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Gygax EF-08 Semester 1, 2024
Entrepreneurial Finance
Lecture 8
Term Sheets
André Gygax
Bibliography:
Da Rin & Hellmann (2020) Chapter 6
I acknowledge the Traditional Owners of the land on which I work, and pay my respects to the Elders,
past and present.
Copyright © 2024 University of Melbourne
To order copies or request permission to reproduce materials write the University of Melbourne, Parkville, 3010 Victoria, Australia, or
go to https://www.unimelb.edu.au. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet,
or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the prior written
permission of the University of Melbourne.
Gygax EF-08 Semester 1, 2024
Course Outline 2
Week Date Topic Required
Reading
DRH (2020)
Further
Reading
S&S (2003)
1 February 28 Introduction to Entrepreneurial Finance 1,10,13
2 March 6 Evaluating Venture Opportunities 2
3 March 13 The Financial Plan 3
4 March 20 Ownership and Returns 4
5 March 27 New Venture Valuation Methods 5
March 29 –
April 7
Easter Non-teaching period / Mid-
Semester Break
6 April 10 Entrepreneur versus Investor’s Perspective 5 11
7 April 17 Venture Capital 12
8 April 24 Term Sheets 6
9 May 1 Structuring Deals 7
10 May 8 Corporate Governance 8
11 May 15 Staged Financing 9
12 May 22 Exit 11
Gygax EF-08 Semester 1, 2024
New Venture Life Cycle 3
The Financial
Plan &
Ownership and
Returns
Venture
Capital, Term
Sheets & Deal
Structure
New Venture
Valuation
Methods &
Perspectives
Exit
Corporate
Governance &
Staged
Financing
Evaluating
Venture
Opportunities
1
2
4
3
5
6
Gygax EF-08 Semester 1, 2024
Agenda
n Last week we discussed the fundamental role of venture capital in
financial markets, and we looked at how an entrepreneur and a
well-diversified investor could jointly finance a new venture.
n In this lecture
q We will learn what term sheets are.
q We will consider cash flow rights of investors.
q We will look at compensation.
q We will discuss other terms.
4
Gygax EF-08 Semester 1, 2024
Practice
Question
Critically discuss the following statement:
“Milestones form an integral part of term sheets
that are beneficial for all parties involved, and in
particular for the entrepreneurial venture.”
Gygax EF-08 Semester 1, 2024
Term Sheet
n Definition: The term sheet is a funding offer from the VC firm to
the entrepreneur.
n Term sheets is a preliminary agreement drafted by the investor. It
consists of some of the terms that may be included in a finalized
contract. It lays out the proposed right and obligations of each
party, namely the entrepreneur and the investor.
n The initial term sheet is an offer subject to negotiation for the final
legal documents:
q Corporate charter
q Investor rights agreement & purchase agreement
q Founder employment agreements
6
Gygax EF-08 Semester 1, 2024
Term Sheets: Principles
n Term sheets play several different
roles:
q govern the potential rights,
obligations, rewards of the parties
q shape the incentives for all parties
(incl. employees)
q bring the parties to clarify their
expectations
q allocate risk across the two parties
q specify the rights and duties of the
parties towards external parties
(employees, future investors)
7
n Term sheets govern several areas:
q Cash flow rights
q Control rights
q Compensation and employment
for founders and key employees
q Other rights
Ø Anti-dilution
Ø Future fundraising
Ø Liquidity
q Entrepreneur should rely on
experienced lawyers for help on
interpreting a proposed term
sheet.
Gygax EF-08 Semester 1, 2024
Contingent Contracting
n Term sheets are preliminary
agreements.
q They are “incomplete” and do not
set out all the terms included in
the final contract.
q They address highly uncertain
prospects.
q It is not possible to account for all
future states in a contract.
q This is expressed as final contracts
being ‘incomplete’.
q It is addressed through
‘contingent contracting’, where
clauses apply to certain situations
only.
8
n Term sheets define
contingencies through
‘milestones’ which identify
salient events that reveal
information on whether the
company’s progress conforms
or not to expectations.
q “The board of directors consists
of five members. The investor
nominates two. If the company
fails to generate sales within 12
months from the closing, the
investor nominates two
additional directors.”
Gygax EF-08 Semester 1, 2024
Term Sheets: Milestones
n Milestones measure
performance in different
dimensions:
q financial (e.g., sales, EBIT,
operating CF, financial ratio)
q operational (e.g., regulatory
approval, supply contract)
q managerial (e.g., hiring of
CxO, independent director)
q technical (e.g., working
prototype, license
acquisition)
9
n Milestones have important economic
roles:
q define performance targets
q align expectations of entrepreneurs
and investors
q provide a focal point for renegotiation
q facilitate negotiation about valuation,
by linking it to performance targets
n Future financing depends on meeting
milestones (i.e., through staged
financing)
q The ability to set meaningful
milestones is an important skill of a
good investor
Gygax EF-08 Semester 1, 2024
But …
n Milestones also have drawbacks:
q defining performance may be elusive (when is a
prototype really working?)
q pursing milestones may lead to under-pivoting, e.g., to
bring a product quickly to market
q pursuing milestones may lead to short-termism, e.g., to
achieve a sales and/or production target
10
Gygax EF-08 Semester 1, 2024
Nobel Insights: Incomplete Contracts
n Oliver Hart (Nobel, 2016):
q Why are contracts incomplete?
q How do contracts deal with unforeseen contingencies?
n He distinguishes between:
q clauses that deal with verifiable actions (need a milestone)
q clauses that allocate decision rights (only need to identify
who has a right to decide)
11
Image Source:
Oliver Hart in
2016, Wikipedia
2021
Gygax EF-08 Semester 1, 2024
Nobel Insights: Incomplete Contracts (continued)
n The former type relies on the
existence of precise
circumstances that disclose
information.
n The latter type deals with case
where this is not possible, as
often in ventures, where
information is opaque and
difficult to interpret.
Ø This explains why it is optimal to
make control over the company
contingent on performance.
12
n Hart’s second contribution is to
understand renegotiation:
q Contracts are dynamic and
respond to changes in
external/internal conditions.
q It also explains how
renegotiation is affected by
initial contract rules:
Ø Series A rounds provide a
reference point from which
contracting can later deviate
Gygax EF-08 Semester 1, 2024
Term Sheets: Which Series?
n Term Sheets come in Series (A, B, …F…).
n Series A sets the terms for future rounds, so it is most salient.
n Each series has a (partially) different set of investors.
n Each series votes as such, by majority.
13
Gygax EF-08 Semester 1, 2024
Term Sheets: Cash Flow Rights
n Term Sheets allocate cash flow
(CF) rights to entrepreneur and
investors to maximize expected
venture value.
n This is done in two ways:
n By giving investors ‘downside’
protection
n By aligning incentives: provide
both parties with strong
incentives to work for high
performance (incentive
alignment)
14
n Investors obtain ‘convertible’
preferred stock instead of
common stock.
n Convertible gives its holder the
right to choose between:
q A debt-like payoff in case of
failure (‘downside protection’)
q Conversion into common equity
if the company succeeds (profit-
sharing in the upside)
Gygax EF-08 Semester 1, 2024
Why Preferred Securities?
n There are three main rationales for using preferred
stock:
q Provide incentives to founders (need for balance)
q Screen out weaker projects
q Align investor and entrepreneur’s expectations
15
Gygax EF-08 Semester 1, 2024
Preferred Terms
n Convertible is always preferred:
q It obtains yearly preferred terms (‘dividend’ – deferred, accruing
or cumulative).
PT = I + DIV = I + I*D*T
q D = stated yield,
q T = time-to-exit
§ When dividends are compounded: PT = I + I*(D)T
q where PT = Preferred Terms; and I = Investment Amount
16
Gygax EF-08 Semester 1, 2024
Convertible Preferred
n Convertible holders will convert it into common stock
(at exit) when their cash flow from common exceeds
the preferred terms (PT):
FINV*X > PT, which defines: CT = PT/FINV
where
FINV = Ownership fraction of new investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
17
Gygax EF-08 Semester 1, 2024
Convertible Preferred (continued) 18
Exit Value Condition
Cash Flows to
Investors
(CFINF)
Cash Flows to
Entrepreneurs
(CFEN)
Large X > CT FINV*X (1 – FINV)*X
Intermediate PT < X < CT PT X – PT
Small X < PT X 0
FINV = Ownership fraction of new
investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ line (X=X)Cash flow to the
investor (CFINV)
X=PT X=CT
Exit value (X)
Cash flow to the entrepreneur
Cash flow to the investor
19Convertible Preferred (continued)
FINV = Ownership fraction of new investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Preferred terms (PT)
45˚ line (X=X)Cash flow to the
entrepreneur
(CFEN)
X=PT X=CT
Exit value (X)
20Convertible Preferred (continued)
Cash flow to the entrepreneur
Cash flow to the investor
FINV = Ownership fraction of new investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Multiple Liquidation Preferences
n Convertible preferred stock may add a (multiple)
liquidation preference to the preferred dividend, so
that the investor gets its capital back several times:
PT = M*I + DIV
CTM = PT/FINV = (M*I + DIV)/FINV > CT
21
where M = Multiple Liquidation Factor
Note: Investors can get their investment back multiple times. Typical factors range
from 1.5 to 3 and vary depending on market circumstances.
A survey of Silicon Valley investments estimates that 11% of deals involve multiple
liquidation preference: 20% of those are above 2x, where x indicates the invested
amount, and the remainder are between 1x and 2x.
Gygax EF-08 Semester 1, 2024
22Multiple Liquidation Preferences (continued)
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ line
Cash flow to the
investor (CFINV)
X=PT X=CT Exit value (X)
Cash flow to the entrepreneur
Cash flow to the investor
PT with multiple liquidation preference (PTM)
X=PTM
X=CTM
PTM = Preferred Terms Multiple Liquidation Factor
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
23Multiple Liquidation Preferences (continued)
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ lineCash flow to the
entrepreneur (CFEN)
X=PT X=CT Exit value (X)
Cash flow to the investor
Cash flow to the entrepreneur
PT with multiple liquidation preference (PTM)
X=PTM
X=CTM
PTM = Preferred Terms Multiple Liquidation Factor
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Participating Preferred
n Participating preferred terms combine debt and equity
features by adding a (multiple) liquidation preference
to the preferred dividend (‘double dip’).
n The investor gets the PT and at exit also shares into
common equity.
n If the company exit value is X, this implies:
CFINV = PT + (X-PT)*FINV
24
Gygax EF-08 Semester 1, 2024
Participating Preferred (continued) 25
Exit Value Condition Cash Flows to Investors (CFINF)
Cash Flows to
Entrepreneurs
(CFEN)
Large X > PT PT + FINV*(X–PT) (1 - FINV)*(X–PT)
Small X < PT X 0
Gygax EF-08 Semester 1, 2024
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ line (X=X)Cash flow to the
investor (CFINV)
X=PT X=CT
Exit value (X)
Cash flow to the entrepreneur
Cash flow to the investor
26Participating Preferred (continued)
Gygax EF-08 Semester 1, 2024
Preferred terms
(PT)
45˚ line (X=X)Cash flow to the
entrepreneur (CFEN)
X=PT X=CT
Exit value (X)
27Participating Preferred (continued)
Cash flow to the entrepreneur
Cash flow to the investor
Gygax EF-08 Semester 1, 2024
Participating Preferred with Cap
n A cap may be imposed on the participation in order to
preserve incentives for the entrepreneur:
q Participation vanishes if X > XCAP
q This implies: CFINV = PT + (X-PT)*FINV
n Full conversion threshold is XCOM:
XCOM = XCAP + PT (1 – FINV)/FINV
n The drop in the cap is usually smoothed out to avoid providing
perverse incentives at the time of exit.
28
Gygax EF-08 Semester 1, 2024
Participating Preferred with Cap (continued) 29
Exit Value Condition Cash Flows to Investors (CFINF)
Cash Flows to Entrepreneurs
(CFEN)
Far Above Cap XCOM < X FINV*X (1 – FINV)*X
Just Above Cap XCAP < X < XCOM PT + FINV*(XCAP – PT) X – FINV * XCAP – (1–FINV)*PT
Below Cap PT < X < XCAP PT + FINV * (X – PT) (1 – FINV)*(X – PT)
Small X < PT X 0
Gygax EF-08 Semester 1, 2024
Preferred terms
(PT)
Converted Equity (FINV*X)
45˚ line (X=X)Cash flow to the
investor (CFINV)
X=P
T
X=CT
Cash flow to the entrepreneur
Cash flow to the investor
Exit value (X)
X=XCAP
30Participating Preferred with Cap (continued)
Gygax EF-08 Semester 1, 2024
Preferred terms
(PT)
Investor Equity (FINV*X)
45˚ line
Cash flow to the
investor (CFINV)
X=PT X=CT
Cash flow to the entrepreneur
Cash flow to the investor
Exit value (X)X=XCAP X=XCOM
31Participating Preferred with Cap (continued)
Gygax EF-08 Semester 1, 2024
Compensation and Employment
n Upon funding, founders
become employees.
n Main implications of founder
employment agreements:
q They can be fired (e.g.,
Steve Jobs & UB)
q They are subject to non-
compete laws
q They confer to the
company their IP
32
n Founders receive compensation
that may include:
q Salary (below market)
q Performance bonus
q Stock options (at later stages,
to restore incentives)
n Two guiding principles:
q Defer pay as much as possible
to save cash
q Provide incentives for long-
term value creation
Gygax EF-08 Semester 1, 2024
Vesting 33
n Most of the compensation
derives from future sale of
common stock.
n Founders’ stock is vested
(‘earned back’) with two criteria:
q Time vesting (linear, with/out
cliff, acceleration)
q Performance vesting
(accelerated upon
IPO/acquisition)
n Vesting is lost in case of
dismissal with cause.
n Example: Founder obtains 60%
ownership; vesting is at 6%
quarterly rate with a cliff of one
year.
q Each quarter the founder vests
6% of its whole allotted common
stock (60%) à vesting completes
after 10 quarters
q Vesting requires one year of
employment to start ‘kicking in’
so after 9 months the founder
has not vested any stock, but
after 12 months the vested part
jumps to 24%
Gygax EF-08 Semester 1, 2024
Stock Options
n Stock options come from an
‘option pool’ that is typically
set up at the first funding
(Series A) and replenished
when needed.
q The pool is 10% to 20% of
the fully diluted stock
base and many companies
‘consume’ 2% to 5% per
year, depending on the
type of talent they need
to recruit.
34
n Stock options are also subject to
vesting, unless they come from a
hiring or yearly bonus.
q They have a strike price, often
very small or linked to the last
round’s price
q Exercise may require a (short-
term) loan from the company
q Importance of granting liquidity
to employees
Gygax EF-08 Semester 1, 2024
Term Sheets: Investor Liquidity
n Investors need to sell their shares at some point.
q Redemption rights: allow investors to ‘redeem’ their shares after a
reasonably long period, at preferred terms.
q where the investor can ask the company to buy back their shares
q Tag-along rights: investors can sell their share along with founders.
q a co-sale right, where one party sells shares to third party, and other party can sell pro
rata as well.
q Drag-along rights: investors can force other shareholders to sell their
stock.
q gives investor the right to force all other shareholders including founders to also sell their
shares in an acquisition.
q Registration rights and Piggy-Back rights: force listing.
q RR: give investors the right to have the company register their securities with the
stock market regulator, making them eligible for public sale.
q PB: milder version which specifies that in case of a public listing, the investor has
the right to sell their stock in the public offering.
35
Gygax EF-08 Semester 1, 2024
Term Sheets: Additional Clauses 36
n Information rights: allow investors
to obtain hard data, useful at early
stages.
n Key Woman/Man insurance: the
company is the founder(s).
n Legal resolutions: applicable law
and disputes.
n Representations and warranties:
q Key to close the deal.
q Legally binding statements in
which any failure to be truthful can
lead to financial liability and can
possibly void the deal.
n Registration rights: force listing
n Negotiation:
q No shop clause (clause that
binds entrepreneur not to seek
other deals)
q Exploding offer (any offer
specifies an expiration date)
q Due diligence conditionality
q Co-investors
q Milestones
Gygax EF-08 Semester 1, 2024
Valuation versus Term
n You cannot ‘have your cake and
eat it,’ i.e., you cannot negotiate all
terms. What should you focus on?
n Valuation is the most visible term.
It is also the easier to grasp for
entrepreneur.
q However, we have seen that
cash flow rights can undo a
generous valuation.
37
n There are some trade-offs that
make clear how negotiation is not a
zero-sum game:
q Valuation vs. control rights
(protecting yourself)
q Valuation vs. compensation and
future payoffs
q Valuation in upside and
downside
Gygax EF-08 Semester 1, 2024
Key Points
n In this lecture
q We learnt what term sheets are.
q We considered various cash flow rights of investors.
q We looked at compensation.
q We reviewed some other terms.
Entrepreneurial Finance
Lecture 8
Term Sheets
André Gygax
Bibliography:
Da Rin & Hellmann (2020) Chapter 6
I acknowledge the Traditional Owners of the land on which I work, and pay my respects to the Elders,
past and present.
Copyright © 2024 University of Melbourne
To order copies or request permission to reproduce materials write the University of Melbourne, Parkville, 3010 Victoria, Australia, or
go to https://www.unimelb.edu.au. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet,
or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the prior written
permission of the University of Melbourne.
Gygax EF-08 Semester 1, 2024
Course Outline 2
Week Date Topic Required
Reading
DRH (2020)
Further
Reading
S&S (2003)
1 February 28 Introduction to Entrepreneurial Finance 1,10,13
2 March 6 Evaluating Venture Opportunities 2
3 March 13 The Financial Plan 3
4 March 20 Ownership and Returns 4
5 March 27 New Venture Valuation Methods 5
March 29 –
April 7
Easter Non-teaching period / Mid-
Semester Break
6 April 10 Entrepreneur versus Investor’s Perspective 5 11
7 April 17 Venture Capital 12
8 April 24 Term Sheets 6
9 May 1 Structuring Deals 7
10 May 8 Corporate Governance 8
11 May 15 Staged Financing 9
12 May 22 Exit 11
Gygax EF-08 Semester 1, 2024
New Venture Life Cycle 3
The Financial
Plan &
Ownership and
Returns
Venture
Capital, Term
Sheets & Deal
Structure
New Venture
Valuation
Methods &
Perspectives
Exit
Corporate
Governance &
Staged
Financing
Evaluating
Venture
Opportunities
1
2
4
3
5
6
Gygax EF-08 Semester 1, 2024
Agenda
n Last week we discussed the fundamental role of venture capital in
financial markets, and we looked at how an entrepreneur and a
well-diversified investor could jointly finance a new venture.
n In this lecture
q We will learn what term sheets are.
q We will consider cash flow rights of investors.
q We will look at compensation.
q We will discuss other terms.
4
Gygax EF-08 Semester 1, 2024
Practice
Question
Critically discuss the following statement:
“Milestones form an integral part of term sheets
that are beneficial for all parties involved, and in
particular for the entrepreneurial venture.”
Gygax EF-08 Semester 1, 2024
Term Sheet
n Definition: The term sheet is a funding offer from the VC firm to
the entrepreneur.
n Term sheets is a preliminary agreement drafted by the investor. It
consists of some of the terms that may be included in a finalized
contract. It lays out the proposed right and obligations of each
party, namely the entrepreneur and the investor.
n The initial term sheet is an offer subject to negotiation for the final
legal documents:
q Corporate charter
q Investor rights agreement & purchase agreement
q Founder employment agreements
6
Gygax EF-08 Semester 1, 2024
Term Sheets: Principles
n Term sheets play several different
roles:
q govern the potential rights,
obligations, rewards of the parties
q shape the incentives for all parties
(incl. employees)
q bring the parties to clarify their
expectations
q allocate risk across the two parties
q specify the rights and duties of the
parties towards external parties
(employees, future investors)
7
n Term sheets govern several areas:
q Cash flow rights
q Control rights
q Compensation and employment
for founders and key employees
q Other rights
Ø Anti-dilution
Ø Future fundraising
Ø Liquidity
q Entrepreneur should rely on
experienced lawyers for help on
interpreting a proposed term
sheet.
Gygax EF-08 Semester 1, 2024
Contingent Contracting
n Term sheets are preliminary
agreements.
q They are “incomplete” and do not
set out all the terms included in
the final contract.
q They address highly uncertain
prospects.
q It is not possible to account for all
future states in a contract.
q This is expressed as final contracts
being ‘incomplete’.
q It is addressed through
‘contingent contracting’, where
clauses apply to certain situations
only.
8
n Term sheets define
contingencies through
‘milestones’ which identify
salient events that reveal
information on whether the
company’s progress conforms
or not to expectations.
q “The board of directors consists
of five members. The investor
nominates two. If the company
fails to generate sales within 12
months from the closing, the
investor nominates two
additional directors.”
Gygax EF-08 Semester 1, 2024
Term Sheets: Milestones
n Milestones measure
performance in different
dimensions:
q financial (e.g., sales, EBIT,
operating CF, financial ratio)
q operational (e.g., regulatory
approval, supply contract)
q managerial (e.g., hiring of
CxO, independent director)
q technical (e.g., working
prototype, license
acquisition)
9
n Milestones have important economic
roles:
q define performance targets
q align expectations of entrepreneurs
and investors
q provide a focal point for renegotiation
q facilitate negotiation about valuation,
by linking it to performance targets
n Future financing depends on meeting
milestones (i.e., through staged
financing)
q The ability to set meaningful
milestones is an important skill of a
good investor
Gygax EF-08 Semester 1, 2024
But …
n Milestones also have drawbacks:
q defining performance may be elusive (when is a
prototype really working?)
q pursing milestones may lead to under-pivoting, e.g., to
bring a product quickly to market
q pursuing milestones may lead to short-termism, e.g., to
achieve a sales and/or production target
10
Gygax EF-08 Semester 1, 2024
Nobel Insights: Incomplete Contracts
n Oliver Hart (Nobel, 2016):
q Why are contracts incomplete?
q How do contracts deal with unforeseen contingencies?
n He distinguishes between:
q clauses that deal with verifiable actions (need a milestone)
q clauses that allocate decision rights (only need to identify
who has a right to decide)
11
Image Source:
Oliver Hart in
2016, Wikipedia
2021
Gygax EF-08 Semester 1, 2024
Nobel Insights: Incomplete Contracts (continued)
n The former type relies on the
existence of precise
circumstances that disclose
information.
n The latter type deals with case
where this is not possible, as
often in ventures, where
information is opaque and
difficult to interpret.
Ø This explains why it is optimal to
make control over the company
contingent on performance.
12
n Hart’s second contribution is to
understand renegotiation:
q Contracts are dynamic and
respond to changes in
external/internal conditions.
q It also explains how
renegotiation is affected by
initial contract rules:
Ø Series A rounds provide a
reference point from which
contracting can later deviate
Gygax EF-08 Semester 1, 2024
Term Sheets: Which Series?
n Term Sheets come in Series (A, B, …F…).
n Series A sets the terms for future rounds, so it is most salient.
n Each series has a (partially) different set of investors.
n Each series votes as such, by majority.
13
Gygax EF-08 Semester 1, 2024
Term Sheets: Cash Flow Rights
n Term Sheets allocate cash flow
(CF) rights to entrepreneur and
investors to maximize expected
venture value.
n This is done in two ways:
n By giving investors ‘downside’
protection
n By aligning incentives: provide
both parties with strong
incentives to work for high
performance (incentive
alignment)
14
n Investors obtain ‘convertible’
preferred stock instead of
common stock.
n Convertible gives its holder the
right to choose between:
q A debt-like payoff in case of
failure (‘downside protection’)
q Conversion into common equity
if the company succeeds (profit-
sharing in the upside)
Gygax EF-08 Semester 1, 2024
Why Preferred Securities?
n There are three main rationales for using preferred
stock:
q Provide incentives to founders (need for balance)
q Screen out weaker projects
q Align investor and entrepreneur’s expectations
15
Gygax EF-08 Semester 1, 2024
Preferred Terms
n Convertible is always preferred:
q It obtains yearly preferred terms (‘dividend’ – deferred, accruing
or cumulative).
PT = I + DIV = I + I*D*T
q D = stated yield,
q T = time-to-exit
§ When dividends are compounded: PT = I + I*(D)T
q where PT = Preferred Terms; and I = Investment Amount
16
Gygax EF-08 Semester 1, 2024
Convertible Preferred
n Convertible holders will convert it into common stock
(at exit) when their cash flow from common exceeds
the preferred terms (PT):
FINV*X > PT, which defines: CT = PT/FINV
where
FINV = Ownership fraction of new investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
17
Gygax EF-08 Semester 1, 2024
Convertible Preferred (continued) 18
Exit Value Condition
Cash Flows to
Investors
(CFINF)
Cash Flows to
Entrepreneurs
(CFEN)
Large X > CT FINV*X (1 – FINV)*X
Intermediate PT < X < CT PT X – PT
Small X < PT X 0
FINV = Ownership fraction of new
investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ line (X=X)Cash flow to the
investor (CFINV)
X=PT X=CT
Exit value (X)
Cash flow to the entrepreneur
Cash flow to the investor
19Convertible Preferred (continued)
FINV = Ownership fraction of new investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Preferred terms (PT)
45˚ line (X=X)Cash flow to the
entrepreneur
(CFEN)
X=PT X=CT
Exit value (X)
20Convertible Preferred (continued)
Cash flow to the entrepreneur
Cash flow to the investor
FINV = Ownership fraction of new investors
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Multiple Liquidation Preferences
n Convertible preferred stock may add a (multiple)
liquidation preference to the preferred dividend, so
that the investor gets its capital back several times:
PT = M*I + DIV
CTM = PT/FINV = (M*I + DIV)/FINV > CT
21
where M = Multiple Liquidation Factor
Note: Investors can get their investment back multiple times. Typical factors range
from 1.5 to 3 and vary depending on market circumstances.
A survey of Silicon Valley investments estimates that 11% of deals involve multiple
liquidation preference: 20% of those are above 2x, where x indicates the invested
amount, and the remainder are between 1x and 2x.
Gygax EF-08 Semester 1, 2024
22Multiple Liquidation Preferences (continued)
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ line
Cash flow to the
investor (CFINV)
X=PT X=CT Exit value (X)
Cash flow to the entrepreneur
Cash flow to the investor
PT with multiple liquidation preference (PTM)
X=PTM
X=CTM
PTM = Preferred Terms Multiple Liquidation Factor
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
23Multiple Liquidation Preferences (continued)
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ lineCash flow to the
entrepreneur (CFEN)
X=PT X=CT Exit value (X)
Cash flow to the investor
Cash flow to the entrepreneur
PT with multiple liquidation preference (PTM)
X=PTM
X=CTM
PTM = Preferred Terms Multiple Liquidation Factor
X = Exit value
PT = Preferred Terms (i.e., I + D)
CT = Conversion Threshold
Gygax EF-08 Semester 1, 2024
Participating Preferred
n Participating preferred terms combine debt and equity
features by adding a (multiple) liquidation preference
to the preferred dividend (‘double dip’).
n The investor gets the PT and at exit also shares into
common equity.
n If the company exit value is X, this implies:
CFINV = PT + (X-PT)*FINV
24
Gygax EF-08 Semester 1, 2024
Participating Preferred (continued) 25
Exit Value Condition Cash Flows to Investors (CFINF)
Cash Flows to
Entrepreneurs
(CFEN)
Large X > PT PT + FINV*(X–PT) (1 - FINV)*(X–PT)
Small X < PT X 0
Gygax EF-08 Semester 1, 2024
Preferred terms (PT)
Converted Equity (FINV*X)
45˚ line (X=X)Cash flow to the
investor (CFINV)
X=PT X=CT
Exit value (X)
Cash flow to the entrepreneur
Cash flow to the investor
26Participating Preferred (continued)
Gygax EF-08 Semester 1, 2024
Preferred terms
(PT)
45˚ line (X=X)Cash flow to the
entrepreneur (CFEN)
X=PT X=CT
Exit value (X)
27Participating Preferred (continued)
Cash flow to the entrepreneur
Cash flow to the investor
Gygax EF-08 Semester 1, 2024
Participating Preferred with Cap
n A cap may be imposed on the participation in order to
preserve incentives for the entrepreneur:
q Participation vanishes if X > XCAP
q This implies: CFINV = PT + (X-PT)*FINV
n Full conversion threshold is XCOM:
XCOM = XCAP + PT (1 – FINV)/FINV
n The drop in the cap is usually smoothed out to avoid providing
perverse incentives at the time of exit.
28
Gygax EF-08 Semester 1, 2024
Participating Preferred with Cap (continued) 29
Exit Value Condition Cash Flows to Investors (CFINF)
Cash Flows to Entrepreneurs
(CFEN)
Far Above Cap XCOM < X FINV*X (1 – FINV)*X
Just Above Cap XCAP < X < XCOM PT + FINV*(XCAP – PT) X – FINV * XCAP – (1–FINV)*PT
Below Cap PT < X < XCAP PT + FINV * (X – PT) (1 – FINV)*(X – PT)
Small X < PT X 0
Gygax EF-08 Semester 1, 2024
Preferred terms
(PT)
Converted Equity (FINV*X)
45˚ line (X=X)Cash flow to the
investor (CFINV)
X=P
T
X=CT
Cash flow to the entrepreneur
Cash flow to the investor
Exit value (X)
X=XCAP
30Participating Preferred with Cap (continued)
Gygax EF-08 Semester 1, 2024
Preferred terms
(PT)
Investor Equity (FINV*X)
45˚ line
Cash flow to the
investor (CFINV)
X=PT X=CT
Cash flow to the entrepreneur
Cash flow to the investor
Exit value (X)X=XCAP X=XCOM
31Participating Preferred with Cap (continued)
Gygax EF-08 Semester 1, 2024
Compensation and Employment
n Upon funding, founders
become employees.
n Main implications of founder
employment agreements:
q They can be fired (e.g.,
Steve Jobs & UB)
q They are subject to non-
compete laws
q They confer to the
company their IP
32
n Founders receive compensation
that may include:
q Salary (below market)
q Performance bonus
q Stock options (at later stages,
to restore incentives)
n Two guiding principles:
q Defer pay as much as possible
to save cash
q Provide incentives for long-
term value creation
Gygax EF-08 Semester 1, 2024
Vesting 33
n Most of the compensation
derives from future sale of
common stock.
n Founders’ stock is vested
(‘earned back’) with two criteria:
q Time vesting (linear, with/out
cliff, acceleration)
q Performance vesting
(accelerated upon
IPO/acquisition)
n Vesting is lost in case of
dismissal with cause.
n Example: Founder obtains 60%
ownership; vesting is at 6%
quarterly rate with a cliff of one
year.
q Each quarter the founder vests
6% of its whole allotted common
stock (60%) à vesting completes
after 10 quarters
q Vesting requires one year of
employment to start ‘kicking in’
so after 9 months the founder
has not vested any stock, but
after 12 months the vested part
jumps to 24%
Gygax EF-08 Semester 1, 2024
Stock Options
n Stock options come from an
‘option pool’ that is typically
set up at the first funding
(Series A) and replenished
when needed.
q The pool is 10% to 20% of
the fully diluted stock
base and many companies
‘consume’ 2% to 5% per
year, depending on the
type of talent they need
to recruit.
34
n Stock options are also subject to
vesting, unless they come from a
hiring or yearly bonus.
q They have a strike price, often
very small or linked to the last
round’s price
q Exercise may require a (short-
term) loan from the company
q Importance of granting liquidity
to employees
Gygax EF-08 Semester 1, 2024
Term Sheets: Investor Liquidity
n Investors need to sell their shares at some point.
q Redemption rights: allow investors to ‘redeem’ their shares after a
reasonably long period, at preferred terms.
q where the investor can ask the company to buy back their shares
q Tag-along rights: investors can sell their share along with founders.
q a co-sale right, where one party sells shares to third party, and other party can sell pro
rata as well.
q Drag-along rights: investors can force other shareholders to sell their
stock.
q gives investor the right to force all other shareholders including founders to also sell their
shares in an acquisition.
q Registration rights and Piggy-Back rights: force listing.
q RR: give investors the right to have the company register their securities with the
stock market regulator, making them eligible for public sale.
q PB: milder version which specifies that in case of a public listing, the investor has
the right to sell their stock in the public offering.
35
Gygax EF-08 Semester 1, 2024
Term Sheets: Additional Clauses 36
n Information rights: allow investors
to obtain hard data, useful at early
stages.
n Key Woman/Man insurance: the
company is the founder(s).
n Legal resolutions: applicable law
and disputes.
n Representations and warranties:
q Key to close the deal.
q Legally binding statements in
which any failure to be truthful can
lead to financial liability and can
possibly void the deal.
n Registration rights: force listing
n Negotiation:
q No shop clause (clause that
binds entrepreneur not to seek
other deals)
q Exploding offer (any offer
specifies an expiration date)
q Due diligence conditionality
q Co-investors
q Milestones
Gygax EF-08 Semester 1, 2024
Valuation versus Term
n You cannot ‘have your cake and
eat it,’ i.e., you cannot negotiate all
terms. What should you focus on?
n Valuation is the most visible term.
It is also the easier to grasp for
entrepreneur.
q However, we have seen that
cash flow rights can undo a
generous valuation.
37
n There are some trade-offs that
make clear how negotiation is not a
zero-sum game:
q Valuation vs. control rights
(protecting yourself)
q Valuation vs. compensation and
future payoffs
q Valuation in upside and
downside
Gygax EF-08 Semester 1, 2024
Key Points
n In this lecture
q We learnt what term sheets are.
q We considered various cash flow rights of investors.
q We looked at compensation.
q We reviewed some other terms.
