Preparing a Venture Capital Term Sheet: Key Terms for

Preparing a Venture Capital Term Sheet: Key Terms for Investors and Companies Seeking InvestmentValuation, Capital Structure, Board Composition, Protective Covenants, Exit Terms

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George Colindres, Partner, Perkins Coie LLP, Los Angeles

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PREPARING A VENTURE CAPITAL TERM SHEET

SEPTEMBER 15, 2021 | PRESENTED BY: GEORGE COLINDRES

| © 2021 Perkins Coie LLP

• NVCA Forms• Term Sheet Provisions• Q&A

Presentation Overview

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• NVCA released its “Model” Legal Documents in 2003• Forms can be found at https://nvca.org/model-legal-documents/• Primary Documents:

- Term Sheet- Amended and Restated Certificate of Incorporation- Preferred Stock Purchase Agreement- Investors’ Rights Agreement- Right of First Refusal and Co-Sale Agreement- Voting Agreement

NVCA Forms

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NVCA: NATIONAL VENTURE CAPITAL ASSOCIATION

https://nvca.org/model-legal-documents/


OVERVIEW

• Price and Valuation• Liquidation Preference• Anti-Dilution: Full Ratchet vs. Weighted Average• Board Composition• Drag-Along Rights• Protective Covenants• Information and Registration Rights• Participation Rights• Rights of First Refusal and Co-Sale

Term Sheet Provisions

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PRICE AND VALUATION

• Pre-Money Valuation: Financing price per share multiplied by the Company’s pre-financing capitalization

• Post-Money Valuation: Financing price per share multiplied by the Company’s post-financing capitalization

• Based on “Fully-Diluted” Capitalization

• Treatment of Option Pool Increases

• Where do Pre-Money Valuations come from?

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Initial Capitalization

Founders 4,000,000 Shares 80%Initial Option Pool 1,000,000 Shares 20%“Fully-Diluted” 5,000,000 Shares

• Series A Financing: $2,000,000 at a $3,000,000 pre-money valuation.

Example Capital Structure

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Pre-Money Capitalization (Series A)

Founders 4,000,000 Shares 66.7%Initial Option Pool 1,000,000 Shares 16.7%Option Pool Increase 1,000,000 Shares 16.7%“Fully-Diluted” 6,000,000 Shares

• “Pre-Money” is $3,000,000, so …• Series A Price = $3.0MM/6.0MM = $0.50 per Share• $2,000,000 Investment (at $0.50) = 4,000,000 Shares, so …

Example Capital Structure - Continued

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Post-Money Capitalization (Series A)

Founders 4,000,000 Shares 40%Initial Option Pool 1,000,000 Shares 10%Option Pool Increase 1,000,000 Shares 10%Series A Preferred Stock 4,000,000 Shares 40%“Fully-Diluted” 10,000,000 Shares

• “Post-Money” is $5,000,000• Called a “2 on 3” Round

• Next: Series B Financing: $10,000,000 at a $12,000,000 pre-money valuation.


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Pre-Money Capitalization (Series B)

Founders 4,000,000 Shares 33.3%Old Option Pool 2,000,000 Shares 16.7%Series A Preferred Stock 4,000,000 Shares 33.3%Option Pool Increase 2,000,000 Shares 16.7%“Fully-Diluted” 12,000,000 Shares

• “Pre-Money” is $12,000,000, so …• Series B Price = $12.0MM/12.0MM = $1.00 per Share• $10,000,000 Investment (at $1.00) = 10,000,000 Shares, so …


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Post-Money Capitalization (Series B)

Founders 4,000,000 Shares 18.2%Old Option Pool 2,000,000 Shares 9.1%Series A Preferred Stock 4,000,000 Shares 18.2%Option Pool Increase 2,000,000 Shares 9.1%Series B Preferred Stock 10,000,000 Shares 45.5%“Fully-Diluted” 22,000,000 Shares

• “Post-Money” is $22,000,000• “10 on 12” Round

• Is the Company really worth $12,000,000?


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LIQUIDATION PREFERENCE

• Multiples (1x, 2x) Before Payment to Junior Classes

• “Participating” vs. “Non-Participating”

• Subsequent Rounds: “Senior” vs. “Pari Passu”

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Examples of Liquidation Preference

Founders 4,000,000 Shares 18.2%Old Option Pool 2,000,000 Shares 9.1%Series A Preferred Stock 4,000,000 Shares 18.2%Option Pool Increase 2,000,000 Shares 9.1%Series B Preferred Stock 10,000,000 Shares 45.5%“Fully-Diluted” 22,000,000 Shares 100.0%

Sale of the Company for $20,000,000

1X Liquidation Preference, Participating Preferred, and Series B Senior to Series A:Because the Preferred is Participating, it does not need to make the decision whether or not to convert: • Series B – First $10MM• Series A – Next $2MM• All Shares – Split $8MM ($0.364/Share)


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1X Liquidation Preference, Non-Participating Preferred, and Series B Senior to Series A:Because the Preferred is not Participating, it needs to make the decision whether or not to convert. If Series B and Series A do not convert:• Series B – First $10MM ($1.00/Share)• Series A – Next $2MM ($0.50/Share)• Founders/Options (12MM Shares) – Split $8MM ($0.667/Share)


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1X Liquidation Preference, Non-Participating Preferred, and Series B Senior to Series A:Because the Preferred is not Participating, it needs to make the decision whether or not to convert. Here is it optimal for the Series A to convert, but not for the Series B to convert:• Series B – First $10MM

(Series B Does Not Convert Because $1.00 > $0.909)• Series A/Founders/Options (12MM Shares) – Split $10MM ($0.833/Share)

(Series A Does Convert Because $0.833 > $0.50)


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ANTI-DILUTION ADJUSTMENT

• Dilution for purposes of Preferred Stock Financings: subsequent sale of stock at a lower price than the current round.

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ANTI-DILUTION ADJUSTMENT (CONT.)

• Applies to “Down Rounds” Only

• “Full-Ratchet” vs. “Weighted Average”

• “Broad-based” vs “Narrow-based”

• Carveouts (Exclusions)

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COMPOSITION OF BOARD OF DIRECTORS

• Size of Board

• Mechanics of Stockholder Voting

• Control Issues

• Voting Agreement- Common Directors, including CEO Director- Investor Directors- “Independents”

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DRAG ALONG RIGHTS

• Enforceability Issues

• Compromises

• Sometimes: Minimum Sales Prices

• More and More: Employees May Be Subject to Noncompetition Agreements

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PROTECTIVE COVENANTS

• Future Financing

• Changes in Rights, Preferences and Privileges of Preferred Stock

• Sale of the Company (Liquidation Event)• Change in Board Composition

• Increase to Option Pool

• Material Transactions

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INFORMATION RIGHTS

• Information Rights

• Inspection Rights

• Observation Rights

• Management Rights Letter

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REGISTRATION RIGHTS

• IMPORTANT: Stock Issued Prior to IPO Is Generally Not Registered

• “Demand” Registration Rights

• “S-3” Registration Rights

• “Piggyback” Registration Rights

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RIGHT OF FIRST OFFER

• AKA Participation Right, Preemptive Right

• Sometimes Limited to “Major Investors”

• Calculation of “Pro Rata Share”


• Waiver of Rights

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RIGHTS OF FIRST REFUSAL AND CO-SALE

• Applies to Founder

• Restricts Liquidity/Secondary Sales


• Creates Cumbersome Process

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OTHER ISSUES

Legal Time and Money Issues

• Investor Legal Expense Reimbursement- Effect of Investor Legal Expenses

Reimbursement on Diligence

• Legal Opinions

• Drafting Control

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OTHER ISSUES (CONT.)

Trends

• CFIUS (The Committee on Foreign Investment in the United States)

• HSR (Hart–Scott–Rodino Antitrust Improvements Act)

• SPACs (Special Purpose Acquisition Companies)

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| © 2021 Perkins Coie LLP30

PARTNER | LOS ANGELES, CA

www.perkinscoie.com/GColindres/

George Colindres is a partner with the Corporate practice and Emerging Companies & Venture Capital practice in the firm's Los Angeles and San Diego offices.

George acts as outside general counsel for clients in a diverse array of industries, including food, biotechnology, pharmaceuticals, medical devices, digital health, internet of things, social networking, e-commerce, online advertising, online gaming, software, hardware, telecommunications, and real estate. His work for these clients includes:

• Corporate governance, including entity formation and capital structuring and equity incentive plan matters

• Commercial agreements

• Employment and compensation matters

• Preferred Stock and other equity financings

• Convertible promissory note (bridge) financings

• M&A transactions

George also represents venture capital firms, strategic investors, angels, and other investors in connection with making investments in portfolio companies and liquidity events related to such portfolio companies.

George Colindres

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The Financing ProcessStep One:

• Forming and Organizing a Corporation

• Management Team• Board of Directors• Board of Advisors• Assigning the Intellectual Property• “Clean” is Better than “Complex”

PREPARATION

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The Financing ProcessStep Two:

• Understand the Business Model• Test the Model• Describe the Model• Understand the Competition• Business Plan, Executive

Summary, PowerPoint

BUSINESS DESCRIPTION(SOMETIMES STEP ONE)

• Due Diligence on Potential Investors

• Creating a “Buzz”• Identifying a Lead Investor• Forming a Syndicate

SHOPPING THE COMPANY

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The Financing ProcessStep Three:

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The Financing ProcessStep Four:

• Defending the Business Model• Educating the Investor• Key References• Management Diligence

BUSINESS DUE DILIGENCE

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The Financing ProcessStep Five:

• Valuation• Key Terms• Understand Which Terms are

Negotiable• Spend the Time to Get the Terms

Right

TERM SHEET

• Capital Structure• Stock and Option Vesting• Employment and Consulting

Agreements • Key Contracts• Intellectual Property

LEGAL DUE DILIGENCE

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The Financing ProcessStep Six:

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The Financing ProcessStep Seven:

• Amended and Restated Certificate of Incorporation

• Preferred Stock Purchase Agreement• Investors’ Rights Agreement • Right of First Refusal and

Co-Sale Agreement• Voting Agreement• Legal Opinion?• Ancillary Documents

DEAL DOCUMENTS

• Collecting Signatures• Addressing Diligence Concerns and

Issues• Show Me the Money

THE CLOSING

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The Financing ProcessStep Eight:

• Closing Documents and Certificates• Schedule First Board Meeting• Meet Milestones• Periodic Investor Updates

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The Financing ProcessStep Nine:

AFTER THE CLOSING