Show Notes from Episode 7 of the Real Deal…What Matters Live
Discussion with attorney Jeremy Glaser of Mintz Levin about Funding Term Sheet Basics
Patrick: Hi, everyone. This is Patrick Henry, the CEO of QuestFusion, with The Real Deal…What Matters Live. I’m here today with my guest, Jeremy Glaser. Jeremy has been a guest on my program before we went to the live format. Jeremy is an attorney at Mintz Levin. He is an expert on securities law. He’s worked with venture capitalists as well as startups. He’s worked both sides of that equation. He’s also been an entrepreneur in addition to working at well-established law firms. Welcome, Jeremy.
Jeremy: Thank you.
Patrick: Today we’re going to be talking about funding term sheet basics. When you’re raising outside capital for your company, you end up with something called a term sheet. It outlines what will be in the definitive agreement for the financing. This is an area that comes up a lot in my consulting practice. There is so much focus on the single term in an equity financing of valuation.
Everyone gets wrapped around the axle in valuation, which is an important deal term, but it’s not the only important deal term. In the age of unicorns, we saw that a number of companies were so hyper-focused on the deal term of valuation that they missed many other things. That’s why we have so many companies now where it’s difficult for them to get acquired or go public because there is this perverse setup within the deal.
Let’s take a step back. Talk to me about debt versus equity and what you see with deals in the current environment.
Considerations on Debt versus Equity
Jeremy: Generally, most early-stage companies are getting funded through a convertible note. There are a lot of reasons for that. The principle reason is that it avoids the conversation about valuation. These convertible notes can be put into place very cheaply and quickly. You don’t need to have a conversation about valuation. You just agree upon some sort of discount in a future round. Those transactions can be done quickly and cheaply. We tend to see those done at that point in the company.
That is at the early stage with friends and family money or early-stage angels. I say “early-stage” angels because we’ve seen a change in the market. Angel groups and more sophisticated angels used to be willing to do convertible note deals. Not so much anymore. They’ve learned their lesson the hard way that they’re better off pricing a deal and doing a series seed type of financing. Note deals and debt deals are very early. It’s the first money in. Quickly, you’ll move into equity preferred stock. It will be that way for quite a while until you’re ready for a sale or public offering.
Patrick: I’m seeing that the million-dollar round is no man’s land. If someone is doing a $250,000 round or half-million-dollar round, they’re typically doing it as a convertible note. I see a lot more deals floated by me as safe agreements, which take the Y-Combinator approach to things. It’s not officially debt. It operates a lot like convertible debt.
Jeremy: It looks like convertible debt, just with no due date.
Patrick: There’s no interest and no due date. It’s a little more favorable for the company versus the investors. Some investors are unwilling to live with safe agreements. I’ve seen that situation. You have a cap. You have a discount. In the case of debt, you have an interest rate. You have a term and maybe some warrants. It’s a relatively straightforward deal.
Jeremy: We were talking about these deals being simple, and you avoid any kind of valuation. The minute you put a cap into it, you have a conversation about valuation. It takes away some of the ease and simplicity. It creates issues. Once you have a valuation cap, a whole bunch of other conversations start to come out. What happens to the end valuation cap? Can you get shares in preferred or in common? It gets very complicated. In the good old days, notes were very simple. They’ve become more complex.
Patrick: At what point does that cap lead you into doing a preferred equity round?
Caps on Convertible Debt May Lead to a Preferred Equity Round
Jeremy: I think it does. This is one of the reasons why we’re seeing more of these series seed simple preferred stock situations. What do I mean by “very simple?” The only right that you give the investor is what’s called the liquidation preference. That means that, if the company ever gets sold or goes out of business, that investor gets their money back first. If you keep it simple, it’s what we call a 1X return. If I sell the company, no matter what price I sell the company for, you the investor are guaranteed to at least get back your money, sometimes plus a simple interest rate.
That’s what you get, unless it’s a more favorable deal for you to convert into common equity, in which case you would get more money. If you just give that one simple right and avoid all the other complexities, you can do a preferred stock financing and not spend much more money than you would with a note. That sounds great in theory. Unfortunately, in practice, investors get a little carried away. I miss the good old days in the 80s. Investors understood, “With early-stage investing, either I’m going to make a fortune or I’m losing it all.” There’s really no in between.
Spending tens of thousands of dollars in legal fees to try and protect my downside is a complete waste of time. I have a 1X that protects me in case something funny happens. I’m probably going to convert and make a bunch of money. Everything else like registration rights, lock-in rights and all of the complexity that we tend to see in venture deals didn’t used to find its way into these early-stage deals. Unfortunately, some of the angel groups have decided that they need to have all of this. Rather than keeping it simple, they’re requiring all of this detail for these early transactions.
As a lawyer, I could say, “Isn’t that great? We get to make more money now in these early transactions.” As an entrepreneur and business-focused lawyer, I think it’s terrible. I think this is money that should be staying in the business. It takes too long to get these deals done. I urge early-stage investors to rethink their mentality. Understand that it’s a high-risk investment. The downside protection that you put in is not going to matter. Either it’s going to be a homerun or you’re going to take a complete write-off.
Patrick: It’s the reality of the current situation. You’re dealing with angel groups and trying to convince them to get off of that. They have lost a lot of money in early-stage deals.
Jeremy: That’s the nature of the investment. The old rule of thumb for these venture capital funds was, one out of ten deals, and you return the funds. As I see more statistics, that’s not true. In early stage, now it’s one out of twenty-five or forty. You need to have massive diversification of investments to get any kind of venture type returns.
Patrick: There’s this focus on the 10X return. It’s the 50X, 70X or 100X return on a company that really drives the appreciation of the fund. It’s back to the basics on the term sheet. For the entrepreneurs who aren’t finance experts or financially savvy, there’s a set of liquidation preferences on your balance sheet. Your employees get paid first, then typically your vendors.
If you have some line of credit, that gets paid next. If you have long-term debt, that gets paid. Eventually preferred stock gets paid and then common stock. As an entrepreneur who starts a company, you have common stock. You’re at the bottom of the pile. You get paid last. You have more upside. As you go further down in the stack, the upside gets bigger. Depending upon how you structure your preferred stock, you can get a massive return.
Getting back to preferred stock, in a venture capital deal, you have valuation. You have liquidation preference. We talked about a 1X liquidation preference, which means that you get your money back. Some VCs, less so angels, want a 2X or 3X liquidation preference. They’re trying to protect their downside. As an entrepreneur, say no to those deals. Anything more than a 1X liquidation presence is not really fair and equitable from both the entrepreneur and the investor standpoint. What do you see in the deals that you’re doing? Are you seeing a lot of requests for more than 1X liquidation preference?
Jeremy: Not really. The good news is, right now, there’s a lot of capital. It always shifts. You want to go back 10 years to 2008 and 2009 when everyone was afraid to make an investment. There was a lot of capital. It was seeing 2X and 3X. I remember that I saw one term sheet that was 5X. “Do you want my money? These are some tough terms. Take it or leave it.” It’s shifted. It’s come back to normal. It’s predominantly 1X transactions right now.
Patrick: What do you see in terms of participating preferred? You get your money back but then you’re participating on the outside on top of that.
Some Typical Stockholder Preferences in a Preferred Stock Offering
Jeremy: We’ve been talking about this 1X liquidation preference that says, “I get my money off the top.” The vast majority of deals are done in this way. You have a participation on the preferred stock as investments with venture capitals. With angels, it’s not as much. Sophisticated VCs are coming in now, consistently wanting participation rights. This means that they get the upside of being a common stockholder. In addition, they get this 1X off the top.
Patrick: There’s protection on the downside plus participation on the upside, up to some level.
Jeremy: Right. I’m baffled by this idea of a fully participating preferred. What that means is, if I make a million-dollar investment in your business and you sell it for $10 billion, I made a massive return. I should be dancing in the streets. Why do I care about the fact that, in addition to my 30% of the $10 billion we just got, I get my $1 million back, too? It seems petty. Most of the time, we try never to have a full participation. We’ll try and cap that participation. If the venture capitalist gets twice or three times their money back on the outside, then the liquidation preference goes away. You’ve made a great return. You don’t need to keep that $1 million on top of that when a deal is successful.
Patrick: In companies that I’ve been involved with, both on the advisory side as well as running them, you might get an excess of a 3X participating preferred. That means that you can stay in preferred stock and get the upside before converting the common. There is this decision point where you’re better off converting the common. If that decision never needs to be made because you’re making so much money by staying in preferred, that’s a perverse mechanism within your balance sheet, from my perspective.
Jeremy: There’s a reason. You’re always going to get that upside, plus you get your initial investment back.
Patrick: As you’re doing subsequent rounds of financing, the later guys are also going to want additional goodies, too. You have to be disciplined about this, even when you’re doing a Series A. I recommend 1X liquidation preference. Maybe a 3X participating preferred before you convert. This is only the case if you’re in an M&A transaction. If you’re selling the company, there is a forced conversion when you go public. Everyone has to be converted. Is that right?
Jeremy: It is. It has some limitations. It’s usually based on a minimum price or a minimum amount of proceeds from the IPO. You have to make sure that it’s a number that you can hit in the initial public offering. If you don’t, then there is a negotiation.
I’ve been involved in those negotiations where companies have tried to go public. They didn’t hit the price point or gross proceeds number. Then there’s a negotiation. You can imagine what that negotiation is. It’s a preferred stockholder who knows that they’re in control of the handout saying, “Hand me a little bit more and maybe I’ll convert it when I do the IPO.” Then they’ll take more ownership.
Patrick: We were very fortunate because we had excellent attorneys working on our deal. When we took Entropic public, we had a provision within our Series A, B and C that included that. There was a willingness from our investors to relinquish control of that to our board of directors. When we took Entropic public, it was in the midst of the subprime meltdown in the mortgage business. It was a very difficult time to get a company public.
We had to reduce the number of shares and lower the price in order to get the company public. It worked out great in the long term for everyone. The company survived through the great recession and eventually drove a billion-dollar valuation. The biggest venture capitalists were part of our board. That was also part of it. The other investors felt like they would be well protected by the guys inside the tent, making the decisions. I thought that was a reasonable way to do it.
Jeremy: It is. It’s not just the issue of going public. Getting back to the term sheet, there are a lot of protective provisions that get put into the term sheet, particularly for the venture capital round. We emphasize to entrepreneurs that, if you can move that decision to the board level rather than the stockholder level, it’s a lot easier. It’s a lot faster. There are some things, unfortunately, that the investors will insist they have at the stockholder level. We can have another discussion around that.
Patrick: Those aren’t term sheet basics. They are term sheet advanced conversations. That’s when you want to make sure that you have an excellent attorney working with you on your side of the table. You want someone like Jeremy who has done seed rounds. They’ve done Series A, B, C, B1, B2 and E. They’ve taken companies public. They’ve gone through a lot of M&A. You want someone who has worked those different types of transactions.
The Dangers of Only Focusing on Valuation
Jeremy: There is something you said about valuations that is important. I want to tell a story that illustrates how valuation gets overly focused on. We had a company that had a great M&A transaction. They came to us with a businessman’s term sheet that had an incredible valuation on the business. My first reaction was, “Wow, that’s fantastic. Congratulations for getting that price.” But as I dug into this businessman’s term sheet, I saw that they didn’t nail down some of the issues. This was a transaction that was being structured as a limited liability company.
You have an operating agreement. Usually on those agreements, you have different levels of payout. You have preferred payouts. You have junior payouts. I pointed out to the client, “It’s great that you negotiated this valuation. But you don’t know what this operating company is going to look like if they’re getting equity interest. You don’t really know what you’re getting.” They said, “What do you mean? We’re getting hundreds of millions of dollars in this equity.” I said, “Let’s try to negotiate this term sheet and get more clarity.” They didn’t want to do it. They were afraid that it would cause issues with their deal. I gave them all the warnings.
The definitive agreements showed up. The purchaser had all of their shares senior to their shares so that they get out of this deal with a fabulous return before my guys see a penny. I said to my guys, “On that structure, I’ll value your company at $1 billion. I’ll tell you you’re getting $10 million of equity. I don’t care. I get my big return. I’m out. Whatever is left is all you get.” This valuation was effectively a scam and we had to renegotiate the whole transaction. Whether it’s an M&A transaction or a venture deal, overly focusing on valuation and not paying attention the terms is always a bad idea.
Addressing the Concern over Investor Influence
Patrick: There is always this concern, especially with founders of a company, of losing control of their company. I always tell them, “If you raise $1 from someone else, you may not lose control, but you have influence.” As soon as you get institutional investors involved, like venture capitalists, you’re doing a deal with someone where you are going to give up a substantial amount of control over your company. Even if they don’t own the majority stake, there are some deal terms related to blocking rights and corporate governments.
Give me your top three that a founder or entrepreneur needs to consider when they’re raising outside capital from someone who wants a board seat or wants to have more influence over what happens with the company when a liquidated event happens.
Top Tips for Founders When Bringing on Investors
Jeremy: I always get concerned when people get overly focused on the sole control issue. I can’t tell you how often an entrepreneur will sit down with me and say, “I don’t want to bring in a venture capitalist or angel because I’m going to be giving up control.” Don’t focus on giving up control. The minute your brain goes in that direction, you’ll make bad decisions about structuring the deal as well as operating the business and how to communicate with investors.
I’ve seen it happen over and over again. You will ultimately end up creating a situation where the fact that you gave up control results in you being escorted out the door. Focus on the right things. Find a venture capitalist or angel investor who shares your values. It should be someone you think could provide great insight as you build your business. Focus on that. Focus on creating value for both of you. That’s what you should be putting your attention on. If you do that, the fact that they have control over certain items isn’t going to matter. Every transaction you do with a sophisticated investor will require that you can’t sell the company without their approval.
Patrick: That’s called a blocking right.
Jeremy: Yes, that’s called a blocking right. The preferred stock has a separate vote as to whether or not you can sell the business. That’s term sheet based. If we can get the term sheet at PhD level where I’ve negotiated metrics and minimums, that goes away. It goes to who has the negotiating power. Patrick, if you have five venture capitalists knocking on the door saying that they want in, we could probably negotiate where that blocking right goes away at certain prices, certain multiples or over a period of time. But if this is the only term sheet that you have, you’re probably not going to have any success in getting anything other than their right to approve a sale.
The other one that’s important is the ability to change the CEO. That’s driven by who’s in control of the board. Depending upon valuation, you could still retain control of your board as the entrepreneur. For example, you have a five-person board. You bring in a VC who is taking a third of the business. They might only have two seats. Then you’ll have two seats on your side. Then there is usually a third seat, or in this case the fifth seat, which is someone from industry that everyone agrees will take that seat. Theoretically, you could still win any vote at that board level by convincing that independent to vote along with your side as opposed to the VCs. That’s the key to making sure that you don’t lose your job. The board can hire and fire the CEO.
Patrick: I ran a company where a very significant Silicon Valley venture capital firm had a unilateral right to change the CEO. They had that card in their deck to play at their will.
Jeremy: Did the CEO have a funding agreement to protect him if they pulled that trigger?
Jeremy: That’s the way that you protect yourself. You put something in place.
Patrick: I have videos out there on that topic with one of your colleagues, Jenn Rubin. Check out my YouTube channel. You can see my interviews with Jenn Rubin. It’s fantastic stuff. They are all things that are very important to consider as soon as you bring outside money into your company and what you want to do from an employment agreement standpoint.
Jeremy: You want to make sure you at least put something like that in place so that, at minimum, your equity vests and you get to keep most of your equity if they push you out the door because they didn’t like the fact that you wore pink shirts, for example.
Patrick: Those are some key things. I have seen this example with clients that I’ve worked with. They end up getting two term sheets. They always prefer the term sheet that has a higher valuation. I understand that. Until it’s a liquidity event, meaning selling the company in an M&A transaction for cash, you get 100% out in an M&A transaction. Over four years, I got 20% out in Entropic.
Jeremy: It’s really hard to sell as an insider at a publicly traded company. It’s challenging.
Patrick: With these intermediate benchmarks of valuation at a Series seed, A, B or C, the objective is to make progress with your company. Unless it’s the last round of financing you’re ever going to need, put yourself in a position where you will increase valuation and not in some perverse situation with your investors. You’re dealing with upward rounds versus dealing with down rounds and cram-down rounds. Get the smartest people around the table that you can. If you have an investor that comes in at a higher valuation, but they have no domain or technical expertise and no connections, I would go with the smart money investor. They can add value. This is someone who will partner with you and make you and your company better will make
Jeremy: They will make your company ultimately more valuable.
Jeremy: Do you want 100% of something worth $10 million or 10% of something worth $10 billion? It’s an easy answer. I think people become overly focused on that issue, especially at early stage where you should be thinking more about how to build the value of your company so that your stake is worth the most eight to ten years from now. It’s not, “How do I make sure that I maintain the biggest percentage of something?” It depends on what that “something” is.
Patrick: Do you have any closing tips or thoughts about these topics for entrepreneurs?
Jeremy: As you can probably tell from this conversation, this is not for the do-it-yourself-at-home crowd.
Patrick: It’s not LegalZoom.
Jeremy: I don’t recommend the online things out there. You need to have really good legal advice. You need to have really good people around you, the experts who have done these transactions and can tell you the upsides and downsides. There might be things in the term sheet itself.
We talked about liquidation preference multiples. Even though the valuation is higher, on the sale of the company at $100 million five years out, when we run all the numbers, you’re worse off than the deal with the lower valuation. You need to know that. You need to know how to model that and think that through. That’s not taking into account the other things that you talked about, like expertise and connections, which matter. The takeaway is, don’t do this alone. Never sign a term sheet with any investor without having had an experienced lawyer look at that term sheet on your behalf before you sign it.
Patrick: That’s excellent advice. How can people get a hold of you, Jeremy?
Patrick: Do you have a lot of basic forms there in terms of proprietary rights and confidentiality agreements?
Jeremy: We don’t have those forms up, but we have some packages available at incredibly reduced rates. It gives you access to all kinds of information and documents that you would need. These things will help you and they’re at a dramatic discount. Mostly there are a lot of really good articles, information and podcasts. I did one with you. This information speaks to entrepreneurs about how to build your business, how to fund your business, how to sell your business and how to take your business public.
They can also email me at email@example.com. I’m also very active on Twitter @sdvclawyer. I’m always posting articles directed towards entrepreneurs about how to raise money and changes in the market. If you go to my Twitter feed, you’ll see lots of stuff around cryptocurrencies, token sales and the regular trade crackdown in the area. It’s important stuff for people to follow.
Patrick: Thank you, Jeremy. I appreciate you tuning in today. Thanks for joining us with The Real Deal…What Matters Live.