Buzz

The 21st Century Term Sheet - Part 1

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


PrivateEquity:Trends and Developments [1]

September 2007

Periodically, we come up with ideas for improvements in the "green goods" business, meaning transactional corporate finance with an accent, in our case, on venture capital and buyouts. By way of ancient history see the following links,[2] for suggested improvements in the areas of: predatory class action litigation; equity flavored executive compensation which better aligns the interest of the executive and the shareholders; and re-opening the IPO window for mid-cap venture-backed companies. If the truth be told, several such suggested improvements have yet to gain the kind of currency which we think they deserve. If at first, however, you don't succeed - the following innovation, accordingly (and hopefully) will catch on and, in the process, cut away a lot of the frictional costs of negotiating placements in the venture sector.

By way of background, a typical lecture from this source to a seminar at, say, Cornell business school class stresses a fundamental truth in corporate finance generally. Every transaction consists of both price and terms. One of the great negotiators on Wall Street was reputed to have made money by repeating the mantra, "your deal, my terms." What that meant was that he would allow the seller or buyer to name the price if he was given the latitude to set the terms.[3]

An idea has occurred to me which can, in my view, lend significant clarity and transparency to negotiation of, say, the Series A round.

Assume the following hypothetical: A promising company is soliciting a Series A round from top decile venture capitalists and the lead investment fund has agreed to a notional pre-money valuation of, say, $50 million. The VCs then propose a $20 million investment, the terms including an uncapped participating preferred with a 12% coupon for 28.6% of the company, reverse vesting on the founder's stock, a put back to the company after four years; a milestone staged schedule for the $20 million commitment, based on the issuer's projections. Issuer's counsel retorts with a 3x cap on the participating preferred, an 8% cumulative dividend, no milestones, weighted average anti-dilution protection. The parties are able to agree on the governance procedures and pre-money valuation; but the deal terms become extremely controversial as the Samurai law firms duke it out over what is "fair" and what is "market" vis-a-vis the terms. The partner of the lead venture firm is constrained because she is a junior member and will be embarrassed if she goes back to the committee, which votes unanimously and is dominated by long time VCs, with deal terms they view as naive ... a product of her less than first rate negotiating skills. The founders and her fellow board members, on the other hand, are confused by the swirling rhetoric ... even after consulting the Fish & Richardson/VC Experts Series A deal terms survey. They are unsure of what they are giving up in real economic terms ... when, shazam the new term sheet model comes to the rescue.

The suggestion made by this "expert" from VC Experts, is that the deal terms discussion is getting the cart before the horse. The 21st Century term sheet can be much simplified ... a model of clarity. The new paradigm has the following characteristics.

First, the assumption is made that the $50 million pre-money valuation is valid for purposes of a Series A, minority investment. That number is posted on a White Board in the conference room. Next, the parties agree that, if the entire company were up for sale, standard economic modeling suggests a 30% control premium. Accordingly, the discussion segues to a stipulation that, were the company to be sold as a unit to either a financial or a strategic buyer, the gross proceeds to the shareholders would be $65 million. The next, and semi-final, act in the drama is to agree on a hierarchy of likely, although of course not certain, valuations for a subsequent trade sale if $20 million were infused and the company managed without further equity financing for, say, the succeeding four years. This is one year short of today's typical VC outside target for an exit but the outer limit the company responsibly thinks its projections can have indicative value; a shorter period of three years, for example, is, of course, acceptable if the market and the business prospects of the company so indicate.

The parties agree that, regardless of the formal control mechanisms, the VCs will be able to put the company in play at the end of the stated period, whether or not the founders continue to believe that prosperity is just around the corner. In fact, one compelling component of what might be called the 'drop dead' date calculation is how long the VCs think they have before they must show results to their LPs so that they can raise the next fund ... and continue to live in Greenwich, Woodside or Chestnut Hill, in the style to which they have become accustomed.

The White Board then shows, a column with pretty simple numbers on it, stopping at a number which is at the outer limits of plausibility viz:

Presumed Gross Proceeds to Newco shareholders from Trade Sale

Share to the Founder
et al.

Share to The VCs

$70 million

$10 million

$60 million

$100 million

_____________

_____________

$125 million

_____________

_____________

$150 million

_____________

_____________

$175 million

_____________

_____________

$200 million

_____________

_____________

$225 million

_____________

_____________

$250 million

_____________

_____________

In the penultimate phase, it is up to the VCs to fill in, at each of these exit valuations, what do we (the VCs) get and what do you (the existing shareholders) get? The red carpet is laid down and the invitation extended to the VCs and their advisers: Fill in these numbers. Assume a trade sale, all cash. How do the proceeds get split up? How much for you? How much for us? Have quants, the fresh faced MBAs in your employ, run your calculations based on what, given the risk/reward calculus, you think you need at the end of the day. Give us an honest count, as we know you will, and focus on the bottom line ... net, net, net, what do the VCs get for hanging in there until we, the current owners, are able to put some more points on the board, operating lean and mean.

The founders, the angels ... the existing shareholders ... should then be able to do their own risk/reward calculation, using their best guesstimates. If it later turns out they are wrong, maybe they should have sold the company ... or scraped by on fumes until the picture improved. That's the luck of the draw. An economy built around entrepreneurship is bottomed on this kind of risk, and the calculations which accompany it.

But, the owners of the company should not need anybody to translate, and often imperfectly, from a foreign language ... i.e., deal terms. They should have clarity vis-a-vis the result which they will enjoy, depending on what they are able to achieve as managers before the company is sold. Once the parties are in agreement ... and our suggestion is they will come rapidly to agreement given the simplicity of the model (or disagreement, for that matter) ... then it is up to the lawyers to fill in the deal terms which will achieve the result. If that proves to be too hard for a given law firm, then the idea is to get another one. The deal terms should laser in on the results desired. The VCs will want downside protection and they will get it at, say, $70 million; since they put up the new money, they will get most of the available money off the table through their liquidation preference. From there on up, the deal terms will be calibrated ... perhaps using examples (which we much admire) to make sure everybody understands what the outcome is destined to be. There are always surprises in this business; but the model term sheet we are suggesting minimizes the surprises, in our view, and more importantly, significantly enhances clarity and transparency.

The last act in the drama is for the principals with their money at risk (the VCs and the issuer) to tell the lawyers what to do ...to take charge of the process, in other words. The instructions are: draft a term sheet which reaches the economic results upon which the parties have agreed. Obviously, there will be down side protection for the investors in the case of disaster. One conventional instrument which would accomplish that goal is a note secured by a protected lien on the company's intellectual property. And, a cumulative dividend will make it easier for the VCs to add to their up side, with due regard for the time value of money, by adjusting the conversion formula periodically. But the bottom line is, "You lawyers! Stop showing each other how tough you are. Sit down and give us language which produces the desired results. Cover the contingencies ... earn outs, escrows, break up fees, etc....in your language, and get us to the finish line."


[1] Readers are invited to volunteer as a contributing editor. E-mail joe@vcexperts.com, if you would like to work with me on a favorite project and we can conjure up the appropriate analysis so that the end result will have instructive value.

[2] Radar_SEC willAdopt Compulsory Arbitration; www.fr.com/news/articledetail.cfm?articleid=723; www.fr.com/news/articledetail.cfm?articleid=697; and see Bartlett & Shulman, "IPO Reform, Some Immodest Proposals" The Journal of Private Equity 2003 www.fr.com/news/articledetail.cfm?articleid=688

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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