Week 4: The Term Sheet – Economic Terms

Week 4: The Term Sheet – Economic Terms

“The Term Sheet – Introduction … New Institutional Economics – Why do term sheets exist? … The Principal Agent Theory … Economic Terms: Stocks … Economic Terms: The Price Term … Economic Terms: The Capitalization Table … Economic Terms: Vesting … Economic Terms: Liquidation Preference … Economic Terms: Anti-Dilution Protection … Case Study / Homework Week 4 … The Entrepreneur’s View … The VC’s PerspectiveV”
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Summaries

  • Week 4: The Term Sheet - Economic Terms > The Term Sheet - Introduction > The Term Sheet - Introduction
  • Week 4: The Term Sheet - Economic Terms > New Institutional Economics - Why do term sheets exist? > New Institutional Economics - Why do term sheets exist?
  • Week 4: The Term Sheet - Economic Terms > The Principal Agent Theory > The Principal Agent Theory
  • Week 4: The Term Sheet - Economic Terms > Economic Terms: Stocks > Economic Terms: Stocks
  • Week 4: The Term Sheet - Economic Terms > Economic Terms: The Price Term > Economic Terms: The Price Term
  • Week 4: The Term Sheet - Economic Terms > Economic Terms: The Capitalization Table > Economic Terms: The Capitalization Table
  • Week 4: The Term Sheet - Economic Terms > Economic Terms: Vesting > Economic Terms: Vesting
  • Week 4: The Term Sheet - Economic Terms > Economic Terms: Liquidation Preference > Economic Terms: Liquidation Preference
  • Week 4: The Term Sheet - Economic Terms > Economic Terms: Anti-Dilution Protection > Economic Terms: Anti-Dilution Protection
  • Week 4: The Term Sheet - Economic Terms > The Entrepreneur's View > The Entrepreneur's View

Week 4: The Term Sheet – Economic Terms > The Term Sheet – Introduction > The Term Sheet – Introduction

  • Because what the investor does and what you can also do but in most cases investor presents the term sheet to you, he really tries to fix the economic terms on the one hand and the control terms on the other hand, in order to give you an idea how he’d like to work with you.
  • The control terms it’s really about getting along with the VC. And both things are necessary to understand and this is what we’d like to discuss within the next week.
  • The second and the third one got more complicated and I started my first company before the new economy bubble bursted, so it was within the new economy and everybody was hot in dealing with Internet companies, and we had an Internet company too so basically they want to give us the money and let us go.
  • I thought “Oh, that’s interesting, just half a year or a year later the term sheets changed so much?” Well, yes they do because investors started to understand how to create value with the entrepreneur together because many entrepreneurs, when the bubble bursted, went off board and this is why it is necessary on the one hand to understand term sheets as they are today, and this is what we’d like to do.
  • This is why it’s so important to understand the relationship and the theoretical background in order to be able to explain a term sheet of today and also a term sheet of the future.

Week 4: The Term Sheet – Economic Terms > New Institutional Economics – Why do term sheets exist? > New Institutional Economics – Why do term sheets exist?

  • On the other hand, that’s the same situation for you as the entrepreneur: What do you know about the VC you’re facing? And is there also anything you don’t know? Will the VC drop you if things go bad? How safe is your own position in the company, will they drop you to save their own position? How much will he interfere in your business and is his interference really skillfull or do you know much better than the potential VC? Will his value add be promising, will this really help you to establish your company? We are able to see there is a big or some information asymmetry, that’s how we call it, between the two parties.
  • Founders might go to a VC and say “Yes I’m exit minded because I want to have your money” but at the very end they are not and they don’t follow an exit path.
  • If you have those hidden intentions, if you have these information asymmetries between those two parties, you need a theory that makes you understand that situation and addresses that situation and helps you also in future events to think about terms that address this situation.
  • It’s about a two sided interaction, so both parties, we already mentioned the VC and you the entrepreneur, with a potential divergence of interest.
  • A time dimension and for sure there’s a time dimension because the contract between a VC and yourself is not forever, it’s restrictive for a certain time frame, and as I said before and as we’ve seen there’s an information asymmetry.
  • The VC doesn’t know everything about you and you don’t know everything about the VC. So how do you make a contract under these circumstances? Well, this is what the New Institutional Economics deals with.
  • It has some basic assumptions and the first assumption is “There’s no perfect market” and that’s for sure.
  • So the VC has his business model and this is how he acts, he wants to realize his business model and we already talked about that, it could also be problematic for you as an entrepreneur.
  • You have your own mindset, you want to be an independent entrepreneur, you might not want to hear too much of a VC and all sorts of things.
  • So you might have hidden intentions and you follow your hidden intentions when you’ve closed a deal and use the money in a way the VC might not like it.

Week 4: The Term Sheet – Economic Terms > The Principal Agent Theory > The Principal Agent Theory

  • Start with an every day or every day life example: We have a principal and that can be an employer for example and an agent who is the employee in our example and they have something like a work contract which puts them basically together.
  • Does the CV of the agent properly reflects the actual skills and experience of the employee? Did he really put everything into his curriculum vita and maybe not too much and did he exaggerate, are the grades correct and all sorts of things.
  • So does he fit perfectly for the job? And you might hand in the paper and the principal, the employer, is never able to get proof for everything you put in a CV. Secondly, when you started working, will the employee use his work pc only for work purposes or also check his private emails? And at the very end, if the employee works well, the company will earn well so will the shareholders and if he doesn’t work well, is that also true? This is why you have to think about these points in the work contract.
  • These two parties are dependent on each other because, as I said before, the employee has to work well because only if he does that, the company can also make their business and make money and the shareholders thus can make also their money.
  • The same situation holds true for an entrepreneur and a VC. And what we do normally is, we conceptualize the VC as the principal and the entrepreneur as the agent and the contract brings these two parties together, it makes these two parties dependent on each other.
  • Again, there is limited rationality, is all the information included in the business plan really correct? And are there more uncertainties the entrepreneur is not talking about? On the other hand, is also the VC telling the truth about how he can help in the future? That’s a typical example for limited rationality.
  • Secondly, the potential opportunism: Will the founder really use the money in the purpose to build the business or also for private consumption because he likes a great company car and only flies business or something like that? And thirdly, these two parties are dependent on each other.
  • Because the VC gives money to the entrepreneur because he wants to have more money back and that’s his dependency.
  • So only if the entrepreneurial team works well and the company becomes valuable and the VC also can realize his own exit.
  • He can for example say “If you buy a company car or lease a company car you have to ask me before” and then he can easily prevent himself from that situation described before that the entrepreneur uses the money for his private consumption.
  • So he puts contractual details in the term sheet and also in the contract in order to have his return, like a drag-along that helps him to drag the entrepreneur to sell his company when he needs an exit.
  • This is what the two parties can do before the deal and you can see, it is in here and over here, so with the control terms and the economic terms about the term sheet.
  • Last but not least, they are both dependent on each other and while the VC will closely monitor the team and on the other hand you as an entrepreneur, you claim promised value-adding activities to the VC, so basically what you do is, you add value to the company and then this dependent relationship is really a very positive relationship.
  • You have a VC and an entrepreneur, they don’t know everything about each other, they depend on each other because they make a contract and you want to prevent that they cheat on each other.
  • It’s a solid business idea, it’s still a business idea, why shouldn’t you do offline what you can also already do online? And the former CEO, and now you can see that the story gets more complicated, Jon Mills, he received high funding by telling his friends and by convincing business angels that he is close to being acquire and by that promising high returns.
  • You might wonder, why is that? As a promising company, close to being acquired? Well what the angels and the friends, the people who invested found out later on that the CEO Jon Mills spend all the money for partying in Las Vegas and dining in Palm Springs.
  • Now the theory is able to explain these contracts in a very general way and we get back when we talk about the terms in more detail because always when new terms come up, and it might be in three of five years, in your life as an entrepreneur that new terms come up and new VC contracts, you’re able to explain them by using the Principal Agent Theory.

Week 4: The Term Sheet – Economic Terms > Economic Terms: Stocks > Economic Terms: Stocks

  • If you make a deal with the VC, he gets shares of your company and by getting shares of your company that means he gets stocks.
  • There are different kind of stocks and different kind of stocks are related to different rights.
  • The type of stocks, what type of stocks are there? There is founders stocks, employees stocks, stock options.
  • The rights which are associated to those stocks.
  • If you want to look at it more closely and try to differentiate this type of stocks, you can basically look at four different types: The first type is Common Stock.
  • There can also be Preferred Stocks and there’s some preference which is granted to these stocks.
  • What you can look at is, the number of stocks Mark Zuckerberg has in Facebook.
  • If you look in the Forbes list, how rich he is and and what the valuation of his company is, but on the other hand, you can also look at articles and you see that he, I think, still has the majority of voting rights.
  • The difference is because of these Preferred Stocks, because others have Preferred Stocks that have higher dividend rights but less voting rights.
  • A Stock Option is a right to buy a stock at a defined time, for a defined prize and not necessarily a stock at the very moment right now.
  • There’s also rights associated to the Stock Options and we gonna look at that more closely on the next light.
  • As I said, these stocks are associated to different rights.
  • As I said before, the most common and the name also says that, are the Common Stocks.
  • I mean, you can define that in your contract, which rights are associated to Common Stocks and also to Preferred Stocks, which is the second category.
  • As I said before, in most cases they have less information and especially less voting rights but have full dividend rights, might be even more than Common Stocks.
  • Stock Options normally, and this is the third category, do not have a lot of rights.
  • There are certain categories of stock and these categories of stock are associated to certain rights.
  • So you can basically build your own Preferred Stock.
  • Keep in mind that you check that and you look at the type of stock, or the type of share, the clause of share, and the rights being associated, and build yourself a table of that and try to understand why the VC wants that division of clauses, or division of stock categories in order to make that deal.

Week 4: The Term Sheet – Economic Terms > Economic Terms: The Price Term > Economic Terms: The Price Term

  • We already talked about a valuation for a company and this valuation is the basis for the price term.
  • Because at the very end in a VC contract you have to find a price, and normally it’s a stock price, and this is known as the price per share.
  • So we have these number of shares and they have a certain price.
  • That’s the first thing, so keep in mind that kind of stock and the attached rights are different but the price per share normally is the same for each share.
  • The difference could be in if the one share is preferred stock and the other is only common, it gets higher dividends and that’s the valuation at the very end when it comes to later stages might be different too.
  • Now when you try to agree with the VC on valuation and then at the very end on a price per share, VC’s love to talk about pre money or post money valuation.
  • So if you have a company and you look for five million dollars for your company and the VC comes up and says “Ok I think it’s a ten million valuation”.
  • If it’s pre money valuation, it’s ten million plus the five million from the investor, also meaning at the very end it’s 15 million valuation and the five million of the investor reflects a third.
  • In most cases VC’s in the US talk about pre money, so that’s a common thing to discuss, however make sure that you and the VC talk about the same thing because if you don’t agree on that thing and you sit there and sign the contract and don’t understand if it’s pre or most money.
  • If you agree on a valuation in a discussion and you don’t differentiate pre or post money, it could really be a big dilution for you.
  • Because this really affects the predefined prize you see over here and this affects future valuations.
  • I mean, we talked about valuation before and the valuation is reflecting the price per share but it’s also about the question pre money – post money, it’s the question of dilution and it’s the question of warrants.
  • If you have warrants that last too long, have a lower valuation for yourself and so on.

Week 4: The Term Sheet – Economic Terms > Economic Terms: The Capitalization Table > Economic Terms: The Capitalization Table

  • The VC wants to invest two million dollars, by the way the same, it’s just a coincidence it’s two million shares and two million dollars invest, so it’s not necessarily the same number.
  • Post money means eight million total, of that it’s two million for the VC, equals 25% and is eight million post money valuation.
  • You start with the two million shares you have by yourself, which are at the very beginning the 100%. Now what you do is and this is your first step, you calculate your share after the investment, which is easy going because as we said before, eight million post money valuation, two million VC, 25% VC, you remain with 75%. So, your share at the end of the investment, after the investment, is 75%. VC’s money is 25% total again 100%. Now the second question is, how many shares do you have to issue that reflect the 25%? What you can basically do is, you calculate the 75% has to equal two million shares, what is the equivalent of a 100%. And in that case a two million 666 and so on shares.
  • This is the calculation you do in order to determine the total number of shares and then it’s really easy to calculate the number of shares the VC gets because this is the difference between the 2.6 million and the two million you have.
  • So the VC gets six hundred thousand, six hundred and so on shares and that exactly equals his 25% he gets in your company.
  • In practice it is a lot more complicated because normally it’s not only one founder, it’s a number of founders and maybe there are stock option programs already involved and there’s an angel investor and so on and so on.
  • So you have to agree on the valuation and if you agree on the valuation and you know how much money the new investor wants to put in, you can start doing all the calculations by looking at the existing number of shares, calculating the additional number of shares and putting all the results into the cap table.

Week 4: The Term Sheet – Economic Terms > Economic Terms: Vesting > Economic Terms: Vesting

  • It is important for employees and also founders to understand the term because in most VC contracts, the shares of these people are vested.
  • So vesting is a clause that protects the VC, at least to some extent, that the interest between VC and entrepreneur is aligned because the VC gives the money to the entrepreneur and he wants to work with this money under a certain time period.
  • What is vesting in general? A company, and this could be a part in the VC’s contract that the company does something, the company issues a certain amount of shares or stock over a fixed period of time.
  • ” Now what you get is, the shares you have will be vested over that four years of time.
  • If you have key employees as an entrepreneur and you give them a work contract and say “If you also beside the work contract get stock options, I want you to be with me over a certain period of time.
  • Vesting period in most cases in VC’s contracts is typically four years, it might be a little less, but in most cases it’s four years and it has a cliff period.
  • So this is how to understand vesting from a theoretical standpoint, it is to align interest between the VC and the entrepreneur.
  • Now how does vesting work? Well, take an example: An employee joins the company you founded in February 2016.
  • Now, let’s look at different scenarios: Scenario one, the employee drops out after five months, what’s happening? Well, if he gets the number of stock options, here 10,000 at the very beginning, and he leaves after five months which is here, the cliff is not reached at the exit of the employee.
  • Let’s look at the next scenario: Same scenario at the very beginning, 10,000 shares of the employee stock option program, vesting 48 months, six months cliff, 42 months vesting period.
  • The employee drops out after a year, so what does that mean? After a year it means, the cliff is already reached, so the vesting starts and if he does an exit in February 2017, which is exactly six months after the cliff started or one year after he started to work for the company, he gets 12/48.
  • Let’s take a next scenario and then you probably have a good idea about what vesting means.
  • Because what you like to do is, you’d like to align these interests, you like to keep key employees, key people in your business and vesting is the way to do that because they only get the full number of shares and the full number of stock and stock options if they stay the period of the time they agreed on.
  • Sometimes in VC contracts you find an so called accelerated vesting because what you can say, it’s not fair when a VC comes in that he takes away everything from the entrepreneur, so entrepreneurs get an accelerated vesting compared to employees.
  • An accelerated vesting means a number of shares, might be 25% or might be 50%, will remain at the entrepreneurs and the rest of the remaining shares will be vested.

Week 4: The Term Sheet – Economic Terms > Economic Terms: Liquidation Preference > Economic Terms: Liquidation Preference

  • The liquidation preference is part of the term sheet and later on of the venture capital deal and is an economic term because if affects how the deal works economically for the VC and also yourself as the founder.
  • The liquidation preference comes into place when a liquidity event or a change of control happens among the owners of the company and basically determines, and that’s the second part, who will get the money back first.
  • We’ll have an example later on which explains how it works in a contract and basically first of all what you have to keep in mind is if you have something like that, and normally the formulation in the contract is “In these cases” and then you see the cases where it could happen, like change of control, going public or whatever, the VC gets certain rights and these certain rights in most cases mean they get money first and afterwards the remaining part is distributed amongst all the other shareholders.
  • So why is that in general? And I said at the very beginning when we started with the term sheets that, in my own case in 1999 when I started my first internet company, we didn’t have a liquidation preference in the contract.
  • So imagine the VC puts in ten million into a company and says “Ok, it’s a 50 million valuation so the founders have 80% and the VC has 20%.” Now someone comes up and says “Why don’t you sell this company for five million?” What happens to those founders? The economy is down, the internet bubble burst and nobody really cares about internet companies and someone comes up “Give me your company for five million”, you say “Yes cool I still own four million, I’ll be comparably rich.
  • ” The VC gets a million, he puts in 10 million before.
  • This is why they put a liquidation preference into the contract and say “Ok, if the company is sold I get ten million first and then the remaining parts will be distributed.
  • Because what you can say is “If we align interest and you don’t want me to walk away too early in the case of I make a lot of money, a hundred million valuation to this company, why should you get a preference because we all made money.
  • Now let’s look at an example: Start with this company, what are the terms of this company? A venture capitalist, again he invests two million money, six million pre money valuation, so a total valuation post money is eight million.
  • What’s the liquidation preference doing? So without liquidation preference, if the company is sold for ten, the VC gets his 25% equalling 2.5 million, you get your 75% equalling 7.5 million, that’s the distribution.
  • You agreed on a single liquidation preference, means the VC gets two million upfront, two, and the remaining eight million, that’s the participation, is distributed according to the shares which means 25 for the VC again, 25 from eight million is another two over here and that adds up to the four million you can see here.
  • Because now you end up with less money, one and a half million less for you as the entrepreneur and you only have a single liquidation preference.
  • If you have a three times liquidation preference, the VC gets 6 upfront, the remaining four will distributed 75% / 25%, so another million for the VC, means seven for the VC only three for you.
  • Someone comes up and says “Well, the company is not really working well but I’m gonna take it for two million”, what happens then? If you don’t have liquidation preference you get your 1.5 which equals the 75% you have.
  • If you have that single or double or triple or whatever liquidation preference, the VC basically gets it all because he gets 2 million upfront which is the preference and there’s nothing left for a participation.
  • Then entrepreneurs start thinking “If my company doesn’t go too well maybe I have to change something and get back to the path of success and have a higher value later on because then it also pays out for me as an entrepreneur.
  • ” And that’s the third case, the scenario number 3: The company is sold for 100 million.
  • That’s a jackpot for both of you because the VC makes a lot of money, you make a lot of money without liquidation preference, 75% or 75 million in that case for you, 25 for the VC and with liquidation preference same thing because liquidation preference becomes invalid.

Week 4: The Term Sheet – Economic Terms > Economic Terms: Anti-Dilution Protection > Economic Terms: Anti-Dilution Protection

  • Anti-dilution protection is also a part of a term sheet and a contract later on and is an economic term.
  • In general what is dilution? Dilution is if you have your 100% shares at the very beginning, if you get new shareholders into your company you have to give away shares means also your percentage gets lower and lower and this is dilution.
  • The main control you have on the one hand with the contract but also with your shares.
  • Your shares becoming less and less, diluted more and more, you lose control and this is how you can prevent loss of control.
  • What happens in this new investment round, all the old investors will be diluted which means they lose control, although they get a higher value for their shares because the whole valuation is going up.
  • If you don’t want to lose control you need the anti-dilution clause because the anti-dilution clause helps the old VC to keep his number of shares or his share of ownership in order also to remain in this position of having control.
  • The downside case scenario: If a new investor invests at a lower valuation it’s not only loss of control but it’s also lower valuation which means, and not only lower valuation, lower value for the shares the VC has.
  • Now the VC can use the anti-dilution clause to compensate for the loss of value and try to buy or convert new shares at a price of a predetermined method and this is the main thing to agree on.
  • The full ratchet anti-dilution clause normally says that the old investor can buy as much stock as necessary to keep the original share of ownership which is again, the case for the upside scenario.
  • In the very general case he can do that at the price per share which the new investor pays.
  • Means if the valuation goes down and you already invested a higher amount of money for a higher valuation, you’d like to get more shares that reflect at least the amount of money you spent for that company and this is the weighted average anti-dilution clause.
  • Now what happens to the shares of the VC? Well, he still starts with 20% but he, if the new VC comes in with another two million, he gets 13%, 13.3% from the 50 million reflecting his two million of 15.
  • If the VC has an anti-dilution clause he can say “Ok, I like to remain with 20% and I would like to buy shares, additional shares, that help me to remain with 20%.” This is possible, however there has to be someone who pays for the additional percentage and this is the entrepreneur.
  • The entrepreneur now ends up with only 67%. So you might wonder why it only goes down from 69 to 67 because we had to round up the numbers, if you calculate the exact numbers you’ll see that exactly what the VC gets in addition in shares, the entrepreneur has to pay.
  • If there’s an anti-dilution clause and it depends on how you do the anti-dilution clause the share of ownership might also stay the same.
  • So what happens is, 40% diluted by those 20% makes them end up with 32% and you as an entrepreneur also 60% diluted by 20%, makes you end up with 48%. That is the easy calculation and is without anti-dilution preference or anti-diluiton clause.
  • If there’s an anti-dilution clause in the contract now the VC has the right to buy more shares to a certain agreed price.
  • That means that he can buy some additional shares which you can agree on how many shares this is, and again what you basically can see, they are your shares because your shares are a lot, lot less than in the case without anti-dilution preference.
  • Now it depends on the economic terms for which share prize he can buy the additional shares.
  • In the downside scenario it’s more important and try to understand the wording in the VC contract, what it means and how the VC can get his additional number of shares, what number of shares and for which valuation because in both cases you have to pay for that.
  • What you can basically see over here, the remaining part of your shares are very, very low in the second scenario.
  • So to sum it up, if you look at the downside scenario without an anti-dilution preference in a down round, the investor will yield a lower value of his stock and decreasing share of ownership.
  • If he has an anti-dilution preference which is subject to negotiation at least he tries to have more shares that reflect the initial money he had put in.

Week 4: The Term Sheet – Economic Terms > The Entrepreneur’s View > The Entrepreneur’s View

  • With having said valuation with a valuation you always have to consider ratchets milestones, all those things they’re coming long term and will have an influence on your valuation so make sure you understand what you’re signing there and what you’re negotiating on with your VC.
  • Second thing the control terms you definitely have to understand what are the occasions when the VC is in control when you will be in control and how to maintain that control within your team or your board of directors.

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