Friday, February 8, 2008

More on Demystifying Term Sheets

From the CVG Workshop on Term Sheets on Jan. 24, 2008 --

Business founders may not realize that investors will be looking for milestones to be achieved. That's why investors list milestones in a term sheet. Sometimes, they dole out the funds as the company reaches the milestones. This is called "staged closings." For example, if you have a dot-com, soft launches or hard launches can be milestones. As you negotiate, make sure your milestones are achievable.

Other things to know: Think about what you as a business owner are giving away to the investors. Is it worth it to you?

VCs usually want preferred stock so that their dividends can be accrued and they can get their money out before others. Preferred owners also get veto rights when voting on corporate matters.

VCs usually want to get their money out in 4-5 years. And they want a clear path to liquidity. The term sheets will have details about conversion of preferred to common stock. Remember that investors want to maximize their investment.

Most entrepreneurs think that they can raise capital quickly, but that's not true. VCs need to do background investigations into the company and the owners -- called "due diligence". Then, there's the negotiation of value and dithering over the term sheets. Once you've signed a term sheet, there's still a lag before you get the funds.

Keep in mind that more important than raising funds quickly is to make sure that your investors have deep pockets and will want to stay in the game for future rounds of investing, as needed. The section of the term sheet that addresses keeping the original investors in the game is called "Pay to Play."

Other clauses that protect investors are ones on antidilution and information rights.

As you go through a term sheet, it's really important to be sure you understand what all these clauses are doing for the investor and for you. That's why you need good attorneys by your side. Institutional investors bring a lot to the table, as they have experience you may lack. On the other hand, remember that they are out to maximize their investment with a clear path to liquidity. That may or may not be your goal. Protect yourself by negotiating intelligently.

If you want to maximize your valuation, do the following:
  • Have a solid plan, a good revenue stream and solid management.
  • Consider a staged closing.
  • Establish a stock incentive pool (5-15%) to incentivize employees.
  • Consider tax ramifications of all your business decisions. (Get a good accountant.)

Le me know if this has been useful. And please send questions for me to answer.

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