Term Sheet

The Keiretsu Forum Northwest & Rockies Roadshow offers investors the opportunity to hear a selection of presentations from top emerging startups across multiple industries, as well as the latest news from past presenter companies. The topic for March was Term Sheets & Cap Tables and we brought together thought leaders like Mike Volker, Rob Tucci, Karen Howlett, and Mark Girouard to deliver keynote speeches at the virtual event. We try to provide investors with best practices using their knowledge and expertise on the subject. 

Joining us for our first forum meeting in Vancouver was Mike Volker, CEO of WUTIF (Western University Technology Innovation Fund), an entrepreneurial angel fund, and president of the Vancouver Angel Network, VANTEC, and Keiretsu Forum Vancouver Chapter. In his keynote, he offered his insights on how investors can protect their investments. We walk you through the key takeaways of his presentation, especially common challenges investors face and suggestions on how to mitigate them.

WHAT CONSTITUTES A TERM SHEET?

According to Mike, whether it's a pre-seed, late-stage, or a Series-A round, the key components of a Term Sheet are securities, valuation (pre-or post-stage), Shareholder Agreement(s) (SHAG), amount, board & governance, legal compliance, rights, restrictions, vesting and CAP tables. Each Term Sheet must include a fully diluted CAP table with options. In the past, when it came to issuing securities, the preferred choice of shares was common shares, but more recently, especially in the U.S., there has been a shift to other classes of Preferred Shares. Other forms of securities offered also include SAFEs, debt instruments such as notes and debentures, and other than Common Shares; all of these instruments are convertible into Common Shares. This is an important factor when planning an exit.

THE DECLINING SECURITY OF SAFEs

Background

SAFE stands for "Simple Agreement for Future Equity" and was created and issued as a simple replacement for convertible bonds. In practice, SAFEs allow startups and investors to achieve the same overarching goals as convertible bonds, although SAFEs are not debt instruments.

The Challenge for Investors

SAFEs offer little benefit to investors, they offer no ownership, no rights, and are fraught with a lot of uncertainty.

Entrepreneurs, on the other hand, benefit from SAFEs because they avoid the valuation question, act as money savers because they don't have to issue many special classes of shares, and can defer legal fees. There are some precautions in using SAFEs, and the SEC and FINRA caution investors against using SAFEs. 

Proposed Solution

Safety: Simple Agreement for Future Equity with Shares Today. This is a simple arrangement for future equity, done by issuing shares.

• Instead of a SAFE, issue common shares priced at valuation CAP
• Include a term (in a subscription agreement) to allow conversion to a new class

Result

Using this method, when Common Shares are issued, they include provisions in your standard subscription agreement that allows the conversion of what the investor buys and saves the Common Shares to convert those into the new class of shares. This provides investors with safety in the form of common or preferred shares and they enjoy all the rights and securities as shareholders. 

WHY SHOULD AN INVESTOR CHOOSE LIQUIDATION PREFERENCE?

Through his keynote, Mike continues to highlight the importance of Liquidation Preference over common or preferred shares. He states that it plays an important role during the time of exit as investors get their capital back and then participate in the remaining cash balance on an as-if-converted basis. This helps reduce high valuations by increasing the IRR potential. In the event of an exit, investors who have a liquidation preference get their invested capital back and the rest is distributed to the remaining investors. Mike provides us with real-world examples of WUTIF investing in 3 different companies, all with different outcomes. The purpose of these examples is to give investors an idea of ​​when Liquidity Preference may or may not be a good strategy.

EXAMPLES:

Case 1: In 2014, a Media Company was looking to raise $500K with a post-money valuation of $3.25M. WUTIF purchased $75K in Common Shares and negotiated a 1X Participating Liquidation Preference on Common Shares. This right was covered in the Shareholders Agreement (SHAG) and approved by all Shareholders. In 2017, the company was sold for only $1.12M, and after repaying all the company debts $110K was available to distribute amongst the Investors. WUTIF received $8K in proceeds due to liquidation preference. WUTIF had also invested $10K in debt instruments which gave them a pay-out of $21K. In an alternative scenario, if WUTIF had invested their initial amount of $75K in debt instruments instead of equity, they would have received a payout of $41K.

Lessons Learned: A liquidation preference offers recovery when the company does not achieve projected profits; it is a better option than investing more in equity or purchasing preferred shares. It's also better to invest in debt instruments, especially when the company's financial outlook doesn't look promising.

Case 2: In 2012, an Agtech Company did a seed round with a pre-money valuation of $1.2M and it raised $300K via Common Shares. Since the company was having difficulty in raising funds, WUTIF negotiated a 1X Participating Liquidation Preference to attract investors and thus $300K. From 2013 to 2017, the company raised $11M in 6 seed rounds. They also exercised warrants during these seed rounds by lowering the price of the warrants originally offered to attract investors who could exercise them before their expiration date. On exit, the company was sold for $26M, which was a 17X return based on the original valuation of $1.2M. However, the share price only saw a 2X return. The investors only got a 2X return on investment. WUTIF received $282K on their investment of $150K by way of regular payout. Their special right for Liquidation Preference was not honored by the company. WUTIF filed a lawsuit against the company and won, after which their right to Liquidation Preference was honored and they received a payout of $432K.

Lessons Learned: As an investor, be careful when including special clauses in shareholder agreements, they are only agreements that can be easily broken. The only way to enforce a shareholder agreement is through litigation. In this case, having preferred shares would be better than adding special clauses.

Case 3: In 2020, an AI company did a seed round for $1M with a pre-money valuation of US $10M and was offering Class Seed Preferred Shares.  WUTIF negotiated a 1X Participating Liquidation Preference with the expectation of a 10X exit in 5 to 10 years. The company exited 10 months later with an exit value of a little more than US $25M. WUTIF received US $330K on their investment of US $100K by way of Liquidation Preference.

Lessons Learned: In this case, with a large payout, the cost to shareholders is minimal. Participating LPs moderated the high valuations and the company was able to raise the necessary capital. A 2x return in 1 year is better than a 10x return in 5 years.

INVESTOR TO-DO LIST

Mike states that you must always put your interests first. Keep this in mind the next time you invest, negotiate a term sheet, or plan an exit. Instead of chasing 10x returns all the time, investors should start thinking more about IRR than multiples. As an investor, it's time to become vary of SAFEs, or even better avoid them altogether. The easiest way to mitigate high valuations is to opt for liquidation preferences, warrants, and sweeteners. Last but not least, please be aware of legal documents, they are not binding and do not guarantee the expected results.

ABOUT THE SPEAKER

Michael ‘Mike’ Volker is an Entrepreneur active in the development of new high technology ventures. A University of Waterloo Engineering grad, Mike started his own company (Volker-Craig Ltd) in 1973. After selling his company in 1981 he decided to work with entrepreneurs in building new companies. Recently he directed Simon Fraser University's Innovation Office. Presently, he is chairman of TIMIA Capital, [TCA.V] a public company that invests in young growth companies. He is CEO of WUTIF - the Western Universities Technology Innovation Fund - an "angel" fund for startups. Mike is President of the Vancouver Angel Network, VANTEC, and the Vancouver chapter of Keiretsu Forum. He's chairman of New Ventures BC - an annual business competition. Mike was chairman of the Vancouver Enterprise Forum for several years. Click here to watch his keynote address.  

In the Keiretsu Forum Northwest & Rockies March 2022 Roadshow, we invited thought leaders from the angel investment world to share their expertise at the event. Angel investor, business owner, and Joylux CFO Karen Howlett joined our forum sessions in Bellevue and Salt Lake City/Boise. In her keynote, she dives into the core components that make up Term Sheets and CAP Tables to help you, the investor, make informed decisions and better manage your deals.

CAP TABLES VALUATION 

Karen emphasized that the most important considerations as an investor in CAP tables are the company valuation, stock price, and fully diluted stock. According to her, different people have different meanings for the concept of fully diluted stock. It is important to know whether it includes all stock options or only stock options that have been granted or exercised. She explained that it's good to thoroughly evaluate and understand what's on the CAP table.

Why do you need to know your fellow investors?

It's imperative to know who the company's investors are, how many of them are outside investors, and how much early-stage investment is from the founder's family and friends. Also, what are you investing in? Common stock, preferred stock, notes, equity, or stock option plans and evaluate these factors before investing.

Why does a Founder/CEO stock matter? 

When it comes to a founder's stock, it's important to know how much he or she owns, which is enough to keep them committed to making the company successful. What is their motivation for staying? Have they invested? Are they getting a salary? Her advice is to understand their motives.

Another strong consideration she puts forth is - What happens to the founder’s equity if the founder leaves? If it is not subject to vesting or repurchase, it will have a substantial impact on the employee stock option. In addition, having to replace the founder can have a big impact on employees' stock options. Lastly, who owns the company IP? Is it the founder, the company or a university? These are a few questions an investor should get answered before investing.

Employee Stock Option Plan

When Karen first started investing, she didn't know much about employee stock options. When she started, she put 10% to 20% into the employee stock option plan. Over the next few years, as she spent more time investing, she realized that it was essential to know what stage the company was in, how much of the capital pool was allocated, how many new employees could be hired, and how many were in the pipeline, such as consultants and advisors. It's necessary to understand where you stand in terms of employee stock options, as adding them can significantly dilute your investment. Here’s an example of how investors lose share value from the employee stock option.

Example: The authorized shares of a company are worth $1 million, and as an investor, you own $250,000 worth of shares or 25% of the whole pool. If the company decides to increase the pool size by 20%, your percentage of ownership will drop below 21% of the company. With no new money coming in, you have no choice besides stock options.

A company has $1M Authorized Shares
Investor buys $250K = 25% shares
The company increases the employee stock option pool to 20%
Investor share value declines to less than 21%

The key learning here is that investors get diluted as there are additions in the pool.

WHAT CONSTITUTES A TERM SHEET? 

Karen stressed that all types of investments should have Term Sheets: equity, convertible, and SAFE notes. The Term Sheet is not a legal document and is non-binding, but it sets out the most basic terms of investment, so investors should pay attention to the content of the document.

SO WHAT’S A CONVERTIBLE NOTE? 

Most convertible notes automatically convert when qualified financing is available. The financing must be higher than what they are raising now. Example: If you raise $2 million, ideally you need to convert the note to a higher amount. As an investor, you also need to know what price to convert at, the discount on the next equity round, or the discount off the next valuation cap. If the company is sold or there is a change of control, how does it affect conversion? What matters is that you have the opportunity to convert it yourself rather than getting paid off. Karen recalled that in some cases, companies were simply trying to pay off investors, rather than turning them into common stockholders, which could generate returns of up to three times as much. She believes the choice of conversion should not be a decision of the company, and you as an investor should not be forced to accept the majority in this situation, so always be aware of this fact when renewing convertible notes.

Is the maturity date of the convertible note, prepayable only with the consent of the note holder, or can companies choose to do so? Most people in the Northwest hate stocks and avoid SAFEs and convertible notes because traditional convertible notes have no valuation cap or maturity provisions. Other factors to consider include interest rates, length of the note, securities conversion, and the type of entity you wish to invest in. All of these are things to consider when reading your Term Sheet and making an investment.

TO-DOS 

For the Investor:

• Like the company you are investing in
• Invest in the team
• Trust the entrepreneur
• Plan to invest in future rounds

For the Entrepreneur:

• Be coachable and be open to feedback
• Have a clear value proposition
• Have the right background & skills appropriate for this stage
• Products/solutions that are exciting/disruptive
• Sizeable market – is it worth the effort?

KEY TAKEAWAYS 

According to Karen, the Term Sheet has a lot to offer, and don't miss a great opportunity when you're focused on the nitty-gritty of the documentation. She states that there was no perfect Term Sheet or prepared proposal document. One insight she offers is that entrepreneurs' responses to questions or feedback can be very revealing about how they run their business and how they feel about it. In their experience, they don't read documentation most of the time, but what matters is whether they have the expertise and are open to feedback. She continues to emphasize the importance of the Keiretsu Forum Term Sheet committee’s feedback on each deal. The Term Sheet committee consists of fellow experienced and accredited members that review each deal and provide their feedback in the Due Diligence report. If there is no feedback; you should request that feedback as it will give you the structure and guidance you need. Finally, if you don't understand something, ask questions and use the resources around you to maximize your knowledge.

ABOUT THE SPEAKER

Karen Howlett is an entrepreneur, angel investor, and CFO of Joylux Inc. She has worked for Corporate America at Ford Motor Company for over 20 years. She has been a small business owner for 12 years in the steel and construction industry. She joined Keiretsu Forum as an angel investor in 2018 and became the CFO of Joylux in 2020. As a small business owner and large international corporation, she has a solid reputation for delivering results. She is a Six Sigma Greenbelt with excellent leadership and mentoring strengths. She has proven capabilities to succeed in multiple industries and has the expertise in developing business, strategic and tactical planning, and building relationships. Click here to watch her keynote address.