MaGIC Startup Academy Launch : Day 3 How To Negotiate A Term Sheet

Venture FinancingHow to negotiate a term sheet

C. Jeffrey Char

J-Seed Ventures, Inc.

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My Name is

Jeff Char

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From Hawaii

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10 years

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23 years

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Securities research analyst

Corporate finance attorney

Serial entrepreneur

Venture capitalist

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J-Seed Ventures Inc.

Venture incubator

Founded in 2000

Self-funded

9 portfolio companies currently

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We start businesses that

address real market needs

with innovative business

models and technologies.

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My ventures

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Before we begin…

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Advice for Raising Capital

Mistakes are costly – plan ahead

Don’t raise too early – OPM is for scaling

Binding vs. non-binding

Valuations – higher is not always better

Find an experienced lawyer

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Common Stock vs. Preferred Stock

Common Stock

Statutory definition

Founders

Preferred Stock

Articles of Incorporation

Investors

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Negotiating A Term Sheet

Preferred Stock Rights

Preferred Stock Restrictions

Contractual Rights

Liquidation Preference

Anti-Dilution Protection

Protective Provisions

Investor Redemption Rights

Conversion Rights

Voting Rights

Automatic Conversion

Company Redemption Rights

Board Representation

Maintain Ownership

Information Rights

Registration Rights

Employee Equity

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Contractual Rights





Conversion Rights

Voting Rights




Maintain Ownership

Information Rights

Registration Rights

Employee Equity

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Preferred Stock RightsLiquidation Preference

Only investment returned, or

participate with common after

investment returned

Occurs on true liquidation

or on sale of company

Liquidation preference increases

over time

Senior liquidation right, or in

proportion to invested capital

(“pari passu”)

Issue Normal Provision

Participate with common unless

fully diluted payout is 3x to 5x

investment price

Merger deemed liquidation

Not unusual

In proportion to invested capital

Preferred Stock RightsLiquidation Preferences Compared

Mobile Tech, Inc. Capital Structure

Class Price Per Share Shares $ Paid In

Common $0.01 6,000,000 $ 60,000

Preferred $1.00 4,000,000 $ 4,000,000

No Liquidation Money Back and Money Back and

Company Sale Price Preference Money Back Only Participate to 3x Cap Fully Participating

$5 Million Common

Preferred

$10 Million Common

Preferred

$20 Million Common

Preferred

$40 Million Common

Preferred

$ Million

Total $ Per

Layout Share

$ 3 $ 0.50

$ 2 $ 0.50

$ 6 $ 1.00

$ 4 $ 1.00

$ 12 $ 2.00

$ 8 $ 2.00

$ 24 $ 4.00

$ 16 $ 4.00

$ Million

Total $ Per

Layout Share

$ 1 $ 0.16

$ 4 $ 1.00

$ 6 $ 1.00

$ 4 $ 1.00

$ 16 $12 $ 2.00

$ 4 $ 8 $ 2.00

$ 36 $ 24 $ 4.00

$ 4 $ 16 $ 4.00*

*

* Preferred converts to maximize returns

** Preferred receives less due to cap.

$ Million

Total $ Per

Layout Share

$ 0.6 $ 0.10

$ 4.4 $ 1.10

$ 3.6 $ 0.60

$ 6.4 $ 1.60

$ 9.6 $ 1.60

$10.4 $ 2.60

$ 24 $ 21 $ 4.00

$ 16 $ 19 $ 4.00

$ Million

Total $ Per

Layout Share

$ 0.6 $ 0.10

$ 4.4 $ 1.10

$ 3.6 $ 0.60

$ 6.4 $ 1.60

$ 9.6 $ 1.60

$ 10.4 $ 2.60

$ 21 $ 3.50

$ 19 $ 4.75**

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Preferred Stock RightsAnti-Dilution Protection

”Ratchet” (full, narrow or

broad base)

Size of employee incentive

pool

Broad base

15-25% of company

(including shares subject to

options and shares reserved

for future options)

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Pre-Money

Number of Shares Original Purchase Valuation at Time

Type of Security Outstanding Price Per Share of Purchase

Capitalization of JS Tech, Inc.

Common Stock 1,000,000 $0.10 $ 100,000

Options to Purchase Common 100,000 $0.10 N/A

Series A Preferred Stock 500,000 $1.00 $1,100,000

Series B Preferred Stock 400,000 $2.00 $3,200,000

New Issue:

Series C Preferred Stock 500,000 $1.50 $3,000,000


Anti-dilution operates by adjusting the

“Conversion Rate” of a series of preferred stock

Conversion Rate = Original Purchase Price (always the same)

Adjusted Conversion Price

• A decrease in the “Conversion Price” increases the Conversion Rate.

• The Conversion Price never exceeds the Original Purchase Price.

Formulas for Determining Adjusted Conversion Price of Series B

Full Ratchet: Narrow Base Broad Base

Weighted Average Weighted Average

BPP A + B + ( ) A + B + CS + O + ( )

CPP A + B + C A + B + CS + O + C

BPP = Series B Purchase Price B = Series B shares outstanding

CPP = Series C Purchase Price C = Series C shares to be issued

C$ = Total amount paid for Series CS = Common Stock shares

A = Series A shares outstanding O = Option shares outstanding

C$

BPP

C$

BPP


Example of Anti-Dilution(3)

Application of formulas to JS Tech, Inc. Series B Preferred Stock

JS Tech, Inc. Issues 500,000 Shares of Series C Preferred Stock at $1.50/Share

Full Ratchet: Narrow Base: Broad Base: $750 $750

500 + 400 + $2.00 500 + 400 + 1,000 + 100 + $2.00

500 + 400 + 500 500 + 400 + 1,000 + 100 + 500

1,275,000 = .9107 2,375,000 = .95

1,400,000 2,500,000

$2.00 X .9107 = $1.82 (new CP) $2.00 x .95 = $1.90 (new CP)

$2.00 $2.00 $2.00

$1.50 $1.82 $1.90

400,000 Series B @ $1.33 400,000 Series B @ 1.0989 400,000 Series B @ 1.0526

convert to 532,000 Common convert to 439,560 Common convert to 421,040 Common

= 1.33 (new rate) = 1.0989 (new rate) = 1.0526 (new rate)

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Preferred Stock RightsProtective Provisions

Actions which require consent

Who must consent

All investors or only new

investors

Percentage required

Preferred Series vote vs. Preferred

Class vote

Sale of Company

Senior securities

Equivalent securities

Change in rights

Repurchases except on termination

All investors

3 of 5, or 4 of 7, largest investors

Sale of Company and Repurchases -

Preferred as a class

Others - Vote by series

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Preferred Stock RightsInvestor Redemption Rights

Earliest demand date

Redemption price

When repurchased

Sinking fund

5 years

Cost plus 10%

Over 3 years

None - so legal limitations apply

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Preferred Stock RightsConversion Rights

When investors can convert at their option

Forced conversion by other investors

At any time, partial or total

80% majority can force remainder to convert

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Preferred Stock RightsVoting Rights

Vote number of Preferred

shares or as if converted to

Common

Classified Board of Directors

Vote on as-converted basis

Each series represented. In Articles of Incorporation if required by investors

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Contractual Rights





Conversion Rights

Voting Rights




Maintain Ownership

Information Rights

Registration Rights

Employee Equity

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Preferred Stock RestrictionsAutomatic Conversion

Earliest date

Minimum valuation

Minimum IPO deal size

IPO only, or also merger

Forced conversion by other

investors

3 years after investment

3-5 times investment value

$10-15 million

IPO only

80% of all investors can force

remainder to convert

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Preferred Stock RestrictionsCompany Redemption Rights

Earliest demand date

Redemption price

When redeemed

Opportunity to convert before

redemption

3-4 years after investment

Cost plus 10%

One-time purchase

Yes

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Contractual Rights





Conversion Rights

Voting Rights




Maintain Ownership

Information Rights

Registration Rights

Employee Equity

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Contractual RightsBoard Representation

Classified Board

Voting agreement and proxies

Company’s best efforts to elect person nominated by Preferred

Observer rights

Termination

Each series represented. Traditionally dominant, but recent trend away from classified boards

Occasional

Most frequently used

Large investors

On IPO or if diluted to below 10%

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Contractual RightsMaintain Ownership

Preemptive right or right to buy after closing

Decision time period

Excluded transactions

Termination

Time

IPO/merger

Failure to exercise rights

Preemptive right (“Right of First Refusal”)

15 days

Employees and consultants

Acquisitions

Bank lending

Equipment financings

Licenses

5 years

Yes

No

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Contractual RightsInformation Rights

Who receives rights

Type of information

Large investors (often $300,000-$500,000 minimum)

Annual audited within 90 days

Monthly unaudited within 20-30 days

Annual budget when presented to/approved by Board

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Contractual RightsRegistration Rights

When investors can demand IPO

How many investors must demand

Participation in IPO

Demand rights after IPO

Lockup after IPO

3-5 years

Holders of over 40%

Cutbacks to zero

1 to 3 on Form S-1, annual on Form S-3

180 days if directors, officers and 1% holders sign

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Contractual RightsEmployee Equity

Buy-back on founders’ shares

Vesting of options

Co-sale rights


Reverse vesting over 4 years; cost buy-back

4 years; 6 or 12 month delay after employment starts

Investors can sell if founders sell

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Contractual RightsEmployee Equity

Reverse vesting of founder shares

1 2 3 4

100%

75%

50%

25%

years

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C. Jeffrey Char

J-Seed Ventures Inc.

[email protected]

JSeedVentures

CJeffreyChar

Small Business & Entrepreneurship

MaGIC Startup Academy Launch : Day 3 How To Negotiate A Term Sheet