An entrepreneur’s first dose of “reality” about the venture capital community often comes when a potential investor generates and delivers a term sheet for a proposed investment. Until that point, platitudes typically abound as the investor talks glowingly and enthusiastically about how much he or she believes in the startup. The entrepreneur’s excitement grows as he or she thinks about the great partner that will be coming into the fold. But the term sheet is where the rubber hits the road and serious business negotiations begin.

For someone who has not been through the process, the term sheet can seem overbearing and confusing, and an entrepreneur’s initial reaction might be, “but I thought we were all friends.” Term sheets serve several useful purposes, however, the most important of which is that they help to efficiently and effectively nail down the major negotiating points. This means that documenting and closing the deal – with a detailed agreement – will move faster, which not only allows the company to get its capital sooner, but also limits the legal costs of the company. This is especially significant when an entrepreneur is dealing with an institutional venture capitalist who will require the company to pay not only the legal fees of the company’s counsel but also the legal fees of the VC’s counsel.

Term sheets differ depending upon the type of investment being made (debt or equity). An equity term sheet typically summarizes the purchase of a type of equity interest in the company (e.g., capital stock, membership interests/units) with preferential rights (i.e., “preferred” stock). Although attention must be given to the preferential rights, the valuation of the company will probably receive the greatest attention during the term sheet phase. This is because the valuation determines the price of the equity to be purchased by the investor and, in turn, determines the amount by which the founders’ ownership interest in the company will be diluted by the investment. The higher the valuation, the less the founders will be diluted in the transaction. When the company is at startup/early stage, haggling over valuation is as much an art as it is a science, and, as such, will involve extensive discussion.

An entrepreneur should try to get a basic understanding of the typical terms of a venture capital investment prior to receiving a term sheet. Here is a summary of some typical terms:

• Dividends: Each outstanding share of preferred equity may accrue dividends upon the purchase price paid by the investor for such share. This acts like an interest rate upon the principal that accrues (and sometimes compounds). Payment of accrued dividends is usually not required until (1) the company is sold, (2) the share is purchased back by the company (i.e., “redeemed”) or (3) the governing body of the company (e.g., the board of directors) declares accrued but unpaid dividends to be paid. If the preferred equity is convertible into common equity (see discussion of “Conversion” below), then dividends may also be payable (or convertible into common equity) upon such conversion of preferred equity.
• Liquidation Preferences: In the event of any sale, merger or winding up of the company for cash or stock (a liquidation event), the holders of preferred equity may be entitled to certain preferences.
  • The holders of preferred equity may receive in preference to the holders of the common equity (e.g., common stock) an amount equal to the purchase price (or a multiple of the purchase price [e.g., 2x]) paid by such investor for its preferred equity plus, if applicable, any accrued but unpaid dividends.
  • If the preferred equity is “participating preferred,” then after return of its purchase price (and dividends), the holders of preferred equity will be able to share in the balance payable to the common equity as if the preferred converted into common as per its conversion rights (see discussion of “Conversion” below).
  • If the preferred equity is “non-participating preferred,” then the preferred equity may be entitled to the greater of (1) its purchase price (and dividends) and (2) the amount that it would receive if converted into common per its conversion rights (see discussion of “Conversion” below).

• Conversion: Preferred equity may be convertible into a number of shares of common equity determined by dividing the original purchase price (and, sometimes, accrued and unpaid dividends) by the conversion price. Usually the conversion price will initially be the purchase price (i.e., there is a 1:1 conversion ratio, or each one share of preferred equity will convert into one share of common equity), but the conversion price may be subject to anti-dilution price protection (see discussion of “Anti-Dilution Price Protection” below). Such conversion may be optional at the election of the holders, or mandatory upon a “qualified” IPO (e.g., an IPO priced at a certain level).

• Anti-Dilution Price Protection: The conversion price may be subject to adjustment downward upon the company’s sale of any security at a price lower than the effective conversion price (i.e., a “down round”). Once the conversion ratio is adjusted, each one share of preferred equity will convert into more than one share of common equity. The anti-dilution price protection may be “full ratchet,” in which event the conversion price will adjust to the lower price, or it may be “weighted average” protection, in which event the conversion price will be adjusted according to formula based upon outstanding shares.

• Redemption: Holders of preferred equity may have the option to have the company redeem (i.e., repurchase) their holdings after a certain amount of time (e.g., five years from the closing). Effectively, redemption rights afford investors with a “way out” if an exit event does not occur. The redemption is usually based upon the purchase price (and could be a multiple of the purchase price) and, if applicable, accrued dividends.

• Preemptive Rights – Percentage Protection: To avoid getting diluted by a new capital raise, the holders of preferred equity may have a right of first refusal to purchase, pro rata, additional securities proposed to be sold by the company based upon the percentage of all outstanding stock held by such investors. For example, if an investor’s holding of Series A Preferred Stock equates to 10 percent of the company, and the company desires to commence an offering and sale of Series B Preferred Stock, the investor’s preemptive rights would allow the investor to purchase at least 10 percent of the Series B Preferred Stock.

• Protective Voting Provisions: Typically, the holders of preferred equity will require their consent prior to the company taking certain actions, which may include:
  • Creating a class/series of equity that has liquidation preferences senior to their preferred equity
  • Mergers, sales, liquidity events, dissolutions, etc.
  • Incurring debt (outside ordinary course; thresholds)
  • Paying dividends
  • Repurchasing/redeeming equity
  • Adopting or amending stock option pools

• Drag-Along Rights: The investors will usually require all holders of equity in the company to be subject to drag-along obligations. If an unaffiliated third party makes a bona fide offer to acquire the company (whether structured as a purchase of equity, merger, consolidation or other reorganization) or substantially all of the assets of the company, and a requisite proportion of outstanding preferred equity (e.g., majority) elect to accept such offer, all other holders of equity will be required to sell their equity or to vote their equity to approve the sale of the company’s assets in accordance with the terms of that offer. In other words, equity holders will be “dragged” to the closing. This provision ensures that a minority owner will not have the ability to hold up a deal that would provide liquidity to the investor.

• Rights of First Refusal and Co-Sale:
  • Holders of preferred equity may have a right of first refusal to purchase their pro rata proportion of any equity proposed to be sold by any other equity holders to third parties.
  • Holders of preferred equity may also have a right of co-sale that provides such holders with an opportunity to participate (pro rata) in any sale of equity by any other equity holder to a third party.

• Registration Rights: Holders of preferred equity may have the right to have their equity registered with the SEC to enable them to sell on the public market.

• Information Rights: Holders of preferred equity may require the company to deliver periodic financial statements and reports, some of which may be required to be audited.

• Board Rights: The investors will often want to ensure that a board of directors (or similar managing body) is of a certain size and composed of certain individuals. Often the holders of preferred equity will require that at least one board seat be designated by the holders of preferred equity.

Navigating the provisions and lingo of a term sheet can be an intimidating process, especially for those who have not gone through it before. Therefore, if at all possible, an entrepreneur/startup should seek help and guidance from advisers who have experience in these matters. These may be lawyers, accountants or other business advisers – individuals who can explain the implications of each of the terms, and what is or is not typical. Ultimately, a productive term sheet negotiation with investors can set the stage for a fruitful partnership between the founders and investors.

About the Author
Gregg Lallier is a principal at the law firm Updike, Kelly & Spellacy and is located at the firm’s Hartford, Connecticut, office. His practice focuses primarily within the high-tech and venture capital industries. Gregg has represented both mature and emerging high-tech growth companies. He also regularly represents angel, venture capital and other institutional investors. You can contact him at glallier@uks.com.

When deciding how much money to ask for, your first instinct is probably to determine how much you need. But, should these amounts be the same? In short, rarely.

How much should you ask for, then?

While some experienced entrepreneurs and investors have a simple, straightforward modus operandi here, most will probably tell you that the “proper” amount to ask for depends on a host of variables. Certainly there are popular schools of thought and some basic guidelines one can follow (which we’ll discuss below). However, at the end of the day, every company has its own idiosyncrasies and subjective considerations. Just as each company will have a unique capital need at any given time, each should have a correspondingly unique (but not necessarily parallel) capital ask – therefore, it’s difficult to point to any universally applicable formula. But, let’s begin by looking at the big picture.

Fundraising vs. Building a Business

Before all else, it’s critical to think about whether it makes sense to pursue venture capital in the first place (at this particular time and in general), both from your perspective and from that of potential investors (a point often overlooked). Is the money and strategic value-add worth the time, money and energy diverted from working on the day-to-day of your startup? Given the product/service, industry and market size, business model, stage of development and so on, is your company truly VC-investable?

I certainly don’t want to discourage any entrepreneurs from seeking venture capital, but I do want to emphasize the importance of fully thinking through the decision before jumping into capital-raising mode, for two main reasons: 1) raising money isn’t for the fainthearted – to do it well requires a significant amount of focus, hard work and perseverance; and 2) as Brad Feld alludes to in a clever 2011 blog post, it is easy sometimes to forget that fundraising, be it VC or other, is simply a means to an end (building a business) and not an end in and of itself.

The point is this: venture capital can be a life-changing catalyst for some entrepreneurs and startups, but it’s not for everyone. Pursue venture capital because it’s the best path to grow your business, not because it can be a sexy headline. But, I digress; you’ve done your homework, you’ve thought long and hard, and now you want to start your raise. So let’s discuss.

3 Rules for Thinking About Your Needs

1) The most fundamental principle to understand when projecting your budgetary needs, and subsequently raising money, is the concept of milestone-based thinking/planning.

Milestones differ from a company’s general goals in that they are specific, tangible, value-creating inflection points. They are well-defined markers in a company’s history, such as a key hire, a beta launch, user metrics met, regulatory clearance achieved, or reaching first revenues.

Demonstrating the ability to map out and achieve meaningful milestones, on time and on budget, can serve as a powerful track record and help compensate for other perceived weaknesses (e.g., lack of previous startup experience for a first-timer). Inevitably, every startup has its rollercoaster moments, but being able to show consistent achievement trends and produce positive momentum is critical for fundraising success. It is an indication of an entrepreneur’s ability to plan and execute, and like it or not, 99% of investors that you’ll encounter believe, as Jeffrey Garten put it, that “A vision without execution is a hallucination.”

In relation to determining your budgetary needs, each time you achieve a specific milestone, regardless of how big or small, you turn guesses into facts by gaining knowledge and experience – some question marks behind your numbers begin to fade away, and slowly your estimates start to become actuals. Following this iterative learning process, the more the individual numbers reveal themselves, the clearer your entire needs picture becomes for the next phase of your business and the more de-risked the venture becomes for yourself and potential investors alike.

2) Anyone can plug in numbers – it’s all about the logic and assumptions behind them.

Related to the milestone and execution-related thinking above, a VC will inevitably poke around your financial model (among other things), asking questions and looking for holes. Essentially, what VCs are doing is taking an inventory of knowns versus unknowns; they’re assessing and weighing what risks have or have not been mitigated at that point in time.

Consider two widget companies (A and B), perfectly identical in every way except that A has recently hit the milestone of producing its first batch of products. A was able to produce its widgets for $X/unit, which is exactly the same as what B is projecting its cost to be; however, B won’t produce its first batch for another three days still. While this is a seemingly trivial difference, an investor will look at this and categorize A’s cost of goods sold (COGS) as a known, and B’s as an unknown; therefore, A’s projected needs are more predictable (that is, less risky) than B’s.

Obviously there will always be a certain number of unknowns and risks, especially with early-stage companies. When figuring out how much money you need, the key is to determine which question marks are material, and back up your best guesses for them with solid assumptions and reasoning. Every entrepreneur will have projections with some numbers plugged in to show the (in)famous hockey stick, because that’s what a VC wants to see and believe. However, a sophisticated investor will undoubtedly dig into any significant unknown variables, and it’s critical that you can support and defend the numbers you picked with clear-cut, grounded logic.

This practice of recognizing holes and defending key assumptions is an important exercise that you and your team should also go through internally – not only to better anticipate investor questions, but, more important, to better estimate your true and full funding needs. Besides, when dealing with investors, it’s best not to drop any major after-the-fact surprises on them – intentionally or unintentionally. When that happens, then the trust and the relationship tend to be pretty short-lived.

3) Plan for the Uncontrollable.

Notice I didn’t include “plain bad luck,” “freak occurrence,” or any other generally uncontrollable circumstances in the above. When determining how much money you need, be sure to build in buffer room for the unforeseen and unanticipated (reasonable, not excessive, buffer room).

Despite what is reported, investors are humans too – we know that even the best-laid plans can go awry, and we understand that sometimes things just happen.

Developing Your Ask Amount and Thinking About Why Versus What

As mentioned in the beginning, some investors have a clear and simple rule of thumb when it comes to the relationship between need and ask. For example, assuming they agree with your needs assessment, the basic thought process is this: calculate the company’s expected monthly burn rate, decide on a critical value-creation milestone in the next 12-18 months, and then ask for enough capital to create a runway for a short time past that point (both as a timeline buffer and also to sustain your company through the next fundraising period).

Sometimes it really is that straightforward, especially if you are pitching to a well-established, institutional firm with which you or your founding team already have a previous (and successful) history of working together. In this case, the parties know and trust each other; there’s an established relationship.

Usually, however, it’s a bit more complex than that. More elements end up coming into play, and it becomes much more of a give-and-take. As such, it’s important to understand what a few of the most common variables are, and why they can (and sometimes should) cause a divergence from the simple guideline above.

Ownership

From the entrepreneur’s perspective, with every equity investment there exists the fundamental tradeoff between raising enough money to reach the next critical milestone and minimizing dilution. VCs, on the other hand, need to be incentivized by a large enough ownership stake in a company to make it worth the level of risk and investment of their time, money and energy in the company. There is a natural tension at play that can lead an entrepreneur to request less than, and can lead a VC to insist on investing more than, what might otherwise be an optimal amount of capital for the raise.

Cash-Flow Management

Even for experienced entrepreneurs, fundraising almost always takes longer than expected, and startups almost always require more money to get off the ground than expected. Therefore, it is critical that a company manage its cash flow appropriately from an operational standpoint – and also pay close attention to cash flow from a personal standpoint. Sam Hogg lays out a great explanation for why a team’s and a founder’s personal cash-flow management is important to think about during the fundraising process as well.

Some investors will always want to provide extra capital for troubleshooting any unforeseen cash-flow issues. Yet, other investors, like Fred Wilson, prefer to see startups operate as lean and low cost as possible – so the companies move quickly and stay hungry. In general, the data does not overwhelmingly support one approach over the other, as there does not appear to be a direct correlation between amount of money raised and startup success. Nonetheless, each VC you pitch will surely have an opinion on the matter, and that in turn will impact your fundraising.

Supply and Demand

Finally, when developing your pitch and ask, it’s essential to do your homework thoroughly and know whom you’re dealing with. Every investor and firm has some sort of reputation. Do yourself a favor and use specific search criteria (profile, preferences, policies) to measure potential fit before meeting with investors. Read up on their investment theses, talk to their portfolio companies, follow their tweets; collect as much knowledge as possible and incorporate that information into your raise strategy. Once you determine the amount of money you need, your investor “intelligence” probably won’t change that number; but, the amount of money you decide to ask for may evolve daily depending on whom you are approaching and what the market environment is like at the time. The basic law of supply and demand will always come into play, so at any given moment, one side will usually have more negotiating power than the other.

At the end of the day, the simple “ask guideline” described above is just that…a simple guideline. Again, most of the time there will be a departure from this basic relational logic, and it can be caused by either one or both sides equally. When these departures do occur, they can lengthen and complicate an already long and difficult process, but it is by no means necessarily a bad thing. In my opinion, the best way to either leverage or counteract the variables noted above when they appear is to identify, understand and communicate the major “why’s” from each side that are the driving forces behind any tension points or disagreements. Ultimately, the “what’s” themselves are usually positions that are hard to move, but when you examine the “why’s” behind them, they usually prove to reveal good workarounds for resolutions.

About the Author

Matthew Bloom is an investment associate at Connecticut Innovations. You can contact him at matthew.bloom@ctinnovations.com.

In an earlier article, I wrote about how important having a “cash runway” is to a new company and that it is a favorite measure for lenders to use in gauging the ongoing financial health of a borrower. In fact, lenders may include a covenant, or contract term, related to a company’s cash runway in the credit agreement. Common covenants include ratios that a borrower must maintain, such as interest coverage, fixed charge coverage and debt service coverage ratios. All of these are referred to as “financial” covenants and are attempts for a lender to watch trends in a borrower’s financial condition and to predict, and hopefully ward off, potential repayment problems.

Financial covenants are at the crux of most credit agreements between borrower and lender. After the interest rate and payment terms, they are perhaps the most negotiated items of the agreement, and they allow lenders to monitor and grade borrowers after closing. Short of an actual payment default, a covenant default is likely the most serious issue a borrower will encounter with its lender post-closing. All borrowers must completely understand how the covenants are calculated and how they impact a lender’s thoughts and actions.

There will, doubtless, be “affirmative” and “negative” covenants in a credit agreement as well. These generally begin with the words “Borrower will…” and “Borrower will not…” and normally refer, respectively, to actions the borrower must or must not take. They don’t necessarily measure financial strength but require the borrower to do things, such as provide notification to the lender of certain events, remain in the same line of business, not to merge or sell assets without lender approval, and the like. While these are also very important, this article focuses just on financial covenants.

So, what happens in that unfortunate scenario when a borrower breaks a financial covenant? Well, let’s be clear about this. The borrower is in default of the loan in virtually the same way it would be if it did not make a payment. The lender has many rights, including some drastic ones, that it may or may not choose to exercise. Every credit agreement reserves those rights so that a lender can postpone taking immediate action without losing its rights to take action later. Examples of actions available include instituting a default rate of interest, accelerating payment (i.e., demanding payment in full) and notifying guarantors or subordinated lenders (if any) of the default. Again, a lender will have those rights, and many more, at its disposal. But, in reality, not all covenants are weighted equally in a lender’s mind. Every situation is unique. What a lender chooses to react to and how the lender responds are determined by many factors, not the least of which is how the borrower approaches the issue of covenant default.

Own the Issue – The Two Best Solutions

No matter the reason for the default, the best approach for a borrower is to “own” the default. You should explain how and what happened, but be careful not to cast blame. Lenders understand that “stuff happens,” but it is not helpful to point fingers.

Focus on the situation and the cure. Ideally, a borrower should be proactive and be able to anticipate the default ahead of time. A communication to your lender that starts, “We are forecasting that we may breach the ABC covenant at the end of this quarter…” is the best way to approach what might otherwise be an unpleasant situation. This approach indicates you are paying attention to the “deal” you struck with your banker and have the ability to foresee issues. This will also give you and your banker time to address the issue without a sense of urgency. A covenant violation should effectively spur a productive conversation between borrower and lender to discuss that something, however minor, is different than was anticipated when the deal was closed. Perhaps the covenant needs to be altered or can be waived altogether for the quarter.

Any verbal agreement, waiver or amendment addressing the covenant default should be documented. This might be a simple letter or email from your banker or a modification to the credit agreement. Keeping a paper trail is always best practice and may be required by your accountant or other interested stakeholders. Expect to pay some legal costs to amend the agreement or prepare a waiver. The lender will also likely charge a fee for the covenant breach. This may seem punitive, but it compensates the lender for its time and increased risk that was not originally contemplated in the deal.

The next best approach is to contact your lender immediately after realizing a covenant was broken. Borrowers are most likely to uncover covenant breaches while preparing their financial statements for the previous quarter. A phone call to your lender alerting it to the breach prior to sending in your financial statements should be your first priority. That call should include a thoughtful explanation and action plan, including new covenant compliance projections showing whether the default will continue or was a one-time occurrence.

Two Non-Solutions That Will Make Matters Worse…

There are two other scenarios that I have encountered regarding covenant defaults. Both are fraught with problems and are liable to cause serious, perhaps permanent, damage to a borrower/lender relationship.

The first is that the borrower is aware of the default but does not bring it to the attention of the lender, hoping that the banker either doesn’t notice or doesn’t care. Neither assumption is correct. If, or rather when, the banker discovers it on his or her own, you can expect a rather abrupt phone call or a very legal-sounding email! Remember those “lender rights” mentioned earlier? You can be sure your banker does. The borrower will be in a position of severe weakness and will have forfeited any benefit of the doubt in this scenario.

The second scenario is that the borrower isn’t aware of the default even after preparing its financial statements, despite the fact that a simple calculation or two would expose the issue.

These two scenarios are equally bad. The former shows a penchant to sweep an issue under the carpet (or worse, to mislead), and the latter shows a lack of attention to or understanding of your loan agreement.

My recommendation is to understand and address the issue, and propose solutions. Remember, being proactive is better than being reactive.

About the Author

Peter Hicks is a vice president and manages the Emerging Growth and Technology loan portfolio at Webster Bank. He works out of the bank’s New Haven and Hartford offices. You can contact him at PHicks@websterbank.com.