I finally got around to my quarterly comparison of deal terms published by our firm, Fenwick (a Valley based firm that reports on transactions in the Valley) and Cooley (a firm with many offices that reports on transactions handled by it).

And here of New York:  No one that I am aware of reports on New York transactions.  But, starting with Q1 o f 2012, we will, because we are doing increasing amounts of emerging company work there.

So here is part 1 of my thesis:  I expect that terms will be most favorable to entrepreneurs in the Valley, least favorable in New England and somewhere in between for the rest.  Of course, I think that the “somewhere in between” number will include Cooley’s New England transactions (which will have the effect of making them generally seem less favorable to entrepreneurs).  We should all note that Cooley feels compelled (at least in some instances) to report numbers for Northern California separately from the others.

So, without further fanfare, below is the table that compares certain of the deal terms reported on by the three firms for Q4 of 2011.

Fourth Quarter 2011 Transaction Terms

Of course I knew what the chart would say before I made the prediction, so no surprise that it supports my thesis.

Here, however, is part 2 of my thesis:  When we start reporting on New York separately (which we will be doing starting with a Q1, 2012 report – to come out soon), it will show that terms in New York are far closer to those in the Valley than to those in New England.  Now I don’t’ know the answer to that question, but we are doing the research now and will have an answer soon.

Keep in mind that New York has gone from nowhere just a few years ago to equaling (or passing by some measures) New England.  Could it be that NYC is just a friendlier place for entrepreneurs than New England?

It does not seem to matter what the articulated reason for the loss of valuation – market conditions, ineffective management, too early to market, too late to market, technology challenges, long adoption cycles, etc. – in each case one down round leads to another.  With each successive down round the common holders (and option holders) become more and more diluted and demoralized.  Key players start to leave.  Vendors are not paid and they put the company on COD terms.  These things all slow product development and sales and also harm morale.  Eventually the CEO is replaced (perhaps the entire team) and the new team is faced with the almost impossible task of bringing Lazarus back from the dead.

If this observation is really true, even in just a majority of cases, why would anyone ever invest in a down round?  The investor would simply be throwing good money after bad. 

There seem to me to be a lot of reasons potentially at play:  The original investment thesis still seems good.  Investors and management (let alone founders) remain enamoured of the business.  Investors are not eager to admit to their limited partners that a mere 12 months or so after they put a large wad of cash into the business there is a total write off.  Investors are afraid that the next guy will pull off a miracle and make the business a success as a result of which they will look like they bailed too soon.

Well, here are some facts.  We sorted our database of venture capital transactions in New England  first by searching for companies that had follow on rounds since 2008.  We then looked at the follow on rounds to determine how many were up and how many were down.  About 71% were up and the other 29% were down.  We then searched the down rounds to see which ones had a subsequent round of financing (13%, as opposed to 49% of the up rounds).  Out of the financings that followed a down round, 30% were up, 15% were down, and the rest (55%) were even. On average the “up” rounds were up by about 56% from the down round price. 

While the sample size is relatively small, the data shows that down rounds are much less likely to be followed by another round of financing, at least within the 2-year period we’re looking at. If they are followed by another round, there’s a good chance (85%, according to our data) that it will be an even or up round.

 Assuming you made equal bets across all down rounds and only 4% of the down rounds had follow on up rounds, that 4% would have to return a lot more than 56% you to break even on the portfolio portfolion of down round securities. 

Now, among other things, this analysis does not account for (1) the possibility that some of the up rounds will improve even further over time or that some of the down rounds will return something, (2) the time value of money, or (3) a host of other factors that are of lesser importance but not of no importance.  Nonetheless, it does suggest that investors would be far better off betting on the flip of a coin than on a down round.

My blogger friends (and the firm’s blogger consultants), indeed, it seems the entire blogosphere seems to agree that blogs are not really an optimal publication platform for dissemination of pure content.  I take that to mean that putting law review articles (or any substantive articles on legal (or other) topics) is really not what blogs are “about.”  

Instead, blogs are supposed to be pithy comments on other people’s posts (or perhaps some other thing going on in the real or virtual world).  Hence the prevalence of blog posts that begin with some reference like, “Harry has a great post about his date with Sally….”  Harry’s post, it turns out, is likely to be some observatlon about something Sally wrote on her blog.  Sally’s blog, in turn, refers to Tom and Dick….

So, the consultants appear to say, blog posts should be pithy comments about pithy comments.

And, the occasional pithy comment is probably a good idea, but when I look at the statistical data concerning this blog and I consider which posts seem to have generated interest and which have not, the numbers (meager as they are) support a completely different notion. 

Readers want content more than conversation – at least as much as conversation.

I am, for example, under the impression that Fred Wilson was very successful with MBA Mondays.  (Now, his entire blog is a huge success.)

Switching gears, Prithvi has told me on many occasions that the content posts I have done in the past are more geared for consumption by lawyers than by entrepreneurs. 

So, I am going to try and take a trick from Fred’s book and apply Prithvi’s advice and write a series of posts (I will try for weekly) that will be both substantive and usable by entrepreneurs.  The posts will be checklists for things that are legal in nature.  The idea is to put the entrepreneur in a position to think about whether he or she has covered everything he or she needs to cover in a document or deal. 

Of course, the usual caveats about how this is not legal advice and does not create a lawyer client relationship etc. apply. 

I thought I would tackle seed preferred term sheets first.  Although these can vary from one pagers to 5 pagers (or more), for the purpose of creating a checklist, I am going with the longish form.  After all, it is the purpose of a checklist to be over inclusive.  Also, I have linked each of the terms (and some other items) to the glossary defining these terms on the EEC microsite and, where it seemed relevant, to my blog. 

Please send me thoughts on the checklist.  If the checklists seem useful (or popular) I will post them on their own site on an easy to use open source basis.

Here goes:

At the risk of fighting the last war, I am going to come back to idea (and in some cases reality) of “standard” open source seed preferred documents. 

To be clear: 

(1) A note that converts at a discount into the next round of equity financing is probably the best deal an entrepreneur can hope to get.  Now he or she may not be able to actually get such a deal (and certainly won’t get it from many VC investors).  Why is this the best deal an entrepreneur can hope to get?  Because it limits the investor’s upside.  Why do VC (and other) investors hate these notes?  Because the notes limit their upside.

(2)  A convertible note with a cap may be the worst deal an entrepreneur can get.  Why?  Because, she is selling equity at the lower of two prices.  One price is a fixed valuation and the other is something less.  If you are going to set a valuation, you might as well just take that.

(3)  The seed preferred is probably the investor’s best friend because it sets a valuation on the closing date.  And, it starts the capital gains clock ticking so that in the case of an early exit, there is some hope for capital gains tax treatment.

It is hard to object to a fair valuation.  Of course, if it is fair, then so be it.  Unfortunately, experience suggests that valuations at the seed stage are chronically too low, with the result that after the first VC round, founder equity is diluted to the point where it is hard to see how (in the absence of a spectacular exit) the founder pay day will be all that good.

Of course, the black magic of valuation is the special provenance of VCs.  So that last paragraph was just an observation from the peanut gallery.  Unfortunately, I have seen this show more than a few times, and it doesn’t change much over time.

But here is one that is more in the provenance of lawyers:  Sometimes seed preferred docs carry in them the germ of a most favored nation clause.  That is the clause that says something like:  The Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms). 

In effect, your seed investor has gotten today’s valuation (the low one) and tomorrow’s terms (the good ones that the VCs negotiate).  If you are an entrepreneur and you believe, as I am told some people do, that investment negotiations sometimes involve a trade off between price and terms, then you just lost on two counts.

Ah, but what did you get?  A nice, simple, clean deal (that give the investor what he wants low price and good terms) at a low transaction cost (whatever fixed fee you agree to with the lawyers).

Unfortunately, many seed investors won’t stop at a simple deal.  They have loads of their own requirements.  But that will be the subject of another post.

Now to the matter at hand: We were retained by an investor leading a $1mm seed preferred type financing for a start-up digital media company. The investor will end up with around 20% of the company after close. The company is pretty hot and the entrepreneur is already a one time winner in the space. The entrepreneur is a huge Fred Wilson fan and can’t imagine how costs could exceed $5K for this deal.

In an effort to control costs, once the investment got passed the “term sheet” (and I use that phrase loosely) stage, the entrepreneur insisted that he would only make and take comments in the form of tweets. Our client agreed to this.

The deal went into hyperdrive as soon as the tweets started to fly, with tweets like:

            “Always get 6% cumulative dividends but only paid on liquidation”

            “why?”

            “standard”

            “won’t agree to have a common vote on the drag”

             “Why?”

             “have in all our deals”

As you might imagine, with this limitation on discussion we are way under Fred Wilson’s magical $5K.

Unfortunately for my client, a well-known angel got wind of all this and tossed her hat in the ring with a convertible note. She wised the entrepreneur up to a number of things including that idea that converts are better for entrepreneurs than priced deals.

So here is my challenge:

Explain in 140 characters or less why the entrepreneur should accept any of the following:

(1) a priced deal and not a convertible deal

(2) a 6% dividend

(3) a drag without a common vote

The winner for best explanation within the 140 character limit gets free legal services from me to the extent of the positive difference, if any, between $5K and my fees at standard rates on this deal.

One problem is that sometimes parties assert that a particular provision is standard in a context that just isn’t the kind of place where it belongs.

My current bug bear is the “drag – along” -- a standard feature of venture investments.

Well the “drag” is standard in venture investments because VCs typically own a controlling interest in the companies they invest in and they want to have more or less unfettered freedom to exit without regard to the structure of the exit.  Here is the pure case:

VC owns 60% (or more) of the voting stock of EasyTech, Inc..  VC wants to be able to force an exit and is concerned that for some unforeseen and unforeseeable reason, the exit may have to be structured as a direct to stockholder transaction.  That is to say the buyer may need to acquire the stock of Easy directly from the stockholders rather than through a merger (as is mostly done).  This means that each stockholder will have to make his or her own decision and, if there is a holdout, it might queer the deal.  So, the VC wants to be able to deliver all the shares (or almost all – not going to get into why not 100% at this time).  The drag is a contract that permits him or her to do just that, if certain conditions are met.  Those conditions are typically (1) board approval of the transaction and (2) approval of the holder of a majority of the preferred stock.  In effect, the holders of common stock are required to sell – it does not matter what they think.

Well, this makes sense in the context described above.  When the majority wants to sell why should the minority be able to hold them up, and why should it matter what form the transaction takes?  That is why the drag is standard in these deals.

But, what about other contexts?  Should an angel investor acquiring just 20% of the stock of a company have the same right to drag the holders of 80% of the stock as a VC who owns 60% of the stock?  There are a lot of angel investors meeting this general description who present this type of drag as a standard provision, and there are a lot of entrepreneurs who simply accept it without further consideration. 

So here are some things to consider.

First, the pure case (where the VC owns a majority):  Why is the board part of this at all:  From the director point of view it puts pressure on the directors to be extra careful from a fiduciary duty perspective because the only protection for the common stock is board approval.  So, in theory, at least, the board may become subject to attack from a common holder who thinks the deal was not “good enough.”  Remember, the board, in this context, is likely to be dominated by representatives of the VCs and the deal may be a direct to stockholder deal that might not otherwise require a board vote.  Why would a VC want this situation?  In the pure case, it might make sense to have the drag be a contract between the preferred holders and the common holders and not involve the board.

Second, the minority investor case:  Is it really the expectation of the majority that the minority can drag them into a sale they don’t want?  I don’t think most entrepreneurs think that when they take on an angel (even a professional angel group) for a minority investment that the angel will have the legal authority to sell the business out from under the majority.  So, in this case, it seems to me that the drag should require some vote of the common as well as the preferred – assuming it should exist at all.  The argument for a drag that requires a common and a preferred vote in this context is that the collective majority should not be able to be held up by a pain in the ass minority stockholder.  This type of drag is sometimes referred to as a “housekeeping drag” , and it makes a lot of sense to me, in the angel investment context.  Again, putting the board in the middle seems to me to invite a potential problem for the directors.  I wonder if it is not more consistent with the expectations of the parties that the drag be a purely contractual arrangement among stockholders and not subject to someone’s interpretation of their fiduciary duties.

Another question is whether the majority should not be able to drag the investor.  It seems highly unlikely than any investor would agree to such a thing on the grounds that they do not want to create a perverse incentive to sell early.

So, when would you put the board in the middle?  How about when the drag becomes a bone of contention in a negotiation and you need some compromise to get over the issue?

For a variety of reasons, drag-along provisions don’t tend to get a lot of thought.  They are often treated as standard or boilerplate with results that sometimes don’t really fit the situation.

As I have done each quarter for some time, this blog presents a comparison of the published statistics relating to venture deals from my firm, Foley Hoag LLP, and the west coast firm, Fenwick & West LLP.  This time I am not including Cooley LLP because their year end edition has not yet been published. 

Here are some general thoughts:

Foley Hoag, in our publication Venture Perspectives, reported on a total of 46 deals in New England.  Fenwick reported on 95 deals in the Valley.  This puts the New England market at about half the size of the Silicon Valley market  -- entirely consistent with historical norms (at least for so long as I have been observing the scene).  The new comer, of course, is New York, where, according to Crain’s New York business.com, there were 51 financings in Q4 in New York in the following industries 20 in software, 17 in media and 14 in IT (for sure there were other in other industries). 

On the one hand, this might suggest that New England is losing ground to NYC.  On the other hand, it suggests that the north east (New England plus New York) is now as big a market as the Valley and is probably growing faster given the velocity in NYC.  (I can hear the Valley folks saying you’ve gotta include Seattle and San Diego – whatever.  If that is where they take it, they have in effect conceded the point.)

Even more interesting, is that most of the New York deals are software, digital media and IT related.  Based on anecdotal evidence there were a significant number of digital media deals in New England (unfortunately, our survey lumps media in with software so I don’t have precise number).  According to Fenwick, the most active sectors in the Valley were software followed by cleantech and hardware then came internet and media followed last by biotech.

If I had to pick something hot today, it would be internet and digital media – and the epicenter is not in the Valley!  The reasons for this are almost certainly that the advertising industry is headquartered in New York, there are lots of digital and data infrastructure companies in New England, and there is lots of money in New England and New York to fund these businesses.  It is efficient to be near the relevant infrastructure (the advertising world).  Apologies to Nivi and all the other “you have to move to the Valley” proponents, but if you are working on a digital media company – don’t relo to the Valley quite yet.

So, with that as a background, below is my usual table comparing actual deal terms.

Comparison of Terms for Q4 2010 Venture Deals from Foley Hoag and Fenwick & West

(some percentages are approximate)

It pains me every time I write this, but there is a persistent and consistent difference in terms between New England and Valley deals.  Look at cumulative dividends and redemption.  The numbers are consistent quarter after quarter.  At least as to these terms (and painful as it is to admit, I suspect as to others), entrepreneurs get a better deal in the Valley than they do in New England.

Now consider the following investment scenario:  you get a $5mm on $5mm valuation, but what does that mean?  If there is a preference, then the investor's $5mm is worth more than yours (this is even more true if there is also a participation).  (Just consider what happens in a low value exit.)

But -- how much more is the investor’s position worth?  I am not a finance maven, but think about the exercise price of your company’s options.  This price is supposed to be the fair market value of a share of common stock.  Now no one (except maybe the IRS) really believes that the strike price of an option is actually the fair market value of share common stock on the date of issue since setting the exercise price of options is mostly an effort to pick the lowest price you think you can get away with.  Nevertheless, everyone agrees that a share of preferred stock is worth a lot more than a share of common stock.  For argument's sake, let's assume a share of common stock is worth half of a share of preferred stock.  In this case your $5mm on $5mm is really $5mm on $2.5mm.

Thinking of your common stock position this way will also give you a sense of how much bigger a score has to be for you to make a return than it has to be for the investor.  I am really thinking of smaller exits, which a lot of people think is likely to be one of the hallmarks of capital efficient businesses.

If you raise $5mm (at $5 mm pre (i.e. $5 on $5) with a preference and a participation) and you sell for $20mm in two years, your investor gets $12.5mm (a return of 150%) and you get $7.5 (a return of 50%).  If the exit is at $200mm, there is still a disparity, but it fades into insignificance.  A capped participation preserves the disparity in the low value exit scenario while making it go away in the high value scenario. 

It sometimes seems to me that the quid pro quo for downside protection should be a diminution of upside return, but that is not the way VC investments are structured.

When you realize that returns to VCs in the last decade have been at or near zero (industry wide, and despite the downside protection), you have to realize that returns to entrepreneurs have been far far worse.

Not many mechanisms have been devised to mitigate this situation from an entrepreneur’s point of view.  One that has been used on occasion is to structure the initial capitalization of the Company (i.e. before venture investment) with common stock and a preferred stock.  Usually this is a preferred "lite."  It does not have all of the bells and whistles of the usual VC preferred, but it carries some important rights such as a preference and anti-dilution provisions.  These preferred shares are issued for “real” consideration (cash for example) and then the argument is made (at the time of venture investment) that they are really an early seed round.

 Whether you can succeed with this strategy is, of course, a matter of negotiating strength.

The article makes for excellent reading, and I will not rehash its contents.  Rather, I’m going to focus on the efforts by lawyers like myself to curb the ability of holders of stock of emerging companies to resell their founder’s stock or vested options to third parties in a private transaction before the company’s stock is available on the public market.  Why do we do this?   To control your shareholder base, after all, as an emerging company the last thing you want (as the founding/executive team) is to be dealing with a belligerent activist shareholder.  There are some other side benefits to this as well.  Keep reading for more...

A right of first refusal gives the company the ability to buy back the shares that a seller is contemplating selling to a third party.  The process usually involves the seller of the private stock approaching the company once he/she has received a good faith offer for his/her shares from a third party.  The potential seller must divulge the identity of the third party, the number of shares offered for sale and the price offered for such shares.  The company then has a set period to decide if it wants to purchase the shares at the price offered.  The company also has additional time to raise/arrange for the funds if it does decide to make the repurchase.  To top it all off, the shares that are transferred to the third party might STILL subject to the right of first refusal and potentially even further restrictions that the original shares might have been subject to, for example if the stock was initially granted subject to a voting rights agreement. 

It might be an understatement to say that all of this has a chilling effect on any transactions in the private company stock market.  For one, any potential outside buyer would have to be aware, or would quickly be aware of the company’s right of refusal and right to match any offer made by them.  Imagine for a second you make an offer on interesting stock only to be told that not only does the company  have the right to match that offer once all the particulars of your offer have been divulged but also that they have 30 days to consider if they want to match such an offer.  Unless we are talking about a Facebook or Zynga, chances are most suitors would probably say, “Forget I ever made an offer.”

Why make this process of selling the company’s private stock so difficult?  As hinted before, we don’t want the company to lose its ability to control its stockholder base while the stock is not publicly listed.  Sure, the stock was offered in consideration of work or investments of some sort, but they still have strings attached.  Directors answer to shareholders and in effect shareholders (in the majority) influence the direction of the company.  Activist shareholders, even those with minority stakes, that have goals for the company that are at odds with those of the founding team can be a giant pain to deal with (read: expensive in terms of time, money and distraction).  The right of first refusalin effect gives the company some control on whom its shareholders are.  Equally important, it allows the company to control the number of shareholders it has since having more than 500 shareholders might require registration as a Public company under the 1934 Securities Act.  The rights of first refusal also facilitates two signaling factors that might be valuable to the company: a) the identity of a potential suitor (you want to know who is interested in purchasing stock in your company) and b) the perceived value of the shares of the company in the market (and hence by some extrapolation the perceived value of the company, though only in the eyes of one potential suitor).  As the old adage goes – “something is only worth what someone else is willing to pay for it.”  Having someone make a bid for the private stock of a company can help determine what the value of the company to an external player, which can be invaluable when considering corporate strategy decisions (read: expansion, mergers, acquisitions etc.)

The right of first refusal, one could argue, helps balance the desire of stockholders for liquidity with the company’s desire to control its stockholder base, while still delivering some fringe benefits to the company.

I don’t want to rehash the now tedious discussion, but the following thought has occurred to me more than once:  Investors who hold notes that are convertible at a discount are indifferent to the next round valuation (sort of – (a) a low valuation theoretically helps the return on the seed investment and (b) everyone likes to invest in a company that made it big).  These investors have a built in return that they will book at the next round no matter what the pricing of that round is. 

At the risk of being boring, a note that converts at a 20% discount to the next round provides a 25% return upon conversion whether the round is priced at $10 million or $500 million. 

So, consider this:  A VC investor who puts $500K into a priced seed round with the expectation of investing $5mm in the A round will want a low valuation on the A round.  It is in the VC’s economic best interest to get a “good deal” on his $5mm investment, to the detriment of the return on his seed investment because the seed investment is nominal by comparison to the A rond investment.  On top of this motive, the VC is probably on your board and probably has blocking rights, rights of first refusal etc.  As a practical matter, bringing in a true competitive bid will be difficult on a good day.  In fact, if there are blocking rights it may be impossible.

Also, consider this:  An angel who puts $500K into a priced seed round without the expectation of participating in the A round (or perhaps hoping to have a minimal participation) will want a really high valuation to avoid dilution.  Note this investor will also be worrying about later rounds.  Again, because of contractual rights (such as the right to block the issuance of senior preferred) this investor may be in a position to affect your ability to raise the next round.  Now, you can usually get around this issue because it always comes down to "raise the new money or die", and the investor will go with the obviously correct choice.  But, make no mistake about it, these investors can and do create major problems from time to time.

Now consider this:  A VC with a $500K principle amount convertible note (at a 20% discount and no cap) will get a 25% return on the $500K at the closing of the A round without regard to valuation.  He will be planning to make his return on his A round investment and will negotiate like a VC to get a “good deal.”  But, these notes are typically done without all the ancillary documentation that accompanies priced seed rounds.  As a result, the holders do not have blocking rights.  Because of signaling and other issues (the investor is already involved with the company, he may have rights of first refusal etc.) the VC investor will be tough to deal with, but, from the entrepreneur’s point of view, it probably beats having to deal with all the contractual rights inherent in a priced seed round.

Finally, consider the angel investor holding the proverbial convertible note:  Economic indifference to the pricing (sort of – see my parenthetical in the second paragraph), fewer contractual rights, and no substantial new investment in the next round – how much better does it get?

As Suster points out, it is hard to argue that investors should like convertible notes (without caps), but it is also hard to argue that entrepreneurs should not like them.  In the end, it seems to me that this is all about supply, demand, familiarly with investments, savvy and negotiation.  Familiarity and savvy are usually on the side of the VC.  Because of the dynamics of the seed market, as it exists today (see Andy Payne’s recent blog regarding the glut of angel money), supply and demand may be on the side of the entrepreneur (for once).  Don’t feel bad about getting a “good deal”; investors sure won’t.

Well, the Q2 results have now been reported on by many sources, including the three law firms that publish data, Foley Hoag (my firm), Fenwick & West (a Silicon Valley based firm), and Cooley.  Unfortunately, I think Dave Pierson from my firm put it well in his analysis of New England based activity, “the environment for venture investing … has generally improved compared to the dismal conditions prevailing last year, but also that pace of improvement has stalled.”

Fenwick described third party analysis of the venture industry as follows, “2010 reported a significant increase in venture investment, mild improvement in venture funded company liquidity, and continued difficulty in capital-raising by venture funds.”

Cooley had this to say, “the second quarter of 2010 produced mixed signals for the venture financing environment.”

In my last post on quarterly results, I described what each firm covers in its reports so I won’t go into that again except to say that my firm’s publication, Foley Hoag Venture Perspectives, is devoted to venture financings for companies headquartered in New England.  Fenwick’s publication is devoted to companies headquartered in Silicon Valley.  Cooley’s is devoted to information taken from transactions in which Cooley served as counsel and is not focused on any particular geography.

Activity Levels

According to Foley Hoag’s research, as a general matter, activity levels for both Series A and Series B and later rounds in New England were up significantly when compared to Q2 of last year.  The data shows a more mixed performance when compared to Q1 of this year.  Perhaps the most striking piece of data is that there were no (as in none) cleantech deals in New England in Q2.  Variability is too great from quarter to quarter to draw much of a conclusion from this fact.  Having said that, it is consistent with anecdotal evidence indicating that VCs are being very cautious about cleantech deals.  Also the flattening between Q1 and Q2 is consistent with anecdotal evidence of a general slowing in the economy.

Fenwick had this to say about activity in the Valley, “Up rounds exceeded down rounds in 2Q10 55% to 27%, with 18% of rounds flat.  This was an improvement over 1Q10, when up rounds exceeded down rounds 49% to 32%, with 19% of rounds flat.  This was the fourth quarter in a row in which up rounds exceeded down rounds. … In general, the cleantech, software and internet/digital media industries had the best valuation-related results in 2Q10, while the life science and hardware industries trailed.”

But, Cooley seems to have slightly different experience.  Cooley had this to say about their findings, “Overall, our data points to mixed signals in the venture financing environment. In Q2, we saw a reversal in a recent trend of increasing up rounds. Though the majority of deals were still up rounds, the percentage decreased to 52% from 61% in the prior quarter. Median pre-money valuations were also mixed. The data showed valuation increases for Series A and C deals, while pre-money valuations declined for Series B and D+ rounds.”

Looked at from 30,000 feet, reports from all three firms seem to have picked up on some mixed results for Q2.  While it is not clear what this augers for Q3 and beyond, it does seem to reflect the general queasiness of the general U.S. economy.

Terms

The flattening trend, if that is a fair description, is also reflected in the terms for transactions.  I have tried to consolidate the deal terms reported on by the three firms in the table below.  This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Cumulative Dividends

Consistent with a long standing trend and as was the case last quarter, the most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them.  As I noted last time, “That is huge difference.  And, it is hard to explain. Many VC funds have offices in both markets.  Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude.  So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley.  It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.”

Preferences with Participation

Also consistent with last quarter, the similarities are striking when it comes to participation.  Foley Hoag’s numbers for Series B and later stage deals and Cooley’s numbers for Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample.  As I noted last time, “This really begs the question why there is a seeming convergence around participation but not dividends.”  I would love to get some commentary from readers on this inconsistency in convergence.  BTW, I have again run across a New England based VC (and counsel) who insist that founder reps (covering all the company reps in a superseed deal but with recourse limited to the founder’s equity) are the norm.  I don’t think this is ever asked for on the West Coast, and I think it has been many years since some version of this was the “norm” on the East Coast, but I would also love to get some commentary on founder reps in the context of superseed deals, as well.

Redemption

With respect to redemption provisions, Foley Hoag continues to find that redemptions provisions exist in more than half of all deals or twice as much as Fenwick reports.  Last quarter I thought I had identified a trend away from redemption, but the numbers seem to be holding steady.  I will be curious to see how the numbers trend over the next few quarters.

Pay to Play

The incidence of pay to play provision is low across the board, and I don’t think the small differences are meaningful.

Antidilution

No surprises here:  Weighted average antidilution rules.  Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it would be nice to be able to report a steady upward trend across the country and across various factors, it ain’t happening.  But the news if not great is not all bad.  As one of my partners, Dave Pierson, put it in his article in Foley Hoag Venture Perspectives, “Thomson Reuters and the National Venture Capital Association have reported that exit activity for venture-backed companies was up during Q2 2010…..There were … 92 M&A exits, down from Q1 2010 but up significantly from Q2 2009.  The M&A exits with reported values generally yielded more favorable returns than in Q1 2010.  Venture-backed M&A exits with reported values greater than 4X the venture investment represented 65% of the Q2 2010 total versus only 45% of the Q1 2010 total. Venture-backed M&A exits with reported values less than 1X the venture investment represented 15% of the Q2 2010 total versus 31% of the Q1 2010 total.”  In addition, there were 17 venture-backed IPO’s in Q2.  This is the most in any quarter since 2007.

Not to be a complete downer on this recent trend, but if you are talking to a VC or a large institution investor about the possibility of incubating your start-up, ther are some possible downsides to keep in mind.

When the time comes the VC may choose to pass up participating in the first round of venture financing for your company.  Are you prepared for this?  Getting passed up during the venture round by the VC that seed-funded you might create a high barrier to overcome when you’re meeting with other potential investors. Do you have a good answer for when an investors asks you:  “You had company X put down $250,000 to seed you through the incubation phase, why haven’t they chosen to lead or even partake in the first round of VC financing?”

Why your company is passed up, unfortunately, could have nothing to do with the viability of your idea or the potential success of your business, but it will get people thinking.  Remember, putting down $250,000 in seed on an interesting idea and a great entrepreneurial team is very different from putting down $4 - 5 Million even if you met your milestones.  Just the loss of a cheerleader at the VC or the fact that your company is operating in a space or using a business model that the VC is not fully comfortable with, might stop them from participating in a larger equity capital round.  

If they are prepared to invest in a venture round, the VC will probably be in the drivers seat.  They probably already have a right of first offer as a provision of their seed investment.  More detrimentally, there will exist a sort of mental curtain around the start-up team in terms of their other financing options.  Think about it, if you are incubated by a VC, chances are that you are probably not making the rounds, talking to potential investors, talking to Angels, being introduced to other VCs as you approach the VC funding stage.  VCs might make a strong play to participate in VC funding only if they can lead a syndicate of other institututional investors.  This comes with its own set of challenges and its own set of downsides for the company, but that is a story for another blog.

Mostly the debate revolves around who is and who is not a “good” angel investor. If the disputants are to be believed, a VC who just plopped $250K into your business to get an option on leading the next round is a “bad” seed investor but a VC who thinks like an angel investor and will give you some bandwidth is a “good” seed investor.

I am going to take the position that the later is just a “less bad” angel investor and that if you are looking for angel money, you should go to someone who does angel investing and has no pretenses to leading (or maybe even participating in) the next round. (I can hear the chorus now: But you want an investor who can support you as you grow etc….) My point of view is that if your business merits VC investment, you will get it on better terms if you started with an angel and then went to a VC than if you started with VC angel money. (Now, I may come to a different conclusion with respect to businesses that require really large amounts of capital, such as biotech and some cleantech companies.)

As I see it, the issue is that VCs who made angel investments are motivated to keep the first round valuation low whereas true angel investors are motivated to keep the first round valuation high.

The reasoning is simple. A VC who will be investing big dollars in the A round will get more for his or her money if the price is low than if the price is high. The dilution resulting from a low price will fall disproportionately on the founders, the holders of common stock and angel investors.

The exact opposite is true for an angel investor who is unlikely to participate in (or at least unlikely to participate in a big way) the first big round. A low price means more dilution to them than a high price.

Once you have a VC inside the tent, they will influence the next round price by their mere presence and because of the contractual rights you will have given them. Your VC investor will in all probability be involved (either as a BOD member or an advisor) in your efforts to find financing. In addition, their financing docs are likely to require that you get their consent to the issuance of new securities or any amendment to the certificate of incorporation (not to mention rights of first refusal and other things that might be in the docs). So, you are going to need their consent to any deal. All this of course assumes that your VC will participate in the new round. If they don’t you may have even bigger issues.

It is hard to imagine that in this context the VC’s presence won’t have a depressing effect on the price you can get from a “new” investor.

So, when you take on a VC angel investment, you are taking a significant risk that your next round valuation will not be as high as it would be if you went with a regular angel investor.

Percentages are fixed, however #'s are always changing.  When a founder is promising a consultant, advisor, team member, investor (or whomever) a percentage of the company he/she is no doubt promising them a percent of the company at that point in time (so if there are 1,000 outstanding and issued shares, 20% would be 200 shares).  However, the pie is always growing so that 1,000 shares today might be a 1,000,000 shares in the future and that 20% is all of a sudden 200,000 shares. 

Now you're probably wondering, PT are you seriously saying that someone could have a credible argument that the 20% of 1,000 shares could be extrapolated to mean 20% of 1,000,000 shares?!! Get real.

I'm not saying it does, but depending on the facts and the circumstances, someone could very possibly make an argument that it might. Also, if it does or does not is besides the point.  Take this in the perspective of an exit or a large round of VC financing.  You really want this joker showing up a week before you close the deal with a document or a written agreement stating that you promised him/her X% of your company?  Granted, it might not be a very credible argument, but it's going to take either time or money (or most likely a lot of both) to make this go away and even worse it will create doubt in the mind of the investor/buyer, at the very worst could crater the deal.

Promising someone X% of your company? Don't do it - you'll sleep easier and so will your lawyer.

Reports from these firms cover a lot of the same types of material however they each look at some different things and they each source the data in different ways.

Foley Hoag, my firm, is headquartered in Boston. Our publication, Foley Hoag Venture Perspectives, is devoted to an analysis of financings for companies headquartered in New England. We try to cover all New England deals (that is we don’t limit our reporting to deals in which our firm is involved). We cover activity levels, valuations, and terms. In each case we break it up between Series A investments on the one hand and Series B and later stage investments on the other hand. We also report on activity and size of deals by industry.

Fenwick describes its report as “Trends in terms of venture financings in Silicon Valley.” This firm reports on venture financings for companies headquartered in Silicon Valley, and reports on financing rounds, price changes, and something they refer to as the Fenwick & West Venture Capital Barometer (you will have to look that one up for yourself). They also report on a variety of deal terms.

Cooley has this to say about its report, “This quarterly report provides data reflecting Cooley’s experience in venture capital financing terms and trends. Information is taken from transactions in which Cooley served as counsel to either the issuing company or investors.” This firm reports on numbers of deals, valuations and certain terms. Cooley has nine offices, so their data comes from many regions but, as noted, is limited to deals in which they were involved.

Because we cover similar data (but not the same data) in different ways and present it in different ways, it just isn’t possible to compare the data from all firms on an apple to apples basis. So, I have focused this post on (1) activity levels (that is numbers of deals) and (2) deal terms. 

Activity Levels

All three firms are reporting increased activity in Q1 of 2010 over Q1 of 2009 and over Q4 of 2009.

Foley Hoag found that activity levels for Series A investments in New England measured by the number of deals was up both compared to Q4 of 2009 and Q1 of 2009. The picture was mixed for Series B and later stage investments. The number of these deals was down from last quarter but up from a year ago. It seems to me that variability is too great from quarter to quarter, so the year on year comparison seems to me to be more telling of the general direction of the venture economy.

Fenwick had this to say about the results they found, “1Q10 results were similar to 4Q09, with up rounds exceeding down rounds in 1Q10 49% to 32%, with 19% of rounds flat.” They also noted that according to their findings, internet/digital media had the best results while cleantech had the worst results.

Cooley had this to say about the deals they were involved in, “Though we saw a slight decline in deal numbers, we saw a significant increase in invested dollars compared to the same quarter a year ago. Additionally, up rounds reached a level we have not seen since the middle of 2008.”

In a big picture way, all three of us observed a modest but steady upward trend in the tech economy. 

Terms

The upward trend also appeared in the terms that companies are getting from their venture investors. I have tried to consolidate the deal terms reported on by the three of us in the table below. This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Comparison of Terms for Q1 2010 Deals from Foley Hoag, Fenwick & West and Cooley
Term	Foley Hoag New England Series A	Foley Hoag New England Series B and Later	Fenwick Silicon Valley All Series	Cooley Internal Series A	Cooley Internal Series B	Cooley Internal Series C
Cumulative Dividends	54%	69%	7%	X	X	X
Preference with Participation	46%	56%	48%	65%	45%	63%
Redemption	54%	64%	24%	X	X	X
Pay to Play	23%	28%	7%	6.30%	11.10%	11.10%
Weighted Average Antidilution	100%	94%	94%		84% all Series
Ratchet Antidilution	0%	3%	5%		16% all Series

Cumulative Dividends

The most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them. That is huge difference. And, it is hard to explain. Many VC funds have offices in both markets. Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude. So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley. It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.

Preferences with Participation

If the differences are striking when it comes to dividends, the similarities are striking when it comes to participation. Cooley’s numbers for Series A and Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample. This really begs the question why there is a seeming convergence around participation but not dividends. I don’t even have a good speculation around this one.

Redemption

With respect to redemption provisions, Foley Hoag is finding numbers that are twice as high as Fenwick (Cooley does not report on this term). This one, however, I think has an explanation. In New England the incidence of redemption provisions is trending downward rapidly. As I have said elsewhere, I suspect that this is in response to changes in accounting practices. The numbers probably reflect a more rapid response to these changes in Silicon Valley than New England, but I predict the will converge at a very low percentage over the next year or so.

Pay to Play

The incidence of pay to play provision is low across the board, but higher in New England than in Silicon Valley and higher than Cooley reports. My sense, entirely subjective, is that the difference is not particularly dramatic and probably reflects a slightly more conservative investment culture in New England than in Silicon Valley. I also predict that, as the venture industry works through the current very rough fund raising environment and more funds know where the stand with investment dollars, that the incidence of pay to play provisions will both decline to a lower number and converge across the country.

Antidilution

No surprises here. Weighted average antidilution is the universal standard. Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it is nice to be able to report an upward trend in our sector of the economy, it is not time for kumbaya yet. Let’s remember that it isn’t 2007 (which was a good, but not a great, year). We are staring at some chronic problems (trends like the retirement of the baby boomers and how is that going to be paid for and the staggering debt the U.S. and other countries have run up) and some acute problems (the debt crisis in Europe and the volatility of the stock markets). We are not going to dig our way out of this hole with a strong manufacturing comeback. We need a thriving entrepreneurial tech economy to lead the way. Fortunately, this sector looks like it may come back to life.

Ok, so you're entrepreneur Joe, and your dad, mom or that rich aunt, who has always spoiled you silly and thought you were God’s gift to this earth, wants to help you and your start-up, so they give you some money to help you get that start.

Pause…so you got some money from a relative/friend who wants to see you succeed. First question: did they give you the money or was it money for the company? If they wrote you a check (lucky you!) this blog will not apply to you. However, if there was an implicit or explicit understanding that they wanted to lend the company some money, then read on....

Most entrepreneurs are usually quite informal about friends and family financing and the loans and arrangements between the company and friend/family investors are often poorly documented, if at all. Ones that are documented, are usually drawn up are hastily between the parties are usually in the form of a promissory note with some rate of interest.

Most start-up lawyers will usually recommend a convertible promissory note for this type of deal. Using this type of transaction, the simple loan has the potential/upside to turn at a future event, either automatically, or at the option of the lender, into some form of equity of the company at a certain conversion price.

Why not just have them buy equity at some fixed price? Bad Idea - By having any investor buy equity at a fixed price (anything above nominal value) this early in your company’s lifecycle, you are practically putting a stake in the ground in terms of valuation of your stock. Transactions you make in the future may be pegged to that valuation, and can have some dire consequences for the stockholder (in taxes) and the ability of the company to grant shares to attract the right employees (among other things).

Back to the convertible note – what is this future event? Most of the convertible notes that this author has seen or worked with tie the future event to some future financing (be it VCs, Institutional Investors etc.) that results in the company raising $XXX (hopefully there at least seven Xs) through the sale of equities primarily for the purpose of raising capital.

What is this conversion price? Well maybe you think you want to give your family/friend investor the same deal that you gave your VC. Makes sense right? Well think about it a little more and in terms of market price and risk. First, you are offering your family/friend investors market price on your stock, that is the price that your securities are pegged to once this future financing event is completed. Second, in terms of risk, the VCs or the entity that is investing in your company is probably doing so at a later stage of your company’s lifecycle then when you received funding from your relative or friend. Your company then should most probably be in a relatively safer position (though still a high-risk venture) then when you first started. You probably have by this point, assembled a solid team, have a workable product, and are starting to make in-roads into the market. Taking both these points together – do you think it is fair that you reward your family/friend investor the same rate then you would your VC investor, even though technically they (your family/friends) took a greater risk when they loaned you the money? I am guessing you will say probably not. The solution – build in a conversion price into the family and friends note that is at a discount from whatever price that the VC investor pays for their shares. So if a VC is buying shares for a $1/share and you have a conversion feature that has a 10% discount built in, your friend/family note converts into shares where the price of each share is $.90. So they end up getting a little more for their money then the VC does (considering they were the ones who had faith in you when other were laughing at your ideas – I think it sounds like a good deal).

Another important thing to consider, these people trust you, have faith in you and want your company to succeed. You see these people at family holidays and get-togethers. When you’re successful and running a big company do you want to deal with the guilt and more importantly the knowledge that you gave them a raw deal? Take your family/friends note seriously and talk to your start-up lawyer on what makes the most sense for your company.

Babak Nivi commented on this post pointing out that people generally, and investors are no exception, are subject to all kinds of social pressures. Here is what Nivi said,

This post seems to imply that BATNAs are the only leverage in negotiations. They're not. Having access to a database of deals and their terms is great normative leverage. Humans are susceptible to a host of psychological principles (consistency, reciprocity, etc.) and normative leverage exploits them. So the non-rock star in this post can and should use norms to get a better deal.

The entrepreneur I was lunching with made another compelling point. Even if the facts don’t matter you have to do your best to fight the battle because small incremental things that happen early in the deal and seem like things you can give or that seem like they could be minor, can have huge effects over time. 

His specific point was that shifting a small amount of ownership (several percent) from the investors to the entrepreneur at the first round can make a huge difference to the entrepreneur after several rounds of investment. In effect a small amount today gets magnified over time. 

Other terms have a similar effect. Two examples are a dividend and a full participation. If you do the numbers and run a spread sheet out over the eight years (or more) that are likely to pass before the venture gets to an exit, you will see exactly how dramatically a few percent or a participation can affect you. This is even more true if you assume a modestly successful exit (as opposed to a big score).

So, fight the battle with everything you’ve got, because in the end it matters.

But I want to make a few points. First, while we all have some experience with both coasts, and some have more than others, no one has a comprehensive view of what is going on on both coasts. As a result, all the assertions are impressionistic. 

Second, a lot of the major VC firms have offices on both coasts and regularly do deals on both coasts. It is hard for me to imagine that they sit in their Monday meetings and say “well this is a west coast deal so no redemption but this one is an east coast deal we have to have redemption.” Just stating the proposition makes it sound ridiculous. There has to be convergence. Perhaps there are some identifiable differences (such as the founder reps thing or the redemption thing), but these are at the margins. If there were significant variations in valuations and terms, arbitrage would be closing the gap.

Finally, and this is what I really want to get to, the founder’s rep variation has really done the east coast a vast disservice. It is undeniably true that seven or eight years ago, when we first started working on the NVCA forms there was a significant difference in practice with regard to founder reps between east and west. For certain kinds of series A deals, east coast VCs insisted on getting founder reps. Whereas, this practice was anathema west coast VCs. 

I am not going to go into the merits of the two positions (BTW – I think the west coast VCs have largely beaten their east coast brethren into submission on the point). Rather I want to point out that the way the argument set up was that one coast (west) was entrepreneur friendly and one coast (east) was not. Despite the fact that, from my limited observation post, the differences between the coasts are very minor, this view of the east coast VC community as less friendly to entrepreneurs than the west coast VC community persists. It has become an unexamined bit of tech culture.

Again, while the practice of asking for founder reps has a sort of nasty edge to it (after all it tries to saddle the entrepreneur with personal liability for a variety of things), I think it rarely (perhaps never) has a practical consequence. I am unaware of even one instance in which a VC has sued to get made whole based upon a failure of a founder rep. Of course, I am not aware of everything. I have a hard time imagining a VC fund suing a founder other than in the context of serious fraud, in which case the VC would have claims outside the purchase agreement. If you agree with what I just said, it is hard to imagine why a VC would insist on founder reps.

This is the one issue that everyone consistently points to when noting the different attitudes towards entrepreneurs between the two coasts. So, I think that the negative view of east coast VCs is largely a self-inflicted wound.

Here is my list of half a dozen things not to negotiate (much) over:

(1)            Voting Rights. Here is a mistake the VCs made a few times way back in the dawn of time, and now they don’t make the mistake any more. Under Delaware law, unless your certificate of incorporation provides otherwise, you need the vote of the holders of common stock, voting separately as a class, to increase the authorized stock of the company. Without this provision, the common have veto rights over all sorts of things, including additional financing. Here is the provision:

The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock, irrespective of the provisions of Section 242(b)(2) of the Delaware General Corporation Law.

Ignore and move on.

(2)            Protective Provisions. I admit there are some nuances in here that merit negotiation (which is why this might have been item 6 (or 7) of terms to negotiate), but the basic principle that there are some things for which the company will need the consent of the series A stockholders voting as a class by themselves is not assailable. Here is the NVCA list:

(i) liquidate, dissolve or wind up the business and affairs of the Company, or effect any Deemed Liquidation Event or consent to any of the foregoing; (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred]; (iii) create or authorize the creation of [or issue or obligate itself to issue shares of,] any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred or of any additional class or series of capital stock [unless it ranks junior to the Series A Preferred]; (iv) reclassify, alter or amend any existing security that is junior to or on parity with the Series A Preferred, if such reclassification, alteration or amendment would render such other security senior to or on parity with the Series A Preferred; (v) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of [_____] Series A Director(s)]; (vi) create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit]unless such debt security has received the prior approval of the Board of Directors, including the approval of [________] Series A Director(s)]; (vii) create or hold capital stock in any subsidiary that is not a wholly-owned subsidiary or dispose of any subsidiary stock or all or substantially all of any subsidiary assets[; or (viii) increase or decrease the size of the Board of Directors].

One thing that people sometimes like to talk about is how many shares of Series A have to be outstanding for the class to have these rights. As a general proposition, the Series A is not going to convert a bunch and leave a bunch just to keep these rights. Pick a number that is sizable enough to discourage gamesmanship and move on.

The nuances that I refer to above are in the bracketed language. Some of these bracketed alternatives could end up having some relevance to you. For example, there are businesses that are looking to get equipment leasing or lines of credit. The notion of being able to do things with the approval of the Series A appointed directors is some modest help. Despite the fact that Delaware law is moving in the direction of making it clearer and clearer that directors owe a duty to the holders of common stock and not preferred stock, there is enough gray zone so that, except in some pretty odd cases, the directors are going to be able to rationalize doing what is in the interest of the Series A holders. Still, in all, it is worth going for that. 

One more word of caution. If the list has more stuff on it than the NVCA list, try to negotiate down to the NVCA list.

(3)            Antidilution. Broad based weighed average antidilution is the accepted standard. According to our research it appears in close to all series A deals. This provision for which it is somewhat hard to find a clear intellectual argument, protects investors (a little) against future issuances of securities at prices lower than those paid by the investors. There are some alternatives. I mentioned full ratchet in the intro. If you see full ratchet, consider running screaming from the room. If you see “fully” broad based, it is good for you. But, you are not likely to see it. Sometimes (rarely) you may get no price based antidilution protection (even better for you). If you want to get into this topic more, here is a link. If you clicked on that link, you probably have too much time on your hands.

            For the sake of stylistic consistency, here is the NVCA antidilution formula:

“Typical” weighted average:

CP₂ = CP₁ * (A+B) / (A+C)

CP₂  = Series A Conversion Price in effect immediately after new issue

CP₁ = Series A Conversion Price in effect immediately prior to new issue

A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)

B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP₁

C  =  Number of shares of stock issued in the subject transaction

            As is the case with all else, there are nuances. In this case, here are some exceptions to the issuances that trigger the antidilution protection for the series A holders. Here is the NVCA list of exceptions:

(i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred; (ii) securities issued upon the conversion of any debenture, warrant, option, or other convertible security; (iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock; and (iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors [including at least [_______] Series A Director(s)] [(v) shares of Common Stock issued or issuable to banks, equipment lessors or other financial institutions, or to real property lessors, pursuant to a debt financing, equipment leasing or real property leasing transaction approved by the Board of Directors of the Corporation [, including at least [_______] Series A Director(s)]

            You need these exceptions, and it is worth spending a few minutes making sure you have them and trying for the max in flexibility. If you don’t have substantially all of these exceptions, there is something wrong, and you do need to raise the issue.

(4)            Registration Rights. These come into play after you have gone public. You should be so lucky. If you have had your IPO and there is a nice market for your stock and some benighted VC is bugging you about registering some sale of her stock while you are busy swilling martinis on your yacht, you can tell Jeeves to give her the run around. Don’t waste your breath arguing about reg rights now.

(5)            Management Information Rights Letter. VCs need this to meet the tax requirements for Venture Capital Operating Companies (the so-called VCOC rules). Your lawyer should make sure the agreement is in fact standard and does not overreach. Beyond that, go back to sleep. But, I hasten to add, if you are dealing with an investor who is not a VCOC, you can, and should, get rid of this nasty little agreement.

(6)            No-Shop. Your investor will want a period of exclusive dealing during which she can negotiate and close. I see a lot of 45 day periods, but 60 is OK too. My advice: go with the flow.

Well, I am at 4000 words (spread across two posts) and I have skipped over a bunch of stuff in the typical term sheet including such gems as the redemption rights provision. The one I feel badly about is things requiring investor director approval. So, here, by special mention, is the NVCA list of things requiring investor director approval. These are things that a company cannot do unless the board approves and that approval includes the affirmative vote of the series A appointed directors (or at least one of them). As noted with respect to other things above, you would like to keep this list to a minimum.   But, you are not going to be able to make it go away. My comment about the duties of directors under Delaware law applies here, but don’t expect these directors to act against the interest of the series A.

(i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment inconsistent with any investment policy approved by the Board; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors]; (vii) hire, fire, or change the compensation of the executive officers, including approving any option grants; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; (ix) sell, assign, license, pledge or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; or (x) enter into any corporate strategic relationship involving the payment contribution or assignment by the Company or to the Company of assets greater than [$100,000.00].

There is lots that can be said about term sheet provisions not discussed above. There are lots more resources on the web (and elsewhere) including our web site here at Foley Hoag's Emerging Enterprise Center to help you with term sheets. Keep in mind that in the end you want to (a) close the deal and (b) establish a good working relationship with your investor. Be sensitive to her needs and she will be sensitive to yours. Argue the points that count and settle when you have gotten what you can get. Strive to be tough but realistic and fair, and hope the other side strives for the same.