In this first episode of a three-part series called “Angel and Venture Capital Investing,” Trusted Counsel’s Mike Siavage reviews the term sheet, a summary document of key terms in contemplation of a financing―along with other elements for entrepreneurs to consider.
Here are three of the top questions from the full interview with Mike:
PRIOR TO THE TERM SHEET, WHAT SHOULD A COMPANY DO TO RAISE MONEY?
What I tell my clients is that there are various stages of investment in your company, and they come from various places. You’ll typically need $30,000 to $50,000 just to start a company, to pay for good advice and then to acquire the people for the management team. So funds will usually first come from your friends and family, people you know in your own network (who are supporters of you)―and from your own pocketbook.
Traditionally, the second phase to raise money is through angel investing. Angel investors are a little bit more sophisticated about putting money into companies, and they’ve done it before. Typically you will not want to set a valuation in this phase.
Next, the entrepreneur will want to go back to the angel investor for another round of raising funds. I usually advise the entrepreneurs with companies who are doing that angel round on a convertible debt instrument (a debt or loan instrument that an investor gives to a company with the intent that it will convert later to equity and not be paid back as a standard bank loan would be) to produce their own term sheet because a lot of times angels will ask you directly, “What are your terms?” It looks professional on the side of the entrepreneur to have something to provide the angel, and it’s typically a convertible debt term sheet.
The last stage is a standard venture capital investment. You get to this stage when your company actually has revenue, a history and a future. The VCs will normally do that term sheet, although it’s quite standard and most of its terms could be argued on what’s commercial at that stage of the investment.
WHAT SHOULD A COMPANY NOT TRY TO NEGOTIATE IN THE TERM SHEET?
Registration rights. Registration rights mean that those who invest in your company have a right to participate in a public offering― if you have a public offering. Well, you don’t usually get to a public offering with your Series-A round. There’s usually going to be a Series B and Series C and D and E. One aspect of that is that the registration rights are going to change in those further-on rounds. So, you might as well not fight about them right now, anyway. Secondly, investors are not going to spend much time with you telling them that you want to only give them two S1 registrations in a year―because I’m not sure they even understand their own term sheets, from that perspective.
AFTER A COMPANY OBTAINS A TERM SHEET, WHAT’S THE TIMING TO GETTING THE SERIES A DONE?
Well, there’s going to be diligence usually after that, so probably a month of diligence, and then a look at the documents and finally negotiating the documents. I’d say two to three months.
Additionally, investors and business owners will learn about:
- Timing for term-sheet preparation
- Finding and picking the right angel investors
- Terms of convertible debt
- Other resources available for entrepreneurs and investors
Learn about the other term-sheet questions Mike addresses by streaming the conversation in its entirety in the player below, or download it to your mobile device via iTunes. Don’t miss a single episode, subscribe to our show “In Process Podcast” on iTunes to receive this episode as well as future episodes to your smartphone.
Angel and Venture Investing, Part One:
The Term Sheet
(c) Trusted Counsel (Ashley) LLC. All Rights Reserved.
Speaker 1: It’s time for In Process, Conversations about Business in the 21st century, with Evelyn Ashley and John Monahon. Presented by Trusted Counsel, a corporate and intellectual property law firm. For more information, visit trusted-counsel.com. And now, with In Process, here are Evelyn Ashley and John Monahon.
John: Hello, and welcome to In Process, conversations about business in the 21st century. Presented by Trusted Counsel, a corporate and intellectual property law firm. I’m John Monahon.
Evelyn: And I’m Evelyn Ashley.
John: We are partners in Trusted Counsel. Evelyn, I’m really excited today. Today we have Mike Siavage, who’s actually a partner in our firm, here to talk about early-stage investing.
Evelyn: Which, you know, this is kind of a really big deal anyway, not just because of the topic, but this is only the second legal conversation we’ve ever had after two years of podcasts. This is groundbreaking.
John: But I don’t think there’s anybody in Atlanta who’s better positioned than Mike to talk about early stage investing. As I like to say in the office, he’s the godfather. He’s the attorney godfather of early stage-investing [crosstalk 00:01:18]
Evelyn: Agreed. He knows it all and he’s dealt with it all …
John: This should be a breeze.
Evelyn: … so we’re going to hear it all. And if he’s not willing to tell, we’ll make him.
John: Well, let me do a quick introduction for Mike. Mike came to Trusted Counsel in 2017 when it combined with Siavage Law Group, the firm he founded in 2004. He has enjoyed a distinguished career in public service, private industry, and private practice. Mike’s practice focuses on the general counseling of technology and other companies and investors. It includes venture capital and corporate finance transactions, mergers and acquisitions, dispute management and settlement, intellectual property transactions, including licensing, OEM, joint venture, and development agreements, reseller and distribution agreements, banking transactions, formation and structuring of new companies, strategic transactions, advice to public companies on the acquisition of growth companies, and commercialization of university intellectual properties. Mike has participated in corporate transactions, representing both companies and investors, involving well over 100 emerging companies in connection with their series A, B, C, and later venture capital investments and liquidity events. Mike, welcome to the show.
Mike: Thanks, John, and thanks for the kudos. I’ll see if I can live up to them.
Evelyn: We know you can. I think before we get down into kind of the nuts and bolts of the actual term sheet and what a company should basically expect when they receive one, let’s talk a little bit about, what is the process to actually get there? This is something that we all field pretty regularly from clients, and it’s still kind of the question. What do I do? What do I do first to actually even go out and try to raise money?
Mike: What I tell my clients is that there are various stages of investment in your company and they come from various places. The first we talk about is friends and family, and we like to tell them that they need $30 to $50 thousand dollars just to start a company, to pay for good advice and to acquire the people that they need on their management team. That usually comes, as I said, from friends and family, people you know in your own network who are supporters of you, and-
Evelyn: Or your own pocketbook.
Mike: Or your own pocketbook, that’s right. The deal terms on those are usually very friendly, and it’s typically common stock at a high valuation because the people are really providing those funds to you because they are friends and family. But sometimes termed friends, family, and fools, by the way.
Evelyn: Yes. A little high risk, typically.
Mike: Pretty high risk.
John: We leave that last part off when pitching to them.
Mike: Right. And usually highly deluded as well. Then traditionally the second phase is angel investing, which are folks who are a little bit more sophisticated about putting money into companies and they’ve done it before. Those folks typically, and you will as the entrepreneur, will typically not want to set a valuation. A typical investment vehicle on those terms are convertible debt, or some of the other things, the newer vehicles that we can talk about later on called safes, and convertible common, et cetera.
Evelyn: Let’s just explore that just a little bit, because you said at that stage you typically don’t want to set a valuation. Why do you generally take that position?
Mike: Because in the early stages it’s very difficult to decide what the true value of a company is going to be going forward. It’s more of an art than a science. Professional valuation experts will tell you that it’s very difficult to value a startup company because you just don’t know what the future of that company is going to be. For a company, it’s inimical to the interest of the company to set a valuation at the early stage, because they’ll usually set it reasonably low so that they can get an investment, and then if they’re very successful they find out later on that that valuation was too low and essentially they gave up too much of their company in the early stage.
Evelyn: What about the other side? Because I know that we’ve seen this, where we’ve got very enthusiastic entrepreneurs that are, “No, no, we’re going out with a $10 million valuation, even though we haven’t even built the product yet.”
Mike: Yes. I see that from time to time. Sometimes Silicon Valley on the West Coast influences entrepreneurs on the East Coast, and it’s a completely different world. Sometimes on the West Coast you’ll see those kinds of valuations for startup companies, but it’s usually to an entrepreneur who’s made a lot of money for VCs …
Evelyn: In the past.
Mike: … and they’ll accept that kind of a valuation. The median valuation for startup companies in 2016 was $2.7 million. In my view, if you can get to that point in Atlanta, you’re doing well.
Evelyn: That makes sense.
Mike: But you’d still want to delay that until later on, until the series A at least.
John: And then after the angel round, what’s the next level?
Mike: The next level is the typical … And just to go back to the angel round for a second, I usually advise folks, entrepreneurs with companies who are doing that angel round on a convertible debt instrument, to produce their own term sheet, because a lot of times angels will say, “Well, what are your terms?” It looks professional of the entrepreneur to have something in his or her pocket to provide to the angel, and it’s typically a convertible debt term sheet that we can get into the detail of later. The third stage is standard VC investment. That’s typically when you actually do have revenue and a history and a future, and the VCs will normally do that term sheet, although it’s quite standard and most of its terms could be argued on what’s commercial at that stage of the investment.
John: You usually suggest that the company … The question I get most is about the term sheet, who prepares it? Because on one hand you have companies who, as you said, they can’t really value it. They’re not really certain of the terms. The truth is, is that they have an idea of what terms they might like, but on the other hand, they’re really open to anything because they really need the money. But someone has to start. Sometimes they’re looking at angel investors, sometimes they’re looking at VCs, if they can get lucky. Generally, your suggestion is, is that they should prepare a term sheet, but then be willing to pivot if asked?
Mike: Yeah, and there’s a lot of pivoting, I mean, with some companies. But I usually try to convince them that they’re in one stage or another, because it can be very disheartening for entrepreneurs to go to professional investors and find out 17 times in a row that they get the answer, “You’re too early.”
Evelyn: Right, no one’s interested. Right.
Mike: Yeah, which is … And these days, if you don’t have revenue and a good future, you are too early, so you should be realistic.
Evelyn: Right. Well, and I think it’s important that most entrepreneurs to really understand that this isn’t a process that they can abdicate to their professional advisors. They really need to spend time understanding what the different kinds of investment is, and the stages that goes along with that. To me, the idea of going through the process of building that convertible debt term sheet, whether it be used in that form or not going forward, is a good exercise so they actually understand what the impact is going to be on their business, just from going through that process.
Mike: Yes, absolutely. The other aspect of that is, I like to coach my entrepreneurs through that process while not getting involved in it at the early stages. Because if an angel sees a lawyer enter the scene, it could have a significant chilling effect on the conversation.
Evelyn: Often kill it, yes. Yeah. That makes perfect sense. Okay, so let’s say we’ve already been through our friends and family round, and we would like to get a little bit of capital, perhaps to … maybe we’ve started building a software product, but we need to add on people, or we need to actually just get it to the next level of growth, so we decide we want to go out after an angel round. First step is, we build the term sheet along those lines. How does an entrepreneur actually go out and identify who these parties might be?
Mike: Just one point before that, which is, I encourage entrepreneurs to develop a financing plan, to think about how much money they need to get to this next level, right? You know, “How much am I going to raise in a debt round, Mike?” Well, it depends on what that gets you to. If it gets you to an operative piece of a SaaS business that you can then take to a VC and that number is 800 thousand, that’s how much you want to raise. Then your series A, you want to get to the next level by … if that’s 2.1 million, that’s what you want to raise. That kind of controls how much you go for in each spot.
Evelyn: That also raises a good point, though. Let’s say you’re on the higher end of that raise. Does that indicate that it’s not likely that you’ll end up doing debt? Is there a range there?
Mike: I think there is, but if it’s going to take you that much to get to a level, you should probably split the level up.
Evelyn: Okay, right.
Evelyn: Yeah, too much included within the money that’s needed.
Evelyn: That makes sense.
John: Welcome back to In Process. We are here with Mike Siavage of Trusted Counsel. Mike, when we left off we were talking about finding the appropriate amount of money to raise, making sure your financial plan is in place to reflect that. Once you figure that out and you know that number, how do you go about finding angel investors?
Mike: There are a couple of different ways. One, of course, is to explore your own personal network. Do you know any people in your space who may have been successful in your space, who have an interest in investing in other companies in that space because they understand it? That just takes a lot of networking and research. If you’re coming out of a technical college, for instance, you can use the alumni of that college to see, for instance, who is an expert in bit streams, that kind of thing, and then talk to those people. I’ve had clients who’ve had good results from that, because those folks, A, understand the space, and usually if they are successful they want to help other entrepreneurs to be successful and support the community.
Evelyn: Support, yeah.
Mike: The second way is that there are some angel groups. I’m on the board of Atlanta Technology Angels. To go through that process, that’s usually a convertible debt round in angel capital. There are various former VCs and VCs who’ve started other entities in sort of seed investment, which would also be an angel round and a little bit different criteria to give you money. The work in angel investing, I think, is probably more intensive than it is in the series A, because there are VCs that you can call out of the universe of VCs who are going to be expectant recipients of your term sheet kind of easier than you can really find angels to invest in your company.
Evelyn: Angels, yeah. It’s really focused on networking and who you know and asking, “Can you introduce me?”
Evelyn: And I think it’s also important to know that angels are probably located within the geographic range of where the company is sitting and coming up out of the ground, because they don’t generally invest across state lines, or …
Mike: Yes. And you should use or professionals and their potential network in your area, your accountants and your lawyers.
Evelyn: What do you think that looks like? Let’s say an application is made to ATA, and I know that they do rotating meetings where they let companies come and present. What’s the expectation when someone gets on the stage to present their company?
Mike: Yeah. First of all, in ATA there’s a screening process. Essentially, you’d go through a process with 10 or 12 members of ATA who will screen and decide whether you’re worthy, if you will, of presenting to the overall group. That’s the typical PowerPoint slide presentation that’s done professionally and covers the critical areas. No more than 12 to 15 slides, on all of the areas that a VC wants to see, the market size, the management, an explanation of the technology, the financials, et cetera.
Evelyn: Competitive barriers.
Mike: Competitive barriers, right. Once that’s done, then it’s presented to, if you pass that obstacle or barrier, you’ll get presented to the general membership. If they decide that they want to invest, after you leave the stage, there’s basically a conversation on who is interested, and they develop a team to go forward with you and due diligence and perhaps make an investment.
John: Can I ask, going back to what we talked about earlier just a little bit, besides having money, which is key to being a good investor, what other good characteristics are there of an angel investor? Because I think we’ve all seen people who are quote-unquote “angels,” but money is only one criteria of that. Without additional benefits, it’s not much help.
Mike: Yeah. There’s a concept of smart money, and what I suggested before was going to folks who know your folks is kind of automatically smart money. But you really want to go to folks who have a history of investing, too. I mean, just because somebody had a $15 million liquidity event doesn’t mean that they want to put their money back in entrepreneurship, right?
Evelyn: That they care about … Yeah, exactly.
Mike: I’ve got a couple that invest in real estate, you know?
Mike: You’ll want to, typically, find folks who’ve invested before. There are some formal and informal groups around Atlanta, of collections of angels that are a little bit more informal than what I was describing as the ATA process, in various spaces.
John: Do you find that a lot of times picking the right angel investors … They’re also advisors, as you noted, but do they also help with a lot of introductions to the actual VCs?
Mike: Yes, and particularly that’s one of the advantages too of getting angels in your space, because the VCs are in your space too, kind of automatically. Having folks who are willing to get involved and, for instance, sit on your advisory board, is a real plus when getting angel investment.
Evelyn: Okay, so we’ve made it through the process, and we’re looking at likely doing convertible debt. What do those terms typically look like?
Mike: One of the principal aspects of convertible debt is, you don’t set a valuation. How much the angel investor gets is dependent upon the next round of financing, the series A financing, which is called a qualified financing. The amount of the financing is usually set at a number, a million or two million dollars, and if that financing happens, the angel who lends you the money then gets the same stock as the investors, and that qualified financing, typically at a discount that’s either articulated in a percentage discount to the number of shares they get … for instance, if they would’ve gotten a thousand shares for their $1,000 investment, they might get 1,025 shares, or 1,250 shares, for the discount, or they might get warrants in a similar situation. That’s the basis of the basic thing in convertible debt.
There are other terms in convertible debt as to what happens if you sell out before you do the financing. And there’s a new aspect of convertible debt that has gotten quite a lot of attention from the commentators, mostly bad, called the valuation cap. The way that works is, when an investor sets a valuation cap, it means that regardless of the size of the qualified investment, they get shares based upon a number, a valuation, again, regardless of what that valuation was in the qualified financing. They typically get more shares. For example, if they set a valuation cap at $2.5 million and you get a qualified financing for $5 million, they get twice as many shares as they would get in the $5 million valuation. The reason it’s attracted a lot of attention is that most folks feel that that has basically destroyed the convertible debt instrument, because you’re setting a valuation. Valuation caps are okay if they’re done correctly, but investors who are sophisticated have began to set them at what they think the value of the company is at the date that they give you the debt instrument, which is really not what they were supposed to function as at the outset.
John: We’ve had a whole conversation about on the past. That’s a function, sort of, of the series A being … or if it’s a series B or C, whatever series you’re on, it going so much further these days, and the valuations becoming runaway, and that the investors are getting really nervous of, “Well, I might have a discount, but I might have a discount to a very high raise at that point. I put my money in very early, so there’s not a proper reward now.”
Mike: Right. That was the basis, the rationale for investors starting the idea of a valuation cap. “You have to protect me.” Again, it came out of Silicon Valley, and you know, a Facebook-
Evelyn: There’s a lot more money looking for a home out there, and …
Mike: Yeah, yeah, and a Facebook-type company did their series A at a $100 million valuation, so you know, I’m getting killed as the original angel.
Evelyn: Right, right.
Mike: So angels got more and more aggressive on what that valuation cap would be. But there are significant problems to it, and John, you mentioned the series A investors. Series A investors aren’t too happy about giving the angels twice as many shares as they would’ve received in a typical qualified financing. I’ve actually had circumstances where you had to …
Mike: … renegotiate the valuation cap when the series A comes in.
Mike: They’re in many, many term sheets, however, and my advice to clients now is, try to go back and talk about the rationale of the valuation cap and argue for one that’s much higher than what they think the value of the company is when they make the investment.
Evelyn: Interesting. So even locally you’re seeing those valuation caps?
Mike: Yes, yes.
Evelyn: Wow, amazing. Other terms that usually come out of this. Do angels taking debt, do they typically get information rights? Do they get a board seat? What are some of the other terms that you see?
Mike: Sure. Typically, you would forestall the granting of a board seat until the series A, so they typically don’t get a board seat. If angels ask for some input on the future of the company, I usually advise putting them on the advisory board. Typically, advisors get between a half a percent and a percent and a half or two for just being on the advisory board.
Evelyn: Playing that role.
Mike: Other terms are, as I said, if there is a liquidity event before the financing, the angel gets the same number of shares that they would’ve gotten in the qualified financing at a discount, sometimes higher. Then the big question is, what if there’s never a qualified financing? My note is due in a year or two, and I’m getting interest on it as the angel, but what do I do at that point in time? That’s a subject of significant negotiation. The most favorable company position in my view is that you don’t have a right to get your money at that point. You-
Evelyn: Yeah. And I don’t want you taking my company off of me.
Mike: Right. The most favorable company position would be, you get convertible stock at a deeper discount. If the discount is 15% in the qualified financing, you might give them … common stock, I’m sorry, at 25% discount. Investors will push back and say, “First of all, I want the option to take my money or get stock, and if I get stock, it’s going to be preferred stock, with all the terms of a preferred stock issuance.” Typically, you don’t want to negotiate the terms of the preferred stock …
Evelyn: Anything else.
Mike: … at the debt stage. But you can say things like, “Upon standard preferred stock provisions in this locale,” or something like that.
Evelyn: That makes sense.
John: What about when people get a little aggressive and they want extra security, and they say, “Well, I actually want this secured by the assets of the company?” Yes or no?
Mike: Yeah. Usually yes, because there’s just no rationale to argue that they shouldn’t get that.
Evelyn: Against it.
Mike: You can argue that their security is going to be a junior security to bank financing. You know, the kinds of things that a company’s going to need to do because the bank always wants to be in first position.
Evelyn: Right. Plus I think it’s important for entrepreneurs and owners to understand that there’s really not a scenario under which an investor wants the assets. They want the company to succeed, but they’re just looking for some level of security that you will stay focused on executing the plan that you’ve agreed to with them.
Mike: Right. Exactly, exactly.
John: We’ve been through a couple of dissolutions, I have to say. The value of the assets post-dissolution really is not there.
Evelyn: Non-existent for the most part, yeah. If you don’t have the people, you don’t really have an asset.
Mike: Or a fire sale, yeah.
Evelyn: Yeah, exactly.
John: Yeah, that stuff is harder to unload than you would think.
Evelyn: Right, absolutely.
John: Welcome back to In Process. We are here with Mike Siavage of Trusted Counsel, our partner, and we’re talking about investor term sheets. Mike, we just went over pretty extensively convertible debt, locating angels, the terms that might be around that. Now let’s move to the series A financing and VCs. We talked about how to find angels. How do you go about finding series A investment and VCs?
Mike: Typically, you can research who your target VCs might be just by determining who has investments in your space. You’re not going to convince a VC who invests in the retail watch business to invest in a SaaS business, and vice versa. You typically want to find somebody, some firm, that’s invested in similar spaces.
Another thing that I like to do is use the network of local VCs who have combined with other folks and who have a good network themselves. Because when you send your executive summary … which we haven’t talked about, but that’s the teaser for the VC investment, and recently they’ve become sort of one-page documents with compartmentalized sections on what your business really is, or two pages at the moment. And so that’s what you want to send to the VC and ask if they want … any interest. But many VCs will tell you, “You know, I get 2,000 business plans a month and I can’t wade through them,” so the way to do that is to try to find a contact in that VC firm through your network or local folks who might say, “Here’s an executive summary of a company that I’m interested in. Would you have a look at it?” That’s exponentially more effective than just going out cold to a VC who might be interested.
Evelyn: What kind of financials do you recommend when someone’s going out after venture?
Mike: I think the financials have become sort of a, “Yeah, right,” or sort of engender that type-
Evelyn: They are pro forma.
Mike: Yeah. That kind of response from VCs. Because the typical hockey stick that we call it is, you know, “I’m losing 500 thousand in the first year, I’m making 500 thousand in the second year, and I’m making 32 million in the third year.”
Evelyn: That’s fantastic.
Mike: And VCs will say, “Hey, Mike, how are you doing that?” You know? If they’re interested, they’ll usually diligence the marketing plan and what your resources are, and they’re figure out what your pro formas look like. But you should have the pro formas in there, and you should know how you’ve developed them, because it becomes almost an entrance exam when you talk to VCs. You know, people used to get hired by Microsoft based on the question, “How many gas stations are there in the United States?” They didn’t want to know how many there were, they wanted to know what your thought process was, right?
Mike: The VCs will do the same thing. You know, “How many widgets do you think you’re going to sell, and why do you think you’re going to sell that many, and what’s your margin?” It’s really a management test on what’s in those financials. I advise entrepreneurs to think long and hard about those, and I think what’s more important is how you develop versus what’s actually in them.
John: What about in the early stages of discussions with the VCs when they’re asking for some light diligence? “Well, let me see your past numbers and some other information about your company.” How guarded do the companies have to be about the confidentiality for that? The question is always, “Well, should I get them to sign an NDA?”
Mike: Yeah, yeah. VCs will almost never sign an NDA, and the reason they won’t is, they will tell you that, “I’m not going to preclude myself from looking at other companies like yours or having conversations about your business with other folks.” So forget about keeping your kimono closed. You basically have to give them whatever they ask for if you want to continue the conversations. The only exception, I would say, is the real crown jewels of your technology. You can talk about outputs. If they start asking you, for instance, about how your provisional patent works or what your claims are going to be in your patent, I would actually say, “Well, at this stage, I’d like to get a confidentiality agreement.”
Evelyn: Right, at least on that.
Mike: But that usually doesn’t happen until later on.
John: Should the company be taking a term sheet to the VC? Or should they … Let’s put it this way. We know the VC is not going to take the company’s term sheet, but should they at least have one to present so that they don’t look like they completely haven’t thought about what terms they might be raising money on?
Mike: Yeah, I think the conversation on the angel versus VC is actually the flip side. They’re not going to look at your term sheet and say that this is truly the starting point. Many times you’ll hear from a VC in that instance, “Hey, I’ll decide what the term sheet is going to say.” It’s a bit nuanced, but I would say that presenting your term sheet to a VC is kind of presumptuous. Most of them would view it that way.
Evelyn: More important to get the meeting.
Mike: Yeah. Yeah.
Evelyn: Yeah. Just in coming back to the financial plan and what we were talking about there, what if I’m … You know, entrepreneurs tend to be very charismatic. Often they are technologists, and not necessarily financial people. What’s your recommendation there?
Mike: I think one of the things, if you’re going for series A financing, one of the components or your pitch is going to be who your management team is, right? If you’re the CTO, you’re going to want a businessperson there, because most VCs don’t trust technologists to be CEO material, although there are exceptions to that of course. But usually they’ll want a businessperson, and they’ll usually want somebody who understands financials as well. The more people you can put on stage, I advise people, the better.
Evelyn: The better.
Mike: And the more you split up your presentation and let your financial person talk about the pro formas, the better. There’s five aspects to valuation, in my view. It’s kind of the scorecard method. One of them is who the management team is, so you don’t want to go up there yourself and say, “I’m the management team.”
John: Let’s say that we get a term sheet for series A. Can you tell us what series A is and what preferred stock is, what that signifies?
Mike: Sure. It’s generally a security by the initial investor, a stock that has rights to it that are superior to the rights of the common stakeholders. Okay? Most of those relate to both rights to participate in future investments or participate in the sale of the company, and to make more money upon a liquidity event, or the sale of the company. One of the critical aspects is a liquidation preference, which means that that company gets a return of their initial investment at a liquidity event off the top, and then they can either participate or convert to common stock. When I say participate, that’s called a participation preference, and they get both the liquidation preference and participate, or the old double dip by a series A investor.
Participating for preferred has become less common, except in some quarters of Atlanta. What happens is, you either take your preference or you convert to common stock, because if you convert to common stock, you’ll get a higher return than your preference. The preference covers the downside, and the convertibility covers the upside. That’s the major component of a preferred investment. There are a lot of other matters in there. Some of them are directly financial, like dividends, anti-dilution. Those are primarily the other financial terms. Dividends means that a company actually issues a dividend to the investor in some percentage, and they can be cumulative or noncumulative, which means that they’re either provided on a yearly basis and if they’re not provided they’re not provided, or they accumulate and you get five years of 8% interest at a liquidity event. The other economic term is anti-dilution, and that means that if you ever sell stock at a price lower than you sell them stock, they get an uptick to the price that you sell at.
John: Well, we need to take a quick break, but we will be back to discuss more investor term sheets.
John: Welcome back to In Process. We’re here with Mike Siavage, our partner in Trusted Counsel. We’re talking about investor term sheets. Mike, the term sheet is pretty complicated. It has a lot of different terms in it. Can you tell us a little bit about what you shouldn’t try to negotiate in the term sheet?
Mike: Sure, and there’s a couple of reasons for that. When you look at some of the issues that might arise in the term sheet, and you can have a look at them yourself, there are things that are very negotiating-intensive at first blush. The example I like to use is registration rights. Registration rights means that the folks who invest have a right to participate in a public offering if you have a public offering. Well, you don’t usually get to a public offering with your series A round. There’s usually going to be a series B and series C and D and E.
Evelyn: D, E, F …
Mike: One aspect of that is that the registration rights are going to change in those further-on rounds, so you might as well not fight about them right now anyway. Secondly, investors are not going to spend much time with you telling them that you want to only give them two S1 registrations in a year. Because I’m not sure they even understand their own own term sheets, from that perspective.
Evelyn: Well, and I think that it’s important to acknowledge that even going there probably shows a venture capitalist or his attorneys that we’re not dealing with a sophisticated advisor or entrepreneur, on the other side.
Mike: That’s an excellent point. Hearkening back to our discussion before about everything being a test, they’re testing you as an entrepreneur the whole time, and how you react to them is a part of that calculus. They can decide very quickly that you’re unsophisticated if you want to fight over registration rights. There’s other things that are not particularly important. Management … I’m sorry, information rights. They’re always going to get information, and it’s really not …
Evelyn: It’s not really … Yeah.
Mike: … cool to fight over those things. Right of first refusal and co-sale rights are pretty standard, so you don’t want … That just means that they have a right to invest in future rounds, and that if some of the entrepreneurs sell their shares the investors can participate in those sales.
Things to bear in mind are, obviously, the valuation. You want to be prepared for that discussion. VCs will also often take the position that, “Well, you’re the entrepreneur. You don’t understand valuations. This is your valuation and you’re stuck with it.” Entrepreneurs recently have gotten a little bit more educated on that fact. I like to start with the median value, and then as I said before, there’s a scorecard method. You know, you get credit for the management team, you get credit for the technology, you get credit for the market and the size of the market, you get credit for the competition in that space and how well you do against that competition. If you scare in each one of those areas, you get a portion of that $2.7 million, is the way I like to put it. Usually, I can get an entrepreneur sufficiently educated to get that valuation up at least over $2 million, or between two and three, on the series A round. That’s obviously a biggie.
Board composition is important. Most investors will not seek to control your company because they don’t want the liability of controlling your company. The typical board’s composition is five board of director members. They’ll usually give two to the company, one the CEO and one another person, and they’ll take two themselves. Then the fifth is usually decided between or amongst all four of the other members. There’s one thing I like to point out to entrepreneurs in that case, and that is, that’s sometimes a wolf in sheep’s clothing, because the investors know exactly who they want to put in that fifth seat, and it’s typically not going to be a friend of the company, it’s going to be a friend of the investor. I like to try to argue for a three-two rather than a two-two-and-one in the board composition. Why is the board important? Because the board controls everything that happens with the company, including firing you as the entrepreneur.
Evelyn: Yes, exactly. I think it also might be important to mention that, because you said, they don’t take control, the VC doesn’t take control of the board, it would typically come in for, what, a 25%, maybe a 25% or 30% position in the company, which to a lot of people, on a basic level, that sounds like, “Oh, that’s great, because they don’t have control. I have control.”
Evelyn: And of course their control mechanisms come through their blocking rights.
Mike: That’s right. That’s the classic conversation with the entrepreneur who wants to quote-unquote “remain in control” because they own 51% or more of the stock, which is completely irrelevant to the real control of the company because the board controls the company. Of course, by the time that you take enough investment to be a really successful company, you as an entrepreneur are going to be down between … if you can be between 10% and 20% by that point, you’re doing really well. So I try to convince entrepreneurs not to worry as much about share control as they do about board composition.
Evelyn: Mike’s got an emergency call from a …
Mike: Let’s see what this entrepreneur has to say.
Evelyn: We’re kind of running out of time. It’s a really great conversation. I have a couple of questions, though. Time from which I start looking for my VC, I get my term sheet, and then we close some money. What do you see as the timing that goes along with something like that?
Mike: If you do better than five months, you’re doing well, I would say. It typically takes that long, because if you do have a VC who’s interested, you’ll be in conversation with that VC between two and three months before you actually close your money.
Evelyn: Before you get there. I think that’s really an important point, because so many people that we actually talk to wait too long, and they can often put strain on the company in the process of trying to raise the capital, so starting early is always a good thing.
Mike: That’s right. Yeah. And if any investor finds that your running out of money, it changes the terms quickly.
Evelyn: Absolutely. Absolutely.
John: Once you get a term sheet, what’s the timing to getting the series A done?
Mike: Well, there’s going to be diligence usually after that, so probably a month of diligence, and then a look at the documents and then negotiating the documents. Two to three months.
John: Everybody always says 30 days. It never [crosstalk 00:41:58]
Evelyn: Yeah. Always really fast. Last thoughts for our listeners, anyone who’s out there thinking about doing this?
Mike: I think one thing I would say is, get as much advice as you possibly can, both on your technology, the marketplace, and put that into your collective cognizance on your business and your term sheets. Use folks like us to be holding your hand through the investment process and the financing plan. More minds are always better, and there are different kinds of minds in this process, one on the business and one on the terms. I’d say it’s really good not to try to invent all of this yourself. But that doesn’t mean, as I said before, that you’re not in charge of the process. You can’t abdicate to your advisors. You want to collect their collective knowledge and use that to be in charge of that process. As I said before, you don’t want a lawyer at the initial stages of the negotiation of your term sheet.
Evelyn: Yeah. I think that’s also critically important for every entrepreneur to understand that, because even … You know, you go through all of this process, and then on the other side you usually go through an exit transaction. It’s understandable that entrepreneurs will basically abdicate to the professional advisors because they haven’t been through it before, but it’s so important that the businessperson continue to be actively involved in the discussions and understand what the negotiations are about.
John: Mike, there’s also a couple good resources out there for attorneys, investors, other people. Specifically the NVCA documents. Can you tell us a little bit about that?
Mike: Yeah, that’s a very good point, John. There is something called National Venture Capital Association, which is a extremely active body. They have forms up on their website, term sheets for just about every kind of investment, and there are also comments to them. The advantage of it for professionals in this space is that has become the default. In other words, we use NVCA forms, and they’re kind of a shield to predatory practices in the investment. You can always argue that somebody who has taken a term and made it very divergent from the NVCA form is not being commercial, because the NVCA forms are based upon the collective experience of many, many, many deals. We usually start with those. There’s going to be aspects of any kind of deal that make those forms change, but that’s what we can start with. And the entrepreneur can have a look at those and use those as a talking point with their advisors.
Evelyn: We’re going to actually put a link on the website where the podcast sits that references the National Venture Capital Association, so anyone can go and take a look at those documents.
Mike: That’s great.
Evelyn: I think this has been really, really helpful. I’m hoping that we will get great feedback from our listeners, because we get these questions so often. We really appreciate your time today, Mike. It’s been really excellent.
John: Thank you, Mike.
Mike: Thank you.
Evelyn: If you’d like to learn more about In Process and the podcasts that we run, please go to our website at www.trusted-counsel.com. We hope that you’ll join us for our podcasts in the future. See you soon.
Speaker 1: This has been In Process, conversations about business in the 21st century, with Evelyn Ashley and John Monahon. Presented by Trusted Counsel, a corporate and intellectual property law firm. For more information, visit trusted-counsel.com.