Ratchets And Other Four-Letter Words
the post-bubble term sheet
Now that the
dot.com bubble has burst, valuations, funding rounds and business practices are
getting back to normal. Many companies
got caught in the transition, however, and are suffering down rounds, cramdowns, full ratchets and other term sheet conditions they’d hoped never to
see in the real world. At this Morino
Institute Netpreneur Coffee & DoughNets meeting held May 23, 2001, a panel
of experts dipped into the glossary of investor speak to help entrepreneurs
understand these terms and avoid trouble in the future.
made at Netpreneur events and recorded here reflect solely the views
of the speakers and have not been reviewed or researched for
accuracy or truthfulness. These statements in no way reflect the
opinions or beliefs of the Morino Institute, Netpreneur.org or any
of their affiliates, agents, officers or directors. The archive
pages are provided "as is" and your use is at your own
Copyright 2002 Morino Institute. All
rights reserved. Edited for length and clarity.
ben martin: welcome
morning, I'm Ben Martin, Director of Investor Services for the Morino
Institute’s Netpreneur program. On behalf
of the entire Netpreneur team and the Morino Institute, I would like to welcome
you to this morning's Coffee & DoughNets session, "Cramdowns, Ratchets
and Other Four-Letter Words."
Don't worry, this isn't going to be
nearly as difficult or as menacing as it may sound. What we're seeing today is that even the most promising
early-stage companies are finding it extremely difficult to secure venture
funding. In fact, I suspect that many
of you are here today because you hope to reach the term sheet stage at some
point during your company’s business development. But what do you do when you get there? What do you, the founder of a company, need to know when you sit
down to negotiate a venture capital term sheet? You can start by getting a good lawyer, but we'll give you some
other things to consider as well.
In the current climate of down rounds
and company liquidations, the negotiated terms of venture funding deals are
becoming increasingly more important to both investors and entrepreneurs. It is critical that entrepreneurs understand
these terms, because, if you don't, you may well pay for it later in terms of
dilution. When you leave today, you
should have a solid understanding of the major deal points that you may
face. Our panel is here to help you
understand those points. We will cover
such ominous sounding terms as conversion
ratios, liquidation preference, anti-dilution provisions, warrant coverage, right of first refusal and, my personal favorite, drag-along rights, just to name a
few. And, of course, we'll cover the
increasingly popular, aforementioned cramdowns
and ratchets. As for the four-letter words, our moderator,
Mr. Andrew Sherman, has promised me that he'll fit as many of those in as he
For some additional information, let
me recommend two resources in the Funding & Finance section of the
Netpreneur Exchange Web site which we've been able to make available to you,
thanks to our moderator and one of our panel members. Anatomy of a Term
Sheet: Venture Capital, An Overview of Trends, Strategies and Structural Issues
has been provided by Andrew Sherman. In
addition to many other things, it includes a sample term sheet that you may
find helpful. In addition, An Entrepreneur's Guide
to Raising Private Capital was developed by panel member Kevin Burns of
Lazard Technology Partners in conjunction with Lighthouse Consulting and the
Mid-Atlantic Venture Association.
In addition to thanking our moderator
and our panel members, we'd like to take a moment and thank our volunteers from
the Netpreneur community who have given their time this morning. We couldn't do it without them, and we'd
like to recognize Sid
Paskowitz of Internet Commerce City Corporation, George DeBakey of TradeCompass, Gabrielle Hervey from
Linsang Partners and Jim Pettit of iroute,
Inc. Thank you very much for
joining us today and helping out.
This morning's panel will be moderated
by Andrew Sherman. He's a senior
partner with McDermott, Will & Emery, an
international law firm with over 925 lawyers worldwide. Andrew manages their multimillion dollar
corporate and transactional practice representing Fortune 1000 corporations, as
well as technology-driven, net-centric and rapidly growing businesses. He is an internationally-recognized
authority on the legal and strategic aspects of entrepreneurship and the
business growth cycle, and has been a commentator and guest on all of the major
television networks, including CNBC's Power Lunch, CNN's Day Watch, CNNfn's For
Entrepreneurs Only and Bloomberg's Small Business Weekly. Among his many distinguished
accomplishments, Andrew is an adjunct professor in the MBA programs at both the
University of Maryland and Georgetown University. He has also authored 11 books on business growth and capital
formation, including the best selling and critically acclaimed Raising
Capital. I have a copy of it
here. Actually Andrew brought it, and
we're not going to let him leave with it today. Somebody in the audience will win it, the person who comes up
with the best question. Stay tuned for
that. We try to make these events
fun. Please give a warm welcome to
andrew sherman: term sheets 101
hope we still have enough time after Ben's wonderful intro. I just want to say a couple of preliminary
things before we get into the program.
First, I am so glad to be here at Dave
& Buster's, without hearing the words, "Dad, can I have five more
tokens, please?" I didn't even
know this side of the place existed. To
celebrate, I showed restraint by limiting myself to just six donuts this
Ben thanked the volunteers and others;
I want to thank Mary, Fran, Ben, Cathlin, Mitch and the whole Netpreneur
team. If you haven't met these people,
they are some of the most dedicated people to entrepreneurship in our
region. They accommodate you monthly with
opportunities to get educated, to eat and to network, and I think that Mary and
her team really deserve a quick round of applause. And thanks to Mario Morino, of course.
When I was preparing my preliminary
comments, I was sitting at my Friday night poker game with John May of New Vantage Group and other local
dignitaries. John said, "Your
comments should be short. Just stand up
there and say, 'There are no term sheets'
then sit back down. That ought
to cut the discussion down."
I said, "John, that really
wouldn't make for one of the great Netpreneur events of all time.” Besides, the good news is that John's
wrong. The second piece of good news is
that John lost about $30 Friday night.
He was willing to contribute his losses toward some lucky entrepreneur,
but we'll save that for another time.
There are term sheets out there.
They may not be the exact term sheets that you were hoping for. As I think you'll hear from our panel, they
may not be the terms that you were praying for. Those rules have changed.
Our focus this morning will be mostly on what you might find in today's
term sheet versus a term sheet from 18 or 24 months ago. I don't think that is all of a bad thing, by
the way. It may not be a wonderful thing from the entrepreneur's
perspective, but you'll hear some of the things you need to understand if
you're getting to that stage. A certain
amount of reality has come back into the marketplace.
Let me give you a couple of broad
thoughts, then we'll get into some details.
I also want to save some of the high-altitude observations for the
First, you've all heard about
valuations shrinking, this phenomenon of down
rounds that we'll talk about further.
There has been more money provided to existing portfolio companies than
ever before, additional rounds that are not quite at the levels that they may
have been previously. There is
definitely a sentiment out there that we've got to look after what is already
in our portfolios as opposed to bringing in new deal flow. I think that a thaw has started to happen a
little bit in the last 30 to 45 days, at least that is what we're seeing. Clearly, the standards have risen in terms
of customers, revenues, profits, the development of your technology and so on. It was said to me recently that angels are
acting more like VCs and VCs are acting more like investment bankers who are
doing an IPO, in terms of their level of due diligence. I added my own twist to this, that the
investment bankers are acting like my grandmother, going down to Florida for an
extended retirement. We’re not sure
when or if she's ever coming north again.
So, are term sheets impossible to
get? No. We've got several clients who are raising money, several who have
raised capital locally as well as in other parts of the region. I see one of them sitting there, Paul Brewer
from Diamondback Vision. The party is not over, but the bouncer just
got bigger and he is more selective about who gets in the door. In many ways, this is a return to reality, a
return to fundamentals. The new rules
are really a return to the old rules.
How do you get a term sheet? What is the process? What are you likely to see in that term
sheet? My role is to introduce the
topic and turn it over to the speakers.
We want to spend as much time on Q&A as possible. I suspect, just in talking to some of you
over my fourth, fifth and sixth donuts, that there are some great stories out
there in the audience, and that there are some people who are raising
capital. I think it's important in this
program to get interactive, to hear what is on your minds and break any myths
that might be out there. Also, those of
you who are in negotiations with venture investors, it’s important to share
those stories with each other.
Let me just cover some preliminary
materials. If you have a copy of the
handout I prepared for today, Anatomy of a Term
Sheet: Venture Capital, An Overview of Trends, Strategies and Structural Issues,
please take it out. How many of you, by
show of hands, have a sense of the venture capital process? Okay, that's less than half of the hands, so
let me give it to you very briefly.
First, some introduction is made. You have heard for years that you really
don't want to be sending business plans blindly through regular mail or even
through email. I still think that is
the case. In fact, it is probably more
the case than ever before. You want to
have your business plan introduced, whether it's by your lawyer, your
accountant, some advisor or by another venture capitalist. Getting access to some of the people on this
panel is not easy, and it doesn't hurt when a business plan is introduced by
somebody who knows them, has a relationship with them or somebody who can
validate or give credibility to your plan.
Next is the preliminary evaluation of
the business plan. Once submitted, it
will be evaluated by any number of people, including folks like Rusty, who may
be part of the evaluation team.
Then, there might -- and I say might because sometimes the process ends
there with someone saying, “Interesting plan, not our space” or “Interesting
plan, too early” or “Interesting plan, too late” or “Interesting plan, actually
not so interesting plan.” You'll get
all kinds of responses in that regard.
So, the next step might be an
invitation to present, and that, in my view, is a very critical step in the
process. In the handout there are some
materials on how to get ready for it.
It assumes that you are already at that stage in the discussions. It didn't make sense to spend a lot of time
on those preliminary issues now, however, like how to prepare a business plan,
because: (a) there are plenty of other
Netpreneur events on that; and (b) our focus today assumes that you've gotten
far enough in the process to have actually been presented with a term
sheet. A lot may be made or broken
during that presentation, however, and almost everything will be evaluated --
how you present, things that you say, the attitude that you take, how you
answer the tough questions, your attitude towards teamwork and listening to the
advice of the venture investors. We
could spend a whole program just on getting ready for that meeting, and
hopefully there are some good tips in the handout.
At that level, due diligence has
probably already begun. There may be
follow-on meetings and presentations that you need to make. There may be a meeting with the other partners. There is a lot more dance going on in this
market than there used to be -- first date, second date -- I don't want to go
too far on the dating analogy, but the point is that you're more likely to have
to go through more of those hoops.
You'll hear more about that as the morning goes on. In this market there is probably more due
diligence and more meetings, but, at some point, a term sheet is delivered
(hopefully), and that is the document we're focusing on today. The venture capitalist is always going to
have a term in there that qualifies the document, saying that if anything
further comes out in due diligence they’ll have an opportunity to back out, or
that if you don't mostly agree to all of the terms in the document they have
the right to back out, but we'll assume that we're far enough along in the dating
process and due diligence process that a term sheet has been delivered.
At that point, there will be more due diligence. In fact, in this market, there is even more
due diligence after that. And there
will be the beginnings of term sheet “negotiations.”
I put the word negotiations in quotes because the bulk of my time is spent on the
company side, as opposed to the venture fund side. There are some things in the term sheet that are definitely
negotiable, and a lot of things that may not be. There are things that you are unrealistic or naive to think are
negotiable, things that are core or fundamental to the venture investing
process. You're wasting a lot of time,
as well as the time of these panelists, to think that you're going to negotiate
From that point, the term sheet is
signed and there will be more due diligence.
Then we're on to the definitive documents, which are prepared by the
counsel for the fund. They're delivered
to your law firm, which hopefully has some experience in negotiating them. Those definitive documents are negotiated
and, eventually, there is a closing and everyone goes out and gets, well,
really drunk for that one night.
The next morning, the realization
occurs that now we have to perform, and, in this market, you have to really perform. Companies that are falling behind on their
schedules or that are not meeting performance targets are going to need more
capital, and the valuation that comes in is critical. That’s one reason why the issue of relationship management and
keeping your venture investors informed is so important. How often will you be meeting? Is it monthly? What kinds of ongoing controls will there be? The point I'm trying to make here is that on
a post-closing basis, there is still a lot of work to be done, particularly if
you're looking for a second term sheet or a second round. Very few companies in this region,
particularly in this market and with these valuations, got only one term sheet
or one round of funding, and that is the last money they ever needed to
raise. It is highly unlikely for most
of you in this room. Possible, but highly unlikely.
So that is the process in a
nutshell. If you could just give me a
loose nodding of heads for yep, or you can shake your heads the other way and
we'll keep going on the process. We all
want you to understand where this term sheet comes up, and it’s a fair bit of
the way down the road following some of the early presentations and meetings
and due diligence.
Regarding the four-letter words that
Ben promised, I was thinking this morning at about 5 a.m. that if I got in
front of you early in the morning without sufficient levels of caffeine and
started talking about technical legal terms, I'd lose all of you very quickly,
so I'll bring them out in Q&A.
You’ll also see some of them explained in the sample term sheet included
in the handout. I'm hoping that Q&A
and the presentations will bring most of them out, and I want to keep us on
If you look at page three in the
handout, there is some discussion about preparing for this meeting with the
venture capitalists. Again, the thing
that I want to emphasize is that if you don't pay careful attention to some of
these things, there will be no term sheet.
These are the precursors or preliminary steps to receiving the term
sheet in the first place. If you blow
it during the initial meeting, you won't be getting a consolidation term sheet,
or you'll be getting a note that says, “Thanks for the meeting. Stay in touch.” Or don't stay in touch, as the case may be. You'll only get to the term sheet level if
you go through some of these points.
Look also at Page five, which covers
concepts like a big market, a big upside and understanding what really
motivates the venture capitalist’s decisions.
These are some of the things that will be reflected in the term sheet,
not just esoteric philosophical points.
The things that come out in the meetings and in due diligence, the kinds
of risks that the venture investor sees in his evaluation of the business plan,
those are going to be reflected in the term sheet. The sample term sheet in the handout is what I call “plain
vanilla.” I made it as vanilla as
possible because it's not reflective of any special risk, concerns or
performance standards. If Rusty and
Kevin have done their jobs, however, the issues that they uncover will be
reflected in that term sheet. It is a
message telling you that they think enough of you to make this commitment, but
they still have concerns. Those
concerns may come out in financial valuation, or they may come out in special
conditions, but they're going to come out in the term sheet; then you are
either going to agree or disagree with those special issues. These steps are reflective of the substance
of the term sheet.
When it comes to negotiating a
structure in the deal, I've laid out a list of concerns in the handout that
attempt to strike a balance, but the balance is going to be struck in favor of
the venture capitalist. They have the
dollars and you want them, so don't expect it to be a perfect balance. Also, don't expect it to be completely
unweighted. Even in this marketplace,
for the better companies, there is not an expectation that you're going to have
to completely lay down and get nothing or that your valuation is going to be
way, way lower than you expected. I
would still hold your ground, but not to the point of stupidity or machismo,
particularly in a market like this.
Now, I'd like to turn it over to our
first speaker, Kevin Burns, who is going to get into the purpose of a term
sheet and some related issues.
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