Thirty second in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital. We expect the series to run for a year after which we will collate the posts into a book. You can find the rationale behind the series here, and the list of questions here. We welcome your comments on any and every aspect of what we are doing.
In Part 1 of this post I said that the terms in a termsheet fall into four categories – those relating to economics, to control, the legally binding ones (exclusivity and costs), and everything else. I then went on to write in a bit of detail about valuation, which is the most important of the economic terms.
In this post I will cover the other key economic terms; liquidation preference and anti-dilution, the most important control terms; board structure and protective provisions, and then finish with a few words on exclusivity and cost. Over these two posts I will then have covered the most important clauses in a termsheet, and you should be able to tell whether a termsheet is attractive or not, but there is a lot that isn’t covered and they are no substitute for a good lawyer.
Most venture capital investments come with a ‘liquidation preference’ which means that on exit the investor gets her money back before the other shareholders get anything. Liquidation preferences come in two flavours; participating and non-participating. If the investor has a participating liquidation preference she gets her money back first and then shares in any remaining proceeds according to her equity percentage. If she has a non-participating liquidation preference then she has to choose between getting her money back or getting a proportion of proceeds equivalent to her equity percentage.
As you can see from this table, liquidation preferences are much more important at lower exits, and lower exits are generally viewed as more likely to occur by the investor than by the naturally bullish entrepreneur, which I think goes a long way to explaining why they are standard feature in most funds termsheets (as well as in the BVCA standard termsheet). You can also see that a non-participating liquidation preference is always better for the entrepreneur and worse for the VC, with the difference more pronounced with larger exits.
In my experience, most VC deals in Europe are done with a participating liquidation preference, although this term is always keenly negotiated.
Anti-dilution is a term which compensates the investor if there is a subsequent round of investment done at a lower share price, often called a down-round. The mechanism by which it works is a retrospective adjustment of the share price so that the investor gets more shares and it is as if they they had originally invested at a lower share price.
There are three flavours of anti-dilution to be aware of:
- full ratchet anti-dilution, in which the investors share price is adjusted all the way down to the share price of the new round
- narrow-based weighted average anti-dilution, in which the investors share price is adjusted part way down to the share price of the new round depending on a formula which considers the amounts invested
- broad-based weighted average anti-dilution, which is like narrow based, but reduces the share price slightly less, thus favouring the entrepreneur
Full ratchet anti-dilution is very favourable to the investor and most termsheets have one of the two weighted average formulas, with broad based being the most common.
Most termsheets stipulate the structure of the board post investment. Most good investors want to ensure a well functioning board which is small enough to act quickly and where every member will make a meaningful contribution. Smart entrepreneurs should want that too, although it can necessitate some difficult discussions with existing board members. Four to seven people is a good size for a board, and generally speaking, the smaller the better. Observers should also be kept to a minimum as in the 99% of discussions that don’t involve a formal vote observers typically act just like full board members and can slow things down in the same way as an extra director.
The other important thing to consider is who has voting control of the board. Voting control can either come from having the right to appoint directors who will presumably vote as directed by their appointer, or by giving multiple votes to a single person. Mark Zuckerberg famously controlled the Facebook board by insisting that he be given three votes. Typically, each major VC will want a vote, the CEO will have one, the chairman will have one, and the founders will have one or two (some of these could be the same person). As the company grows and raises more money the number of VCs on the board typically rises and the number of founder votes typically declines, so at the early stages the founders will control the board but at later stages that control will pass to the investors.
Whether the investors or the founders have the right to appoint the Chairman can be a swing factor in who has de-facto control of the board.
Most termsheets have a list of ten to fifteen actions which the company will only be allowed to complete with the explicit approval of the investor. These terms are designed to make it impossible for the management of a company to go off-piste and not respect the agreements they have made with their investors and for most companies most of the time their impact is limited to the minor administrative task of getting occasional signatures or email approvals from the investor director.
Typically you would expect to see operational provisions like ‘approval of the annual budget’, ‘material expenditure outside of plan’, ‘sale or disposal of all or part of the business’ on the list.
You would also expect to see shareholder related provisions including ‘change of the company’s articles of association’ and ‘issue of new securities with superior rights’ on the list. These are more important as they mean that the company won’t be able to raise more money without the consent of the investor.
All the protective provisions listed above are pretty standard and I don’t know many VCs who would invest without them. Watch out though for unscrupulous investors who load their termsheets with onerous protective provisions with the aim of gaining control of the company via the back door.
Exclusivity and costs
Every termsheet that I can remember, and certainly every termsheet I have ever issued, contained a paragraph at the top saying it was not legally binding except for the clauses relating to exclusivity and costs (and sometimes confidentiality). Exclusivity and costs are important to the investor because they are about to start spending significant sums on legal fees and maybe other advisors, and they want to know that the company is serious about taking their money.
By agreeing to the exclusivity clause the company shows it is serious enough to forego conversations with other VCs, typically for an initial 4-8 week period (which can be extended).
The cost clause is more evidence that the company is serious about taking investment. It usually stipulates that if the company pulls out of the investment then it will cover the VCs costs up to an agreed cap, usually of £20-50k for a venture investment, depending on the legal complexity and the advisors the VC intends to use.
The company and entrepreneur should also expect that the VC is serious, and shouldn’t be shy in seeking to understand how far through their due diligence process the investor is, what extra work they need to do (beyond legals), and whether they see any reason why the deal shouldn’t complete. Some investors list out the extra work they need to do as ‘conditions precedent’ to completion. If there are any material doubts on behalf of the investors then it is probably better to get them resolved before signing the termsheet.