced formulation is referred to
as weighted average conversion. This formula takes into account the size of each
investor's investment in a given round, the pricing assigned to that round,
weights each such round and investment accordingly, and averages them. This then
becomes the means of calculating each investors conversion right at the future
conversion date. While conceptually, the weighted average notion is simple, it
is often more difficult to express in narrative than it is simply to set down an
algebraic formula in the definitive agreements. In the term sheet, it is
sufficient simply to use the term of art of "weighted average conversion." The last anti-dilution related concept that should be addressed in the
term sheet is whether the original investors must participate in the new round
of financing in order to receive any adjustment to their conversion ratio. This
is often referred to as a "pay-to-play" provision. A pro-investor formulation
has no pay-to-play feature. A pro-company approach requires full ratable
participation in each and every subsequent round of financing or the anti-
dilution ratchet (full or weighted average) is forfeited. In a more balanced
approach each round stands on its own, and while some level of original investor
participation in the subsequent round is required, it is not necessarily full
pro rata participation.
* Preferred Investor Protections
Preferred investors are most often minority investors. This status adds
peculiar levels of risk that are commonly addressed by including specified
preferred investor protections in the term sheet and ultimately in the company's
charter and the other definitive agreements. Such provisions require either a
supermajority or the outright consent of all preferred investors. While each
investment, company and industry sector may well demand tailored protections,
some protections are so common as to be considered basic starting points for
investors. These include:
* any change in any charter document;
* any change in the terms of the preferred equity;
* any issuance of new equity interests;
* the grant of any rights equal or superior to any outstanding
preferred equity class;
* entering into any affiliated party transaction or making any
distributions to affiliates;
* any business combination, merger or sale of all or substantially
all of the assets of the Company;
* any change of control;
* certain changes in the board of directors or any key committees of
the board;
* any change in senior executive leadership;
* entry into any long term or other material contracts not in the
normal course of business; * declaration or payment of distribution on any class of equity
other than the investors';
* any material change in the company's strategic plan or line of
business.
Pro-investor protective provisions lists can be very comprehensive and in
some instances unreasonably burdensome. The challenge for all the parties is to
achieve a balance between the legitimate interests of the investors and of the
company.
* Company Governance
Regardless of the nature of the governing body (e.g., board of directors,
supervisory board, board of managers, etc.), the preferred equity investor will
want to ensure its representation on that body, and its involvement in or
ability to veto material changes in the makeup or powers of that entity. The
investors may also want to limit the number of management seats on the governing
body and specify the precise number of independent members. Depending upon the
size of the investment and the prevailing market, an investor may seek not only
to have influence on the governing body but indeed to control it. Wherever the
balance of power may lie in this negotiation, it is generally desirable to have
an odd number of governing body members (to reduce the chances of a deadlock)
and some number of independent members who will bring fresh perspectives and a
degree of neutrality to the governing body's meetings and decisions. It is also
appropriate to establish in the definitive documents if not in the term sheet a
regular frequency of governing body meetings. Depending upon the relative
maturity of the company, strength of its management team, market conditions, and
other factors, a physical meeting schedule of four to six times per year (with
any other necessary meetings being held by telephone or video conference) is
often appropriate. Much as is the case with supermajority votes and vetoes associated with
the preferred security itself, the investor (or the common equity holders in the
event the investor controls the governing body and the common holders are in the
minority position) will want to ensure that various minority protections are
built into the board proceedings as well. While the scope and character of the
supermajority and unanimous consent provisions associated with board action vary
from transaction to transaction, items to be negotiated often include the
following:
* annual budget approval and any interim changes in such budgets;
* annual strategic plan approval and any interim changes in such
strategic plan;
* material hiring and firing, as well as changes in compensation
programs;
* any proposed issuance of new securities or any material borrowing;
* any change in any charter document provision, including as relates
to classes of interests and control;
* affiliated party transactions;
* dividends and distributions;
* any business combination, merger or sale of all or substantially
all of the assets of the Company;
* any change of control;
* changes in the governing body or any key committees thereof;
* entry into any long term or other material contracts;
* any activity or action not in the normal course of business.
* Information Rights
For so long as an investor continues to hold its equity interest in the
company (or some predefined minimum level of ownership in the company) and the
company remains privately held (i.e., there has been no public offering of the
company's stock or it is not otherwise required to be a reporting company under
the rules and regulations of the Securities and Exchange Commission), the
investor will want to ensure that the company has an ongoing obligation to
provide various types of material information to the investor. Separate and
apart from whatever role the investor has in connection with the company's
governing body, it will be better able to monitor and manage its investment by
staying current and fully up to speed on developments affecting the company. In
a typical pro-investor formulation of information rights, the company covenants
to provide, among other things:
* audited annual financial statements,
* un-audited quarterly financial statements,
* any monthly financial statements regularly prepared,
* any internal planning or flash reports used by management,
* strategic plan and any changes to such plan,
* material employment agreements or amendments,
* press releases and press clippings,
* marketing materials and related content,
* annual operating plan,
* regulatory notices or service of process,
* other specified materials prepared in the normal course of
business.
If the preferred investment does not carry a right to a governing body
seat (as might be the case if the investor is a small part of a club deal or an
add-on investor in a round dominated by a primary fund, for example), then the
investor will likely seek "observer" status at any governing body meetings. As
an observer, the investor would not be entitled to cast a vote on any issue
before the governing body, but would be entitled to attend governing body
meetings and to receive all information provided to the members of the governing
body. The investor may also seek certain audit and inspection rights, such as
the ability on relatively short notice to visit the company's office and review
its financial and other records.
* Demand and Piggyback Registration Rights
A common goal of preferred and common holders alike is attaining liquidity
in their investments in the company at an attractive valuation. The registration
rights section of the term sheet and definitive agreements sets forth the
relative priorities among the preferred and common holders in the event of a
public offering of shares. Registration rights sections usually will contemplate
both a "demand" registration, in which an investor or group of investors has the
right to demand the filing of a public offering, and a "piggyback" right, in
which the investor is entitled to include some or all of its shares in any
offering not triggered by exercise of the demand right. In a typical pro-investor formulation of registration rights, investors
holding as little as 25-30% of the issued and outstanding shares of the
preferred class have the right to demand (sometimes once, sometimes more than
once) that the company use its best efforts to file and effect a registration
statement for the company's securities having an aggregate offering price to the
public of not less than a stated amount, usually $20-25 million. Such a demand
registration provision would usually be unexercisable during the first twenty-
four to thirty six months of the investment, and in certain circumstances, the
company would have the right to delay the registration filing for ninety to 120 days. A typical pro-investor piggyback registration provision would grant the
investor a right to participate in (i.e., to piggyback) all registrations of
securities by the company or any demand registrations of other investors.
Piggyback rights are, however, subject to "cut-back," which allows the
underwriter to reduce the number of shares to be registered as it deems
appropriate in light of then prevailing market conditions. In a cut-back,
investors who exercise one of their demand rights have priority over those
merely exercising a piggyback right. It is customary that the company bear all
the registration expenses, other than underwriting discounts and commissions,
associated with any investor registration, whether piggyback or demand.
Registration clauses also will include a host of other relatively technical
provisions, such as a limitation (sometimes called a "standoff" or "lock up"
clause) creating a post-registration blackout period in which an investor may
not sell shares into the market (often expressed as 120-180 days). In a pro-
investor provision, all registration rights enjoyed by an investor are fully
transferable. In a more balanced provision, such rights will be transferable to
certain identified classes of transferees only (e.g., affiliates, tax planning
trusts, etc.).
* Right of First Refusal
Pro-investor rights of first refusal usually provide that the investor
shall have the unfettered right to subscribe for its pro-rata share of any
future equity issuances by the company, provided the investor is willing to pay
the same amount of consideration being paid by the new investor. Equity
securities issued pursuant to stock option or other employee plans, or interests
issued in connection with a merger or acquisition that has been approved by the
company's governing body, are usually excluded. However, all other issuances are
usually broadly included. It is common to provide a short exercise window (ten
to thirty days) to ensure that the right of first refusal does not unduly
restrict the company's ability to issue new equity interests.
* Conditions to Closing of Proposed Investment
The term sheet and definitive agreements should set out in reasonable
detail all of the conditions that must be satisfied before the investor is
obligated to make its investment. Typical conditions include:
* satisfactory completion of due-diligence review,
* preparation of mutually agreeable definitive documentation,
* final approval by investors' board or partners,
* receipt of all required contractual consents,
* receipt of all required regulatory consents,
* no injunction,
* no litigation,
* key employee retention (through employment agreements or
otherwise),* receipt by investor of specific legal opinions of company counsel.
* Definitive Agreements
While the term sheet is a relatively complete outline of the preliminary
agreement of the parties regarding the proposed investment, the ultimate
statement of the parties' agreement will be contained in a definitive
subscription agreement. Once the term sheet has been finalized and signed, the
parties and their counsel will begin immediately to draft the definitive
subscription agreements. The term sheet will provide expressly that the
obligation to invest shall be set forth in a customary and mutually acceptable
subscription or purchase agreement containing, among other provisions:
* customary representations and warranties of the company,
* customary representations and warranties of the investor,
* customary representations and warranties of the founders of the
company (depending upon the stage of its development cycle),
* customary covenants of the company,
* conditions of closing, including legal opinions.
