1. Raising Capital with Term Sheets: Focus on What’s Important
By Korey Cowan & Garrett Miller

2. Questions to be Answered
Are you looking to raise capital for your business?
Did you know there is a difference between raising capital through debt and equity?
You just received a term sheet for an investment in your company, congratulations! Now what?
Did you know that there can be terms more important than valuation when raising capital? What do you mean my founder shares must be revested?

3. Presentation Outline Investment Overview
Venture Capital Term Sheets Overview
Economic Rights of Preferred Stock
Control and Governance Rights of Preferred Stock

4. INVESTMENT OVERVIEW

5. Stages of Investment Seed Financing Angel Financing Series A Financing
First capital raised by a company
Often comes from friends and family
Angel Financing
Capital raised by a company that has exhausted their seed financing, but are not developed enough to attract venture capital investment
“Angel” refers to a class of high net worth individuals who invest capital
Series A Financing
First round of institutional capital (i.e. venture capital) raised by a company
“Series A” refers to the first series of preferred stock sold to investors
Followed by potential alphabet financing (Series B, Series C, etc.)

6. Start-Ups Raise Capital in Two Ways
Debt Financings
Typically found in Seed and Angel rounds
Convertible Notes
SAFE (Simple Agreement for Future Equity)
Equity Financings
Typically found in Venture Capital Series A rounds
Preferred Stock
Capital Structure – Claim Priority in Liquidation or Bankruptcy
Debt
Equity
Preferred
Common

7. Debt Financings - Convertible Notes
Debt with an equity feature, means it converts upon specified events into stock of the company
Most common conversion is upon a “qualified financing” (generally an equity financing of a certain dollar size), but can covert on other events
The main financing documents are a Note Purchase Agreement and the Note itself
Generally speaking,
$500k or less, use convertible notes
$1m or more, use preferred stock (even if “seed preferred”)

8. Convertible Notes cont.
Benefits:
Defer valuation
Founders retain control
Simplicity
Downsides:
Dilution
Possibly complicates next equity round

9. Convertible Note Term Sheets
Conversion Terms – Most important terms to investors and the company
Conversion triggers
Qualified Financing - Usually an equity financing that raises $1-2 million
Non-Qualified Financing - Equity round that doesn’t meet the qualified financing threshold
Change of control or liquidation
Conversion price
Companies almost always give early-stage investors financial incentives in the form of a discount, valuation cap, or both
Discount - Set percentage off the price per share in the next qualified round of financing
Valuation Cap
Sets a maximum pre-money valuation that will be used to determine the conversion price
Protects against a later valuation that is very high and the investors converting into shares that are less than they anticipated
Conversion Shares
Typically convert into the same type of equity issued in the financing (usually preferred stock)

10. Convertible Note Example
$500,000 Convertible Note Seed Financing with 20% Discount
Conversion Trigger - Series A Preferred Financing at $1.00/Share
Convertible Note Holder:
Converts debt into preferred stock at $0.80/share
$1.00/Share x 80% = $0.80/share
500,000 / $0.80/share = Receive 625,000 Series A Preferred Shares
125,000 more shares than a Series A investor would receive for a $500,000 investment

11. Convertible Note Example
$500,000 Convertible Note Seed Financing with $5 million valuation cap
Series A Preferred Financing pre-money valuation of $10 million
Series A Preferred is $1.00/Share
Convertible Note Holder:
Converts into preferred stock at $0.50/share
Receives 1,000,000 Series A Preferred Shares
500,000 more shares than a Series A investor would receive for a $500,000 investment

12. Equity Financings – Preferred Stock
Preferred stock is special stock created by the terms of a company’s charter that is entitled to seniority rights over the common stock of a company
Preferred stock terms provide investors additional protections
Liquidation preference
Anti-dilution protections
Right of first offer
Governance and control rights
Generally speaking
Venture capital investment requires preferred stock

13. Venture Capital Funds
“Venture Capital” refers to early stage investments of institutional capital into private companies, particularly in start-up companies
Venture capital funds take a minority equity interest in a company
Venture capital funds typically make several investments across a range of companies in order to diversify their portfolio companies

14. Venture Capital Firm Structure
GENERAL PARTNER
VENTURE CAPITAL FIRM
- Limited Liability Company
LIMITED PARTNERS
Endowments
Pension funds
Family offices
VENTURE CAPITAL FUND
- Limited Liability Partnership
PORTFOLIO COMPANY
PORTFOLIO COMPANY
PORTFOLIO COMPANY

15. Late Stage/Growth Equity
Venture Capital Funds
Fund Type
Typical Profile
Seed Funds/Micro VCs
Very early stage investments
A few tens of millions in assets
Up to $1.5 million per investment
Series A/B Funds
$ million in assets
$5-10 million per investment
Late Stage/Growth Equity
$200 million+ in assets
Very large investments

16. What VC Firms Look for When Making Investment Decisions
Experience of founders
Educational background
Prior successes/failures
Personal interactions
TEAM
Pain point being addressed
Comparison to competitor products
Easily copied?
IP ownership
Product roadmap
PRODUCT/SERVICES
Market size
Growth rate
Potential share
MARKET
Who are the current competitors?
Who might they be in the future?
Barriers to competition
COMPETITION

17. What VC Firms Look for When Making Investment Decisions
Evidence of market demand
Speed of product development and customer acquisition
Any “buzz”?
TRACTION
General approach
Customer acquisition cost
Customer long-term value
CUSTOMER ACQUISITION
Revenue and cost assumptions
Amount raised
How has money been spent?
FINANCIALS
How much money is being raised?
Appropriateness
Is valuation fair?
Likelihood of future rounds
VALUATIONS

18. VENTURE CAPITAL TERM SHEETS OVERVIEW

19. Venture Capital Term Sheets
Summarizes key terms of a proposed investment
Covers economic terms, governance and control rights, and employment matters
Non-binding with some binding provisions (confidentiality and exclusivity clauses)
May be arranged as a list of issues or structured according to the transaction documents
Once the negotiations are complete, the parties sign the final term sheet and start drafting the transaction documents

20. Offering Terms
The first section of a term sheet usually contains the most fundamental economic terms of the investment, including:
How much is being raised
The valuation/dilution
The type of securities being sold
Who the investors are
There are three important variables that often make up the financial terms of a financing – the aggregate proceeds, the valuation/dilution, and the price per share

21. Aggregate Proceeds How much the company is raising.
Discussed by the company and the investors before the term sheet is issued
Should be enough capital for the company to move to the next stage of its development
The value of any outstanding convertible notes that will convert in the financing is usually included in the aggregate proceeds

22. Valuation How much the investor thinks the company is worth
May be expressed as either “pre-money” or “post-money”
“Pre-Money Valuation” = imputed dollar value given to the company before the new money is invested
“Post-Money Valuation” = pre-money valuation + the amount invested OR investment amount / % ownership
Investors may express their investment as a percentage of the company, usually for a set investment amount

23. POP-QUIZ $5.9 million / $20.9 million = 28%
Consider the following questions if the aggregate proceeds is $5 million, plus $900,000 in principal (plus any accrued interest) in convertible notes and pre-money valuation is $15 million:
What is the post-money valuation?
$5 million + $900,000 + $15 million = $20.9 million
What percent of the company is being sold to the investors?
$5.9 million / $20.9 million = 28%

24. Price Per Share
Calculated by dividing the pre-money valuation by the company’s pre-money fully diluted capitalization
Fully diluted capitalization = total number of shares outstanding prior to the financing

25. POP-QUIZ #2
A company has a pre-money valuation of $20 million with 5 million shares outstanding prior to a financing. What is the price per share?
$4.00/share

26. Capitalization Tables
A record of the securities issued and reserved for issuance by a company
Provides an up-to-date snapshot of the company’s stock ownership
Important info when the founders are considering issuing additional stock and to help ensure the right percentages are in place for stockholder votes
They’re updated and maintained and should include shares that have been transferred, repurchased or cancelled, as well as new stock issuances

27. Cap Tables cont. Often split into parts: Summary table
Detailed capitalization page
Detailed tables for each class of stock or other securities.

28. ECONOMIC RIGHTS OF PREFERRED STOCK

29. Equity Financings – Preferred Stock
Preferred stock is special stock created by the terms of a company’s charter that is entitled to seniority rights over the common stock of a company
Preferred stock terms provide investors additional protections
Most important economic rights and protections investors want:
Liquidation preference
Anti-dilution protections
Right of first offer
Governance and control rights

30. Liquidation Preference
Describes how proceeds will be distributed among the stockholders if the company is liquidated or acquired
Entitles preferred stockholders to be paid before other stockholders in a liquidation event
They get their original investment back plus any unpaid dividends – which is a 1x liquidation preference
A liquidation preference can also be a multiple of the investment
For example, a 2x liquidation preference

31. Liquidation Preference cont.
May be participating or non-participating.
Non-participating:
All remaining proceeds after the preferred stockholders are paid are distributed to the common stockholders
Participating:
Investors are repaid their investment amount first, and then share the remaining proceeds pro-rata with the common stockholders
Participation rights may be capped at a specific amount of proceeds, making it “partially participating” preferred

32. Liquidation Preference cont.
With a partially participating right or non-participating right, investors want to make sure they receive the greater of what they would get from their preference and what they would get if they forego their preference and convert to common stock.
Founders want to minimize the amount of proceeds paid out before the common stockholders receive any funds from liquidation (“liquidation overhang”).

33. POP-QUIZ #3
VC firm invests $5 million for 20% with a 2x liquidation preference
Post money valuation = $25 million
The company sells for $25 million
How much are the VC firm and founders entitled to if the liquidation preference is non-participating?
VC firm = $10 million
Founders = $15 million
What if the liquidation preference is participating?
VC firm = $13 million
$10 million liquidation preference + $3 million equity (20% of remaining $15 million)
Founders = $12 million

34. Anti-Dilution Protection
Protects investors if the company sells preferred stock or other securities at a price lower than in an earlier financing round (called a “down round”)
Anti-dilution protections re-price the original preferred shares to minimize dilution in a down round
Two types:
Full ratchet
Weighted average

35. Right of First Offer
Entitles investors to maintain their percentage ownership by buying a pro rata portion of equity issued in future transactions
Usually limited to VC investors because founders want to retain the flexibility to decide who invests in later rounds

36. Right of First Refusal and Co-Sale
Gives investors the right to purchase shares proposed to sold by other shareholders
Co-sale:
Gives investors the right to participate in sales of shares by other shareholders
Allows control over who becomes a stockholder

37. Drag-Along Right
Gives investors some control over the timing and terms of a sale of the company
Gives the company, the board and sometimes certain investors or key holders, the ability to force other stockholders to approve and participate in a potential sale of the company

38. CONTROL AND GOVERNANCE RIGHTS OF PREFERRED STOCK

39. Control and Governance Rights
Control and governance rights covered in a term sheet include:
Size and composition of the board, including a seat
Board observer rights
Protective provisions
Information and inspection rights
Founder vesting

40. Board of Directors
Investors expect to influence the size of the board and designate at least one investor director
A smaller board is usually best to stay nimble in decision making
Investors want to make sure the founder directors won’t outvote them
When there is a founder director and investor director, adding an independent director alongside them is a common compromise, referred to as a “neutral board”
The term sheet will specify which stockholders have the right to designate each director

41. Board Observer Rights
Negotiated for by large or important investors that don’t have a board seat
Entitle a representative of the investment firm to participate in board meetings in a nonvoting capacity
Company generally tries to keep number of board observers to a minimum to keep board meetings manageable

42. Protective Provisions – “Veto” Rights
A list of corporate actions that require the approval of the preferred stockholders or approval by the director designated by the preferred stockholders
Examples:
Change in control
Issuing new equity securities that have preference over preferred shareholders
Change in size of board of directors
The company usually tries to keep the number of actions limited to retain flexibility and minimize the administrative burden

43. Information and Inspection Rights
Allow the preferred stockholders to monitor their investment by receiving periodic financial and business information and holding meetings with management
Usually limited to VC investors

44. Founder Vesting Investors invest in the team
VC investment typically requires the founders shares to be subjected to vesting
Usually time based
Vesting of shares is a means to keep the founders in the company by aligning their interests
Vesting Acceleration
Sometimes vesting will automatically accelerate upon certain events
Termination without cause and change in control

45. Agreements Memorializing the Term Sheet
Stock Purchase Agreement
Amended & Restated Charter
Investor Rights Agreement
Right of First Refusal and Co-Sale Agreement
Voting Agreement

46. Questions?
Set up an appointment with the Entrepreneurship & Intellectual Property Clinic for more information.
What can we do to help?
Entity formation
Founders’ equity
Convertible notes