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Cramdowns, Ratchets And Other Four-Letter Words
Dilution and the post-bubble term sheet

Now that the bubble has burst, valuations, funding rounds and business practices are getting back to normal.  Many companies got caught in the transition, however, and are suffering down rounds, cramdowns, full ratchets and other term sheet conditions they’d hoped never to see in the real world.  At this Morino Institute Netpreneur Coffee & DoughNets meeting held May 23, 2001, a panel of experts dipped into the glossary of investor speak to help entrepreneurs understand these terms and avoid trouble in the future.

Statements made at Netpreneur events and recorded here reflect solely the views of the speakers and have not been reviewed or researched for accuracy or truthfulness. These statements in no way reflect the opinions or beliefs of the Morino Institute, or any of their affiliates, agents, officers or directors. The archive pages are provided "as is" and your use is at your own risk.

Copyright 2002 Morino Institute. All rights reserved. Edited for length and clarity.

 Kevin Burns, Managing Principal, Lazard Technology Partners
Rusty Griffith, Director of Portfolio Management, Steve Walker & Associates
Andrew Rosen, EVP and General Counsel, Blackboard, Inc.
 Andrew Sherman; Senior Partner, McDermott, Will & Emery

ben martin: welcome

Good morning, I'm Ben Martin, Director of Investor Services for the Morino Institute’s Netpreneur program.  On behalf of the entire Netpreneur team and the Morino Institute, I would like to welcome you to this morning's Coffee & DoughNets session, "Cramdowns, Ratchets and Other Four-Letter Words."

          Don't worry, this isn't going to be nearly as difficult or as menacing as it may sound.  What we're seeing today is that even the most promising early-stage companies are finding it extremely difficult to secure venture funding.  In fact, I suspect that many of you are here today because you hope to reach the term sheet stage at some point during your company’s business development.  But what do you do when you get there?  What do you, the founder of a company, need to know when you sit down to negotiate a venture capital term sheet?  You can start by getting a good lawyer, but we'll give you some other things to consider as well.

          In the current climate of down rounds and company liquidations, the negotiated terms of venture funding deals are becoming increasingly more important to both investors and entrepreneurs.  It is critical that entrepreneurs understand these terms, because, if you don't, you may well pay for it later in terms of dilution.  When you leave today, you should have a solid understanding of the major deal points that you may face.  Our panel is here to help you understand those points.  We will cover such ominous sounding terms as conversion ratios, liquidation preference, anti-dilution provisions, warrant coverage, right of first refusal and, my personal favorite, drag-along rights, just to name a few.  And, of course, we'll cover the increasingly popular, aforementioned cramdowns and ratchets.  As for the four-letter words, our moderator, Mr. Andrew Sherman, has promised me that he'll fit as many of those in as he possibly can.

          For some additional information, let me recommend two resources in the Funding & Finance section of the Netpreneur Exchange Web site which we've been able to make available to you, thanks to our moderator and one of our panel members.  Anatomy of a Term Sheet: Venture Capital, An Overview of Trends, Strategies and Structural Issues has been provided by Andrew Sherman.  In addition to many other things, it includes a sample term sheet that you may find helpful.  In addition, An Entrepreneur's Guide to Raising Private Capital was developed by panel member Kevin Burns of Lazard Technology Partners in conjunction with Lighthouse Consulting and the Mid-Atlantic Venture Association.

          In addition to thanking our moderator and our panel members, we'd like to take a moment and thank our volunteers from the Netpreneur community who have given their time this morning.  We couldn't do it without them, and we'd like to recognize Sid Paskowitz of Internet Commerce City Corporation, George DeBakey of TradeCompass, Gabrielle Hervey from Linsang Partners and Jim Pettit of iroute, Inc.  Thank you very much for joining us today and helping out.

          This morning's panel will be moderated by Andrew Sherman.  He's a senior partner with McDermott, Will & Emery, an international law firm with over 925 lawyers worldwide.  Andrew manages their multimillion dollar corporate and transactional practice representing Fortune 1000 corporations, as well as technology-driven, net-centric and rapidly growing businesses.  He is an internationally-recognized authority on the legal and strategic aspects of entrepreneurship and the business growth cycle, and has been a commentator and guest on all of the major television networks, including CNBC's Power Lunch, CNN's Day Watch, CNNfn's For Entrepreneurs Only and Bloomberg's Small Business Weekly.  Among his many distinguished accomplishments, Andrew is an adjunct professor in the MBA programs at both the University of Maryland and Georgetown University.  He has also authored 11 books on business growth and capital formation, including the best selling and critically acclaimed Raising Capital.  I have a copy of it here.  Actually Andrew brought it, and we're not going to let him leave with it today.  Somebody in the audience will win it, the person who comes up with the best question.  Stay tuned for that.  We try to make these events fun.  Please give a warm welcome to Andrew Sherman.


andrew sherman: term sheets 101

I hope we still have enough time after Ben's wonderful intro.  I just want to say a couple of preliminary things before we get into the program.  First, I am so glad to be here at Dave & Buster's, without hearing the words, "Dad, can I have five more tokens, please?"  I didn't even know this side of the place existed.  To celebrate, I showed restraint by limiting myself to just six donuts this morning.

          Ben thanked the volunteers and others; I want to thank Mary, Fran, Ben, Cathlin, Mitch and the whole Netpreneur team.  If you haven't met these people, they are some of the most dedicated people to entrepreneurship in our region.  They accommodate you monthly with opportunities to get educated, to eat and to network, and I think that Mary and her team really deserve a quick round of applause.  And thanks to Mario Morino, of course.

          When I was preparing my preliminary comments, I was sitting at my Friday night poker game with John May of New Vantage Group and other local dignitaries.  John said, "Your comments should be short.  Just stand up there and say, 'There are no term sheets'  then sit back down.  That ought to cut the discussion down."

          I said, "John, that really wouldn't make for one of the great Netpreneur events of all time.”  Besides, the good news is that John's wrong.  The second piece of good news is that John lost about $30 Friday night.  He was willing to contribute his losses toward some lucky entrepreneur, but we'll save that for another time.

          There are term sheets out there.  They may not be the exact term sheets that you were hoping for.  As I think you'll hear from our panel, they may not be the terms that you were praying for.  Those rules have changed.  Our focus this morning will be mostly on what you might find in today's term sheet versus a term sheet from 18 or 24 months ago.  I don't think that is all of a bad thing, by the way.  It may not be a wonderful thing from the entrepreneur's perspective, but you'll hear some of the things you need to understand if you're getting to that stage.  A certain amount of reality has come back into the marketplace.


          Let me give you a couple of broad thoughts, then we'll get into some details.  I also want to save some of the high-altitude observations for the panel.

          First, you've all heard about valuations shrinking, this phenomenon of down rounds that we'll talk about further.  There has been more money provided to existing portfolio companies than ever before, additional rounds that are not quite at the levels that they may have been previously.  There is definitely a sentiment out there that we've got to look after what is already in our portfolios as opposed to bringing in new deal flow.  I think that a thaw has started to happen a little bit in the last 30 to 45 days, at least that is what we're seeing.  Clearly, the standards have risen in terms of customers, revenues, profits, the development of your technology and so on.  It was said to me recently that angels are acting more like VCs and VCs are acting more like investment bankers who are doing an IPO, in terms of their level of due diligence.  I added my own twist to this, that the investment bankers are acting like my grandmother, going down to Florida for an extended retirement.  We’re not sure when or if she's ever coming north again.

          So, are term sheets impossible to get?  No.  We've got several clients who are raising money, several who have raised capital locally as well as in other parts of the region.  I see one of them sitting there, Paul Brewer from Diamondback Vision.  The party is not over, but the bouncer just got bigger and he is more selective about who gets in the door.  In many ways, this is a return to reality, a return to fundamentals.  The new rules are really a return to the old rules.

          How do you get a term sheet?  What is the process?  What are you likely to see in that term sheet?  My role is to introduce the topic and turn it over to the speakers.  We want to spend as much time on Q&A as possible.  I suspect, just in talking to some of you over my fourth, fifth and sixth donuts, that there are some great stories out there in the audience, and that there are some people who are raising capital.  I think it's important in this program to get interactive, to hear what is on your minds and break any myths that might be out there.  Also, those of you who are in negotiations with venture investors, it’s important to share those stories with each other.

          Let me just cover some preliminary materials.  If you have a copy of the handout I prepared for today,  Anatomy of a Term Sheet: Venture Capital, An Overview of Trends, Strategies and Structural Issues, please take it out.  How many of you, by show of hands, have a sense of the venture capital process?  Okay, that's less than half of the hands, so let me give it to you very briefly.


          First, some introduction is made.  You have heard for years that you really don't want to be sending business plans blindly through regular mail or even through email.  I still think that is the case.  In fact, it is probably more the case than ever before.  You want to have your business plan introduced, whether it's by your lawyer, your accountant, some advisor or by another venture capitalist.  Getting access to some of the people on this panel is not easy, and it doesn't hurt when a business plan is introduced by somebody who knows them, has a relationship with them or somebody who can validate or give credibility to your plan.

          Next is the preliminary evaluation of the business plan.  Once submitted, it will be evaluated by any number of people, including folks like Rusty, who may be part of the evaluation team.

          Then, there might -- and I say might because sometimes the process ends there with someone saying, “Interesting plan, not our space” or “Interesting plan, too early” or “Interesting plan, too late” or “Interesting plan, actually not so interesting plan.”  You'll get all kinds of responses in that regard.  So, the next step might be an invitation to present, and that, in my view, is a very critical step in the process.  In the handout there are some materials on how to get ready for it.  It assumes that you are already at that stage in the discussions.  It didn't make sense to spend a lot of time on those preliminary issues now, however, like how to prepare a business plan, because:  (a) there are plenty of other Netpreneur events on that; and (b) our focus today assumes that you've gotten far enough in the process to have actually been presented with a term sheet.  A lot may be made or broken during that presentation, however, and almost everything will be evaluated -- how you present, things that you say, the attitude that you take, how you answer the tough questions, your attitude towards teamwork and listening to the advice of the venture investors.  We could spend a whole program just on getting ready for that meeting, and hopefully there are some good tips in the handout.

          At that level, due diligence has probably already begun.  There may be follow-on meetings and presentations that you need to make.  There may be a meeting with the other partners.  There is a lot more dance going on in this market than there used to be -- first date, second date -- I don't want to go too far on the dating analogy, but the point is that you're more likely to have to go through more of those hoops.  You'll hear more about that as the morning goes on.  In this market there is probably more due diligence and more meetings, but, at some point, a term sheet is delivered (hopefully), and that is the document we're focusing on today.  The venture capitalist is always going to have a term in there that qualifies the document, saying that if anything further comes out in due diligence they’ll have an opportunity to back out, or that if you don't mostly agree to all of the terms in the document they have the right to back out, but we'll assume that we're far enough along in the dating process and due diligence process that a term sheet has been delivered.

          At that point, there will be more due diligence.  In fact, in this market, there is even more due diligence after that.  And there will be the beginnings of term sheet “negotiations.”

          I put the word negotiations in quotes because the bulk of my time is spent on the company side, as opposed to the venture fund side.  There are some things in the term sheet that are definitely negotiable, and a lot of things that may not be.  There are things that you are unrealistic or naive to think are negotiable, things that are core or fundamental to the venture investing process.  You're wasting a lot of time, as well as the time of these panelists, to think that you're going to negotiate those provisions.

          From that point, the term sheet is signed and there will be more due diligence.  Then we're on to the definitive documents, which are prepared by the counsel for the fund.  They're delivered to your law firm, which hopefully has some experience in negotiating them.  Those definitive documents are negotiated and, eventually, there is a closing and everyone goes out and gets, well, really drunk for that one night.


          The next morning, the realization occurs that now we have to perform, and, in this market, you have to really perform.  Companies that are falling behind on their schedules or that are not meeting performance targets are going to need more capital, and the valuation that comes in is critical.  That’s one reason why the issue of relationship management and keeping your venture investors informed is so important.  How often will you be meeting?  Is it monthly?  What kinds of ongoing controls will there be?  The point I'm trying to make here is that on a post-closing basis, there is still a lot of work to be done, particularly if you're looking for a second term sheet or a second round.  Very few companies in this region, particularly in this market and with these valuations, got only one term sheet or one round of funding, and that is the last money they ever needed to raise.  It is highly unlikely for most of you in this room.  Possible, but highly unlikely.

          So that is the process in a nutshell.  If you could just give me a loose nodding of heads for yep, or you can shake your heads the other way and we'll keep going on the process.  We all want you to understand where this term sheet comes up, and it’s a fair bit of the way down the road following some of the early presentations and meetings and due diligence.

          Regarding the four-letter words that Ben promised, I was thinking this morning at about 5 a.m. that if I got in front of you early in the morning without sufficient levels of caffeine and started talking about technical legal terms, I'd lose all of you very quickly, so I'll bring them out in Q&A.  You’ll also see some of them explained in the sample term sheet included in the handout.  I'm hoping that Q&A and the presentations will bring most of them out, and I want to keep us on track time-wise.

          If you look at page three in the handout, there is some discussion about preparing for this meeting with the venture capitalists.  Again, the thing that I want to emphasize is that if you don't pay careful attention to some of these things, there will be no term sheet.  These are the precursors or preliminary steps to receiving the term sheet in the first place.  If you blow it during the initial meeting, you won't be getting a consolidation term sheet, or you'll be getting a note that says, “Thanks for the meeting.  Stay in touch.”  Or don't stay in touch, as the case may be.  You'll only get to the term sheet level if you go through some of these points.

          Look also at Page five, which covers concepts like a big market, a big upside and understanding what really motivates the venture capitalist’s decisions.  These are some of the things that will be reflected in the term sheet, not just esoteric philosophical points.  The things that come out in the meetings and in due diligence, the kinds of risks that the venture investor sees in his evaluation of the business plan, those are going to be reflected in the term sheet.  The sample term sheet in the handout is what I call “plain vanilla.”  I made it as vanilla as possible because it's not reflective of any special risk, concerns or performance standards.  If Rusty and Kevin have done their jobs, however, the issues that they uncover will be reflected in that term sheet.  It is a message telling you that they think enough of you to make this commitment, but they still have concerns.  Those concerns may come out in financial valuation, or they may come out in special conditions, but they're going to come out in the term sheet; then you are either going to agree or disagree with those special issues.  These steps are reflective of the substance of the term sheet.

          When it comes to negotiating a structure in the deal, I've laid out a list of concerns in the handout that attempt to strike a balance, but the balance is going to be struck in favor of the venture capitalist.  They have the dollars and you want them, so don't expect it to be a perfect balance.  Also, don't expect it to be completely unweighted.  Even in this marketplace, for the better companies, there is not an expectation that you're going to have to completely lay down and get nothing or that your valuation is going to be way, way lower than you expected.  I would still hold your ground, but not to the point of stupidity or machismo, particularly in a market like this.

          Now, I'd like to turn it over to our first speaker, Kevin Burns, who is going to get into the purpose of a term sheet and some related issues.


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