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Term Sheets 101 by Justin Fishner-Wolfson, Founders Fund
BUILD A COMPANY
FOR THE LONG TERM
CONTROL YOUR OWN DESTINY

JUSTIN FISHNER-WOLFSON
COMPANIES ARE BEING FUNDED
Despite the tough environment


     $1,300M

        $975M

        $650M

        $325M

           $0M
                           Q1 2008           Q2 2008          Q3 2008          Q4 2008        2009 YTD
     Total Amount Raised    $1,078,325,793   $1,196,744,097   $1,227,841,647   $758,107,693   $762,108,423




Source: Cooley Godward Kronish LLP

                                                                                                             3
VALUATIONS ARE LOWER
Median Series A pre-money valuations

  $9M


  $7M


  $5M


  $2M


  $0M
                  Q1 2008            Q2 2008   Q3 2008   Q4 2008   2009 YTD


Source: Cooley Godward Kronish LLP

                                                                              4
TYPES OF EQUITY

• Common
• Preferred
• Series FF




                  5
LIQUIDATION PREFERENCES ARE
BECOMING MORE COMMON
            Percentage of Deals with Fully Participating Preferred
  70%

  60%

  50%

  40%

  30%

  20%

  10%

    0%
                  Q1 2008            Q2 2008   Q3 2008       Q4 2008   2009 YTD


Source: Cooley Godward Kronish LLP

                                                                                  6
UNDERSTAND THE TERMINOLOGY
• Options
• Warrants
• Fully Diluted
  Ownership (FDO)




                             7
PROPOSED SERIES A FUNDING

• $1M Financing
• $4M Pre-money valuation
• 20% option pool




                            8
HOW TO CALCULATE DILUTION

Step 1:

Determine post
money valuation




                            9
HOW TO CALCULATE DILUTION

Step 1:

Determine post
money valuation

    Money invested

+         Pre-Money

 Post-Money Value




                            9
HOW TO CALCULATE DILUTION

Step 1:               Step 2:

Determine post        Determine investor
money valuation       ownership

    Money invested

+         Pre-Money

 Post-Money Value




                                           9
HOW TO CALCULATE DILUTION

Step 1:               Step 2:

Determine post        Determine investor
money valuation       ownership

    Money invested         Money invested

+         Pre-Money
                       ÷        Post-Money

 Post-Money Value      Investor Ownership




                                             9
HOW TO CALCULATE DILUTION

Step 1:               Step 2:                Step 3:

Determine post        Determine investor     negotiate
money valuation       ownership              employee
                                             option pool
    Money invested         Money invested

+         Pre-Money
                       ÷        Post-Money

 Post-Money Value      Investor Ownership




                                                           9
HOW TO CALCULATE DILUTION

Step 1:               Step 2:                Step 3:

Determine post        Determine investor     negotiate
money valuation       ownership              employee
                                             option pool
    Money invested         Money invested

+         Pre-Money
                       ÷        Post-Money

 Post-Money Value      Investor Ownership
                                              Investor Ownership
                                             +       Option Pool


                                                  = Dilution

                                                                   9
WHAT DO THE
FOUNDERS HAVE LEFT?
                              Brian   Robert

• Before:
  • 2 equal co-founders
• After:
  • 30% for each co-founder




                                               10
WHAT DO THE
FOUNDERS HAVE LEFT?
                              Brian        Robert
                              Investment
• Before:
  • 2 equal co-founders
• After:
  • 30% for each co-founder




                                                    10
WHAT DO THE
FOUNDERS HAVE LEFT?
                              Brian        Robert
                              Investment   Option Pool
• Before:
  • 2 equal co-founders
• After:
  • 30% for each co-founder




                                                         10
AVOID DILUTION
Try a convertible note


• $500K note
                                 Equity
• 10% warrant per month



                          Debt




                                          11
AVOID DILUTION
Try a convertible note


• $500K note
                                 Equity
• 10% warrant per month
• This converts at the
  next financing round
                          Debt




                                          11
FIND A COMPROMISE ON PRICE
Convertible Debt

 Other benefit is... less paperwork
 • Fewer terms to negotiate
 • Faster


 You need to realize...
 • Investors want a lower price
 • Creates overhang on next financing round


                                              12
THE COST OF CONVERTIBLE DEBT
                               After 6 months:
• $1M Series A
• Pre-money valuation of $4M
• 20% option Pool


                                Post-Money Value




                                                   13
THE COST OF CONVERTIBLE DEBT
                               After 6 months:
• $1M Series A
                                    Pre-Money      $4M
• Pre-money valuation of $4M
• 20% option Pool


                                Post-Money Value




                                                         13
THE COST OF CONVERTIBLE DEBT
                               After 6 months:
• $1M Series A
                                    Pre-Money      $4M
• Pre-money valuation of $4M
                                       Series A    $1M
• 20% option Pool
                                +
                                Post-Money Value




                                                         13
THE COST OF CONVERTIBLE DEBT
                               After 6 months:
• $1M Series A
                                    Pre-Money      $4M
• Pre-money valuation of $4M
                                       Series A    $1M
• 20% option Pool                        Notes     $500K
                                +
                                Post-Money Value




                                                           13
THE COST OF CONVERTIBLE DEBT
                               After 6 months:
• $1M Series A
                                    Pre-Money      $4M
• Pre-money valuation of $4M
                                       Series A    $1M
• 20% option Pool                        Notes     $500K
                                +     Warrants     $300K

                                Post-Money Value




                                                           13
THE COST OF CONVERTIBLE DEBT
                               After 6 months:
• $1M Series A
                                    Pre-Money     $4M
• Pre-money valuation of $4M
                                       Series A   $1M
• 20% option Pool                        Notes    $500K
                                +     Warrants    $300K

                                Post-Money Value $5.8M




                                                          13
THE COST OF CONVERTIBLE DEBT
                                   After 6 months:
• The note cost 13.8%
  of the company                   Option Pool
                                   20%               Robert
• This is an addition 11% vs the   Note
                                                     24.5%
                                   8.6%
  original series A termsheet
                                   Warrants
                                   5.2%              Brian
                                                     24.5%
                                   Series A
                                   17.2%




                                                              14
EQUITY MEANS EVERYONE
IS ON THE SAME TEAM

• Investors and founders want to
  maximize the value of the company

 Be careful of...
 • Dilution
 • Have to negotiate a lot of important terms




                                                15
TERMSHEET: OPTION 1
3x liquidation preference
• $1M Series A Financing
• $4M Pre-money valuation
• 20% option pool




                            16
LIQUIDATION PREFERENCE
EVENTUALLY GOES AWAY
$1M Series A at $4M Pre with 3X liquidation pref

 How it works:

 First $3M goes to investors




                                                   17
LIQUIDATION PREFERENCE
EVENTUALLY GOES AWAY
$1M Series A at $4M Pre with 3X liquidation pref

 Acquisition   Founders and
 Price it works:
 How           Employees get:

 @ $3M$3M
 First      goes to investors
              $0




                                                   17
LIQUIDATION PREFERENCE
EVENTUALLY GOES AWAY
$1M Series A at $4M Pre with 3X liquidation pref

 Acquisition   Founders and
 Price it works:
 How           Employees get:

 @ $3M$3M
 First      goes to investors
              $0

 @ $5M          $2M (40%, not 80%)

 @ $15M         $12M (80% - inflection pt)


                                                   17
LIQUIDATION PREFERENCE
EVENTUALLY GOES AWAY
$1M Series A at $4M Pre with 3X liquidation pref

 Acquisition   Founders and
 Price it works:
 How           Employees get:

 @ $3M$3M
 First      goes to investors
              $0

 @ $5M          $2M (40%, not 80%)

 @ $15M         $12M (80% - inflection pt)


                                                   17
TERMSHEET: OPTION 2
Fully participating preferred
• $1M Series A Financing
• $4M Pre-money valuation
• 20% option pool




                                18
PARTICIPATION IS NOT
AN ISSUE AT LARGE EXITS
$1M Series A at $4M Pre with participating preferred

 How it works:

 Take $1M off the top then take 20% of what’s left




                                                     19
PARTICIPATION IS NOT
AN ISSUE AT LARGE EXITS
$1M Series A at $4M Pre with participating preferred

 Acquisition   Founders and
 Price it works:
 How           Employees get:

 @ $3M$1M
 Take        off $1.6Mtop then take 20% of what’s left
                  the (53%)




                                                         19
PARTICIPATION IS NOT
AN ISSUE AT LARGE EXITS
$1M Series A at $4M Pre with participating preferred

 Acquisition   Founders and
 Price it works:
 How           Employees get:

 @ $3M$1M
 Take        off $1.6Mtop then take 20% of what’s left
                  the (53%)

 @ $5M          $3.2M (64%)

 @ $15M         $11.2M (75%)


                                                         19
PARTICIPATION IS NOT
AN ISSUE AT LARGE EXITS
$1M Series A at $4M Pre with participating preferred

 Acquisition   Founders and
 Price it works:
 How           Employees get:

 @ $3M$1M
 Take        off $1.6Mtop then take 20% of what’s left
                  the (53%)

 @ $5M          $3.2M (64%)

 @ $15M         $11.2M (75%)


                                                         19
THIS IS WHAT YOU WANT
1x liquidation preference
• $1M Series A Financing
• $4M Pre-money valuation
                                Interests
• 20% option pool

Align Incentives
• The investor interests are
  very similar to yours
                               Common   Investor




                                                   20
SINGLE LIQUIDATION PREFERENCE
$1M Series A at $4M Pre with 1X liquidation pref


 Acquisition   Founders and
 Price         Employees get:

 @ $3M         $2M (66%)

 @ $5M         $4M (80%)

 @ $15M        $12M (80%)



                                                   21
SINGLE LIQUIDATION PREFERENCE
$1M Series A at $4M Pre with 1X liquidation pref


 Acquisition   Founders and
 Price         Employees get:

 @ $3M         $2M (66%)

 @ $5M         $4M (80%)

 @ $15M        $12M (80%)



                                                   21
SINGLE LIQUIDATION PREFERENCE
$1M Series A at $4M Pre with 1X liquidation pref


 Acquisition   Founders and
 Price         Employees get:

 @ $3M         $2M (66%)

 @ $5M         $4M (80%)

 @ $15M        $12M (80%)



                                                   21
DON’T OVER-OPTIMIZE

• Lower the valuation
• Last money in is the first
  money out
• Terms only get
  worse over time

                               YOUR COMPANY
DON’T OVER-OPTIMIZE

• Lower the valuation
• Last money in is the first
  money out
• Terms only get
  worse over time
                                    $1 M
                               YOUR COMPANY
DON’T OVER-OPTIMIZE

• Lower the valuation
• Last money in is the first
  money out
• Terms only get
  worse over time
                                    $5 M
                                    $1 M
                               YOUR COMPANY
DON’T OVER-OPTIMIZE

• Lower the valuation
• Last money in is the first
  money out
• Terms only get                   $20 M
  worse over time
                                    $5 M
                                    $1 M
                               YOUR COMPANY
DON’T OVER-OPTIMIZE

• Lower the valuation
• Last money in is the first      $100 M
  money out
• Terms only get                   $20 M
  worse over time
                                    $5 M
                                    $1 M
                               YOUR COMPANY
DON’T OVER-OPTIMIZE

• Lower the valuation
• Last money in is the first
  money out
• Terms only get
  worse over time

                                  $100M
                                   $20 M
                               YOUR COMPANY
                                    $5 M
                                     $1
RAISE ENOUGH MONEY
TO REACH YOUR MILESTONES
Flat rounds & down rounds are now common
  70%

  53%

  35%

  18%

    0%
                  Q1 2008            Q2 2008   Q3 2008   Q4 2008   Q1 2009

Source: Cooley Godward Kronish LLP



• Understand the effects of anti-dilution
                                                                             23
CONTROL YOUR OWN DESTINY

• Board composition
                             Investors              Founders
• Voting rights/thresholds

                             Visualization: Board room
                             table –Would need to purchase.
                                     removing founders,
                             removing board members




                                                               24
KNOW WHAT YOU
ARE AGREEING TO

 01

 02

 03
KNOW WHAT YOU
ARE AGREEING TO

 01 Do the math

 02

 03
KNOW WHAT YOU
ARE AGREEING TO

 01 Do the math

   Think about incentives
02
   at various outcomes

 03
KNOW WHAT YOU
ARE AGREEING TO

 01 Do the math

   Think about incentives
02
   at various outcomes

03 Know who has control
   in important situations
GET GOOD COUNSEL
PAY SOMEONE TO
WATCH YOUR BACK
Q&A
© 2009 Founders Fund All right reserved

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Term Sheets 101 by Justin Fishner-Wolfson, Founders Fund

  • 2. BUILD A COMPANY FOR THE LONG TERM CONTROL YOUR OWN DESTINY JUSTIN FISHNER-WOLFSON
  • 3. COMPANIES ARE BEING FUNDED Despite the tough environment $1,300M $975M $650M $325M $0M Q1 2008 Q2 2008 Q3 2008 Q4 2008 2009 YTD Total Amount Raised $1,078,325,793 $1,196,744,097 $1,227,841,647 $758,107,693 $762,108,423 Source: Cooley Godward Kronish LLP 3
  • 4. VALUATIONS ARE LOWER Median Series A pre-money valuations $9M $7M $5M $2M $0M Q1 2008 Q2 2008 Q3 2008 Q4 2008 2009 YTD Source: Cooley Godward Kronish LLP 4
  • 5. TYPES OF EQUITY • Common • Preferred • Series FF 5
  • 6. LIQUIDATION PREFERENCES ARE BECOMING MORE COMMON Percentage of Deals with Fully Participating Preferred 70% 60% 50% 40% 30% 20% 10% 0% Q1 2008 Q2 2008 Q3 2008 Q4 2008 2009 YTD Source: Cooley Godward Kronish LLP 6
  • 7. UNDERSTAND THE TERMINOLOGY • Options • Warrants • Fully Diluted Ownership (FDO) 7
  • 8. PROPOSED SERIES A FUNDING • $1M Financing • $4M Pre-money valuation • 20% option pool 8
  • 9. HOW TO CALCULATE DILUTION Step 1: Determine post money valuation 9
  • 10. HOW TO CALCULATE DILUTION Step 1: Determine post money valuation Money invested + Pre-Money Post-Money Value 9
  • 11. HOW TO CALCULATE DILUTION Step 1: Step 2: Determine post Determine investor money valuation ownership Money invested + Pre-Money Post-Money Value 9
  • 12. HOW TO CALCULATE DILUTION Step 1: Step 2: Determine post Determine investor money valuation ownership Money invested Money invested + Pre-Money ÷ Post-Money Post-Money Value Investor Ownership 9
  • 13. HOW TO CALCULATE DILUTION Step 1: Step 2: Step 3: Determine post Determine investor negotiate money valuation ownership employee option pool Money invested Money invested + Pre-Money ÷ Post-Money Post-Money Value Investor Ownership 9
  • 14. HOW TO CALCULATE DILUTION Step 1: Step 2: Step 3: Determine post Determine investor negotiate money valuation ownership employee option pool Money invested Money invested + Pre-Money ÷ Post-Money Post-Money Value Investor Ownership Investor Ownership + Option Pool = Dilution 9
  • 15. WHAT DO THE FOUNDERS HAVE LEFT? Brian Robert • Before: • 2 equal co-founders • After: • 30% for each co-founder 10
  • 16. WHAT DO THE FOUNDERS HAVE LEFT? Brian Robert Investment • Before: • 2 equal co-founders • After: • 30% for each co-founder 10
  • 17. WHAT DO THE FOUNDERS HAVE LEFT? Brian Robert Investment Option Pool • Before: • 2 equal co-founders • After: • 30% for each co-founder 10
  • 18. AVOID DILUTION Try a convertible note • $500K note Equity • 10% warrant per month Debt 11
  • 19. AVOID DILUTION Try a convertible note • $500K note Equity • 10% warrant per month • This converts at the next financing round Debt 11
  • 20. FIND A COMPROMISE ON PRICE Convertible Debt Other benefit is... less paperwork • Fewer terms to negotiate • Faster You need to realize... • Investors want a lower price • Creates overhang on next financing round 12
  • 21. THE COST OF CONVERTIBLE DEBT After 6 months: • $1M Series A • Pre-money valuation of $4M • 20% option Pool Post-Money Value 13
  • 22. THE COST OF CONVERTIBLE DEBT After 6 months: • $1M Series A Pre-Money $4M • Pre-money valuation of $4M • 20% option Pool Post-Money Value 13
  • 23. THE COST OF CONVERTIBLE DEBT After 6 months: • $1M Series A Pre-Money $4M • Pre-money valuation of $4M Series A $1M • 20% option Pool + Post-Money Value 13
  • 24. THE COST OF CONVERTIBLE DEBT After 6 months: • $1M Series A Pre-Money $4M • Pre-money valuation of $4M Series A $1M • 20% option Pool Notes $500K + Post-Money Value 13
  • 25. THE COST OF CONVERTIBLE DEBT After 6 months: • $1M Series A Pre-Money $4M • Pre-money valuation of $4M Series A $1M • 20% option Pool Notes $500K + Warrants $300K Post-Money Value 13
  • 26. THE COST OF CONVERTIBLE DEBT After 6 months: • $1M Series A Pre-Money $4M • Pre-money valuation of $4M Series A $1M • 20% option Pool Notes $500K + Warrants $300K Post-Money Value $5.8M 13
  • 27. THE COST OF CONVERTIBLE DEBT After 6 months: • The note cost 13.8% of the company Option Pool 20% Robert • This is an addition 11% vs the Note 24.5% 8.6% original series A termsheet Warrants 5.2% Brian 24.5% Series A 17.2% 14
  • 28. EQUITY MEANS EVERYONE IS ON THE SAME TEAM • Investors and founders want to maximize the value of the company Be careful of... • Dilution • Have to negotiate a lot of important terms 15
  • 29. TERMSHEET: OPTION 1 3x liquidation preference • $1M Series A Financing • $4M Pre-money valuation • 20% option pool 16
  • 30. LIQUIDATION PREFERENCE EVENTUALLY GOES AWAY $1M Series A at $4M Pre with 3X liquidation pref How it works: First $3M goes to investors 17
  • 31. LIQUIDATION PREFERENCE EVENTUALLY GOES AWAY $1M Series A at $4M Pre with 3X liquidation pref Acquisition Founders and Price it works: How Employees get: @ $3M$3M First goes to investors $0 17
  • 32. LIQUIDATION PREFERENCE EVENTUALLY GOES AWAY $1M Series A at $4M Pre with 3X liquidation pref Acquisition Founders and Price it works: How Employees get: @ $3M$3M First goes to investors $0 @ $5M $2M (40%, not 80%) @ $15M $12M (80% - inflection pt) 17
  • 33. LIQUIDATION PREFERENCE EVENTUALLY GOES AWAY $1M Series A at $4M Pre with 3X liquidation pref Acquisition Founders and Price it works: How Employees get: @ $3M$3M First goes to investors $0 @ $5M $2M (40%, not 80%) @ $15M $12M (80% - inflection pt) 17
  • 34. TERMSHEET: OPTION 2 Fully participating preferred • $1M Series A Financing • $4M Pre-money valuation • 20% option pool 18
  • 35. PARTICIPATION IS NOT AN ISSUE AT LARGE EXITS $1M Series A at $4M Pre with participating preferred How it works: Take $1M off the top then take 20% of what’s left 19
  • 36. PARTICIPATION IS NOT AN ISSUE AT LARGE EXITS $1M Series A at $4M Pre with participating preferred Acquisition Founders and Price it works: How Employees get: @ $3M$1M Take off $1.6Mtop then take 20% of what’s left the (53%) 19
  • 37. PARTICIPATION IS NOT AN ISSUE AT LARGE EXITS $1M Series A at $4M Pre with participating preferred Acquisition Founders and Price it works: How Employees get: @ $3M$1M Take off $1.6Mtop then take 20% of what’s left the (53%) @ $5M $3.2M (64%) @ $15M $11.2M (75%) 19
  • 38. PARTICIPATION IS NOT AN ISSUE AT LARGE EXITS $1M Series A at $4M Pre with participating preferred Acquisition Founders and Price it works: How Employees get: @ $3M$1M Take off $1.6Mtop then take 20% of what’s left the (53%) @ $5M $3.2M (64%) @ $15M $11.2M (75%) 19
  • 39. THIS IS WHAT YOU WANT 1x liquidation preference • $1M Series A Financing • $4M Pre-money valuation Interests • 20% option pool Align Incentives • The investor interests are very similar to yours Common Investor 20
  • 40. SINGLE LIQUIDATION PREFERENCE $1M Series A at $4M Pre with 1X liquidation pref Acquisition Founders and Price Employees get: @ $3M $2M (66%) @ $5M $4M (80%) @ $15M $12M (80%) 21
  • 41. SINGLE LIQUIDATION PREFERENCE $1M Series A at $4M Pre with 1X liquidation pref Acquisition Founders and Price Employees get: @ $3M $2M (66%) @ $5M $4M (80%) @ $15M $12M (80%) 21
  • 42. SINGLE LIQUIDATION PREFERENCE $1M Series A at $4M Pre with 1X liquidation pref Acquisition Founders and Price Employees get: @ $3M $2M (66%) @ $5M $4M (80%) @ $15M $12M (80%) 21
  • 43. DON’T OVER-OPTIMIZE • Lower the valuation • Last money in is the first money out • Terms only get worse over time YOUR COMPANY
  • 44. DON’T OVER-OPTIMIZE • Lower the valuation • Last money in is the first money out • Terms only get worse over time $1 M YOUR COMPANY
  • 45. DON’T OVER-OPTIMIZE • Lower the valuation • Last money in is the first money out • Terms only get worse over time $5 M $1 M YOUR COMPANY
  • 46. DON’T OVER-OPTIMIZE • Lower the valuation • Last money in is the first money out • Terms only get $20 M worse over time $5 M $1 M YOUR COMPANY
  • 47. DON’T OVER-OPTIMIZE • Lower the valuation • Last money in is the first $100 M money out • Terms only get $20 M worse over time $5 M $1 M YOUR COMPANY
  • 48. DON’T OVER-OPTIMIZE • Lower the valuation • Last money in is the first money out • Terms only get worse over time $100M $20 M YOUR COMPANY $5 M $1
  • 49. RAISE ENOUGH MONEY TO REACH YOUR MILESTONES Flat rounds & down rounds are now common 70% 53% 35% 18% 0% Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Source: Cooley Godward Kronish LLP • Understand the effects of anti-dilution 23
  • 50. CONTROL YOUR OWN DESTINY • Board composition Investors Founders • Voting rights/thresholds Visualization: Board room table –Would need to purchase. removing founders, removing board members 24
  • 51. KNOW WHAT YOU ARE AGREEING TO 01 02 03
  • 52. KNOW WHAT YOU ARE AGREEING TO 01 Do the math 02 03
  • 53. KNOW WHAT YOU ARE AGREEING TO 01 Do the math Think about incentives 02 at various outcomes 03
  • 54. KNOW WHAT YOU ARE AGREEING TO 01 Do the math Think about incentives 02 at various outcomes 03 Know who has control in important situations
  • 55. GET GOOD COUNSEL PAY SOMEONE TO WATCH YOUR BACK
  • 56. Q&A
  • 57. © 2009 Founders Fund All right reserved