🦄Venture Capital and Private Equity Unit 8 – Term Sheets & Deal Structuring in VC/PE

What's a Term Sheet?

• Summarizes key terms and conditions of a proposed investment deal between investors and a company seeking capital
• Non-binding agreement outlining the basic terms and conditions under which an investment will be made
• Serves as a template and basis for more detailed, legally binding documents
• Includes details such as valuation, investment amount, percentage stake, voting rights, and liquidation preferences
• Key tool used to negotiate and align the interests of investors and entrepreneurs before a deal is finalized
  • Ensures all parties are on the same page regarding the essential terms of the deal
  • Helps prevent misunderstandings or disputes down the line
• Typically used in later-stage venture capital financing rounds (Series A and beyond) and private equity transactions
• Not exhaustive and does not cover every aspect of the deal, but includes the most important terms

Key Players in Deal Structuring

• Entrepreneurs and management team of the company seeking investment
  • Responsible for negotiating terms that align with their goals and vision for the company
  • Aim to maintain control and minimize dilution while securing necessary capital
• Venture capital firms and private equity investors providing capital
  • Seek to maximize their return on investment and protect their interests
  • Often have specific investment theses and criteria they use to evaluate deals
• Legal counsel for both the company and investors
  • Advise on the legal implications of various terms and clauses
  • Draft and review legal documents to ensure compliance and enforceability
• Investment bankers or financial advisors
  • Assist in structuring the deal and negotiating terms on behalf of their clients
  • Provide guidance on valuation, market trends, and comparable transactions
• Board of directors and key shareholders of the company
  • May need to approve the terms of the deal, especially if it involves significant changes to the company's capital structure or governance
• Accountants and tax advisors
  • Provide input on the financial and tax implications of different deal structures
  • Ensure compliance with accounting standards and tax regulations

Essential Terms and Clauses

• Valuation and investment amount
  • Pre-money valuation determines the company's value before the investment
  • Post-money valuation is the sum of the pre-money valuation and the investment amount
• Type of security (equity, preferred stock, convertible debt)
  • Each security type has different rights, preferences, and implications for investors and the company
• Dividend rights and preferences
  • Determines if and how investors will receive dividends on their investment
• Liquidation preferences
  • Specifies the order and amount of proceeds distributed to investors in the event of a liquidation or sale of the company
• Anti-dilution provisions
  • Protects investors' ownership percentage from being diluted by future rounds of financing
• Voting rights and board representation
  • Outlines the level of control and influence investors will have over key company decisions
• Vesting and stock options for founders and employees
  • Ensures key personnel are incentivized to stay with the company and contribute to its success
• Information rights and reporting requirements
  • Specifies the type and frequency of financial and operational information investors will receive

Valuation Methods

• Comparable company analysis
  • Values the company based on the metrics of similar publicly traded companies in the same industry
  • Multiples such as Price-to-Earnings (P/E), Enterprise Value-to-Revenue (EV/Rev), or Enterprise Value-to-EBITDA (EV/EBITDA) are applied to the company's financials
• Precedent transactions analysis
  • Looks at the valuation multiples paid in recent M&A transactions involving similar companies
  • Helps establish a range of potential values based on market demand and industry trends
• Discounted Cash Flow (DCF) analysis
  • Estimates the company's intrinsic value based on its projected future cash flows
  • Discount rate is applied to account for the time value of money and the risk associated with the investment
• Berkus Method (for early-stage startups)
  • Assigns a range of values to the company based on five key success factors
  • Factors include sound idea, prototype, quality management team, strategic relationships, and product rollout or sales
• Risk Factor Summation Method
  • Starts with an average pre-money valuation for pre-revenue companies in the industry
  • Adjusts the valuation up or down based on 12 risk factors, such as management, stage of the business, and competition
• Venture Capital Method
  • Calculates the required return on investment for investors based on their target ownership percentage and expected exit valuation
  • Works backward to determine the pre-money valuation that would achieve the desired return

Negotiation Strategies

• Understand your Best Alternative to a Negotiated Agreement (BATNA)
  • Knowing your alternatives gives you leverage and helps you set a reservation price
• Research and benchmark against industry standards and comparable deals
  • Use data to support your position and justify your asks
• Prioritize and rank your objectives
  • Focus on the most important terms that align with your goals and be willing to make concessions on less critical points
• Use anchoring to your advantage
  • Make the first offer and set the initial range of the negotiation in your favor
• Create a win-win situation
  • Look for ways to expand the pie and find mutually beneficial solutions
• Be prepared to walk away
  • If the terms don't align with your objectives or fall below your reservation price, be willing to pursue your BATNA
• Negotiate in good faith
  • Be transparent, honest, and respectful to build trust and maintain long-term relationships
• Involve experienced advisors
  • Rely on the expertise of legal counsel, financial advisors, and mentors to guide you through the process

Legal Considerations

• Securities regulations
  • Ensure compliance with federal and state securities laws, such as Regulation D and Blue Sky laws
  • Properly document and file exemptions, such as Form D for private placements
• Intellectual property (IP) protection
  • Secure patents, trademarks, and copyrights to safeguard the company's proprietary assets
  • Address IP ownership and assignment in employment and contractor agreements
• Employee stock options and equity incentive plans
  • Follow IRC Section 409A regulations for valuing and granting stock options
  • Adopt a formal equity incentive plan and obtain board and shareholder approval
• Due diligence and disclosure requirements
  • Conduct thorough due diligence on the company, its financials, and its legal matters
  • Disclose all material information to investors, including risks and potential liabilities
• Shareholder agreements and voting rights
  • Define the rights and obligations of shareholders, such as drag-along and tag-along provisions
  • Specify voting thresholds for key decisions and board appointments
• Compliance with industry-specific regulations
  • Adhere to regulations specific to the company's industry, such as FDA approval for healthcare startups or data privacy laws for tech companies

Deal Structure Types

• Priced equity round
  • Investors purchase preferred stock at a fixed price per share
  • Valuation is determined upfront, and the investment amount is divided by the price per share to determine the number of shares issued
• Convertible debt
  • Investors provide a loan that converts into equity at a future priced round
  • Conversion price is typically discounted from the future round's price, and investors may receive a valuation cap to limit dilution
• Simple Agreement for Future Equity (SAFE)
  • Similar to convertible debt but without a maturity date or interest rate
  • Investors receive the right to convert their investment into equity at a future priced round, subject to a valuation cap and/or discount
• Revenue-based financing
  • Investors provide capital in exchange for a percentage of the company's future revenue until a certain return multiple is achieved
  • Suitable for companies with predictable revenue streams and low profit margins
• Venture debt
  • Combines traditional debt financing with warrants or rights to purchase equity
  • Provides growth capital without significant dilution, but requires the company to have assets or cash flow to service the debt
• Equity crowdfunding
  • Allows startups to raise capital from a large number of non-accredited investors through online platforms
  • Subject to specific regulations, such as Regulation Crowdfunding (Reg CF) in the US

Common Pitfalls and How to Avoid Them

• Overvaluation or undervaluation
  • Use multiple valuation methods and benchmark against comparable companies to arrive at a fair and defensible valuation
  • Be realistic about growth projections and risk factors that may impact the company's value
• Misalignment of investor and founder objectives
  • Clearly communicate goals and expectations upfront, and structure the deal to align incentives
  • Include provisions for founder vesting, performance milestones, and governance rights to ensure all parties are working towards a common vision
• Inadequate due diligence
  • Conduct thorough due diligence on the company, its market, and its legal and financial matters
  • Engage experienced advisors to help identify and mitigate potential risks or liabilities
• Overly complex or unconventional deal terms
  • Keep the deal structure as simple and standard as possible to facilitate future rounds and avoid unintended consequences
  • Be wary of unusual terms or conditions that may deter future investors or acquirers
• Neglecting legal and regulatory compliance
  • Work closely with legal counsel to ensure the deal structure and terms comply with all applicable laws and regulations
  • Properly document and file all necessary paperwork, such as securities exemptions and board and shareholder approvals
• Focusing too much on the short-term
  • Balance short-term objectives with long-term goals and the company's overall vision
  • Avoid deal terms that may hinder the company's ability to grow, adapt, or raise future rounds of financing
• Not seeking professional advice
  • Engage experienced legal, financial, and strategic advisors to guide you through the deal process
  • Leverage their expertise to negotiate favorable terms, identify potential issues, and ensure a smooth closing