Trendsetter Inc. was formed by Wendy Borg and Jason Kushdog, the CEO and the COO respectively, in March 2000, to deliver innovative warehouse and distribution management software program for clothing retailers. The “founders” started the firm after quitting their respective jobs and decided to pool in their savings in the firm. The software produced by the firm would contain a demand forecasting module that would be capable of performing tasks for the fashion industry with the same impact that the spreadsheet had done for accounting. Initially the firm started out its operations with the savings of both the owners, but each of them knew that they would not last very long with limited capital at their disposal. The software would require a lot of money to develop and they also knew that they would need a partner in the development stage. At this point, they knew that they had to approach Venture Capitalists that would be willing to believe in the potential of their product and invest in their firm.
They had approached a few firms through high level contacts established in their previous jobs. After making as many as 7 presentations, they received 2 offers from the firms that they most wanted, Alpha Ventures and mega Funds. There was just one small hindrance though, neither of them had any experience in dealing and evaluating offers from venture Capitalist firms. Alpha, although interested, were skeptical of the firm’s ability to get a five star client like Waldo, on board at an early stage. As a result, they valued them lesser than other Venture Capitalists as they were not convinced of their ability to generate $500,000 in revenues in the first year of operations. One thing that both the owners of the firm knew was that even though the initial valuation of both the VCs was not very different, they would need to be careful in analyzing the term sheets so as to see which one of them was making a firm and better offer for the founders.
Alpha had given an initial valuation of the company as $7.35 million and they had agreed upon an initial investment of $5 million. They had priced the shares at $1.05. The post money valuation of the offer stood at $12.35 million. This makes a total of 7M shares of which 4M are common and 3M are option pool shares. They also had Escrow shares provision of 501,253 which are to be released if the Company has not achieved the fiscal year 2000 revenues of $500000. Without the escrow shares, they had prepared a term sheet which would see outstanding shares of 11761905 shares in the market. In the scenario of the escrow shares being released, it would amount to an increase in % share to the investors with an equal percentage decrease for the owners and these escrow shares for a further capital of 470195.35 as these would be priced at $0.95.
The offer term sheet from Mega worked a little differently as they valued Trendsetters a little lower than Alpha, at $4.5 million but were investing the same amount of $5 million into the firm. There was no concept of Escrow shares in the Mega offer, but there were 929889 shares in the form of previously granted options. They value their share price initially at $1 per share and hence the capital from the shares would be a firm lock of $5 million. The post money valuation of the firm according to Mega was $9.5 million. From a very layman point of view, it was very obvious for a start-up firm that there was a better investment from Alpha ventures as their Post money valuation would suggest. But, it was always better to go a little deeper into the term sheets of both companies to find out the better term offer in more than one aspect:
1. Give a detailed analysis of Alpha and Mega Term sheet offers with details on the following. Follow the guidelines given in class: a. Valuation (both pre-money and post-money) b. Capitalization c. Liquidation and Anti – Dilution
A merger, reorganization of the firm is a transaction in which the control of the company is transferred away from the founders and investors. A VC investor takes adequate precaution to protect its investment against such liquidation incidents. In the case of Alpha investors, in case of liquidation, they require the payment of the unpaid dividends per Share A preferred stock. This amounts to a value of $ 380,952.40. Apart from the unpaid dividends, the investor will participate prorate basis with the common shares until it has received three times its initial investment. Hence Alpha will receive an amount of the dividends $ 380,952.40 plus the prorate participation of $ 15,000,000. From the below table, we see that the VC will get pro-rata share of the liquidation until the value reaches three times initial investment, which is $ 15,000,000. Post this there is no indication from the VC as to whether they will acquire more worth from the firm.
With regards to Mega ventures, the liquidation process was defined thus. The merger or consolidation of the firm which involves transfer of control to another entity, or a sale or acquisition of 50% or more of the firm of the company assets in a single or series of related transactions will be termed as liquidation. Such a transaction will not be deemed liquidation if 70% of the Series A shareholders, elect not to consider such a transaction as liquidation. In case of liquidation, Mega investors required 1.25 times their initial investment, combined with pro-rata participation along with the common shareholders. Mega ventures also required the accumulated dividends till date which will form part of the returns for the investor.
Based on the table shown, there is an increasing amount of share withdrawn by the VC. This is a clear indication that with respect to liquidity, there is a strong indication that Mega investors will cause a larger reduction in the firm’s value after the fund withdrawal.
Alpha VC firm has a weighted average method of protection for its ownership in case of dilution of the firm. This protection is not exercised in case of issuance of 3,000,000 shares which are utilized for the purpose of employee distribution to directors and employees with the consent of the board as part of equity incentive plans. Mega has a more complex formulation for addressing the dilution effect. If the new issue price is between 50 %– 100%
of the initial price, weighted average method is used to calculate the stock ownership. This dilution adjustment is full ratcheted in case the issue price is less than 50% of the original issue price.
d. Corporate Governance and Voting Rights
The governance structures established by both the term sheets are quite identical. The requirement is for a 5 person board. One member is the CEO while two are Series A representatives. The other two are outsiders nominated by the founders and by the board respectively. In the case of releasing the escrow shares, Alpha has placed a restriction on the 5th member of the board which allows them to replace the outside member with their nomination. This was a clear message sent out to the founders of the firm that Alpha would tilt the control of the board and take control of the operations if the firm does not look like it will be in a position to meet the obligation of $500,000 in revenues in the year.
Another governance piece is the formation of the compensation committee. Alpha requires that this would be a 3 person committee with 2 representatives from the investor with one outside director. In such case as well, the founders do not have say over the compensation committee actions. Mega does not need define any such clauses and hence it is assumed that the founders are free to choose the committee.
Alpha seems to clearly indicate that they want more control over the governance of the company which directly ties into the risk mitigation policy that they have followed throughout the term sheet. Voting Rights:
The voting rights on the different term sheets focused on the management control of the firm. The Alpha term sheet had a simple voting rights term and it would purely be on an “as-converted” basis. The Mega funds term sheet focused a lot more on the management control aspect of the firm. The voting rights would be on an “if-converted” basis to vote along with the common shareholders. There were also provisions where there was protective provisions consent for majority holders of the series A preferred shares.
2. Compare the term sheets of the two firms highlighting the similarities and differences.
3. Which offer is preferable for the investor?
The Mega term offer is preferable to the investors as it looks like they will be more profitable through the sponsorship/investing in the company.
4. If you were one of the founders which offer would you accept without negotiation and why? We believe that both VC’s had more or less the same terms. However, it seems to us that Alpha Ventures are looking to improve the firm and stay in for the long run. Mega Ventures demand a 10% cumulative dividend, whereas Alpha ventures require just an 8% non- cumulative dividend. Mega Ventures require participating series A stocks whereas Alpha Ventures require non-participating series A preferred stocks. The impact of this is that, during an IPO the VC’s i.e. Mega Ventures will not only receive their $1.25 in preference to common stock holders but also share the profits on a pro rata basis with common stock holders in addition to the profits they make as series A preferred stock holders. It is clear that Mega Ventures is looking to make money out of this rather than standing by the idea of the firm. Another important difference is the escrow account for Alpha v/s the full ratchet adjustment for Mega Ventures.
During stock issuance, if the stock is sold for less than $5.00 per share and the issuance is less than $15 million, Alpha will exercise the Escrow account and as shown above increases their share by just 2.43% and decreases the owners share by 1.39%. This is not a huge difference and the owners are not affected much by this decrease in their ownership. Whereas, in the case of Mega Ventures, if the share issuance price is less than 50% in value of the series A preferred stock price a full ratchet adjustment will be implemented and the owners and the common stock holders will be heavily affected; for example: If the stock is issued at $0.5 then the due to the full ratchet clause, there will be a conversion ratio of 2. Let us assume that there is an investment of $3 million as part of series B financing.
Therefore, total capitalization is now $18 million and the number of shares that Mega will now have for conversion is 10 million shares ($5million/$0.5). This will cause tremendous dilution for the common stock holders and the owners. Alpha explicitly states that any kind of merger or re-organization where there is a transfer of control will force it to liquidate and cash out, whereas in the case of Mega they need the consent of 70% of series A preferred stock holders to approve its liquidation. However, as most of the series A preferred stock holders are from Mega ventures and, and looking at their other terms such as the ‘full-ratchet’ it can be deduced that they would cash out. But, Alpha does not like the transfer of control as it believes in the owners and states directly that it would liquidate if any such situation arises. Thus, Alpha is clearer on its terms.
However, one disadvantage with Alpha is that when it exercises its Escrow account it gets the right to choose the fifth member on the Board and this gives Alpha control over the firm that is undesirable for the owners.
5. If negotiating what terms would you attempt to alter? Please detail reasons in order of importance. There is always a fear of the worst case scenario when a person starts a firm. The first thing that we would negotiate with the investors is the returns on a down-sided valuation. In case of Alpha, removal of the Escrow clause is needed. In case of Mega, there should be a removal or renegotiation of the full ratchet clause. In Alpha’s case, there should be reconsideration with the extra board member that would be brought in by the investors in case the Escrow shares are exercised.
If this is allowed to stand, then it gives unprecedented control to the investors to take over the matters of the entire functioning of the firm. In case of the dividends, Alpha’s dividends clause is reasonable, but there is a higher dividends clause in case of Mega ventures. The compensation committee set up by Alpha is something that a founder would not prefer as it would lay too much power of the firm on the investors. The severance packages are undefined and should also be placed in the terms for Mega. Vesting plans are better with Alpha and hence unemployment vesting and accelerated vesting on IPO can also be included in the Mega term sheet.
6. How do things change if Trendsetter grows fast or if it grows slowly? For any VC, there is always going to be only one motive. To move in, help the firm grow and then cash in ASAP. It is a mutual benefit arrangement that is agreed upon by all parties involved. Now, if the firm grows too fast, then it facilitates a faster exit. In case of Alpha, it is better that the company grows faster because, if it does not, then more Series A preferred shares are granted to the investors, thereby diluting the position of the owners.
7. What are the consequences for IPO vs. merger for the founders in each offer? A merger of the firm will cause a liquidation of the company thereby lowering the worth of the firm the founder can expect for it. An IPO would be the ideal case since this will result in a substantial worth retained with the founder. An IPO with Alpha ventures will be the best case scenario since it will result in only a small pro-rata portion of the firm being taken up by the VC investors.
8. As an entrepreneur which of the two offers did you find easier to understand? The term sheet by Alpha is easiest to understand under numerous categories. Categories like the dividend policy, liquidation, anti-dilution, election of the board are described to the point in terms of Alpha ventures.
Courtney from Study Moose
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