VC Experts has teamed up with Aspatore Books to reprint some of the more salient sections of Alex Wilmerding’s Deal Terms, The Finer Points of Venture Capital Deal Structures, Valuations, Term Sheets, Stock Options and Getting Deals Done. This excerpt features an interview with a leading legal expert in the private equity arena, James M. Crane, who has served as counsel at the Boston law firm of Testa, Hurwitz & Thibeault, LLP.
Jim’s perspective is representative of the candid, forthright demeanor that entrepreneurs and venture professionals look for in counsel. And it’s a fascinating look at what a seasoned lawyer thinks you should look out for term sheet.
What to Look Out for in A Term Sheet:
Alex Wilmerding: What exactly would you consider typical when looking for common ground in the form of a term sheet? Is there a neutral form of term sheet we can use as a starting or reference point for our discussion?
Jim Crane: While it is certainly relevant to include a balanced form of term sheet as a reference point it is frankly unlikely that any two lawyers would ever agree on the neutral form of any term. Each term sheet is affected by the subjective dealings of two parties; you can always come up with an argument for its favoring one party or another.
AW: Are the terms that are generally incorporated into a Series A Preferred by VCs created specifically for the current financing, or do they reflect some standard a lawyer or venture firm prefers?
JC: When you’re talking about an early-stage preferred financing (such as a series A or perhaps a series B that occurs a year or two after the series A) very often the things that are coincidentally found in the term sheet and sometimes end up in the deal documents are terms that VCs have used in other recent financings.
AW: It may be most interesting for entrepreneurs to consider how lawyers look at a term sheet when representing a VC’s interests. As companies progress through successive rounds of financing, it is standard that new VCs will bring new capital to a company. In these instances, it is important to consider how VCs interpret the terms presented to a company. Considering how VCs look at term sheets is important if entrepreneurs are looking for a perspective on the priorities VCs have when they draft a term sheet to be presented to a company. Let’s consider the core terms to look out for in a term sheet. Which core terms do you first examine and consider when examining a term sheet that has been presented to you for review?
JC: The things that are important to me may be different if I’m representing a VC. A VC may draft a term sheet and have me review the draft before it is submitted to a company. A VC who is already invested in a company may pass me a term sheet that has been presented to the company by a prospective new investor.
If I am representing a VC who has a working first draft of a term sheet, the first thing I do is to take a quick look at the valuation of the company. The valuation section gives you a framework from which to work. The first questions I ask when examining valuation are the amount of capital going into the company and the price per share.
I also look closely at the key terms of the preferred stock. They may be a little different or have different protections, depending on whether it’s a first round of preferred stock, a Series A round, or a later round, a Series E round, for example.
If you’re looking at a Series E round, very often just by way of precedent, the other rounds and their attendant leverage predetermine much of the nature of the framework and context for the terms of a Series E round. The extent to which the new money will have leverage over the old money will be spelled out here. A Series A, by being the first preferred to be issued, has the opportunity to define terms for the preferred. A Series E sometimes will need to incorporate provisions from prior classes of preferred that you have to live with. In these instances, you have to pick and choose your battles for things you want changed in the structure coming in.
In this respect, I always glance at the dividend provision, as well. I don’t think whether there will be cumulative dividends is something a lawyer will dwell on, but the dividend provision is important to pay attention to, particularly when considering the implications for the preferred and the implications for a company with multiple classes of preferred, should they also hold dividend provisions.
Next, I look at vesting. What you’ll usually want to do if you’re the VC is to put right up front what you want the vesting of the founders’ shares in an early-stage financing and the options pool to be. You don’t want to create a situation where your founders can sneak out and leave the company high and dry when they are more often than not–and certainly in the early stages of the company’s life span–vital to a successful venture.
Beyond the economic parameters that some of the other terms mentioned will dictate, the restrictions on the founders and key employees will be critical to an early-stage venture’s success. After a company has been around for a while, shares will have vested; and if the company is starting to make it, then maybe the importance of keeping any one individual starts to decline. Vesting schedules are probably the biggest thing to look at when I am looking at an early-stage term sheet. These schedules could be more important to consider than the terms for the preferred; if there are few restrictions in place on the founders’ and key employees’ stock, there is the potential need to issue incremental stock options.
While not considered part of the options pool, investors may also ask founders in an early-stage round to have their shares subject to vesting. This is sometimes generically referred to as “reverse vesting”–agreeing to have existing common stock, typically founders’ shares, subject to vesting–to give founders incentive to perform. People don’t often consider the importance of vesting schedules because people are trained to start digging into the terms of the preferred. And usually those provisions on the restrictions on the founder are stuck toward the back of the term sheet. But the implications for a company’s future are significant.
AW: Options, and particularly the subject of vesting, are of great interest to entrepreneurs. Clearly, the terms defining vesting and valuation are, to some extent, interrelated. Is this a good example of the inherent flaw in dwelling too much on any one single term without considering implications of others?
JC: It is a good example of how many terms are intricately linked and cannot be considered entirely independently. The value you put on a company, assuming you’ll add key people in the future, will be affected if additional shares need to be added to an option pool after a closing to provide appropriate incentive to management. I don’t think this is necessarily obvious in the math of the valuation of the company unless, when you do your initial analysis, you consider vesting schedules for existing staff and whether the number of options included in the proposed capital structure at the time of closing anticipates options needs for the foreseeable future. For a relatively early-stage company, one that has been in existence for one or two years, language describing vesting schedules and treatment of options vesting should give a pretty good picture of the profile of a company’s options pool.
Vesting and the subject of options are sensitive for founders because many have not been involved in this process before. With good reason, founders and key employees need to be prepared to accept the shock that their shares will be restricted right off the bat. Usually key employees and founders form the company. They set it up; they issue themselves common stock; and they think they own that stock. In a sense they do, but if they want to be financed, they’ll have to put the restrictions on their ownership positions that the VCs are looking for, and that’s often an emotional battle. I’ve had clients who were virtually throwing up at the thought that they had to turn over their shares and earn them back again. It is hard to educate highly educated people, but it is understandably new territory for them. Entrepreneurs can have trouble getting around it. The company’s lawyers, if they have not done so already, have to get their clients to realize this is how venture financings work.
AW: Assuming entrepreneurs and companies are well advised, are there ways to anticipate some of this heartburn? What then are the preemptive strikes you would advise a company to make to mitigate terms that may appear on a term sheet?
JC: Accepting that a stock restriction agreement will be part of what will be expected by VCs is the first step. Very often what I do if I am representing a company in an early-stage investment is to try to preempt the VCs on this issue and set up the stock restriction agreement for the company and their founders before opening the negotiations with the VC. This way a company is prepared to say it already has an agreement in place, and it makes the issue a little tougher because the VCs then have to impose harsher vesting terms than the ones that already exist in the stock restriction agreement.
If no agreement exists, it is easy for a venture firm to ask for certain thresholds straight off the bat. Many times, the VCs don’t want to make enemies with the founders because doing so is in nobody’s best interest, so changing an existing agreement may be something less likely to be initiated, once established.
You can’t really preempt VCs on any of the charter provisions and preferred stock terms. Usually a new company will have a very plain vanilla common stock charter. The VCs typically will come in and know what they’re looking for, and you may have to redo your whole charter if they want to make changes. Probably the only meaningful battle you can preempt the VCs on is the type of vesting. You have to take an educated guess based on where the market is in any particular month. A common VC approach is to have founders’ shares put on a four-year vesting term. Entrepreneurs may try to preempt the vesting issue for their existing shares by adopting an agreement to have one-third vested immediately and the rest on a three-year term. Often the VCs will come in, and, depending on the relationships and how much they want to offend the parties, they’ll say they’ll let that stand. This is a good way for VCs to express their acknowledgement of the founders’ value before the game even starts.
AW: Let’s move on to liquidation preference, which is often a sticking point and an important term on which to focus. What do you look for when examining a liquidation preference clause?
JC: Liquidation preference is really what the deal is all about. The liquidation preference section defines how much each class of preferred stock will receive in preference to other stockholders if a company is sold or generates liquidity as a result of a transaction before any of the other stockholders receive proceeds. The definition of a liquidation event is therefore very important; it will define when liquidation preference terms take effect and how individual classes of preferred shareholders will be treated as compared to common. Liquidation will be defined as an actual dissolution of the company, and the definition could also include a merger, an acquisition, a sale of the company, or a change of control of anywhere from 50 percent to 80 percent to 100 percent of the voting power of the company–often referred to as a deemed liquidation. In the event of what is defined as a deemed liquidation of the company, liquidation preference terms would take effect.
AW: What other term sheet text may reveal preferential treatment to the preferred?
JC: If protective provisions are incorporated into a term sheet, the preferred are looking for a form of blocking power to block management from making certain decisions without their approval. Protective provisions typically require that a certain percentage of the preferred be required to vote to approve certain actions the company chooses to take. Without the vote and approval of a certain percentage of preferred stock, the company is blocked from taking certain actions. For example, protective provisions can stipulate limits on the amount of debt a company can take on.
AW: How might protective provisions restrict a company from increasing its option pool or pursuing a subsequent financing without prior approval?
JC: Protective provisions could restrict certain actions, including amending the charter of the company, pursuing a merger or acquisition, and increasing the size of the equity pool, for example.
On the subject of options, protective provisions that require approval of some majority of the preferred to make any amendment to the charter of the company in effect limit a company’s ability to increase its options pool beyond the authorized shares stipulated in the charter. The charter will detail the total authorized capital stock of the company, which has a limiting effect on the number of shares in the company’s option pool. If the company wanted to increase the option pool and protective provisions required that approval from some majority of the preferred be secured to do so, the company would in effect be restricted from increasing the options pool unless some majority of the preferred were to approve an amendment to the charter.
Assuming a company has an options pool of sufficient size to serve its needs, this power will give the preferred a degree of leverage, should a board and management look to increase the size of the options pool at some future point. If, subsequent to a financing, additional options were required to create an additional incentive for additional staff, a further increase to the size of the options pool would be dilutive to the preferred. The preferred may exercise their blocking power to, in effect, require that the existing option pool be reapportioned, for example. Such a provision does not have to be an obstacle to future expansion to an option pool; companies that meet and exceed the business plans they commit to and that require an expanded option pool to accommodate growth will most probably receive the support of their investors if such an initiative is in line with investors’ expectations.
Protective provisions may also forbid the issuance of additional stock and hence a subsequent equity financing without approval of some majority of the preferred. This is an additional source of leverage for the preferred and presumably a deterrent to management who might otherwise assume that serial rounds of equity financing could be a panacea to their capital needs.
AW: How creative can investors and lawyers get with protective provisions?
JC: You can incorporate just about anything your heart desires. There are certain terms you almost always see, such as in the case of a merger or sale of the company. Similarly, provisions preventing changes in the nature of the company’s business are not uncommon; an investor does not want to be buying stock in a company that’s doing X, and the next thing they know the company’s doing Y instead.
AW: How are protective provisions of some early form of preferred–a series A, for example–incorporated into future rounds of preferred?
JC: One thing that’s important for a late-stage company financing is for the interests and therefore the protective provisions associated with early rounds of preferred to be balanced with the interests of later-stage investors. A company does not want investors from early rounds who may not have the capital to participate in later rounds of financing to hold the power to prevent the company from pursuing a good deal later on in the life of the company. It would be very unlikely that a Series B would agree to let an existing Series A vote independently on this issue unless, of course, the investors in the Series A and the Series B were the same. Instead, often a later series of preferred will require the protective provisions of earlier preferred be revised so that all classes of preferred vote collectively.
AW: We’ve talked about valuation, vesting, liquidation preference, and protective provisions. What’s next on your list?
JC: One of the most important things is the impact of dilution protection provisions. That’s always a key thing. In the term sheet stage, negotiating the terms for dilution protection provisions is not always easy. Often investors won’t actually spell out the dilution protection provision formula in the term sheet; they’ll wait to do so in the final definitive closing documents. They just say a weighted-average formula.
AW: But there are several types of weighted-average formulas.
JC: That can be the tricky part. It probably would be a better practice to actually put the formula into the term sheet, or at least clearly define it. It’s not as much of an issue if anti-dilution is a full ratchet because that’s pretty cut and dry. If it’s a later-stage company, maybe it’s not so much of an issue because they’ve had a weighted-average formula in their charter, and the VCs have already seen it, and they’ll just go with it. In an early-stage company, there might be a little bit of an argument about which shares will be included in the anti-dilution formula when you actually get to the drafting stage and have to put the language in. At that stage, there may be disagreement over what shares are included in the calculation.
Another thing is that you’d be amazed at how often someone can later go back to the formula, or the language if there is no formula, and it doesn’t read right. It’s very tricky to use the English language to write out a mathematical formula. The language is awkward and weird, and it gets screwed up more often than you think it should. This is the nuts and bolts of the economics of the deal, and I think it’s critical that any time you’re going through anything involving numbers in a term sheet, you actually do the math and make sure the numbers work. I never read an anti-dilution provision and say, “Oh, that looks right. Those are the words I’m familiar with.” Even if I am 99.999 percent sure that’s the way I have seen them every other time, I still take out my calculator and a pen and paper. I take some numbers from the term sheet somewhere else and assume a scenario and plug in numbers to see how it comes out. Sometimes a very subtle mistake in how the words are transcribed from whatever previous deal you used will screw up a formula.
AW: Let’s consider the IPO process and how it is reflected in term sheets. Could you comment on registration rights and how they are treated?
JC: Registration rights are almost more of a leverage tool that plays later on when a company goes public. This subject does not necessarily get a lot of attention from entrepreneurs when they are focused on getting enough capital in the door to get to cash flow break-even. Registration rights are one area of language in a term sheet that levels out the most in a down market–IPOs are more distant in everyone’s minds.
The things to look for there are the number and types of registrations and the time frames involved–how quickly a registration can be forced and when the registration rights expire. Very often registration rights agreements will have some built-in expiration, usually based on a period of time or when the shares become otherwise salable, for instance under SEC Rule 144.
The expenses of registration are another thing to focus on. Typically the company bears the cost of registration, but if someone requests a registration and withdraws the request, it is not uncommon for the company to retain the right to pass the expense on to the investor who requested the registration. This is one important way for a company to put in place disciplines that encourage investors to make sure their requests for registration are well thought out. On the other hand, if you’re a VC, you might agree to this approach but try to ensure that expenses will be covered by the company if the registration is withdrawn for reasons that were beyond the VC’s knowledge or ability to foresee. A war or bombings that rattle the financial market are extreme examples.
Investors will also want to include piggyback registration rights; they will want the right to participate not only in the first but also in subsequent public offerings. Investors will want to detail what happens if there’s a cutback in how much stock can be sold on the public markets; they’ll want to detail how each type of stock will be treated. Usually there will be a hierarchy: If there’s a cutback, this one goes first, and we’ll take it from there. I’ve seen some cutback provisions that get quite intricate about who gets to register their shares in what order. But often that level of detail is worked out in the deal documents and not in the term sheet. “With appropriate cutback provisions” is about as specific as the term sheet language will get.
One thing that’s very important with respect to registration rights is that you don’t want to have a lot of registration rights agreements out there. It’s important that everyone is all tied up in one agreement. It’s easier and less complicated because you don’t want to have to go back through the old terms. If there are varying terms you want, at least try to have them all in one document, so you have only one place to look to find out where everyone stands. You want to have everyone who has registration rights at all to be party to the one agreement.
Whether you’re representing the company or the investor, I can’t imagine a scenario where it would be in your interest to allow multiple registration rights agreements out there. The registration rights contained in the agreement are rarely used, but it’s an extremely powerful tool that has very powerful consequences for everyone registering shares for public sale. You don’t want those rights to just be floating out there–you want to know where they are, and you want everyone to be wrapped up in the same agreement. If you don’t do that, or at least vigorously fight for it, then I don’t think you’re doing a service to anyone. Usually there’s no objection at all–I’ve never had anyone say no to it.
AW: Give some examples of how term sheet style and approach can be unique.
JC: The terms commonly used by one investor for one type of deal can begin to creep into term sheets for companies facing very different situations for which such terms may not be appropriate. Take for example an investor who’s been working in an environment where they go into struggling companies because they can pick leverage situations or turn companies around long enough to put some money in and then get out. It is not uncommon to see the terms used by these individuals popping up in term sheets in early-stage ventures where such terms may not be the common practice. Often when companies are struggling, the term sheets and deal documents might include milestones that spell out consequences for the company’s failure to meet those milestones. Very often these consequences might include existing stockholders losing control of the board and investors taking control of the company if the company is not performing. In a different investing context, such as an early-stage financing, if you have a VC who’s used to getting those terms, it’s harder than you’d think to get them to drop them.
The most dangerous thing about term sheets is for an investor to get into the habit of just grabbing the last one he had from a recent deal and revising it. Whenever I’m asked, I’ll provide an original term sheet that covers all the bases. Term sheets are restrictive in nature because you’re stuck with the terms spelled out on the page. As the corporate attorney sometimes you’ll be given a draft of the term sheet you’ll recognize from having worked on it in a previous deal. Just because you did it last time doesn’t mean you want to do it this time. I try to start with a blank term sheet, not one I’ve used before.
There’s nothing wrong, however, with using a form as a tool, as long as you use it in the right way.
I have a formal term sheet I like to look at, but it doesn’t have everything that could possibly be incorporated into a term sheet. This one has suggestions for alternatives, bracketed items, and notes about things to consider. It includes alternative clauses. It does not have everything. When you keep building off an older version of a term sheet, at some future point, you’ll miss the chance to take another direction because the forms you always use say X, and you’ve forgotten the alternatives because they are not in front of you or you haven’t had them in your deals lately. You’ve forgotten about the possibility of doing Y instead.
AW: Is there a strategy you recommend people follow when negotiating a term sheet?
JC: It depends on the facts for the particular deal and your sense of what’s important to the company and to the VCs. As for the pricing and that kind of thing, that’s better left out of the hands of the lawyers. Very often that’s been settled before the lawyers even get the call from the client to look at the term sheet.
I don’t know that I have any advice on strategy that would apply to every situation. I think in early-stage investing, the key is the founders and their level of sophistication. If they’re not sophisticated, investors may end up having problems getting past the hurdles I mentioned before, like the vesting on the founder ownership, which is hugely important. I don’t know if there’s a good way to soften them up before an investor starts hitting them with the other points. It really just depends on the people involved and the facts of the situation.
AW: Have you seen really gross variances or differences in the evolution of the term sheet over the years?
JC: Over the past five years, the staples of term sheets have remained relatively the same, and yet we have seen a big swing from company-favorable to investor-favorable financing climates, influencing which party the language favors. Consider protective provisions, for example. In a company-favorable investment climate, it is almost unheard of for a company to have a charter with a ratchet provision or very onerous provisions. In a more investor-favorable climate, the deals happen at a slower pace, and there’s more time to negotiate in favorable terms. When deals are happening so fast that it may seem there are other VCs around the corner, in some cases, tripping over themselves to give a company money, investors are unlikely to incorporate extensive protective provisions.
In both types of investment climates, the issues are the same. The biggest shift is in the negotiating leverage. In a very company-favorable climate, there are a lot of vanilla terms, and deals get papered very quickly. As the deals slow down, the terms get negotiated harder, and companies find themselves with more terms they have to live with.
AW: Do larger law firms have certain views about how much work they’ll do for early- or expansion-stage companies?
JC: Large firms will be selective; they often will not get involved in every angel round. That’s not to say they won’t do them if there’s a relationship there or something they’re interested in. Usually the angel rounds happen at very small amounts, and the terms aren’t so complex; it’s a friendlier negotiation, and everyone is just trying to get the company into the game. The company is not quite ready to venture into the real arena yet, so they don’t need a large venture law firm to work on the documents. There are individuals or small firms that will do it, and there are groups of angels who support them. Either way, you want to engage a qualified professional, with experience, who won’t create problems in documentation that will cost more money later to fix. Angel investors get in and pay attention to protecting their ability to stay in the game and going forward a little bit; they’re trying to make sure that down the road they’re not just lumped in with common. Such terms are not necessarily complex enough to justify use of a large firm.
AW: How would you recommend an entrepreneur go about selecting a lawyer or a particular firm to work with?
JC: In the very early stages of a company, you at least want someone who’s done this before who can hold your hand. The point is that there’s almost nothing in the term sheet that isn’t worth looking at. Depending on a company’s bargaining position, it’s important for a company to get good legal advice because you never know to what extent great thought has been put into the term sheet that may be presented to you, or if it’s a remake of a previous form–some terms might not be entirely germane to the company in negotiation.