Two aspiring entrepreneurs have just been offered by two venture capital firms term sheets which are documents for venture funding. Having no experience yet with raising capital, these two entrepreneurs face the problem of comparing the proposals and how to decide which one to go ahead with. Though the term sheets are similar in structure, they differ in more significant ways as both have their advantages and disadvantages. Thus, the entrepreneurs must carefully analyze the term sheets in relation to the assumed growth of Trendsetter, Inc.
Walter Kuemmerle; William J. Coughlin
Harvard Business Review (801358-PDF-ENG)
January 25, 2001
Case questions answered:
- What are the main differences between the two venture capital firms term sheets?
- If you were an entrepreneur and could not negotiate any of the terms in either term sheet which one would you prefer and why?
- How would you seek to alter the terms in each term sheet during negotiations with each venture capitalist? Which terms would you seek to alter first?
- Does it make a difference to your answers whether you expect Trendsetter.com to grow fast or grow slowly?
- Does it make a difference to your wealth whether you expect to realize on Trendsetter.com through an IPO or merger?
- If you were an aspiring venture capitalist looking for a “blueprint” term sheet to use at your firm, which one of the two venture capital firms term sheets would you use? Why?
- What aspects other than TS would you take into consideration when choosing among potential venture capital investors?
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Case answers for Term Sheet Negotiations for Trendsetter, Inc.
This case solution includes an Excel file with calculations.
Question 1: What are the main differences between the two venture capital firms term sheets?
The two venture capital firms term sheets (TS) firstly vary to a great extent regarding their dividend provisions: Mega’s term sheet involves cumulative accruing dividends for preferred shares that are not only payable when declared by the board of directors of Trendsetter Inc., but also in the event of a liquidation. Also, under Mega’s TS, in order for a dividend to be paid to common shareholders, consent of 60% of preferred shareholders is required.
In contrast, Alpha Investment’s (AI) term sheet does not include accrued, cumulative dividends, which do not require the above consent and are in turn only payable when declared by the board of directors and not in liquidation.
Furthermore, in the event of a liquidation, Mega’s term sheet requires Trendsetter Inc. to pay all preferred shareholders the amount of 125% of the initial issuance price ($1.25 at an initial issuance price of $1) plus declared, but unpaid dividends, while under AI’s TS, only the dividends have to be paid to the investor.
In addition, AI’s term sheet is more sensitive towards a sales target on Trendsetter’s side (namely $500,000 in sales in year one). This sensitivity results in two cases: in case the sales target is met, Trendsetter will give up 40%. If this target is however not met, AI will receive 43% (please see Appendix I).
In contrast, in Mega’s term sheet, a fixed 42% is given up by Trendsetter. The two TSs also differ regarding their automatic conversion policies in an IPO: while for AI the share price only has to be $5 (or alternatively an overall amount of $15m has to be raised), Mega’s TS requires the share price to be at least $20 and the overall amount to be at least $25m.
Question 2: If you were an entrepreneur and could not negotiate any of the terms in either TS, which one would you prefer and why?
From an entrepreneur’s perspective, AI’s TS is more favorable as it entails neither the high premium payment of 125% of the initial issuance price to all preferred shareholders nor the cumulative, accrued dividends, which both represent a high financial burden for Trendsetter. Moreover, AI’s TS involves a lower share price and overall amount raised in an IPO compared to Mega’s offer. Also, many terms in AI’s offer are more clearly defined than the corresponding ones in Mega’s term sheet, which in these respective sections leaves significant room for interpretation.
Examples of these include the actions under which voting rights apply, the majority % required under these voting rights, and the right of first refusal. Also, the fact that AI’s information rights only apply in case the number of preferred shareholders is at least 250,000, while under Mega’s TS they apply as long as some preferred shareholders exist, leads to lower costs for Trendsetter Inc. under AI’s offer.
Question 3: How would you seek to alter the terms in each TS during negotiations with each venture capitalist? Which terms would you seek to alter first?
Regarding AI’s term sheet, it is advisable to renegotiate the sales target of $500,000 in the first year of operations, as it poses significant pressure for the firm and add uncertainty to the founders regarding the size of the share of their company that they will have to give up.
Moreover, one should try to renegotiate the right of first refusal allowing the preferred shareholders the first right to any common shares that are for sale, which hence dangerously…