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Cramdowns, Ratchets And Other Four-Letter Words
Dilution and the post-bubble term sheet

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kevin burns: upside, downside, lateral

Thank 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 win.

          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 there.

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 perspective.


rusty griffith: talking the talk

I 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 management behavior.

          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 technology risks.

          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-enhancing technology.  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.”  Okay, 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 12 months.

          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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