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Funcing Early Stage Venture

Term Sheet

Term Sheets

  • Notes with high interest rates
    • Not from banks
    • From high net worth individuals
  • Notes with warrants
    • warrants gives lender to buy equity at future dates
    • It helps investors stuck on the fence of making investment to commit
  • Convertible Notes
    • Debt has a maturity date and can be converted into equity in the next round
    • Could be a useful way to raise capital before going to an institutional investor
    • The note holders get to convert at a discount rate, e.g. 25%
    • First round: $1M funding at $1 per share. You would have the opportunity to convert and buy share at 75 cents per share. That represents risk premium.
  • SAFE investments (Simple Agreement for Future Equity)
    • Developed by Y-combinator
    • Investor purchase SAFE in exchange rights to purchase stock for future equity round
  • Preferred Stock
    • Equity has all sorts of special features that protect these investors in the event (e.g. poor outcome)
    • In case of liquidation, these investors get their dollars before common shareholders
    • Enjoys various “preferences” over common stock (liquidation preferences, dividend rights, redemption rights, conversion rights and voting rights)
    • Asset Priority Claim: Bondholders -> Preferred Shareholders -> Common Shareholders
    • Usually have rights to convert preferred stock to common stock
  • Common Stock
    • The basic equity interest
    • The type of stock typically held by founders and employees

Debt vs. Equity

  • Debt: preferred by entrepreneur
    • Short term clarity
    • Avoid prematurely selling equity (sell equity at $5M valuation is way more expensive than at $10M valuation)
    • Cheaper to transact
  • Equity: preferred by investor

Terms - allocation of economic benefits

  1. $ invested
  2. Valuation/Price per Share
  3. Size of Option Pool
  4. Liquidation Preference
  5. Participation
  6. Antidilution Provision

Terms - determination of control

  1. Board Composition
  2. Protective Provisions
  3. Drag Along Rights

Liquidation Preference

The dollar amount that a older of a series of preferred stock will receive prior to holders of common stock in the event that the company is sold or liquidated. e.g. * VC1 invests $1MM in a company with a $4MM pre-money valuation for a 20% equity stake * The company is later sold for $3MM * Without a liquidation preference, the VC would received $600K * With a liquidation preference of 1x, the VC would receive their original $1MM investment. With a 1.5 liquidation preference, they would receive $1.5MM.

Senior Liquidation Preference

A series of preferred stock has a “senior” liquidation preference when it is entitled to receive its liquidation preference before another series of preferred stock.

Participation

Preferred stock is said to “participate” when, after the holders of preferred stock receive their full liquidation preference amount, they are then entitled to share with the holders of common stick in the remaining amount being paid for the company or otherwise distributed to stockholders. * In a loss year, investors are entitled to their fixed dividends. * In a profitable year, they are entitled to dividends and to participate in the profit of the company on a pro-rata basis.

Multiple Liquidation Preference

Investors may require that their liquidation preference amount be greater than the amount they originally invested.

Anti-dilution Provisions（反稀释条款）

Retroactively reduce the per share purchase price of preferred stock if the company sells stock in the future at a lower prices. * Weighted Average * Increases the conversion rate of the preferred stock based on a formula that is intended to take into account of the sale of new stock by the company. (more entrepreneur friendly) * Full Ratchet * 完全棘轮条款是指投资人过去投入的资金所换取的股份全部按新的最低价格重新计算。

Preemptive Rights

Preferred shareholders will insist upon the right to invest in future financings in such a manner as to maintain their pro rata ownership of the company 优先认购权（Pre-emption rights）指公司发行新股或可转换债时老股东可以按原先持有的股份数量的一定比例优先于他人进行认购的权利。

Pay to Play

Imposes penalties on investors for not investing their full pro rata (按比例) share in the next round. (Typically only comes into play if the next round is a down round. It is less common.)

Board Composition

Investors will require that: 1. The board have a defined composition; 2. That all shareholders contractually afreee to vote their shares for that structure.

A type board structure for typical early stage venture: * 5 Person: * 2 Seats: common shareholders (CEO + Founder) * 2 Seats: investor * 1 Seat: industry expert choosen by the investor

An investor might be deciding 3 out of 5 of the board seats even they share small portion of the company.

Protective Provisions - Veto Power 否决权

Specific actions that require approval from the Preferred Shareholders including such things as issuing a secuirty that is senior to existing shareholders; selling significant assets of the company; and borrowing monet above some limit.

Drag Along Rights 领售权

A provision that enables a majority shareholder to force a minority shareholder to follow a key decision, especially the sale of a company. The majority owner doing the dragging must provide the minority shareholder the same price, terms, and conditions as any other seller.

No-Shop Clause

Founders may not use a term sheet to solicit other offers from investors. (The only piece of the term sheet that is legally binding.)

The Investors' Funding Timeline (2-8 months)

  1. Review Business Plan
  2. Bring in Management Team to Present
  3. Initial Due Dilligence
  4. Internal Fund Partners Meet
  5. Term Sheet Negotiations
  6. In Depth Due Dilligence
  7. Legal Documentation
  8. Funding