Introduction
Trendsetter Inc was started by Wendy Borg and Jason Kushdog to deliver innovative warehouse and distribution management software program for clothing retailers. The firm was created with the knowledge and experience that Borg and Kushdog had in the supply chain management and specialty fashion industries respectively.
The crux of the solution was a demand forecasting module which would draw a large number of retailers. This type of software could be developed with active participation from prospective customers. Fortunately Borg and Jason were able to convince one such customer into the development pipeline. It is this confidence that retail customers may find this solution incredibly useful that has led the founders to seek more funding.
Six weeks. In such time Trendsetter, Inc will run out of their seed money. The founders Borg and Kushdog have no experience in raising capital from venture investors. Both the founders are inexperienced in the funding processes and consider a counsel to address their concerns. Their due diligence in pitching the firm to VC’s has brought the two term sheets which look identical but have many clauses both similar and dissimilar.
Unfortunately they don’t have the expertise to evaluate the term sheets they have received from two VCS: Alpha Ventures and Mega Fund. These two term sheets came after the founders presented to seven VC’s over a two month period. Both Alpha Ventures and Mega Fund provided almost similar top-line valuations even though Alpha has concerns about the company’s revenue stream. There were also concerns about booking a five-star client early to confirm credibility in the product.
In this analysis we look at the business valuation of the company before and after each VC’s offers. We will also try to understand the difference in the offers given several scenarios. Vesting schedules and anti-dilution concerns of the founders and the investors is also discussed. Finally we shall delve upon the governance section to close the initial analysis. Later we try to answer the specific questions posed to complete the understanding of the term sheets and what they really mean to the founders and the VC’s.
Basic Valuation
Alpha has given a pre-money evaluation of $7.35M at a share price of $1.05. Their investment will be $5M. This makes a total of 7M shares of which 4M are common and 3M are option pool shares. Note that there is a provision of escrow shares of 501,253 which are to be released if the Company has not achieved the fiscal year 2000 revenues of $500000.
The total post money valuation comes to $12.35M but the total shares in the market will be less by the escrow shares for a total of 11,761,905. In the scenario that the escrow shares are released to the investors, one can see that the total share ownership for the investors goes up. At the same time the financing for the escrow shares will come to $476,190.35.
For the Mega term sheet, we can see that there is no escrow clause involved whereas there is a sum of 929,889 previously granted options. The pre-money valuation of $7M and the investment of $5M make it a total of $12M with a given share price of $1. There is a reserved section of 2.5M shares in addition to the 4.5M common shares. Dividing the total shares of 12M gives the investors and the founder’s 42% and 38% respective ownership in the firm.
From a basic valuation perspective, Alpha is a better deal for the founders. The reverse holds good for the investors. Note that Alpha initially valued the firm at a much lower value and then came back with a better approximation. But from the ownership perspective, the founders have larger control with 38% Emerging Company Finance FNCE 480 –TrendSetter, Inc | Basic valuation
4 in the Mega term sheet. Note that the 350K difference in the pre-money valuation comes precisely from the $0.05 share price difference between the two offers. As a founder, one wouldn’t want the escrow clause because their ownership falls 1% while the ownership of the investors rises by 3%.
Liquidation
Alpha possesses a liquidation preference which allows the investors to make a choice between the equity returns during liquidation. Trigger events maybe a merger, an acquisition or any event where is transfer of control. This could be an IPO situation as well. In the event that they choose to collect on the liquidation preference, they would receive three times their investment. This could result in a payoff of $15M.
On the other hand, if they decide to pick up on the pro-rata equity return, then the investors would have to account for the terminal value to estimate such a return. Two similar upside scenarios are depicted below. The third scenario is the conversion ratio clause where the trigger requires a qualified IPO offering of at least $15M. The final scenario is the downside valuation of $10M when everyone wants an immediate exit.
In the case of Mega Funds, the participating feature allows the investor to pick up 1.25 times the investment and then also participate in the remainder of the funds available on a pro-rata basis. Note that this feature allows the investor to double dip into the equity pool for a nearly 8% jump in the total ownership.
As can be seen from the below graphs, the investor ownership jumps radically as the terminal value of the firm reduces. The reverse is true from the founder’s perspective (though not as radical). The ownership of the founder’s falls as the value of the firm also follows a similar trend.
Putting the scenarios together, we can see the returns that the founders and the investors receive at each terminal value junction. The ownership of the investors is much more safeguarded from risks in the Alpha term sheet as opposed to the Mega term sheet. Interestingly the investors also seem to be in a better position on their returns in the Mega term sheet. Approximately $9M equity returns more than Alpha with a larger % ownership as well on the upside. Of course the downside is not comparable because Alpha wants all the valuation when the result is an offering less than $15M.
Dividends
Both Alpha and Mega offer dividends. Alpha’s dividends are non-cumulative and 8% of the shares are expected to return non-cumulative dividends. Assuming that we look at the company’s performance at the end of year 5 and no dividends were declared before, the total dividends of the investor would be $380,952.4. On the flip side the Mega Funds dividends plan maybe cumulative, but only 10% (500,000) is available after 1 year for dividends growing year over year. So in year 5, assuming no dividends was declared before, a future value of $732050 is dispersed as dividends. For the investors, from a dividends point of view, Mega offers much better terms giving a larger % return cumulatively.
Anti-dilution
In the case of Alpha, if we assume a share price of $0.65 ( between the required 50-100% ) and series B accounts for a total of $6.5M, we can see that a weighted average anti-dilution protects the investor by offering 735,608 more Series A shares whereas an offering of the same amount at $0.50 raises the free shares of Series A to 1,210,897.
With Mega, we are faced with the full-ratchet possibility which would give the investors a much larger number of series A shares. Also note that the weighted average anti-dilution doesn’t give the Series A investors as much as they obtain through the full ratchet. This is a huge issue for the founders who are now under pressure not seek new investment in the firm. On the other hand, they have more leeway to seek further funding in the Alpha term sheet. But note that in the case the revenue stream is lower than 500K, and then Alpha would get both the weighted average Series A shares and the escrow Series A shares –a double whammy for Borg and Kushdog.
Vesting
Vesting schedules for either term sheet are similar. The founders can vest 25% when they purchase and spread the remaining over a 36 month period. Employees get a 12 month 25% cliff and then spread the remaining over a 48 month period. These are standard terms with the expectation that the 180 day lockup period will be in place in the case of an IPO. Employees are expected to have a longer shelf life and hence retention is the key to the longer vesting period. Entrepreneurs being the champions of the firm get early returns and a shorter cycle (starting acceleration for their innovation).
Governance
The board of directors’ structures established by both the term sheets is quite identical. The requirement is for a 5 person board. One member is the CEO while two are Series A representatives. The other two are outsiders nominated by the founders and by the board respectively. In the case of releasing the escrow shares, Alpha has placed a restriction on the 5th member of the board which allows them to replace the outside member with their nomination – clearly this is designed to tilt the board in their favor in case the firm is floundering in its attempts to reach a run rate of 500K+ revenue stream.
Another governance piece is the formation of the compensation committee. Alpha requires that this would be a 3 person committee with 2 representatives from the investor with one outside director. In such case as well, the founders do not have say over the compensation committee actions. Mega does not need define any such clauses and hence it is assumed that the founders are free to choose the committee.
Alpha seems to clearly indicate that they want more control over the governance of the company which directly ties into the risk mitigation policy that they have followed throughout the term sheet.
Liquidation Preference
Employees have 48 month vesting with Reserved shares have 48 month vesting 12 month cliff and linear monthly vesting with 12 month cliff and linear monthly thereafter. Founders vest 25% upon vesting thereafter. Founders vest 25% purchase and 75% linear vesting over 36 upon purchase and 75% linear vesting months and subject to buyback.
Upon over 36 months and subject to buyback. employment termination, Company will Upon employment termination, repurchase unvested shares. Founders Company will repurchase unvested also receive accelerated vesting on IPO. shares.
First dibs of 3x on preferred and then also an option to collect pro-rata isuance price and declared but unpaid dividends. Could be triggereed by a merger, reorg, transfer of control(IPO).
Conversion
- If you were the entrepreneur and could not negotiate any of the terms in either term sheet which one would you prefer and why?
Mega seems to be the better choice between the terms. The valuation is a tad lower and the anti-dilution ratchet may cause an excessive Series A shares granted to the investors together with the participating preferred clause. But the equity returns to the founders does never go to 0% in the case the firm doesn’t prove successful. With Mega, the founders make at least 10% even in the 10M downside scenario. One would not want to be left with nothing if the valuation of the firm during the IPO phase is less than $15M, which is the case with the Alpha term sheet.
Due to the participating nature of the Mega term sheet, the founders always have some pro-rata ownership left to divide among them. Alpha requires a 180 lock up period together with an unattractive escrow release clause. Further the governance structure that Alpha requires is unattractive. Alpha’s term sheet is based on a high risk factor which reflects on the (poor) confidence level in the company. A long term relationship with the VC’s would be a good starting point and hence Mega Funds would be the choice.
- How would you seek to alter the terms in each term sheet during the negotiations with each venture capitalist? Which terms would you seek to alter first?
Alternate scenarios can be drawn to give the founders some returns in the downside valuation. This is especially true for the Alpha term sheet which is lopsided to suit the investors. In the case of Alpha, the liquidation preference choice is a limiting factor and should be negotiated. Removal of the escrow clause with the same valuation is needed. The governing structure of the Alpha term weakens the founders and should be tilted in their favor.
There could be poor, weak or incorrect long term management decisions made by the board which could derail the progress of the firm. In the case of Mega, the anti-dilution full ratchet clause causes much damage and needs to be removed or negotiated down. The participating should be removed completely. The severance packages are undefined and should also be placed in the terms. Vesting plans are better with Alpha and hence unemployment vesting and accelerated vesting on IPO can also be included in the Mega term sheet.
- Does it make a difference to you whether you expect Trendsetter.com to grow fast or grow slowly?
Alpha term sheet places a time limit on the amount of revenue expected (fiscal year 2000). While Alpha does have the escrow shares as a backup together with the governance issue, Mega doesn’t have either. In either case growing too soon can only help to get a quicker exit. Growing too slow can result in more Series A shares granted in the case of Alpha. So from a founder standpoint, Mega Funds is a safer term sheet. For the founders, choosing Alpha would be disastrous in case the company does not grow!
- Does it make a difference to your wealth whether you expect to realize on Trendsetter.com through an IPO or merger?
Either IPO or merger is defined as a change of control event. The difference is in the valuation that Mega requires during an IPO which would kick in the liquidation preference and the PCPT clauses in to action. From the founders point of view this is critical, since the same clause in the Alpha term sheet leaves them with nothing when the offering is at the minimum. Usually a merger would leave a firm’s valuation lower thereby directly affecting the pro-rata ownership that the founders can expect. The ideal choice would be an IPO under the Mega Fund VC’s which would at least give the founders 27% prorata of the terminal value assuming the worst case scenario.
- If you were an aspiring venture capitalist looking for a ‘blueprint’ term sheet to use at your firm which one of the two term sheets would you use? Why?
It would be the Mega Fund term sheet again. With the full ratchet anti-dilution and the PCPT clauses the VC is assured of returns greater than those the Alpha sheet can offer. Also the entrepreneurs are not left with nothing in the downside. This leaves both parties happy in such case. The number of governing clauses is lesser leaving the entrepreneurs the freedom to drive the firm with their leadership. Giving trust would help them make better decisions.
