Restructuring Liquidation Preferences

Guest Post by Eric Hanson-WilmerHale

Job candidates may choose to work for a startup to help build something new, to work in an environment that fosters and rewards creativity, or to get the thrill of climbing aboard a “rocket ship.” New employees rarely, if ever, guide the rocket ship’s trajectory, even though they often directly help determine it. And startup employees’ incentives usually skew heavily toward equity in the company’s option plan—rather than salary—even though these employees usually have no say in how the company’s fundraising activities will impact the eventual value and payout of the common stock held by the employees.

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Savage Deal Terms

Joseph W. Bartlett

Some of the financings in ugly investment climates are typically proposed by venture capitalists on deal terms that approach the punitive. By that I mean a Series A Round (or any professional round) which contemplates a “participating preferred” with anywhere from a ‘2X’ to a ‘3X’ return to the holder. What those abbreviated terms mean numerically is the following:

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What Do Those Deal Terms Mean?

In today’s venture financing environment, knowledge of the venture financing process is vital to ensuring fair business practice between entrepreneurs and investors. Many times, deal terms are often agreed to by entrepreneurs without a clear and concise understanding of what the terms actually mean to their company.

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Term Sheets and the “Boilerplate” Fantasy

Joseph W. Bartlett

The classic “boilerplate” in a non-binding term sheet (a/k/a a letter of intent or memorandum of understanding) includes express language that the indicative terms are “non-binding” except for such as the paragraphs on confidentiality, no brokers on either side, and responsibility for expenses. Amongst the provisions ostensibly non-binding one often finds a provision regarding the upcoming definitive agreement(s), which the parties undertake to negotiate in “good faith.” All boilerplate in the eyes of many practitioners.

I am a determined advocate for the proposition that there is no such thing as “boilerplate” if that means language which can be inserted robotically in an agreement, including a term sheet, because the wordsmiths need not waste their time in hyper-analyzing the meaning … just plug in the excerpts from a model form.

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Late Stage Deal Term Teardown

Take a moment to check out some of the trends surrounding Late Stage Valuations and Deal Terms. Included in the report is an analysis of over 200 companies and 270 deals.
VC Experts – Late Stage Deal Term Teardown is FREE, please don’t hesitate to pass it along.

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How Venture Capitalists Talk

Joseph W. Bartlett

This post reviews basic terminology commonly used in the venture world. First, the entities into which capital sources are aggregated for purposes of making investments are usually referred to as “funds,” “venture companies,” or “venture partnerships.” They resemble mutual funds in a sense but are not, with rare exceptions (AR&D was one), registered under the Investment Company Act of 1940 because they are not publicly held and do not offer to redeem their shares frequently or at all. The paradigmatic venture fund is an outgrowth of the Greylock model, a partnership with a limited group of investors, or limited partners, and an even more limited group of managers who act as general partners, the managers enjoying a so-called carried interest, entitling them to a share in the profits of the partnership in ratios disproportionate to their capital contributions. Venture funds include federally assisted Small Business Investment Companies (which can be either corporations or partnerships) and, on occasion, a publicly held corporation along the AR&D model, styled since 1980 as “business development corporations.” This book, following common usage, will refer to any managed pool of capital as a “fund” or “partnership.”

Once a fund makes an investment in an operating entity, the fund or group of funds doing the investing are the “investors.” A company newly organized to exploit an idea is usually called a “start up,” founded by an individual sometimes referred to as the “entrepreneur” or the “founder.” Any newly organized company, particularly in the context of a leveraged buyout (LBO), is routinely labeled “Newco.” The stock issued by a founder to himself (and his key associates) is usually sold for nominal consideration and those shares are labeled “founders stock.” (The use of the male gender is used throughout for ease of reference only.) The founder, as he pushes his concept, attracts professional management, usually known as the “key employees.” If his concept holds particular promise he may seek from others (versus providing himself) the capital required to prove that the concept works—that is, the capital invested prior to the production of a working model or prototype. This is called “seed investment” and the tranche is called the “seed round.” Each financing in the venture process is referred to as a “round” and given a name or number: “seed” round, “first venture” round, “second” round, “mezzanine” round, and so forth.

Once the prototype has been proven in the lab, the next task ordinarily is to place it in the hands of a customer for testing—called the “beta test” (the test coming after the lab, or “alpha,” test). At a beta test site(s), the machine or process will be installed free and customers will use and debug it over a period of several weeks or months. While the product is being beta tested, capital is often raised to develop and implement a sales and marketing strategy, the financing required at this stage being, as indicated above, “the first venture round.”

The next (and occasionally the last) round is a financing calculated to bring the company to cash break-even. Whenever a robust market exists for initial public offerings this round is often financed by investors willing to pay a relatively high price for the security on the theory that their investment will soon be followed by a sale of the entire company or an initial public offering. Hence, this round is often called the “mezzanine round.” A caution at this juncture: The term “mezzanine” has at least two meanings in venture-capital phraseology. It also appears as a label for junior debt in leveraged buyouts. In either event, it means something right next to or immediately anterior to something else. As used in venture finance, the financing is next to the occasion on which the founder and investors become liquid—an initial public offering (IPO) or sale of the entire company. As indicated earlier, the measures taken to get liquid are categorized as the “exit strategies.”

One of the critical elements in venture investing is the rate at which a firm incurs expenses, since most financings occur at a time when the business has insufficient income to cover expenses. The monthly expense burden indicates how long the company can exist until the next financing, and that figure is colorfully known as the “burn rate.”