ORRICK Term Sheets + Transaction Process

Term sheets & Transaction process -Term sheets & Transaction process -life cycle of a start-up company

Dr. Albrecht von Breitenbuch 31 Jan 13

Agenda

1. Introduction

2. Initial and Seed funding

3. Series A financing3. Series A financing

4. Strategic Investor and Exit

5. Wrap-up

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Company’s transaction life cycle

Formation Seed Financing AdditionalFinancing

Strategic InvExit

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• Emerging Companies face unique challenges

Emerging Company Needs

Formative Financing IP Protection “Bet the Company”

• Success leads to even more challenges

FormativeCounseling

Financing IP Protection “Bet the Company”Technology Transactions

AdditionalFinancing

AddressingGlobal Markets

Litigation – Swordand Shield

ExitStrategies

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Opening remarks on Company Formation

• Why? – for the right reasons.

• When? – at the right time.

• Where? – at the place to be.

• What? – the best fit.

• How? – make it happen.

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IncorporationWhat?

• Form of entity:

– private limited company (GmbH/UG)

• Others:

– stock corporation (AG)

– limited liability partnership (oHG/KG)

– civil law partnership (GbR)

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Agenda

1. Introduction




5. Wrap-up

7

Prior to Fundraising

• Networking

• Investor pitch

• Cap Table:

– shareholder structure– shareholder structure

– allocation of equity

• Due diligence preparation

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PreparationThe Boy Scout motto …

• What can you do to prepare?

– ensure that information is to hand

– ensure that contracts are all up to date

– conduct internal reviews:

• legal review to ensure compliance with legislation (especially in relation• legal review to ensure compliance with legislation (especially in relationto IP and employment agreements)

• financial/accounting review to ensure financial information is accurate

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The Preliminary ApproachArranging the first date …

• Preliminary Due Diligence:

– Commercial

– Technical

– Accounting

– Legal

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Legal Due DiligencePreparing for the first date …

• Key legal considerations include:

– change of control provisions in contracts

– consent requirements

– IP licenses:

• assignability• assignability

• term

• renewal

– copyright assignments by authors, both employees and sub-contractors

– litigation: current, pending or threatened infringement actions

– employment

– property leases

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The Preliminary ApproachBefore you go on the first date …

• Confidentiality Agreement (NDA):

– restrict the use of confidential information to evaluating thetransaction

– standard exceptions include:

• information in the public domain• information in the public domain

• information that the non-disclosing party already had; and

• information that the non-disclosing party gets from a third party

– clauses not related to confidential information include:

• non-solicitation of staff

• “no shop” / exclusivity provision

• …or at least think about it!

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Initial FundraisingWhich structure?

• Equity vs. Convertible Debt

– rule of thumb (in US, at least)

– philosophical debate

• Alternative funding

– crowdfunding / crowdinvesting

– mezzanine debt

• … but the path will ultimately depend uponwho your investor is.

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Courtesy of Venture Hacks

Initial FundraisingConvertible Debt

• Convertible Note:

Investment in the form of a promissory note thatconverts into equity on the terms of a “qualifiedfinancing”, typically at a discount to the price of thequalified financing.qualified financing.

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Initial FundraisingEquity Investment

• Valuation, valuation, valuation

• Typically, full negotiation of preferred shares (even if“pref light”, “Series Seed” or other structure):

– liquidation preference

– investor consents & protective provisions

– anti-dilution

– drag / tag provisions

– warranties

– board seats

– etc.

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HousekeepingYou have the term sheet, now what?

• Due diligence investigation

• Be prepared

• Key areas:

– employees & consultants– employees & consultants

• signed employment agreements

• signed IP assignment agreements

– Intellectual Property

• protected through trademark application or otherwise

– litigation?

• no investor wants to fund a law suit

– third party debt?

– cap table16

HousekeepingYou have signed the term sheet, now what?

• Negotiation of “definitive documentation”:

– Subscription/Investment Agreement

– Shareholders Agreement

• often combined as “Investment and Shareholders’ Agreement”

– Articles of Association– Articles of Association

– Disclosure Letter

• Run your business

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HousekeepingCongratulations, you closed the deal – now what?

• Investors & Corporate Governance:

– essential role:

• maximise shareholder value for ALL of the company’s shareholders

• oversee and promote fiscal, legal and ethical governance standards

– fiduciary duties:– fiduciary duties:

• duty of care: “… requires directors to act with the amount of care that areasonable person would use in similar circumstances.”

– directors are required to act on an informed basis, in good faith and in amanner that they reasonably believe is in the best interests of the company

• duty of loyalty: “… requires directors to put the interest of the companyahead of their own interests.”

– Board / Supervisory Board / Advisory Board

– Information rights and communication

– Try to get as much out of your investors‘ experience as possible.

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Agenda

1. Introduction




5. Wrap-up

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Term Sheets

• Importance

• European vs. US VCs

• VCs vs. Strategic Investors

• Transactions in different jurisdictions• Transactions in different jurisdictions

• Additional (binding) terms:

– governing law

– break fees

– exclusivity / “no shop”

– confidentiality and non-solicitation

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Term SheetsTop 10 Term Sheet Provisions

– Liquidation Preference

– Anti-dilution Protection

– Redemption

– Dividends

– Drag-along Right– Drag-along Right

– Right of First Refusal

– Founders’ Stock (Vesting)

– Protective Provisions

– Board Representation

– Registration Rights

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Liquidation PreferenceWhat is it?

• Basic definition:

– Investors get their money back before anyone else

• Legal definition:

– “… a right given to holders of a preferred class of shareswhereby such holders, in the event of a liquidation event, areentitled to receive their investment back (plus accrueddividends) before the holders of ordinary shares receiveanything.”

• Why is it important?

– gives investors “downside protection”

– guarantees the investor that they will see the “first money”out in a liquidation scenario

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Liquidation PreferenceTips & Tricks

• Tips:

– run the exit model (a VC has already done so)

– multiple liq. pref. & participation reflect state of economy

• Tricks:

– horizon / time based inflection point

– cap / participation removed above $$ value

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Liquidation PreferenceTraps

• Traps:

– high pre-money valuation with multiple / participating liq.pref.

– liquidation preference on IPO

– participation = “double dip”– participation = “double dip”

– accrued cumulative dividends

– liq. pref. stack from multiple rounds can be oppressive

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Anti-dilution ProtectionWhat is it?


– Investors get price protection


– “… a mechanism which insures that an investor’s equitystake in a company will not be reduced through subsequentinvestments in the company at reduced valuations.”


– gives investors “downside protection”

– guarantees the investor that they will benefit from favourableterms of subsequent investment round

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Anti-dilution ProtectionTips & Tricks

• Tips:

– full ratchet vs. weighted average

– ensure carve-outs are listed

– do the math

• Tricks:

– time-based conversion from full ratchet to weighted average

– “pay to play”

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Anti-dilution ProtectionTraps

• Traps:

– high pre-money valuation with full ratchet

– when weighted average ≠ weighted average

– miscalculating the liquidation preference (money in vs. pershare)share)

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RedemptionWhat is it?


– Investors get another kind of exit


– “… an investor’s right to require the company to repurchaseshares that the investor has purchased (often at a price thatis greater than what the investor paid).”


– another form of “downside protection” (or even insurancepolicy), but investor may exercise this right if they realise thatthe company has no real prospect of an exit (the “cash cow”scenario)

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RedemptionTips & Tricks

• Tips:

– resist, as not all VCs or investors require it

– should be justified by the VC

• Tricks:

– stagger the redemption (⅓ / ⅓ / ⅓)

– ensure carve-out for legal ability to do so

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RedemptionTraps

• Traps:

– full redemption at a single date

– multiple return (pseudo liquidation preference)

– “we have never exercised our right of redemption”

– long term debt on the balance sheet (increasing if dividendas well)

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DividendsWhat is it?


– Investors get additional return on their money


– “… distributions to shareholders from the company’s profits,usually on an annual basis at a specified rate.”


– Investors sometimes want a guaranteed rate of return ontheir investment

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DividendsTips & Tricks

• Tips:

– resist, as not all VCs or investors require it

– if have multiple liquidation preferences, may not be justified

• Tricks:

– non-cumulative

– delay commencement of earning / accruing dividends

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DividendsTraps

• Traps:

– cumulative (accumulate at a specified rate)

– multiple rounds + liq. pref. + dividends = mountain

– effect on redemption

– accounting treatment

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Drag-along RightWhat is it?


– Investors can force other shareholders into a joint sale


– “… if a certain threshold percentage of a company’sshareholders agree to sell their shares, then all othershareholders are obliged to sell their shares in connectionwith such transaction.”


– insure that a sale of the company will not be blocked byother shareholders

• Tag-along Right / Co-Sale Right?

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Drag-along RightTips & Tricks

• Tips:

– avoid low majority requirements

• Tricks:

– ensure participation by all shareholder groups in decision

– list carve-outs (e.g. below market sale, sale to affiliate)

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Drag-along RightTraps

• Traps:

– VC investor only?

– if right can be triggered by only a few shareholders (nochecks and balances)

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Right of First RefusalWhat is it?


– Investors get first dibs on transfers of shares


– “… a right to acquire shares being sold by existingshareholders to third parties.”


– allows investors to increase their percentage ownership ofthe company going forward

– bargaining tool for the Investor:

• complementary (or flip side) to “Co-Sale Right”

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Right of First RefusalTips & Tricks

• Tips:

– ensure broad range of carve-outs (including tax planning)

– may not want “offer round” if numerous small shareholders

– Company may not always be able to purchase

• Tricks:

– class by class RoFR

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Right of First RefusalTraps

• Traps:

– VC investor only

– timings

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Founders’ Stock (Vesting)What is it?


– Founder no longer really owns his/her shares


– “… the shares held by a founder, typically issued atincorporation, that are subject to reverse vesting granting acall option to the Company to acquire certain number ofthese shares in case of a leaver event.”


– Investor ensures that Founder is incentivised to remain withthe company (“golden handcuffs”)

– overcomes the “free rider” problem with Founder who hasleft

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Founders’ Stock (Vesting)Tips & Tricks

• Tips:

– know what you’re getting into

– define “good leaver / bad leaver”

– define the compensation for unvested shares

• Tricks:

– use bad leaver as the benchmark

– bad leaver = fraud, join competitor or “moral turpitude”

– credit for “time served”

– acceleration -> single & double trigger

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Founders’ Stock (Vesting)Traps

• Traps:

– “standard” good leaver / bad leaver

– use good leaver as benchmark = out the door “feet first”

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Protective ProvisionsWhat are they?


– Investors (negatively) control the company


– “…veto rights that are given to investors, or somecombination of shareholders, which require the company toobtain the prior consent of the investors before takingvarious corporate actions.”


– Investors need to have a degree of control over theirinvestments

– veto rights over important aspects of the business

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Protective ProvisionsTips & Tricks

• Tips:

– define the “laundry list” in term sheet

– split consents / vetoes between shareholder and board (ifany)

• Tricks:• Tricks:

– carve-outs for “ordinary course of business” & budgeteditems

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Protective ProvisionsTraps

• Traps:

– “standard” protective provisions

– straightjacket thresholds

– Articles (public) vs. Shareholders’ Agreement (private)

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Board RepresentationWhat is it?


– Investor oversees the company


– “… a requirement that the investor receives a seat on thecompany’s board of directors in consideration for theirinvestment.”


– allows the Investor to monitor the status of their investment

– should be in the company’s best interest, as Investor shouldbring degree of experience and guidance to the table

– certain veto rights will be allocated to the board or certainboard members

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Board RepresentationTips & Tricks

• Tips:

– define roles for each board seat (including Founder seat)

– keep board lean

– part of “Information Rights” that Investor will seek

• Tricks:

– ownership threshold for board seat

– if multiple classes, seats on a class-by-class basis (ratherthan unique to Investor)

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Board RepresentationTraps

• Traps:

– entrenched seat for irrelevant Investor

– observers & expenses

– director’s fees for Investors

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Registration RightsWhat are they?


– Investors get to sell if company goes public in the US


– “… contractual rights of investors to require the company toregister their shares for sale to the public.”


– Investor’s shares included as part of IPO or secondary

– if eventual exist is IPO in the US

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Registration RightsTips & Tricks

• Tips:

– resist, as not all European VCs require it

– not all that relevant anymore

• Tricks:

– know the difference between:

• “demand”

• “piggy back”

– don’t waste time on it

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Registration RightsTraps

• Traps:

– more than two “demand” rights

– low $$ thresholds to trigger rights

– “customary registration rights”

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MiscellaneousTerms

• Co-Sale Right:

– What is it?

• “… rights which entitle an investor to include a percentage of their shares in apurchase by a third party of another shareholder’s sale.”

– Why is it important?

• investor is able to control the exit of other shareholders, while ensuring that they• investor is able to control the exit of other shareholders, while ensuring that theyare able to participate in exits on a pro rata basis

• Subscription:

– What is it?

• “... a right to acquire shares being issued by the company in future offerings at thesame price to be paid by the new investors.”

– Why is it important?

• allows shareholders to maintain their same percentage ownership of the companygoing forward

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MiscellaneousTips

• Tips:

– co-terminus: “no shop” and projected closing date

– include cap table (pre- and post-closing)

– cap liabilities under warranties (duration and quantum)

– thresholds: look at cap table

– cap on transaction fees and expenses

– standardised documentation

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MiscellaneousTrick

• Trick:

– no confidentiality obligation until signed …

– team up to outbalance any weakness (for Founder it is firsttime, for VC not)

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MiscellaneousTraps (Part 1)

• Traps:

– “… as are customary in a transaction of this nature.”

– the two page term sheet (AKA “you’re great & we’re great,so let’s make lots of money together”)

– “exploding” term sheet– “exploding” term sheet

– payment of fees & expenses even if doesn’t close

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MiscellaneousTraps (Part 2)

• Traps:

– “option pool shuffle”

– price adjustments / ratchets

– milestones: with or without adjustments

– “forced exit” provisions

– unwritten terms (typically, founder stock & good leaver / badleaver) ….

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Agenda

1. Introduction




5. Wrap-up

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Strategic Investors

• Strategic Investors can come from:

– competitor in different region

– partner along the product chain

– complementary product

– old economy / industry

• Choose strategic investors carefully:

– true intention

– best fit to build or just competitor to destroy

– block others

– Tip: Networking

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ExitsTypes of Exits for Private Companies

• If your company has received VC investment, then be preparedfor the exit (and the pressure for an exit from your investor).

• Assuming, you have a VC-backed company, there are onlythree types of exit normally available:

– sale

– IPO (Initial Public Offering as admission to stock exchange)

– that which shall not be named (bankruptcy)

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OverviewTwo basic types of deal structures for sale …

• Basic deal structures

– share sale

– business sale (aka “asset sale”)

– “acqui-hire”

• Understanding the differences

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Share SaleStructural Principles

• Purchaser acquires everything:

– Purchaser takes the tax position as it is

– All employees remain with the company

– No assignment of permits, licenses or contracts

– “lock, stock & barrel”

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Business or Asset SaleStructural Principals

• Purchaser can cherry pick assets and liabilities

– but beware of application of Transfer of Undertakings(Protection of Employment) (“TUPE” (Betriebsübergang))

• Purchaser will have limited liability for unpaid taxes ingeneralgeneral

– however, seller could have a double tax hit

• Third party consents and transfer of permits andlicenses

• Contracts must be assigned in order to be transferred

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Agenda

1. Introduction




5. Wrap-up

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Helpful Resources

• The Funded

– www.thefunded.com

• Venture Hacks

– www.venturehacks.com

• Brad Feld & Jason Mendelson:

– “Venture Deals: Be Smarter than your Lawyer and VentureCapitalist”

• Katharine Campbell:

– “Smarter Ventures: A Survivor’s Guide to Venture Capitalthrough the New Cycle”

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Questions & Answers

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About OrrickEmerging Companies Practice

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Thanks

Dr. Albrecht von Breitenbuch, M.A.

[email protected]

+49 30 88574 2-0

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ORRICK Term Sheets + Transaction Process

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