In 2005, Jason Mendelson (my partner and co-author of AsktheVC) wrote what has become an extremely popular series dissecting the “term sheet.”  The feedback we got from it encouraged us to write several more series of blogs and ultimately led to us deciding to start writing AsktheVC to answer random questions from entrepreneurs.

Last Friday I pointed to a post from Dave Naffzinger (Judy’s Book) about Stock Options from an Entrepreneurs Point of View.  I woke up today to two more great entrepreneur posts on term sheets.  The first is from Dick Costolo (FeedBurner) titled Venture Terms – Liquidation Preferences and Participation.  The second was titled Term Sheet Hacks was on a new blog titled Venture Hacks and written by Naval Ravikant (Vast.com) and Nivi (EIR at Atlas Ventures.) 

When I started this blogging thing back in May of 2004, I stated that I was motivated by Fred Wilson’s post on Transparency.  I love that smart entrepreneurs are adding to the body of knowledge out there around the funding process.  I’ve always been befuddled that a financing (both angel and VC) and the “term sheet” are such as mysterious thing.  It has been rewarding to get thousands of emails over the past two years thanking me / Jason for what we’ve written – and it is fun to see some smart entrepreneurs continuing to add to the demystification of the term sheet.

Rick Segal is in the middle of a negotiation and is having some frustration with his co-investor – a “US VC” – around settling on a few terms that he thinks are silly.  I agree with two of them but struggle with the third.

• Expenses: If the deal doesn’t close, the startup pays.  I agree – that’s silly, especially for an early stage company.  I can imagine some later stage / VC buyout type deals where this might apply, but it doesn’t make sense in an early stage deal.  However, the company should always pay (using their newly raised money) when the deal closes.
• Exclusivity Term: 90 day exclusivity is too long.  I agree – if you can’t get the deal done in 45 days from the signing of the term sheet, something is wrong.
• Founder Buy Back: This one isn’t simple – it’s very context specific, personality dependent, and linked to stage, capital structure, roles and responsibilities of the founders, existing and future management team, and a whole bunch of other stuff.  I don’t think there’s a general case here – I think you have to address this deal by deal.

Rick – don’t worry about the “US VCs” – if they are offended by the philosophy of Canadians, just offer to take them to a hockey game.

Every now and then I run into a new VC term in a term sheet that I’ve never seen before. My legs tremble with excitement as I stare at the words to dissect what they mean.  On Friday, a long time friend sent me the following new and exciting term.

Compelled Sale Right: So long as VC (together with its permitted transferees) continues to hold at least 10% of the outstanding common shares (on an as-converted basis), and so long as an IPO has not been completed, then, at any time from and after the seventh anniversary of the transaction, if VC or the Company shall receive a bona fide offer from an unaffiliated third party to purchase 100% of the equity of the Company, VC shall have the right to cause each other stockholder to sell such stockholder’s equity securities on the same terms and conditions applicable to VC.

My first reaction was “what the fuck?”  My second reaction was “eh – this is just a different twist on redemption rights.”  But – then I thought about it some more and thought “you’ve got to be kidding me!”

So – after seven years, if there hasn’t been a liquidity event, a VC that owns at least 10% of the company can force all the other shareholders to sell their shares to an unaffiliated third party.  Read it slowly and think about it.  Basically, this term gives a minority shareholder the right to sell the company after 7 years, with no input from any other shareholders.

Be forewarned – this is not a nice term.

Tim Wolters has written a post on anti-dilution clauses from an entrepreneurs point of view.  Tim promises to write more on other terms like liquidation preferences, reverse vesting, dividends, class voting rights, “and any other terms that have bitten [him] on the ass before.”  Tim is co-founder and CTO of Collective Intellect, a new company that just recently closed a Series A funding.  He was previously the co-founder and CTO of Dante Group, a company I funded that was acquired by webMethods.  Expect straight talk and some good insights from Tim.

For my 40th birthday, I got a couple of cool t-shirts with photos of me substituted for Jack Bauer on 24.  The only thing disconcerting was the image of me holding a handgun.  I was pondering how ripped I looked (on Jack’s torso) when two questions on term sheets came in from someone at Ernst & Young.  Being the excellent delegator that I am (much better than Jack, if you know what I mean), I forwarded the questions on to Jason who promptly answered them.  They are as follows:

1. What would you deem the most hotly contested points of the term sheet? The most hotly negotiated term (after price) is the liquidation preference. In a Series A deal, it is between the company and the investor. While it’s often an intense negotiation, it’s straightforward because there are only two interests to consider (the founders and the Series A investors). In later stage, the negotiations become even more interesting. Take a situation where you have a Series D deal with each Series (A, B, and C) having different prices. By definition each of the different Series investors will have different payouts on their previously purchased stock and the Series D investors will be negotiating with several sets of interested parties (the founders, the Series A investors, the Series B investors that are not in the Series A, and the Series C investors that are not in the Series A / B).  Of course, the notion of participating preferred plays into this negotiation also.

2. In your view, how has the role of legal counsel changed over time during the deal process (in the past 10 years or so)? Legal counsel is relied on more heavily these days to be a business arbiter, rather than a “take no prisoner negotiator” who must win every last deal point. These deals aren’t rocket science and any good lawyer knows that.  As a result, legal counsel (at least good legal counsel) is now much more of a deal maker than hard ass negotiator.

Jason and I hope you enjoyed reading our term sheet series at least as much as we enjoyed writing it.  While we won’t be competing with our friend Jack Bauer for any drama awards (I tried to make it 24 posts, but could only get to 20), we’ve tried to take a balanced and pragmatic approach to explaining the mysterious “VC term sheet.”  Remember – we’re not lawyers (ok – Jason is) and this isn’t legal advice so you should not rely on it for anything, yada yada standard disclaimers follow.  In other words, use at your own risk.

For ease of reference, following are the various sections (linked to their corresponding post) that we covered.

• Price
• Liquidation Preference
• Board of Directors
• Protective Provisions
• Drag Along
• Anti-Dilution
• Pay-to-Play
• Dividends
• Redemption Rights
• Conversion
• Conditions Precedent to Financing
• Vesting
• Information Rights
• Registration Rights
• Right of First Refusal
• Voting Rights
• Employee Pool
• Restriction on Sales
• Proprietary Information and Inventions Agreement
• Co-Sale Agreement
• Founders Activities
• Initial Public Offering Shares Purchase
• No Shop Agreement (also Unilateral or Serial Monogamy)
• Indemnification
• Assignment

If you have any questions, comments, or suggestions for things we missed, email me anytime.  We have had numerous requests for republishing this content – if you are interested, please contact me.  We’re usually happy to oblige – we just want to make sure we know about it.  Until next season …

We’re down to our last two sections on a typical VC term sheet.  Since they are both things that most entrepreneurs simply live with as part of a financing, we decided to combine them into one post.

The first clause is indemnification and usually looks as follows:

“Indemnification:  The bylaws and / or other charter documents of the Company shall limit board member’s liability and exposure to damages to the broadest extent permitted by applicable law.  The Company will indemnify board members and will indemnify each Investor for any claims brought against the Investors by any third party (including any other shareholder of the Company) as a result of this financing.”

Given all the shareholder litigation in recent years, there is almost no chance that a company will get funded without indemnifying its directors.  The first sentence is simply a contractual obligation between the company and its board.  The second sentence – which is occasionally negotiable – indicates the desire for the company to purchase formal liability insurance.  One can usually negotiate away insurance in a Series A deal, but for any follow-on financing, the major practice today is to procure director and officer (D&O) insurance. 

The next clause – assignment – looks as follows:

“Assignment:  Each of the Investors shall be entitled to transfer all or part of its shares of Series A Preferred purchased by it to one or more affiliated partnerships or funds managed by it or any or their respective directors, officers or partners, provided such transferee agrees in writing to be subject to the terms of the Stock Purchase Agreement and related agreements as if it were a purchaser thereunder.”

The assignment provision allows venture funds to transfer between funds and make distributions to their limited partners (their investors).  This is something companies must normally live with and is a term that is rarely availed upon by investors. 

Neither of these terms should be controversial.  The company should be willing to indemnify its directors and will likely need to purchase D&O insurance in order to attract outside board members.  The assignment clause simply gives VC firms flexibility over transfers which they require to be able to run their business and – as long as the VC is willing to require that any transferee agrees to be subject to the various financing agreements – the company should be willing to provide for this (although entrepreneurs should be careful not to let the loophole of “assignment without transfer of the obligation under the agreements” occur.)

Earlier this week I did a brief post on the “no shop agreement” that is a common feature in a term sheet.  I compared signing a no shop to the construct of serial monogamy in a relationship.  I had a couple of comments (one that was intellectual, one that was a little harsher and painted VCs as “duplicitous.”)  I was mulling over my obviously (in hindsight to me) asymmetric view when Tom Evslin very clearly and coherently articulated why my analogy was really unilateral monogamy (e.g. the VC isn’t signing up for serial monogamy – only the entrepreneur is.)

Tom – and the comments I received – are correct (although I don’t agree with the generalization that “VCs are duplicitous.”)  After reading Tom’s post, I thought about my own behavior (at least my perception of my own behavior) vs. the general case and realized I’ve mixed the two up.  I’ve been on the giving and receiving side of unilateral no shops many times and – when on the receiving side – have usually been sensitive to why the other party wouldn’t sign a reciprocal no shop.  In most cases, I simply don’t put a lot of weight behind the no shop due to the ability to bind it with time (30 – 45 days), plus whenever I’m on the receiving end, I’ve done my best to test commitment before signing up to do the deal. 

In addition to Tom’s post, Rick Segal wrote up his thoughts in a post titled “The Handshake Clause” where he makes the point that his firm doesn’t sign a term sheet until they are committed to doing a deal.  His explanation of how he approaches this is useful, but it is important to acknowledge that there is a wide range of behavior among VCs – the group that doesn’t put a term sheet down until they are committed are at one end of the spectrum; the group that puts down a term sheet to try to lock up a deal while they think about whether or not they want to do it is at the other.  I’d like to think that we are at the “good” end of this spectrum (e.g. we won’t issue a term sheet unless we are ready to do a deal.)  Obviously, your mileage will vary with the VCs you are dealing with – hence the value of doing your own due diligence on your potential future partners.

As I mulled this over, I came up with a couple of examples in the past 10 years where the no shop had any meaningful impact on a deal in which I was involved.  I could come up with an edge case for each situation, but this was a small number vs. the number of deals I’ve been involved in.  In addition, when I thought about the situations where I was a VC and was negatively impacted by not having a no shop (e.g. a company we had agreed with on a term sheet went and did something else) or where I was on the receiving end of a no shop and was negatively impacted by it (e.g. an acquirer tied me up but then ultimately didn’t close on the deal), I actually didn’t feel particularly bad about either of the situations since there was both logic associated with the outcome and grace exhibited by the participants.  Following are two examples:

1. We signed a term sheet to invest in company X.  We didn’t include a no shop in the term sheet – I don’t think there was a particular reason why.  We were working to close the investment (I think we were 15 days into a 30–ish day process) and had legal docs going back and forth.  One of the founders called us and said that they had just received an offer to be acquired and they wanted to pursue it.  We told them no problem – we’d still be there to do the deal if it didn’t come together.  We were very open with them about the pros and cons of doing the deal from our perspective and – given the economics – encouraged them to pursue it (it was a great deal for them.)  They ended up closing the deal and – as a token – gave us a small amount of equity in the company for our efforts (totally unexpected and unnecessary, but appreciated.)
2. I was an existing investor in a company that was in the process of closing an outside led round at a significant step up in valuation. The company was under a no shop agreement with the new VC.  Within a week of closing, we received an acquisition overture from one of the strategic investors in the company.  We immediately told the new lead investor about it who graciously agreed to suspend the no shop and wait to see whether we wanted to move forward with the acquisition or the financing.  We negotiated with the acquirer for several weeks, checking regularly with the new potential investor to make sure they were still interested in closing the round if we chose not to pursue the acquisition.  They were incredibly supportive and patient.  The company covered their legal fees up to that point (unprompted – although it was probably in the term sheet that we’d cover them – I can’t recall.)  We ended up moving forward with the acquisition; the new investor was disappointed in the outcome but happy and supportive of what we did.

As I said earlier, these are edge cases – in almost all of my experiences the no shop ended up being irrelevant.  But – as both of these example show – the quality and the character of the people involved made all the difference.  Near the end of his post, Tom makes the point that it’s “good negotiating advice to make sure that every clause which can be mutual is mutual.”  I completely agree.

As an entrepreneur, the way to get the best deal for a round of financing is to have multiple options.  If you’ve been a studious reader of our term sheet series, you are painfully aware that there are many other terms – beside price – that help define what “the best deal” actually is.  However, there comes a point in time where you have to choose your investor and shift from “search for an investor” mode to “close the deal” mode.  Part of this involves choosing your lead investor and negotiating the final term sheet with him.

A “no shop agreement” is almost always part of this final term sheet.  Think of it as serial monogamy – your new investor to be doesn’t want you running around behind his back just as you are about to get hitched.  A typical no shop agreement is as follows:

“No Shop Agreement:  The Company agrees to work in good faith expeditiously towards a closing.  The Company and the Founders agree that they will not, directly or indirectly, (i) take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company, or (ii) enter into any discussions, negotiations or execute any agreement related to any of the foregoing, and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing.  Should both parties agree that definitive documents shall not be executed pursuant to this term sheet, then the Company shall have no further obligations under this section.”

At some level the no shop agreement – like serial monogamy – is more of an emotional commitment; it’s very hard to “enforce a no shop agreement” in a financing, but if you get caught cheating, your financing will probably go the same way as the analogous situation when the groom or the bride to be gets caught in a compromising situation.

At some level, the no shop agreement reinforces the handshake that says “ok – let’s get a deal done – no more fooling around looking for a better / different one.”  In all cases, the entrepreneur should bound the no shop by a time period – usually 45 to 60 days is plenty (and you can occasionally get a VC to agree to a 30 day no shop.)  This makes the commitment bi-directional – you agree not to shop the deal; the VC agrees to get things done within a reasonable time frame.

Jason and I are planning to finish strong with some serious stuff in our term sheet series, but we figured we’d put one more term in that has us sniggling whenever we see it (a “sniggle” is a combination “sneer-giggle” – sort of like how I reacted to Kidman / Ferrell in Bewitched last night). The last sniggle term is as follows:

“Initial Public Offering Shares Purchase:  In the event that the Company shall consummate a Qualified IPO, the Company shall use its best efforts to cause the managing underwriter or underwriters of such IPO to offer to [investors] the right to purchase at least (5%) of any shares issued under a “friends and family” or “directed shares” program in connection with such Qualified IPO. Notwithstanding the foregoing, all action taken pursuant to this Section shall be made in accordance with all federal and state securities laws, including, without limitation, Rule 134 of the Securities Act of 1933, as amended, and all applicable rules and regulations promulgated by the National Association of Securities Dealers, Inc. and other such self-regulating organizations.”

We firmly put this in the “nice problem to have” category.  This term really blossomed in the late 1990’s when anything that was VC funded was positioned as a company that would shortly go public. However, most investment bankers will push back on this term if the IPO is going to be a success as they want to get stock into the hands institutional investors (e.g. “their clients”).  If the VCs get this push back, they are usually so giddy with joy that the company is going public that they don’t argue with the bankers.  Ironically, if the VC doesn’t get this push back (or even worse, get a call near the end of the IPO road show) where the bankers are asking the VC to buy shares in the offering, the VC usually panics (because it means it’s no longer a hot deal) and does whatever he can not to have to buy into the offering.

Sniggle.  Our recommendation – don’t worry about this one or spend lawyer time on it.