Part 1: What Are Mergers And Acquisitions
Part 2: Synergies In M&A Deals
Part 3: Outline Of Business Valuation Techniques
Part 4: Quick Overview Of M&A Process
Part 5: Selling Business To Private Equity
Part 6: Selling Business To Venture Capital
Part 7: Letter Of Intent (or “LOI”) In Mergers And Acquisitions
Part 8: Due Diligence Process
Part 9: Principles Of Negotiating In Mergers And Acquisitions
Part 10: Sale And Purchase Agreement
Part 11: M&A Deal Closing
Venture capital is technically a form of equity financing. Private VC firms with institutional investors purchase a stake in other companies with the goal of earning a profit. Venture capital firms often specialize in investing in young companies and startups to help them get off the ground and grow. And as said, VC firms are quite different from private equity firms.
In this article we will outline the context of selling your business to a VC firm. And there is no better way of doing it than by explaining the concept and application of term sheets which is the heart of M&A deals that involve venture capital.
A term sheet is a non-binding agreement, typically entered between a venture capital investor and a young start-up, that shows the basic terms and conditions of an investment by the VC firm to fund the growth of the start-up. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up. Here are the key things to understand about term sheets:
A term sheet basically provides both the investor and the seller of share participation with an outline agreement, heads of terms, a letter of intent if you like, which sets out the structure or the proposed deal. And this then becomes a roadmap for the lawyers to make sure both parties get all the terms correct in the investment agreement. So you, as a seller of the share participation, negotiate the big points, and that should make it easier, although there is always negotiation to be done, but term sheets should make it easier for the lawyers to do the drafting.
And you should remember that at this stage, this agreement is not a binding agreement. However, the confidentiality and the exclusivity terms in it are, and that is normally quite clearly spelled out. The idea is that you get your term sheet agreed, and that will enable you then to put together the structure, negotiate, and sign the investment agreement.
And may well need new articles of association as well. This is something which you do have to get lawyers involved in. This is not something you can do yourself.
The first thing you are likely to see relates to the price and the numbers of shares. And this is all to do with the valuation that’s being put on the company and therefore the basis on which the investors are making their investment.
The terms pre-money and post-money valuation are important to be familiar with and to understand. The pre-money valuation is the price per share very often including warrants and options before the investment is made. And then on that basis the investors make their investment and the total of the pre-money valuation, plus the money they put in leads to the post money valuation. Another way to think of this is that the pre-money valuation establishes the starting point for the value of the shares and the price of the shares at which the investors will make their investment. And of course, the post money valuation is the pre-money valuation plus the financing amount that is provided. When coming up with the valuation, look at things like multiples of earnings, trailing revenues (which is basically the revenues of the business in the previous period up to the point of the investment).
You can negotiate that the investment is made on a fully diluted basis, which basically means that any outstanding options and warrants are basically priced into the shares held by existing investors. The VC investor will also almost certainly require you provide a number of shares for the option pool, typically 10 to 20% before they make their investment. And that’s it for exactly the same reason, so that you as the existing investor, the founder, the entrepreneur, take the dilution hit on the option pool, and they do not.
In the section below we will discuss in detail the key elements of the term sheet.
INVESTOR SHARES
So what does VC firm invest in or what form will they make their investment in? Let’s look at the investor’s shares. They may simply invest in a class of shares, which is exactly the same as the shares you have. So they may go into the common stock or the common equity or the ordinary shares. It is not unusual, however, for them invest in a different class of shares, with preferential rights. So you may have common stock, class A, class B, class C, or a completely different class of shares altogether. It is quite usual for this to happen so that the investors can have different rights associated with those shares as they want to protect themselves over the initial series A investors.
But if you, as a seller, can keep your share classes as simple as possible, it will make life a lot easier in the future. The investor may, of course, want convertibles. So effectively they have rights of debt and they have priorities on the equity, on money in the event of a liquidation, and to convert their convertibles to ordinary stock in their circumstances of a liquidation event such as and IPO or a trade sale.
If you have a new class of shares, what are the implications? Well, the investor will almost certainly require the revision of the articles of association to include in them liquidation preferences, and this is really the right to capital in the event of a liquidation event.
LIQUIDATION PREFERENCES
And a liquidation event, although it is normally assumed to be a negative event, it can also be a positive event such as in a trade sale. This basically to say that the investor gets their money back before the other investors. If there is a trade sale and the investor just sells his shares, that is fine, but if there’s a real problem and there is an undervalue and the risk that not everybody will get their money back, this is protecting the investor who gets first grabs on the money.
And the liquidation preference can get the investor its original money back but it can also be two times its original money if this is how the deal was structured. These liquidation preferences can be participating or non participating. And what that means is that if they are participating, not only do they get their money back one or two times, but they also then prorate participate in whatever is left.
If liquidation preferences are non participating, the investor has no further entitlement to any capital, so they get their money back, and then the remaining shareholders split the balance of the proceeds. So you need to be very careful and think about how you can negotiate that and what is most appropriate for your business.
Essentially, these liquidation preferences are there to provide downside protection for the investors. And investors in these agreements are always looking to protect their downside. Of course, if they do have a convertible or some sort of other class of share, they may well have a right to convert to ordinary shares at any time on a one-to-one basis, in which case the liquidation preference falls away.
Liquidation preferences are all about how much money the investors get back when things go wrong. And what investors are looking to do is to say: “well, look, I’m gonna make 10 investments in this fund, I know that several of them are not gonna do terribly well, and hopefully a few of them will do really well, but for the ones that don’t do terribly well, I want to try to get back as much of my original investment as possible”.
And that is what the liquidation preference is designed to do. Typically the investors ask for a one times liquidation preference. So they will try to get, for each dollar they put in one dollar out, and that is before anybody else. As mentioned before, sometimes you do see VC firms asking for two times liquidation preferences, which means basically if every dollar they put in, they get twice their money back.
CAPITALIZATION CHANGES PRIOR TO INVESTMENT
There are sometimes capitalization changes required by investors prior to the investment, and these are not unusual and they can be in everybody’s interests, particularly if you have a founder who is now no longer active in the business and still has a significant block of shares. You really want to bring these shares back in so that the people who are working in the business get the benefit of this share-holding. And some passive and totally inactive original founder does not hold onto a whole stack of value, which fundamentally he has walked away from and is not earning. So it is not unusual to see these equity stakes being bought back before the investment is made, and that would be set out in the term sheet.
DIVIDENDS AND DISTRIBUTIONS
Let’s talk about rights to dividend and distributions. The VC investor may have preferential rights, which means that they get a fixed dividend every year. And if that is not paid, then it may be cumulative and it rolls up.
The investor may insist on having redemption rights on their shares and enhanced voting rights on their shares. All of this can be negotiated and should be negotiated, but you have to decide what will be most important to you. Typically, investors will look for board seats, at least one per investment round. And you must be quite careful on how you get the balance of your board so you do not end up with a tied board.
BOARD MEMBERSHIP
The investors look and want to focus on the team’s experience, and term sheets will spend quite a lot of time looking at the board and the management of the company. And one thing in particular, which can be quite complicated is the allocation of board seats.
Having a VC on your board is actually quite a good thing because they have a lot of experience not only of helping companies grow, but they’ll have typically a lot of industry experience and contacts and networks, and they should bring some real value added and you want to make sure they do real value addage to your board. But of course, if you end up with a too big a board or too unwieldy board, it gets very difficult. So typically at this point in the company’s history, you may well have to reorganize the board so that some of the original founders actually step back from the board freeing up seats for the investors to come on board. And you may have to accept as a founder that you may at this point actually lose majority of control of the board. But that is just something which will be particular to your deal and something you’ll have to give serious consideration to do.
Choose very carefully who you get on board as an investor. It is not all about the money. It is very much about the contribution they can make to your business. And you really want to have the best possible quality people on the board that you can.
Couple of other tips. You should really try to have an odd number of people on your board so that when you put something to a vote, you are not constantly deadlocked and referring it back to the chairman. Another quite good thing to have on a board is having an independent director or directors, people who are not founders, people who are not representatives of the investors but who may still have a lot of industry expertise and who can bring a lot of value to the board, and who will then be able to see both sides of the coin when any issue is being discussed in particularly if it’s contentious.
If there is a syndicate of investors, they may have a right of one seat, but they may also have a right of observation, to have an observer at the board, somebody who can participate in the meetings but cannot actually vote. You will almost certainly at this point have to reorganize your board so that you get the balance between the new investors, the existing investors, and the founders, and the entrepreneurs.
This is something which is down to each individual company. If there are board fees to be paid to the investor’s board members, then these should be spelled out in the term sheet and agreed. Typically, investors may come in at this in a series B of shares, and they will be a minority investor, but their classes of shares may well have what are called swamping rights, so that under certain circumstances, they get extra rights so that they can effectively control certain situations where effectively they will want a veto on anything fundamentally major to again protect themselves. So although they have a minority equity position, they will have a majority voting position under certain circumstances.
CONSENT RIGHTS
Let’s look now at some positive undertakings that investors will want to be able to enforce once they invest. Typically these will be spelled out in detail in the investment agreement. It may be something that has come up in due diligence and the investor specifically wants to be rectified. But if there is something major, then they may well spell it out in the term sheet itself. There are also consent matters, which are things that must not be done without the consent of the investor. And these are normally material corporate actions such as increases in shares or an agreement to sell a company that the investors will want to have effectively control over.
You may find in the term sheet that the investor simply refers to the consent right, rather than detailing them all out. If that is the case, it is worth, if you are not sure what these mean, asking your lawyer to explain them and then seeing between you and your attorney whether there is something in that you are particularly uncomfortable with. The sorts of things they will want to cover is changes to the capital structure, any changes to board composition, any changes to borrowing limits, control over capital expenditure and hiring of key employees. So these are pretty fundamental milestones, and none of this is terribly unusual.
INFORMATION RIGHTS
The next thing they will include in the term sheet is what are called information rights. And this is basically saying, look, we are investors, but we are shareholders. We want to have a right to regular access to information, which may under other circumstances only be available to the members of the board. So they will specify things like the annual accounts, monthly management accounts, maybe a quarterly capitalization table statement, regular access to bank statements and regular updates and views of the company’s business plan. And again, you may find these referred to in the term sheet as customary information rights. If you are unsure what they mean, speak to your attorney and make sure you get clarification that you’re happy with what the investor is asking for.
SHARE VESTING RIGHTS
Let’s talk about share vesting, because this can be a really contentious issue because what the investors may require is for the founders to basically agree to reinvest their equity. And this basically is an incentive to keep the founders focused on exclusively spending their time on the company. And the vesting means that the right to have the shares only accrue over time to the founders.
So even though they are the ones who founded the company, they may be asked to basically start again and earn their shares back. If the founders leave early shares could be bought back at a nominal price or they founders can even lose their rights altogether. So this is a pretty hot potato, and there needs to be a pretty good reason why they want to put this in.
The shares can be vested on “a cliff basis” which means that a large proportion of them vest at a certain date and thereafter they accrue on a monthly basis. And they may also tie the vesting process into the achievement of specific milestones. So if vesting will be an issue, you really do need to look at this very carefully.
Let’s look at some of the factors behind whether or not the investor will ask for vesting. If it is a relatively mature business, this is less likely to happen. If the business is already revenue generating, then it is very possible the investor may not be so keen on including vesting provisions in the term sheet. Equally, the investor will look at what founder investment has been made in the company today, and if the founders have not put any significant equity in, the it is just “sweat equity”, and the investor may ask for real equity. And of course, if there has already been an investor around, the founders may have gone through one vesting process already and will be understandably reluctant to have to repeat the whole exercise for the next set of investors.
GOOD AND BAD LEAVERS
Let’s talk about good and bad leavers, because basically what this is trying to do is to that if you, as the founder or key member of the management team, leave under certain circumstances it maybe you are in breach of your contract and if this happens it enables the compulsory transfer of your equity position away from you to the investor. This provision in the term sheet is meant to ensure that you do not disappear off with the whole trench of the equity.
If departure is due to resignation, the circumstances of the departure will be important and usually set out in the investment agreement. If departure is considered as a bad leaver, as defined in the investment agreement, it means that you basically lose your equity position and unvested shares. But the term sheet should also contain “reliever provisions”, and you should definitely get clarification on these provisions and understand exactly under what circumstances you can leave the company, by speaking to your lawyer and your attorney and take their advice.
ANTI-DILUTION RATCHETS
Let’s talk now about anti-dilution ratchets. These are in the event that there is a down round, and a down round is when there is another round of investment, but it is done at a lower value to the previous one so that previous investors may suffering a dilution of their stake.
And what the investor will try to achieve is that he basically has their dilution mitigated by these anti-dilution ratchets by receiving additional shares at a nominal consideration. And this will automatically then average them out to a lower price per share, and that they actually do not suffer any dilution.
There are different ways of measuring this. You can have a full ratchet when basically the investor gets dollar for dollar back, and their position is undiluted. But you can calculate a weighted average ratchet this means that in the event it is a relatively small down round, then the impact will be averaged out and it will be less of a dilution. The investors will get less shares than if it was a major round.
These weighted average ratchets can be either narrow based, which means they just refer to the issued equity, or they can be broad based, in which case they cover also the warrants and the outstanding options as well. And there may be another rinky-dink in this, which says that they may be paid to play, which means that the investor will only benefit from the anti-dilution ratchet if they participate to their entitled level of entitlement in the round, in the down round that follows.
DRAG ALONG RIGHTS
And let’s talk about the drag along rights, because this is often found in term sheets especially if the VC investor gets a minority stake in the business.
A drag along right is a term that stems from the notion that majority shareholders will ‘drag’ minority shareholders against their will to sell their shares with the majority. Likewise, a drag along right allows a majority of shareholders to force minority shareholders to sell the company to a third party. The shareholders agreement will often specify the majority required to invoke a drag along right. Typically, this will range between a 51% and 90% majority. Aside from majority shareholders forcing the minority to sell their shares, drag along rights do not have any other disadvantages for the minority shareholders. Indeed, minority shareholders still receive an equal sale price and benefit from the same terms and conditions as the majority. VC investors will definitely want control the drag along rights.
The other side of this is the tag along rights, which says that as a minority shareholder, if there is a sale, I will have the right to enforce the same terms for my shares as the majority. So the majority will not be able to sell their shares and then leave the new controller of the company arguing and offering a lesser deal to the minority.
There is one other circumstances, which can be quite complicated, and that is what is called co-sale rights. And this is when, some shareholders decide to sell a proportion of their shares, but not all of them to a third investor.
And if the other investors (VC firm) have co-sale rights, then they can ask for the same deal, alongside, so they all get something off the table at that time. This can get quite complicated and it can lead to a prevention of liquidity events prior to exit. So from that point of view, it may be a good thing, but it really does depend on the the arrangements you have in your business and the investors you have in the business as well.
Term sheets will say what is subject to contract, but at near the bottom of it, you will see a couple of paragraphs to say these paragraphs are legally binding, and they relate typically to confidentiality, which basically says that you will not go and tell anybody else you are in negotiation or about the deal terms.
Secondly, exclusivity is legal binding, which basically allows the investor to have a period when he is just talking to that you are not talking to anybody else. So the investor can negotiate the whole investor agreement and they can do their due diligence. And when they are doing that, they will be spending money, and they want to have a window of opportunity to close that deal with you without having a competitive element turn up. It is often baited how long the investor should have the right to exclusivity, and an unduly long period basically locks you up and stops you from being able to talk to anyone else, so be careful with the duration of exclusivity you grant to a potential investor.
If the exclusivity period is too short, the investor may not have time to get the deal done. Typical periods range from two to six weeks, so that is what you six weeks is most common and you should accept it. You might even go out as far as eight weeks, sometimes you see break fees, which cover legal and other costs, but definitely get advice from your solicitor or your attorney before you agree to six or eight weeks.
The whole idea of the term sheet is to make the investment agreement more simple and easy to understand, but nonetheless, you need to make sure you get your term sheet right, because once that is agreed, it is very difficult to change it and to renegotiate things in the investment agreement.
There are typically three key areas in a term sheet, the sections that refer to issues to do with the funding. Then there is the governance of the company afterwards. And then basically there is what happens if things go badly wrong, and these are the conflicting areas that that need to be resolved and agreed when you are putting a term sheet together and an investment.
So let’s talk firstly about the goals of the investor. The whole idea from the investor’s point of view is that they want to maximize the proceeds they will get out of the business when it is finally sold, and they realize their investment. And they typically do this by using convertible preferred shares or indeed using a separate class of shares, which give them different rights to the ordinary shares.
Clearly from an investor’s point of view, the whole idea is to put his money in and get the most money he can out. Now, the other side of that coin is that if things do not go as well as the investors hope, then they want to be able to protect their downside as much as possible and have provisions in there which will actually give them more of the downside from the exit than is exactly proportional to the equity that they hold. Because in those scenarios, it is very likely the investors actually will not be getting all their money back. So they are trying to get as much of their money back as possible to the expense of the other shareholders.
The investors also want to have a degree of say and control, even though very often they will have a minority position in the company. So they do not want to be in a position where other investors can gang up against them and undermine their position or dilute them or do things which fundamentally they are not in agreement with, and therefore they have provisions in there which give them vetoes over certain corporate governance issues.
They also want to be able to force again, even though they are in a minority position, a sale of the company at the point that suits them, so that you may find a situation where the existing founders or other shareholders actually want to keep going, but an offer is put on the table and the institutional investor wants to get out. They want to have provisions in the investor agreement and therefore in the term sheet, which will enable them to do that.
Another thing they are very keen on is to make sure that the founders of the company and the key management are very much tied into and focused on the business. So they do not want them running any other ventures. They do want to try to make sure that maybe their shares have to revet whatever the circumstances are. It is a key objective of the investors to make sure that the founders and the key management are working extremely hard to make them lots of money and not getting diverted onto other projects.
From the perspective of the entrepreneur, what is the relevance of terms sheets? The entrepreneurs are trying to get as much money raised without suffering too much dilution, without giving up too much of the company, and therefore they are looking for as high a valuation as they can get away with so that the share price is high. Therefore, the investors get fewer shares and they suffer less dilution. They also want to balance protections for the investor without giving up too much of the upside at the same time, so that if the investor is able to disproportionally protect their downside they should not be in a position to get a disproportional upside.
So there is a balance to strike in putting terms of sheet together. In return for getting anti-dilution, liquidation rights or whatever it is, the existing founders are trying to make sure that they get a fair crack of the upside for the risk they are taking i.e. protecting the investors on the downside. And by using non-participating preferred shares, then what it basically says is that the investor can get their money back. Maybe it is one time, occasionally it might be two or more times, but once they have their money back, they do not participate any further in the proceeds from the liquidation of the business. Of course, they want to keep as much control. This investor is after all a minority investor. So they will be looking to negotiate down a lot of these vetoes and these control rights that the investors will be asking for.
And this is something that as an entrepreneur, you should take advice from your attorney or your solicitor from. Of course, entrepreneurs will want to protect their own individual positions because if they basically get sacked and bad leaver provisions are applied against them, then they will lose their equity, lose their investment, and all their hard work putting this business together is going to be wasted. So looking for their own personal downside protections will be quite important to the entrepreneurs, the founders, the key managers in the business when the term sheets put together.
These are the two sides of the coin, and the point of this whole negotiation is that you really want to end up with an agreement which aligns the interests of both parties so that they are not pulling against each other because they have different incentives to get a different result.
You really want to try to align the founders and the key management with investors by giving them options and maybe founder shares so that they have an upside from these warrants or options or whatever it is, which encourages them to really keep working hard on the business. The vetoes and the drag along or tag along rights are really there to try to make sure that nobody can force the sale of the company before really sufficient value is created to give everybody a good return. So if you have one dissenting shareholder, and it may be the institutional shareholder, he may have a separate agenda for some reason, you really want to try and have these checks and balances so that they cannot actually do that to you.
The vesting schedule is designed to try to tie in the important founders and managers of the company so that they stay committed to the business. If they have all their shares and can walk away with them or somebody decide they want to exit or try to force the sale of the company early, then that may not be in all shareholders’ interests. So again, there is a purpose behind some of these mechanisms other than just on the face of it looking like they penalize one party over the other.
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