Ratchets And Other Four-Letter Words
the post-bubble term sheet
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kevin burns: upside, downside, lateral
you very much. It's great to be here.
The first point I would make is that
laying down the term sheet, for most venture capitalists, is basically a sign
for you that the whole discussion is moot from the early phases of building
interest and learning about your plan, to the business due diligence. In our case, Lazard uses the act of putting
down a term sheet and the discussion of its terms as a transitioning vehicle to
tell you, and to tell ourselves, that we're moving from the business due
diligence to actually doing a legal transaction. As was pointed out, there is still some due diligence going on,
but it usually takes the form of legal due diligence, such as your corporate
standing, Delaware corporation and things like that. Usually, if we're going to put down a term sheet, we've decided
that we like you, we believe you can pull off the business idea, we like your
team, we like your business model and we like the space that you're in. It's very important to understand that
venture capitalists invest in jockeys on horses in racetracks in specific
weather conditions -- we're looking at all
of those things. In order to get to a
term sheet, we have to have decided that you are in a space that we think can
matter. As Warren Buffett will tell
you, when great management with great ideas meets a bad space, the space will
We look at the fundamentals of the
space, we look at the human capital, the passion of the entrepreneur, their
ability to rally the vision that they have in galvanizing execution with their
current management team partners, with other constituencies and the like. We've already decided that we like all of
that when we're going to the term sheet phase, which means we're probably 30
days away from actually wire transferring capital into your bank account.
The term sheet is just like any other
negotiation, except we do it monthly, maybe five, 10, 15 or 20 times a
year. Hopefully, you do one every other
year or so. Basically, what we're
looking at in a negotiation is yet another test to find out how good you
are. We'll judge how you negotiate with
us as how you might negotiate a tough supplier or a tough OEM deal that you're
trying to do for third party channels.
We don't think it's very much different.
Like all negotiations, first you want
to know thy audience. Rule number one:
Know thy audience. We are venture
capitalists, not banks. We're not going
to lend you money at two points over prime with a few warrants on the
side. We are high risk, high return
equity investors. We basically go big
game hunting. We give money to people
that no one else will give money to.
A lot of entrepreneurs are overly
emotional about the process, by the way.
I think their mothers-in-law told them, “Don't give away the farm!” You're giving up your stock, and there are a
lot of other very emotional tests of volatility around the discussion of the
term sheet. We actually believe that the
negotiation is not an end, it's a beginning, because what is unknown is the
size of the pie. I like to think that
if we knew that we were going to build a, really, no fooling, $100 million
revenue company in a killer space that can go public with a price-to-revenue
ratio on the street of 10X and a billion dollar market value, somehow the
“liquidation preference” wouldn’t seem all that that important. You can calibrate your venture capitalists
on whether they're focusing on the upside -- that billion dollar pie, where
everybody has so much money that none of these terms matter -- and you can also
remember that all these terms in these venture agreements blow up and go away
upon a qualified IPO, usually. So term
sheets have a specific life of their own, and, if the pie is big enough, a lot
of these terms are non-operative, but let’s talk about the high anxiety liquidation preference.
The liquidation preference is
basically part of a downside scenario where we've sold the company a couple
months after we've invested for a valuation not much higher than what we
invested in. The liquidation preference
is designed to allow the venture capitalists to get their money back out of the
transaction. It's a downside protection
device, and I would encourage you, strategically, to think about all these
provisions as either being upside drivers, downside protection defensive
measures or wimpy lateral measures. You
can classify all of these things as fitting into one of those three buckets.
Some other advice I'll make in my
introductory remarks is that there are certain red flags we use about the
behavior of entrepreneurs. First of
all, we look for and hate dysfunction among the partners. Some of the companies we invest in have
multiple partners. They're the Three Musketeers
who founded this company -- one left-brain technical person, one salesperson
and one finance person. The Three
Musketeers are sitting there and they have not established who is going to be
the point person to lead the tough discussions on terms. They are huddling. They're a democracy or consensus group, and we just look at that
and say, "My God, never mind the term sheet, how are they ever going to
move the business forward if they have this kind of goofy consensus style of
negotiating?" You can have
discussions in the background, but at the table, there should be the front
person who has the proxy to drive the discussion.
So, we don't like the Three
Musketeers. We also hate it when we're
sitting across the table from people on the other side who do not understand
what a market rate deal is. Like all
negotiations, if you don't know what industry practice is . . . What is the
bandwidth of bid asked? What is the favorable
of the company? What is the range of
industry practice we can arm wrestle within, rather than asking, “What is a
preferred stock?” Why would you get an
interest rate? Is this a loan? We just think, “Man, we don't have time to
lobotomize these people.” We may just
spook and move on. We're not college
professors, so we're not here to train anybody in anything.
Who is your legal counsel? Many people who are smart enough and
energetic enough to form a business make the mistake of thinking that anything
they don't know they can go study up on over the weekend. Then, on Monday, they proclaim themselves to
be expert at it. Well, that is a
limiting thought. What we would like to
see is you being smart enough to say, “I'm going to have a great legal counsel
who is skilled in negotiating venture capital deals.” Compared to what?
Compared to many times when we ask, “By the way, who is your legal
counsel going to be?” and we hear, “Uncle Fred. Uncle Fred helped us with our
real estate lease and he is going to help us with this. We trust Uncle Fred on this deal.” Here is Uncle Fred and he is worse than you
are. Then we worry that you're not
going to surround yourself with best in class counsel, or that you don't know
how to listen to or use your counsel.
When you are young, you want to be the
bride at every wedding and the corpse at every funeral. You want to drive everything yourself. When you get a little older and you are
building a killer growth business, you learn how to keep your own thoughts in
reserve. Use your legal counsel. Send them out front to take bullets. You have dry powder to sit with in the back
and say, "I agree” or “I don't agree." You're the entrepreneur.
You still have that power. But
if you're spending emotional chips and negotiating chips barking at every moon
and defining every term, you actually lose negotiating leverage. I would encourage you to go out and find
good counsel. There are a lot of them
around this region now, thankfully, who understand how to do private equity
transactions. Tell them that you want
to be involved in business discussions about the basic economic terms -- these
five things that really matter: the valuation, anything that changes the
capitalization table, anything that deals with economics, the governance, what
turkeys are going to be on this board and on down the line. As a businessperson and entrepreneur, you
want to know those five things. Lock yourself onto them, then send your legal
counsel off to battle and arm wrestle the other stuff which is nice to have.
Keep yourself in reserve for those important issues that you may have out
Mr. Sherman: Thank you, Kevin. Our next speaker is Rusty Griffith, who will talk about term
sheet strategies and negotiations from an angel and early-stage investor's
rusty griffith: talking the talk
would reiterate a lot of the things that Kevin has discussed. It's not so different at the angel, early
seed and early-stage investments.
We have a few other problems that we
have to address as well, just because of the stage of the business. For example, often you don't even have a
product yet. You have an idea, or you
may have something in beta. Or you may
not. You may have a good development
staff in-house, or you may be outsourcing.
There are all sorts of risks associated with being very early stage that
we have to consider and that Kevin might not once the company has gotten to a
certain point and has started to prove itself.
Some of the things we might do to help
mitigate our risk would be things like staging the financing. You may have heard of that as tranching, and there may be some other
terms. That’s where, if the total
investment may be a million dollars, we'll give you $500,000. If you achieve X by date Y, we'll give you
another $250,000, and so on. That helps
to improve our returns and it also helps us deal with some of the issues that
may crop up along the way. One of the
lessons we've learned is that once you give the money, often you're forgotten.
You are not kept in the loop on things.
You have to pursue companies to try to follow what is going on and
understand that they are adding value to the business.
Another term we might use would be a valuation slide, and that slide can go
up or down. I've seen it go both ways,
but typically it's going to be down.
We'll negotiate a valuation with you at $5 million, let's say, then, if
you don't do certain things, that valuation will slide to give us a larger
share of your company over time. That
makes sense for us, because you have shown that you are a higher risk than what
we first expected.
Board representation is important, and
the composition of the board is something that companies often ignore. You have to look at your board as a critical
factor in the success of your company.
Don't take it lightly. Make sure
that everyone you add to your board is going to add value to the company, that
they bring something to the table. I've
seen companies that have brought on all sorts of board members who are
inexperienced, or they may add strategic investors who have totally different
motives and incentives than the management or the others investors. The board falls apart. You can run into really big issues if you
have a board that becomes dysfunctional.
Building a solid, core board of directors is something we'll often help
with. We might be able to make
recommendations for outside directors who can add a lot of value to your
company. Don't take those
recommendations lightly. The intent is
to help you build a strong company.
Another technique we might use would
be warrant coverage which may kick in
under certain events, and, of course, negative
covenants. Those would be things
where we might say that we don't want you entering into any leases that would
be over X amount, or we don't want you to pay employees salaries of $150,000 or
$200,000 for a startup, which some do without our approval. There could be a lot of things that we don't
want you doing without our approval.
Those are often up for negotiation, and they're usually pretty
reasonable, but they have to be there to protect us from some irrational
Sometimes we'll use an entirely
different investment instrument. We
won't invest in preferred stock,
we'll invest with convertible notes. That allows us to provide you with the seed
capital that you need to get to a certain milestone, but we may not really know
what your valuation should be at this point, or we may not want to establish a
valuation yet because we think you can improve the value of the company if you
can get over certain hurdles. As a
result, we might do something like a convertible note that will have a discount
into another round or that will allow us to convert at a certain price to some
preferred equity if there isn't some sort of a successor round.
Some of the other issues that we have
to deal with as early-stage investors sometimes involve helping you establish
the company. It might be three people,
and that leaves a lot to be desired in terms of all the support that is
necessary to help run a rapidly growing company. Perhaps we'll help you identify additional markets that you can
target for your products or help you develop company processes, such as
financial and accounting systems. I've
seen companies whose general ledger is their checkbook -- literally their paper
checkbook. That is not a good
sign. It's kind of hard to run a
business if all you're doing is keeping a list of invoices in a checkbook.
I touched on strategic investors before.
Be careful of having strategic investors in the company early. They have different motives and different
ways of looking at the company.
Probably nine times out of 10 their valuations will not coincide with a
VC's valuation, so what you could have happen, similar to the last couple of
years, is that your valuation gets inflated early. Then, when you need a serious round of venture capital, the
valuation comes down. You may have all
sorts of other nasty little terms that start to kick in that you probably don't
want to have to deal with.
Generally speaking, there is going to
be a higher risk profile associated with an early-stage company. There is operational risk, where there are a
lot of costs that are not going to be covered by revenues, because you probably
don't have revenues at that point.
There will be funding risks. We
take a chance that maybe you won't get funding from other sources later on, and
that is something that we have to consider.
And, of course, there are always going to be the market risks and
Some of the things we need to see when
you come to talk to us and we consider whether or not we want to invest in you
are very similar to what Kevin is looking for.
We want to see a solid management team.
You may not have that much in terms of management experience, but it is
important to see that you have the willingness to create that team. We
understand that at a very early stage you may not have brought together the
entire team. That is usually the
case. We also want to make sure that you
have real technology; not the equivalent of a technological pet rock, but something
that is going to blossom, not die on the vine.
We want to see enabling technology, not necessarily just
Productivity enhancement might be a good business, but it's not
necessarily a good VC investment.
I want to emphasize that point. Kevin has said that just because a VC does
not invest you, it does not mean that you're not a good company. I tell that to a lot of people. I see their faces as soon as I say,
"Well, you're not a VC play."
The face just kind of goes flat.
I tell them, "Look, you have a good company, but it's not something
you want a VC to invest in. You've got
a different set of circumstances there."
You also want to avoid being a
technology solution looking for a problem.
That doesn't work, as I'm sure everyone knows, although there are still
some who haven’t. I hope there are not
too many engineers in the room. Often
the engineers will develop a really great product, but you can't figure out
what it's going to do for people in the market. That is a good sign that maybe this is not a good investment for
us to make. I want to be able to
understand the market you're looking at.
If you can't articulate the market that you're going after, don't expect
us to tell you what it is. That is not
a good sign for us that you understand what you're doing. We also want you to have a solid sales
strategy. It may change. In fact, we expect that it will change, but
you want to show that you've given it a lot of thought and that you know what
to do to get your product to the market.
One of the things that people often
forget is to explain how much money you need and why you need it. We're not going to sit there and try to
decipher what it is you're asking for.
You have to tell us and, in that respect, you have to be blunt.
Bootstrap mentality. At the last Netpreneur event they hammered
home the idea that bootstrapping is important, and it is important.
In the past, the cash kept flowing from the
investors. It was like an
allowance you were given. You knew that
as soon as you ran out of cash you could run back to your VCs and they would
infuse another $10 million into your company.
That is not going to happen anymore.
You're going to have to show that you're smart with the money, and
you're going to have to show how you're going to get cash positive. If you can't get to a positive cash flow
within a reasonable amount of time, you need to go back home and re-think how
you're operating your business.
The form of the business entity is
often important. We've seen LPs, LLCs
and other types of non-corporate entities, and we don't invest in those. It's got to be an incorporated company. There are reasons for using other forms
which you can discuss with your counsel, but we don't invest in them, so you'll
have to change the form of business.
Also, don't make the mistake of
telling us that you have no competition.
I don't know how many times we've heard that. “Who is your competition?” “Well, we don't have any.”
then you really need to go back and think about what your product is. Your competition may not be another company
doing the same thing that you're doing.
There could be alternatives that are not high tech that would be
competition for you, so you really have to think about that.
Briefly, some of the terms we'll use
to protect ourselves are: antidilution,
voting rights -- there are often special voting situations where we will
have to give consent for something as shareholders, as opposed to voting along
with all the common -- preemptive rights
and rights of first refusal -- those
are important rights to us. We want to
make sure that when the next round comes along we're able to maintain at least
our pro rata share. Milestone performance is something that
you may be seeing more often in your term sheets, where you have to achieve
certain things. Mandatory redemptions are apparently getting more awareness now
because people are realizing that they can't exit into the IPO market inside of
12 months anymore. Generally speaking,
you'll see anywhere from four to six years, five probably being the norm, so
there should be plenty of time for the company to develop before a mandatory redemption right kicks in. Another term you should understand is exit strategy. Sometimes you have to help us understand where you see the exit
for the investor. When we put cash into
your company, we want cash back, hopefully a lot more than we put in. That is the reason we do it, so the exit
strategy is important. An IPO is not
the answer these days. You would be
hard pressed to convince a VC these days that you're going to be able to IPO in
When you're talking early-stage, liquidation preference is important.
That was touched upon earlier. Conversion rights and getting yourself
into a cramdown -- I assume everybody
understands what cramdown means? I see
some heads shaking. Cramdown is when
you've lost all leverage. You're out of
money. You can't make payroll. You can't get any other money interested in
you and you come to your inside investors and say, "I need
money." Don't expect highly
favorable terms because now you've worked yourself into a corner. You're going to get crammed down with the
terms. That is basically what it means;
you've lost all your leverage to negotiate.
A lot of entrepreneurs are not
completely familiar with terms like fully
diluted common shares. That doesn't
mean what you're only going to represent in a capitalization table. Does
everybody know what a capitalization table is?
The capitalization table (also called cap table) shows the ownership in your company. You are going to have all your common
stockholders listed, all the options based on your employee stock option plan,
any preferred stock that is out there, and, for fully-diluted, you are going to
have to show any debt that has conversion rights into stock, any warrants you
have outstanding, etc. You may have
agreements with vendors where you will be paying them X amount of stock, for
example. You have to represent all of
that in a cap table because, when I make the investment, I am anticipating that
I'm getting a certain percentage of your company. If I invest $5 million and your valuation is $10 million, then
I'm getting a third of your company, so I would expect that the number of
shares I get will represent a third of the company. If it's incorrect, you are going to suffer. The venture capitalist is not going to take
dilution because you forgot to put in the 100,000 shares that you promised to
Aunt Sophie years ago when she gave you $20,000 for this company. That is probably one of the biggest problems
that we run into with people who are starting a company for the first time. They don't understand those terms and it is
kind of shocking to them when they really see all the ownership impact on their
fully diluted common share table.
Mr. Sherman: Now, the perspective you've been waiting
for, the entrepreneur who has actually raised capital. A real local success story has been
Blackboard, Inc. Andrew Rosen is the
company counsel, and his discussion will be on negotiations from the
perspective of a company founder, what to look for in an investor and what to look out
for in an investor.
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