Week 5: The Term Sheet – Control and other Terms > The Term Sheet – Control Terms and Recap > The Term Sheet – Control Terms and Recap
- Now we are in week 5 and we’re going to talk about control terms in a VC contract or in a term sheet and to start with that I’d like to do a little recap where we are.
- We talked about the economic terms last week, so the terms which are economically really important because the effect, the value of your shares, your founder shares and this week we’d like to talk about the control terms.
- Why does a VC want control terms in a contract? Well actually, this is again because of the principal-agent theory, because of the relationship between an entrepreneur and a VC. As we said before, the VC doesn’t know everything about you, the entrepreneur, so he has to gather more and more and more information.
- These control terms can be contractual terms, confidentiality and so on, they can be protection terms and they’re also about other terms like board representation which helps the VC to control via the board and so on.
Week 5: The Term Sheet – Control and other Terms > Ratchets > Ratchets
- So it’s a protective right as you can see over here and let’s look at an example in order to understand how ratchets could have worked or could work.
- Webvan was a great idea, you see a van over here and it was actually a Webvan and Webvan wanted to bring grocery and all sorts of things to your home.
- They received millions from Sequoia Capital and other investors and tried to build up the business model and by the way, it was a hype and is still a hype to do something like that.
- Could Sequoia Capital have done something to secure the money or at least not to lose everything, which actually I don’t know in detail what kind of contract they had, but ratchets could have held Sequoia at least to manage that kind of risk which could have coming up for bankruptcy and especially by using milestones for the payout.
- Let’s take the example of this company and the VC says “Ok, basically I’d like to invest in the company because it’s a very promising company, I’d like to invest three million USD” and the entrepreneurs also agree with that.
- This convertible debt can be converted if the company doesn’t go so well and is not converted if the company goes well.
- So what the VC basically will do is, he looks into your business plan, he says “Ok, we don’t really agree on the valuation but let’s do it like this, if I am right and the company doesn’t develop like you promised, I get a higher share.
- ” At the very end, if the milestone is not achieved, the VC can convert and this is what happens over here the additional million into shares and he ends up with 30% for his three million.
- So if you can’t agree on the valuation but both parties are happy to do an investment, why don’t you try to work with someone which can reduce your risk in that way that after a certain amount of time you look how the development was and then agree on what the right number is.
- If you look at that from a theoretical standpoint again, it can reduce risk over time, means it reduces basically information asymmetry which, or asymmetry not really I mean, it gives better information base for the valuation at the very end and this is how it works.
Week 5: The Term Sheet – Control and other Terms > Drag-along and Tag-along > Drag-along and Tag-along
- These two rights are part of the control terms in a term sheet and also a VC contract and they are especially designed to align interest between the VC and the entrepreneur.
- So they are part of protecting the VC deal, the VC’s money, because what the business model of a VC is and you remember that is, he puts money into your company and he wants a return.
- Maybe the VC investor has a liquidation preference and valuation is still low so you as an entrepreneur don’t want to sell? This is a typical case which really exists and then the VC needs at least to some extent drag along rights.
- What if some of the shareholders don’t want to sell? Drag along, tag along rights help eliminate these blockers or potential exit blockers, this is how they work.
- Shareholder, the VC wants to sell in order to realize returns, a drag along right helps to force founders.
- So the case is a little different here, if a big cooperation comes up and says “I’m interested in buying founder shares, I just want to have access to technology for example, I give the founders some money” so the founders want to sell and if there’s no tag along, the others are not able to sell but the tag along rights they tag shares to founder shares and then all the other investors, especially the VC’s who would like to have this tag along right, they can sell along.
- Engineers normally want to run their company for a long time because they have this engineering focus, they love their product and they love their technology and they love to make it a perfect technology.
- So if you as an entrepreneur don’t want to sell, the VC will exchange you and then he’ll sell the company and drag you along.
- So make up your mind, your own mind: Do you want to run the company forever or is it a restricted timeframe and you can imagine also to exit the company? The other case, and this is the tag along case, is like the typical businesspeople, the guys who found the company because they have a great idea but they also want to be rich.
- If someone comes along and buys their own shares, they don’t care about the others too much.
- Then you need a tag along right because you want to tag shares to go along with these who want to sell.
- Normally VC’s try to take in both, drag along and tag along and normally it shouldn’t be a too big of a problem and especially if you understand the business model of a VC, if you understand that he has to exit one day, it’s ok to accept a drag along right by then.
- Again, using theory really helps you understand drag along and tag along rights.
Week 5: The Term Sheet – Control and other Terms > Protective Provisions > Protective Provisions
- You remember the Motionloft story, the guy who spent his money partying or the VC money partying? You can protect yourself from that situation as a VC and VC’s will do that with the help of so-called protective provisions.
- So they are also protection terms, finds themselves here, and in general they’re part of a term sheet and they are really standard in like every term sheet.
- So if the company for example wants to change terms of stock, authorize creation of more stock or issue stock, it is typically a protective provision that the VC has to go along with that.
- Borrow money for example or spend more than 10,000 USD, hire people, typical examples where protective provisions come into place, the VC has to agree to that.
- A list of protective provisions typically help VC’s to protect the investment and from a theoretical perspective, again, the VC wants to align interest and especially prevent hidden intentions and hidden actions an entrepreneur could do.
Week 5: The Term Sheet – Control and other Terms > Redemption Rights > Redemption Rights
- A redemption right is a right that the target grants the investor to redeem the outstanding stock at least at the purchase price plus declared and unpaid dividends.
- The stock the VC has is to be sold to the entrepreneurs or to the company and the VC gets his initial prize plus x and that x is either dividends and in most cases it’s also like a yearly interest rate of 7, 8, 10% at least so it’s not a really low interest rate.
- We all know the business model of the VC and we have to agree with him on the business model that’s the deal we made, so if the fund ends he has some right to get back his investment.
- I mean, we are always still talking about risky investments and venture capital, so does he really have a right for a payback, you can argue that, otherwise it’s just bank money or loans or debt but at least it’s understandable that the VC tries to get a redemption right in the case the fund structure or the fund ends.
- Actually as an entrepreneur I’d be very careful with that because if it’s not well defined the VC can also use that as a cheap excuse to leave the venture in those cases and in most cases nobody’s really able to pay for the redemption right because the money is gone or most of the money is gone and that might mean bankruptcy for the whole company and the VC walks out with everything.
- So maybe you can agree on a redemption right in the first case, try to avoid it in the second case and in total try to avoid a redemption right, try to work on value creation and the right business model.
- So this is what the VC wants if you talk about aligning interests, that’s the interest of the VC and at least you know about this interest, so aligning interest means you agree on the fund structure, you agree and a redemption right.
- You can to some extent prevent moral hazard if the entrepreneur never wanted to sell and this is what, again, the theoretical perspective on this right is about and that makes it really understand that.
Week 5: The Term Sheet – Control and other Terms > Board Representation > Board Representation
- Because he sits in the board, in the Board of Directors in most cases, and he listens to everything which is being discussed in that board and takes part in the decisions and so on.
- In some cases boards are really, really powerful and can decide many, many things for the company and so it is important to have someone there to be part in that board to follow all the information, to be informed and also to be able to influence some of the decisions.
- In most cases you at least have the founder on the board, or the founders on the board, maybe CEO and founder is also the same person or the CEO is also a founder.
- If you look then at the development of the company and it goes into later stages, it could be up to nine members and then, if there’s a new VC around for example, there’s room for more capitalists on the board or there’s also room for other people, specialists on the board that can help the company to develop in a proper way.
- We were just discussing our board of one of my companies and we also think about expanding the board in order to have more people on that that represent also some technological and business aspects in the better way in order to develop the company better and this is also a way to build a board.
- So for him it also could be important to have a good VC, a very representative VC on board like having a Michael Moritz on your board was always good in the economy era and is probably still today, so this is also an important point from the perspective of the entrepreneur towards the theory but also towards the board.
Week 5: The Term Sheet – Control and other Terms > Confidentiality Exclusivity > Exclusivity and Confidentiality
- Besides what we all heard I’d like to add a couple of words on confidentiality and exclusivity which are also part of term sheets, contracts, the VC process and so on.
- VC’s don’t sign NDA’s, they have reasons for not signing because they say “Ok, we get so many potential investments and we get always the same idea at the same time, so it’s hard to differentiate and our business model is not to copy you, to build a business but to finance businesses, so we are not talking about that.
- You might want to have a confidentiality when it goes into later stages of really looking into patterns and so on but maybe not the confidentiality only for the VC and especially not for the VC but for all those attorneys and people who do the due diligence.
- What you will find in most cases is the term confidentiality in term sheets and contracts because in most cases what’s written in the term sheet and the contract is confidential.
- VC’s love to have exclusivity because they want to look at your deal really closely without having someone else who’s bidding at the same time and the price is going higher and so on.
- Because if you as an entrepreneur give the exclusivity to one VC and this VC walks away, you have to explain all the others why the VC walked away.
- So the way to deal with that is, if you can’t avoid exclusivity and if you want to avoid it you can try to negotiate that, you pay for some of the expenses of the VC if the deal is not happening.
Week 5: The Term Sheet – Control and other Terms > Conditions Precedent to Financing > Conditions precedent to financing
- Conditions precedent are also part of the term sheet and they are part of the other clauses so to say and I’d like to add a couple of words to those conditions because you can find them in many term sheets, however they don’t play a really important role like liquidation preference or something else.
- So what is a condition precedent first of all? In most cases you’ll find that one of the like, the last sentences or in the last paragraphs in a term sheet and the conditions precedent are those conditions which have to be fulfilled between like agreeing on a term sheet and really signing the contract.
- So if you have a term sheet with the one VC, what happens to all the other investors who have rights because of their stocks? And what do you have to do then? So pay attention to what’s written in there and how much time does it cost and try to agree on something within the negotiations, within negotiating basically the term sheet.
- That should be part of the term sheet and not a condition precedent or something which is to be discussed between signing the term sheet and signing the contract.
- So basically what you should try to do is, if you negotiate the term sheet, try to negotiate everything and try to make it a very short time between term sheet and signing the contract that nothing could happen, like financial crisis, nobody should walk away out of whatever reasons and if the time frame is shorter, you don’t give others a chance to do that.
Week 5: The Term Sheet – Control and other Terms > Control Terms – Others > Control Terms – Others
- We’re talking about term sheets and we are basically finished with talking about term sheets, however there are more details in the term sheet I’d like to add and these are especially three other aspects which might be of importance, at least you might want to pay attention also to those aspects.
- The first one is the non-competition agreement: As a founder and a CEO, a president of a company, in most cases you have to sign a non-competition agreement, also for the time when you step back from your company or from the company in general.
- The second thing is transaction and monitoring fees, who’s gonna pay for the deal basically.
- So if you can kick something back to the VC and the VC for example pays for the due diligence or just pays a fraction up to a certain amount, that’s fair.
- The third point is enforceability and it’s interesting because a term sheet normally is non-binding but it can be transformed into some binding contract by one party.
- If you as an entrepreneur you can negotiate a deal with one VC and you have a term sheet ready and then take that term sheet and go to a different VC and say “Oh I have have a term sheet if you change the terms in like point one, three and five, I will take your money” the VC doesn’t like that who has put much effort into talking to you.
Week 5: The Term Sheet – Control and other Terms > The Term Sheet – Effects and Hazards of the Terms > The Term Sheet – Effects and Hazards of the TermsV
- Welcome to The Introduction to Venture Capital – Effects and Hazards of the Terms in the term sheet.
- We’ve seen and I don’t go in every detail here but what we have seen is, we have seen a lot of terms.
- Those drag along and tag along right, they are rights to force others to sell or to sell along and so on, so it basically affects the exit of the company.
- The effect of such a term is really significant and that’s what we said before but again, you should keep that in mind.
- Look at some of the terms, especially the economic terms, with your economic background, with the knowledge you have because they affect at the very end the value you get.
- You can look at more of these terms and try to discuss all of them, like employee options and it’s very important to have an employee option pool but how big should this be? Is it 10, 20%? When should you grant those options and all sorts of things.
- So all those terms can affect your business, positively, your value negatively and some of them are more important, some of them are less important and that’s the art of dealing with this term sheet to understand which are the real important ones and to especially negotiate those.
- By the way, lawyers help you to understand the term sheet, but they in most cases don’t help you with the economic understanding of the terms.
- Because if you look at this principal-agent theory again: Why does a VC put all these terms in the contract? It’s not because he’s a bad guy, it is because a principal agent problem exists.
- Because he doesn’t have full information, he doesn’t know everything about your startup, he doesn’t know everything about you and maybe you have other intentions than he has and you’re not telling him.
- Syndicated financing with other venture capitalists, why do VC’s do that? Because there’s someone else sitting at the table and he has additional information.
- The one measure is: The VC tries to be informed and that’s why he wants board participation, advisory capacity and formal monitoring.
- It is a natural thing that nobody knows everything about someone else and we still marry and do all sorts of things although we do not have full information.
- Last but not least, he tries to, and this is also part of aligning interest, he tries to realize his business model, like with these exit conditions, tag drag along rights and so on.
- This is the basis and if a VC comes up with a new contractual detail, with a new term he puts on the table, try to understand it from that standpoint.
- If you understand that, don’t be afraid of new terms because you can put them in your ideas of theory and you can understand it easily.
- That’s a little summary of what we’ve seen in all the videos concerning the terms and now you really understand term sheets.