Term sheets

Below is an article written by Peter Rosenblum for the Angel Capital Association. Peter is a partner at Foley Hoag, which is a law firm that CommonAngels often uses for our financings.

Attorney Recommendation: Writing and Negotiating Term Sheets with a View toward Success by Peter M. Rosenblum, Partner, Foley Hoag LLP

A good term sheet sets up the business for success. While we do include a variety of terms that may be useful at various times, everyone needs to recognize that the principal reason for a term sheet is to outline the participants’ understanding, not necessarily to set up a plan to enforce in court every right at every time. When it comes time to negotiate terms, I encourage angel investors and entrepreneurs to keep these points in mind: How is everyone going to make money from the deal? How do you want to do the next round of financing because there will almost certainly be another round? What is your exit strategy? Success and prosperity is a good theme; there are ways to draft the documents along those lines. For purposes of this discussion, I will exclude valuation as a separate topic, recognizing its extreme importance and complexity and that it is more a business than legal issue. Standard Documents Early stage deals need a term sheet that is credible but doesn’t get in the way of future financing by having terms that can’t be waived or will be unpalatable to future investors. I like to start with a standard, middle of the road set of documents that are fairly standard in the venture capital community. This sets a tone, and I find that sometimes the VCs will simply add their deal-specific terms to the documents as written. If the terms look like what the VCs are expecting, they will tend to do minor amending and then their deal will move forward. Even when they want to negotiate or change some of the terms, we don’t have to go back to square one. Board Provisions The ability to set strategy and move the company in the proper direction is a very important thing. The terms that define the composition of the board of directors are among the most strategically important conditions of the deal and should be based on significant dialogue between the company and the angel investors. For all but the smallest deals, it probably isn’t appropriate to allow the founders and existing management team to control the board. This does not necessarily mean that the angels control the board, just that the founders and management cannot overwhelm them. On smaller rounds (say, $250,000 and under), angels might take one seat or an observer position; for larger rounds they should seek significant angel representation on the board. An effective angel group is not just contributing money; they also provide perspective, expertise, and assistance. The place where that is most easily expressed and applied is at the board level. My preference is to have a five-person board with two angels; the CEO; one other representative of the common stock, and then an independent member from the industry who can add perspective. Preferred Stock Other than for very small deals, I recommend preferred stock and tend to avoid any form of convertible debt. Using a debt instrument postpones the time that that the company can show any stockholders equity and leaves the company with an insolvent balance sheet from day one, which can create a variety of legal issues at unfortunate times, as the law treats an insolvent company differently than it treats a solvent one. An unintended and difficult consequence is that every time a third party views the company’s balance sheet, all they see is debt because there is no equity. This will discourage risk-adverse third parties. Preferred stock is useful for all of the usual reasons that people choose preferred over common. There is also a more subtle reason. If the angel investors buy common stock, that will set the company’s stock option price at that level—usually too high. If they take a preferred stock, there will be opportunities for better option pricing. In terms of the preferred stock itself, the question is: how is it preferred? I like it to look like a middle of the road Series A preferred. It doesn’t cost more to use a standard form as opposed to tinkering, and, as mentioned, I believe there can be a real advantage to standard terms when you reach subsequent rounds. We do like to put in a provision allowing two-thirds of the preferred stock (or other majority) to waive provisions that would otherwise favor the preferred. The idea is that if you have to do something quickly, you have a way to do it. If someone is unavailable to vote (for example, they might be having surgery or be visiting Antarctica), or if one or two small holders are adverse, it will not frustrate necessary corporate action. We want documents to be protective but not to get in the way of making money for the company and all of its stockholders. Employee Option Pool Assume that the pre-money valuation of a particular deal is $1 million and that the angels are putting up $500,000. If there is no option pool, the angels receive equity reflecting one-third of the $1.5 million post-money valuation. Now suppose you want to create a 10 percent (or larger) option pool for managers and employees (not founders)—a very important thing to do if you want to attract the right talent to the enterprise. What percent of the company do the angels get now? The angels will prefer that the option pool comes out of the founders’ shares. If this approach is followed, the angels will retain one-third of the stock, while the founders’ percentage of ownership drops from two-thirds to 56 2/3 percent because 10 percent of the founders’ shares go into the option pool. The founders might respond by asserting that if the company had made all of its key hires and allocated the option pool to them, the company would have a higher valuation. Split responsibility for the pool reflects the company reality. The founders then negotiate for responsibility for the pool to be split in proportion to allocated pre-money valuation—producing 30 percent of the equity going to the angels, 60 percent to the founders, and 10 percent to the pool. How this finally settles out depends on who has the most bargaining power. Here’s why the allocation of the pool is important. If you think of a company going public at a $100 million pre-money valuation, every one percent is worth $1 million to someone. By the time a company has an IPO, even if the initial capitalization is diluted by four to one, the 10 percent which is retained by the angels from the founders is worth about $2.5 million—which is real money and worth negotiation. In the next round with the VCs, there may be a substantial fight over the same issues. Many VCs view the option pool as the responsibility of the management team and the angel group, and they won’t take responsibility for any part of it. Consistency in approach may help, but then again the VCs may not care about what went before. Anti-dilution Terms For most term sheets, angels are better served with weighted-average than full-ratchet anti-dilution .Even though full-ratchet terms may appear more beneficial by effectivelyadjusting the price of previously issued shares to the price of a new issuance, they set a precedent for the VCs and may produce very undesirable results in future rounds. Investments in certain industries (biotech comes to mind) lend themselves particularly to a full-ratchet approach. Liquidation Preferences, Cumulative Dividends, Warrants, Registration, and Conversion Rights I’m not a big fan of cumulative dividends, warrants, or participating preferred stock that has liquidation preference and then participates with common stock on a share per share basis. When I include any of these terms in a deal, I keep in mind that I’m setting a baseline for subsequent rounds. The VCs are going to ask for whatever the angels have (and more) and any participating preferred the VCs have will drain away a substantial amount of money from the founders and angels. Cumulative dividends are seldom, if ever, paid. Practically speaking, angels will only receive them to the extent that the VCs decide not to require that the angels give them up. The same goes for warrants. If they survive, they complicate the balance sheet, and VCs often ask for additional consideration to permit the warrants to remain outstanding. That said, business considerations may suggest that cumulative dividends and warrants are important for future positioning of the investment. Registration rights raise a variety of complex issues, but also should receive a practical approach. The important registration rights are piggy back (granting the investor the right to register unregistered stock when either the company or another investor initiates a registration) and so-called S-3 registration rights (which allow use of a short-form registration on Form S-3 after the company is already public). In over 30 years of practice, I think I’ve only done one demand registration (where the investors can initiate the registration process) that was not an S-3 registration. Protective Covenants Protective covenants become more important depending on board composition. They matter more if angels don’t have a significant role on the board. I try to think of the protective covenants in two groups. The first category consists of actions which relate to the operations of the company, such as changes to the stock option pool, incurrence of debt, and certain kinds of licensing. These should require only a vote of the board including angel directors to authorize them. Once the board has spoken, why appeal to the stockholders? The second category includes actions which fundamentally affect the angels’ investment and should go back to them for authorization—for example amendments to the charter or bylaws or mergers and acquisitions. The term sheet also should have tag-along rights which are integrated with the basic rights of first refusal in the documents. Tag-along rights (also called co-sale rights) allow the angels to sell their shares if the management team is selling. If management has the right to sell shares, then you want the passive investors to be able to participate, too. The deal should also provide for drag-along rights, which compel people to sell their shares if a specified group decides the company should be sold and prevent an attempt by minority stockholders from obstructing the sale. Such rights can be a particularly good idea in angel deals because frequently there is a large group of people investing and some of them develop a very close relationship with the company founders. You need the drag-along rights to be able to profit from the success of the company, and you don’t want one or two hold-outs on the founder or angel side to be able to halt a deal that is advantageous. This goes back to my original themes of future financing, success, and exit. When a good exit shows up, you want to be able to grab hold and run with it. Sometimes founders will worry that drag-along rights will allow someone to steal the company. One way to address this concern is to require a reasonably high threshold of approval to trigger the drag-along rights. For example, if the board (which has a fiduciary duty) and some reasonably substantial percentage of the stockholders (perhaps 75 percent of the total or two-thirds of each class) vote “yes,” then everyone has to go along. An anti-circumvention clause, a charter provision that says the company and other investors will not undertake a merger or any other transaction which would have the effect of depriving investors of their rights, is designed to prevent a cram-down without consent and can be useful. It doesn’t necessarily have to go into the term sheet but can be part of the deal documents. Vesting Many times the founders will argue that they should be fully vested in their equity in the company when the deal closes because of all the work they’ve done before the closing. However, from an investor’s point of view, the day the deal closes is day one and there is considerable work to be done for the founders to earn their shares and justify the claims that induced the investment. A variety of compromises are possible. I frequently see management with 20 to 25 percent of their equity vested at closing and the balance vesting over four years. Many investors favor a one-year cliff and then monthly or quarterly vesting after that. I resist acceleration of vesting because of an IPO or sale of the company for a number of reasons. Equity is typically provided to founders and management to assure that they will remain with the company for a period of time. Performance triggers to vesting can be used but raise a host of other independent issues. In fact, the time of an IPO is precisely the time when continuing “golden handcuffs” is most important. Public investors and underwriters want to make certain that management remains in place after their investment. Many sophisticated acquirers feel the same way about a post-sale period and penalize companies and their selling stockholders if there is acceleration of vesting at the time of sale. Indeed, there is no guarantee that a sale is a “success” and mandatory acceleration might be providing a reward for failure. Finally, there are a number of venture capitalists who have policies precluding so-called single trigger acceleration, and this could become an issue in a later round. Termination for Cause Termination for cause and the definition of “cause” seem to have become flash points in negotiations in recent years, if not at the term sheet phase then in the negotiations of basic documents. In the real world after all the lawyers get done, almost no one admits that they have been fired for cause. That being said, there is no reason not to have a good, tight definition of cause in a transaction. At a minimum, it will shape negotiations on termination, but it also will set forth the company’s expectations of its employees. The way we typically handle this issue in negotiation is to ask the CEO to take off the CEO’s employee hat and consider how he or she as CEO wants to manage these issues with every other person employed by the company. Most CEOs get it after that. Conclusion: There is no perfect term sheet, just as there is no perfect deal. The term sheet is simply a manifestation of the deal prepared against the background of expectations of both parties. A lot of the terms have to be worked out on a person-to-person basis to achieve the basic business understanding that underpins the deal and shapes the parties’ future relationship. I’m one of those lawyers who think that the best documents are the ones that I draft, that people sign, and that never come out of the drawer.

The Economic Shock to Venture Investing

The following is a column that appears in today’s edition of Xconomy:

Over the past several years, and especially since this summer when CommonAngels (where I serve as managing director) became the first angel group to join the National Venture Capital Association (NVCA), I’ve frequently been asked in varying tones of voice from the curious to the cynical, “Is CommonAngels an angel group or a venture capital firm?” The definite answer is “yes,” which is less a statement about CommonAngels than it is about the substantial changes in the capital market affecting entrepreneurs.

Here’s some history and context. The Tech Bubble of 1999-2000 and subsequent Tech Wreck of 2001-2004 did a lot more than just flood the market with money and leave it dry. This boom-bust was part of a classic economic supply shock that has led to a restructuring of the capital for new ventures and changes in investment strategy that determine how that capital is deployed.

In a supply shock, the dynamic between price and availability of a good—in this case cash—changes significantly. Often, there follows a restructuring of the market as more efficient or more successful suppliers gain market share, buyers shift to more reliable or specialized suppliers, and both sides seek to alter their strategies to accommodate the changed market.

Click here for the rest of the column…

What has my new home got to do with our newest investment?

I just purchased a new home. Well an old home with character as they say. An exciting (and exhausting) time for the family and our list of “to dos” and ideas grows daily.

These ideas of course include the kitchen. New appliances? Maybe, but I want to learn more about what we currently have. However there is a problem. I don’t have any of the user manuals. Which leads me to CommonAngels’ latest invest in OwnerIQ. In simple terms, OwnerIQ is an online place where you can find support information for many of those items in your home, including finding those lost (or non-existent in my case) user manuals.

So back to my kitchen. I have a Maytag oven, Whirlpool microwave and dishwasher, and a Kenmore fridge. The sticker inside the built-in microwave says 1990. I visit one of OwnerIQ’s sites, kitchenmanuals.com, and start searching. I find the microwave manual, then the dishwasher. The Kenmore fridge is a little more challenging, not because of the site, but because I did not know who the manufacturer was. Some more searching and I discover its Amana. Armed with this knowledge I locate an Amana side-by-side fridge manual on the site. For the Maytag oven, the site included a helpful link to Maytag’s user manuals and viola, the manual I’m looking for is there. OwnerIQ now keeps my manuals in my online library, ready for access anytime.

Ok, so enough of my home adventures. Why did CommonAngels invest in OwnerIQ? At its heart, OwnerIQ is an online advertising business built around helping us, the consumer, with self support issues, such as finding user manuals. We are all aware that advertising dollars continue to move online. But what is interesting is that were starting to see not just search and transaction oriented advertising dollars, but money being spent to support brand and awareness, and coming from consumer product companies. OwnerIQ plays neatly into these developing trends with its ability to deliver what it has termed ownership targeted media programs. These are programs based around what consumers own combined with demographic information – providing advertisers opportunities to strengthen relationships with folks like you and me. And as I think about replacing that old microwave and oven (the family has said it must go), it’s an opportunity for manufacturers to influence my purchase decision.

We also had a chance to invest in a tremendous team whom we have had the pleasure of working with before. We’re excited, the team is pumped, and good things are happening. And if you need to find that long lost manual, I suggest a visit to OwnerIQ

Meet CommonAngels-Funded CEOs

As a way to get to know the types of people we have backed, we have begun posting detailed profiles about the companies and founders. Our first post is about on-line backup company Carbonite, which we first funded  two years ago and which recently received a $15M Series B from Menlo Ventures. Click here to read the full profile….

NDAs, Subtext and Sales

An entrepreneur asked me the following question this weekend, “I’m having a problem with submitting a business plan and been told by some that they wouldn’t sign a confidentiality agreement… how do I submit a business plan without a some confidentiality agreement?” There are lots of blogs, websites and entrepreneurial advice columns that will list all the reason why investors, particularly VCs don’t sign confidentiality agreements or non-disclosure agreements (NDAs), but I’m glad this person asked the question because I’ve always found the answers inadequate.

Most advisers recount that investors receive lots of plans and can’t keep track of all the NDAs. Others are somewhat accusatory, saying of your plan needs an NDA, it must not be a good one. Others, usually by investors themselves trying to put a positive spin on the answer change the focus to affirm the team by saying such things as “we want to back you not just an idea.” While accurate, these responses miss a more basic premise: it’s not the question to ask.

Raising money is a strategic sales process, not just a paperwork exercise initiated by an application. To the contrary, I prefer the term “selling equity,” which emphasizes not only this point but also that the entrepreneur is about to enter into a long-term, co-ownership relationship with a partner. So, the question becomes, “how do I find the best financial partner to join me in building this business?” Starting such conversations with an NDA is either like saying “Hi, I don’t trust you, but…” or, because it is acceptable to use NDAs in detailed diligence on technical items, it’s like asking for a pre-nuptual agreement on the first date…it’s going too fast. If the company’s counsel or other adviser suggests using an NDA as part of this process, here are a few things to consider:

1. Only send your business plan to people or organizations you trust. Would you want to send one to people you don’t trust? And, would people you don’t trust signing an NDA really protect you?
2. Do due diligence on investors to find out not only whom you can trust–a fairly low standard–but more importantly, who is a good fit for your business and strategy.
3. The most likely harm an investor will do to an entrepreneur isn’t to steal their idea–their likely not to be able to execute on it well anyway, and if they could, almost anyone could do it an the business will likely succumb to competition anyway. Rather, it’s to tell other potential investors, “yea, I saw that…I passed.” An NDA won’t protect you from that; the best defense against that it to make the investor so eager to invest that they don’t want to tell anyone about the company lest they lose the deal!

Confidentiality agreements and NDAs certainly have their place in business. They are most appropriate for governing the exchange of information between two parties in the same market, or among people in related businesses such as suppliers and buyers. For organizations in different business, such as operating companies and investors, they carry more problems than they are usually worth except for the most detailed trade secrets, patent applications and similar material that needs legal documentation to maintain its status.

Simply put, investors lack the time, disposition or skills to do what entrepreneurs do. But that doesn’t mean to be injudicious about sending out your business plan and materials. Rather, if you’ve been told by some people that either you should have confidentiality agreements or won’t be able to get them, just say “That’s OK, I don’t need them. I’m talking with people I trust.”

CommonAngels Again in Top 100 VCs… Go Figure

Well, it happened again…CommonAngels made Entrepreneur Magazine’s list of top 100 venture capital firms. This list is by early stage deal count, so you need to ask what exactly does that mean, and is quantity the same as quantity. But that
said, we’ve found it of interest over the past several years that a growing number of these “top” firms are, in fact, angel groups.

Right in the “top 10″ are our sister organizations Band of Angels and Tech Coast Angels, both in California. Of course, there are the classic early stage VCs such as Sequoia and DFJ and many of our friends in the VC community here in Boston. But even the highest numbers on the list are still less than one early stage deal per month. And, there’s double counting. For example, most of our investments either had VC co-investors in the first round or later rounds while the company was still “early stage.”

Bottom line: capital is still scarce, and it’s as important as ever to focus a search for capital on the potential partners who are likely the best fit for your business.

New Investment: Xconomy

For some time now, we have tracked the changes being created by the next generation of the internet (often referred to as Web 2.0). We’ve made several investments in this area including PermissionTV and Skyhook Wireless (both companies helping to build out the infrastructure layer in the Web 2.0 world by providing tools for video publishing and location enabling web sites respectively). Others include Carbonite (unlimted on-line backup for your PC for $49.95/year and Nimbit (web based tools for independent musicians).

Our latest investment in the Web 2.0 world is another online media site – Xconomy. Through its blog, Xconomy reports on a wide range of interesting stories that deal with the innovation economy around Boston. Based in Kendall Square it’s led by world renowned editor, Bob Buderi.

We like the opportunity because it had many of the attributes we were looking for in an Web 2.0 online media investment:(a) passionate, world class editor; (b) untapped space; (c) an ability to create user generated content….leading to a tight and valuable demographic of readers that advertisers and sponsors will find valuable.

We’re thrilled to be backing Bob, Rebecca, Steve and the rest of the team!

Click here to read Editor In Chief Bob Buderi’s post on the funding and comment on the financing yourself!

Creating an Early Stage Series A Pitch

We see hundreds of early stage pitches every year. While some are good, many could be improved with better structure and content. Series A pitches have a different emphasis than pitches for later rounds. In early rounds, you need to convince investors that there is an attractive market opportunity when there is often very little real world validation around your business. You also need to convince investors that the team can execute in what is often the most difficult (or rephrased risky) time of trying to build a company.

If you search the web, you will find lots of resources on what to include in a pitch – however, here are some of the basics (these need to be adjusted as appropriate for your type of business and industry):

Market: the market should be described in such a way that it makes it interesting for the group of investors you are targeting. Sometimes it’s about bringing a disruptive innovation to a large established market (think Dell in PCs) or an emergent market that’s showing explosive growth (think YouTube in online video). All investors focus on the size of the market – basically the bigger the ultimate market, the more attractive it will be, but that does not mean you should throw out wild estimates (that has the affect of questioning your credibility which will hurt you more with investors than any small market size estimates)

Team: (a major focus for investors) — do they have right skills, experience and credibility?

Product: the product/solution should flow naturally from your analysis on the market i.e. it meets a critical need in the market; customers will want to buy (as opposed to you needing to convince them that they need this); and for business customers, the economic value is real and quantifiable.

Customers and market entry: as a Series A round its unlikely that you have many customers (if any). This is a very tough place for new startups and one of the major areas of risk for investors. You need to show investors you understand cold who your initial target customers are, their buying process, and how they will likely use the product (note: consumer Web 2.0 applications are different — its about the user experience rather than ROI). If you don’t know these or at least have some well grounded, working assumptions around them, then its like sailing in a fog. Based on these assumptions flow your target customers, channels, sales models, and product roadmap. The product direction and market focus is likely to change (almost always does) as the company grows and the market shakes out, but you need a starting point in which to rally the team and allocate your scarce resources.

Revenue model: product or service? price points? who pays? revenue sharing?

Competition: present and future, substitutes?

Financials and milestones: how much, how big, and how quickly are all questions that investors will ask around your financials. In addition, what milestones will you achieve with the money you want to raise? Now that you have the key points, organize them in a way that logically tells the story. Start with a summary slide. Your audience’s attention is at its highest level at the start, so look for an opening that hooks them in to the story you are about to tell! Avoid clichés and buzzwords.

To help get you started, click here for a sample template.

Good luck!

Think Twice: Startups May Be Too Hot Again

After years of falling out of favor, startups are back in vogue. From Silicon Valley Web 2.0 darlings to East Coast technology idols, everyone seems to want to be in startups again, but startups are not for everybody. While they can challenge your mind and your capabilities, they also can be physically and mentally costly. For good and for bad, they push you to do things beyond your expectations.

Start-ups are especially not for particular types of people. Great business ideas do not automatically create great business. A person having a great business idea does not automatically make them great business leader. When I recollect and calculate the experiences I have had starting businesses, I can count nine out of ten times when the idea generator tried to run the start-up and failed miserably. They would have been better off working in a larger company with all the established infrastructure and process to make their idea successful. Rather, they tried to start their own business to be the person in charge and lead it to become a successful business venture.

One of the most frequent mistakes is failing to hand over the idea to someone else whose main skill lies in team building and who can grow the organization into a full-fledged business. I have seen that a number of times after the person with the idea suffered through many of the tribulations of doing an unsuccessful start-up, including personal bankruptcy.

All of us have a tendency to have personalities and talents that are strong in some aspects and weak in others. So, naturally, people who have the personalities and talents to be great idea generators, also usually don’t have the personalities and talents to be great business leaders and leaders of groups of people. For more on this subject, take a look at Bi/Polar by J.W. Thomas, Ed.D, and T.J. Thomas, Ph.D and Managing Corporate Lifecycles by Ichak Adizes.

(Dick is now President and CEO of Us Unlimited, Inc., an investment and development company in the materials, food, and electronics businesses. He started is first company in 1977, which has been the source of many lessons…)

Is Boston Blowing the Northeast VC lead?

My friends at Xconomy (www.xconomy.com) are concerned about the recent dip in venture capital investment in Boston, according to the most recent data released from Ernst & Young/Dow Jones Venture One. (”Boston Blows Northeast Lead in VC Investment, New York Takes Over”)

There are many factors to consider, and I wouldn’t make too much of any one quarter’s numbers. Also, the deal counts are so small that it is hard to make generalizations (eg. for Boston there were only 29 investments total during Q2, one third were biotech).

That said, rather than look at totals, I find it more useful to look at trends and averages. Also, since the quarter is somewhat of an arbitrary break, I look at least half years or trailing 12 months. (Click here for the E&Y publicly available spreadsheet filtered for Boston-area and with averages added.)

Looking at the first half of the year, dollars and deals are down about 10% over last year. However, that could be because more Boston VCs are investing abroad, making private equity investments or not reporting deals until later (we’ve made several investments that won’t be announced until later in Q3 if not Q4 or next year, for example).

More catching is for the sector I care about, information technology, average deal size is UP 27% over last year ($11.9M/deal for 1H07 vs $9.3M for 2006). Bigger is not always better in venture capital. It means higher post-money valuations, higher expectations, more dilution for all parties, and the company assuming more risk trying to hit the higher exit. The net can easily be diminished returns.

Over half the IT deals were software, which is typical. But, only 1 was networking.

Take a look at the NVCA/PwC/Venture Economics numbers as well. They use a different methodology and report stage of deal. More telling information may well be there.