Bennett Best Burn LLP: Barristers and Solicitors (Lawyers)

Venture Capital Term Sheets

Introduction

The debate continues over when a private company should become eligible to receive its first round of serious venture capital financing. When, in other words, can it graduate beyond the family and friends of its founding shareholders and the few “angels” prepared to invest in it, and seek deeper pools of equity capital? Chances are that the company will have to have at a minium a highly marketable product or service, an achievable business plan, an experienced and capable management team, and the potential to generate $75 to $100 million in revenue within three years. It should also have a network of sophisticated strategic partners and a board of well-connected directors, and preferably be placed among the top three in its market space.

Whenever the company satisfies these criteria and gets the attention of a venture capital firm willing to invest, the basic terms of the proposed investment are often set out in a term sheet. Although it is intended to be replaced by one or more definitive agreements, the term sheet can become quite a detailed and comprehensive document. The company should therefore involve legal counsel at the term sheet stage, whether the term sheet is to be legally binding or not, since most of the important provisions are negotiated and settled early on. Many venture capital term sheets are not legally binding, and those which are binding are often so loaded with conditions precedent that the obligations which they set out may be difficult to enforce. The need for approval by the boards of directors of each of the signing corporate parties is a common condition.

The term sheet provisions discussed below may be used either in binding or non-binding formats, although the expense reimbursement, lock-up and confidentiality provisions are generally made binding. The term sheet precedent attached as Schedule A, which represents a non-binding agreement in principle, illustrates just one of the many possible variations of term sheet provisions outlined herein and should not be taken as reflecting a “best practice” or as favouring one party over the other.

While venture capital firms invest in both public and private companies, the term sheet provisions discussed below are generally appropriate for investment in a company which is currently private but has the potential for going public. For the purposes of this paper, these provisions are based upon the use of convertible preferred shares as the form of security issued by the company to the venture capital firm making the investment.

Also for the purposes of this paper, many of the term sheet provisions discussed below commonly appear in term sheets used by U.S. based venture capital firms. Such provisions are often reflected in term sheets for Canadian companies because U.S. based venture capital firms often “co-invest” with, and sometimes invest directly on their own without, participation by Canadian based venture capital firms. Furthermore, an initial public offering by a Canadian company which allows the venture capital firm an “exit” from its investment may just as likely take place on an American stock exchange, such as the NASDAQ, as on a Canadian exchange.

Overview of the Term Sheet

Ordinarily the venture capital firm will be prepared to give the incumbent managers considerable latitude and autonomy in the running of the company so long as defined milestones are being met. The term sheet is often silent on how the company should be run on a day-to-day basis. Many of the provisions of the term sheet apply only on the occurrence of certain events or upon the satisfaction of certain conditions. However, because the venture capital firm often views itself as supplying board representation, strategic planning, financial advice and industry contacts as well as capital, it generally retains a right to approve certain company decisions.

And because it is a major investor seeking to maximize its financial returns, the venture capital firm will ensure that the term sheet sets out the rules for subsequent issuances and transfers of equity interests. The term sheet may provide the venture capital firm with “co-sale rights” allowing it to participate in any equity sales by the founders or managers, and “drag along” rights allowing it to force the founders and managers to participate in any sale of its own equity interests. The term sheet may also provide priority downside protection against loss, allowing the venture capital firm to manage and control its investment if the company appears unable to meet the business plan, and to enjoy certain exit rights through a sale of the company to a strategic buyer or upon an initial public offering.

In contrast to what the venture capital firm generally wants to be contained in a term sheet, the founders and managers of the company usually want to obtain funding as quickly as possible, minimize dilution of their own equity interests and ensure that they retain control over all of the key decision-making functions. They often want the term sheet to afford them some flexibility for tax and estate planning purposes, allowing their interests to be freely tradeable among family members, personal trusts and holding companies without the application of any mandatory prior approval or right of first refusal provisions.

While venture capital investment often takes the form of convertible preferred shares, especially if the venture capital firm is U.S. based, it may also be structured as a common share, convertible debt or subordinated debt investment. Debentures convertible into common shares, and debentures with warrants for common shares, are often used in debt structured investments, almost always made on an interest-free basis in the absence of an event of default. Security realizable on default, or options to acquire specific assets such as intellectual property on default, may be requested if a debt structure is used. But since equity, and the unlimited potential returns which equity represents, are the foundation of venture capital investments, any debt or other instruments used to reduce risk will generally be coupled with, or convertible into, equity of the company.

The term sheet will usually set out the principal features of the preferred shares to be specified in the company’s articles of incorporation or other charter document, including voting rights, dividends, liquidation preferences, conversion and redemption rights, and possibly special rights to assume control in the event of certain prescribed defaults. Each round or tranche of venture capital investment may involve the issuance of a different class or series of preferred shares.

Some term sheets are considerably more detailed than others, even though they may all cover the same basic terms. Though some may simply incorporate such other “standard” terms and conditions as are used in “generally comparable transactions”, others may be quite specific, sometimes attaching certain portions of the definitive agreements as schedules to the term sheet. Some term sheets identify the specific definitive agreements to be produced, which may include a subscription or purchase agreement, shareholders agreement, employment and consulting agreements, confidentiality agreements, non-competition agreements, revised articles and by-laws or other charter documents, registration rights agreement, put and option agreements, and possibly many more.

Parties

Unlike “angels” who are generally individuals who invest their own personal funds, venture capital firms are often professional fund managers who invest other people’s money. Usually they are institutional, or act for institutional investors. Many Canadian based venture capital firms, but far from all, are members of the Canadian Venture Capital Association. Some are private independent funds, which raise the capital they need from institutions like pension funds and insurance companies, or are venture capital units of large commercial or investment banks. Others are affiliates of industrial corporations, obtaining their investment capital from their corporate parent and investing in companies having some connection to their parent’s current or proposed lines of business. Still others are public sector funds, established by the federal or provincial governments. And some are labour-sponsored funds which derive their capital from public solicitation, particularly during the winter “RRSP season” since individuals investing in these funds get certain tax benefits.

While the venture capital firm may be viewed by the company as the “investor”, the party advancing the monies to the company and taking the preferred shares in return may actually be a separate fund established as a limited partnership (of which the venture capital firm or its special purpose affiliate may be the general partner) or corporation in which a number of institutions or “high net worth” individuals have invested. Consequently, it may be this separate limited partnership or corporation which signs the term sheet, not the venture capital firm itself. However, for the purposes of this paper, the venture capital firm and not the fund it represents will be referred to as the venture capital investor having the rights and obligations under the term sheet being discussed.

Furthermore, despite the common practice of having more than one venture capital firm “co-invest” in a company at the same time, thereby involving each as a contracting party to the investment transaction, the venture capital investor for the purposes of this paper will be only one venture capital firm. This paper will also assume that there will be only one holder of the company’s preferred shares, namely the venture capital firm.

In addition to the venture capital firm, the term sheet will ordinarily include as parties the company and each of the founders and other shareholders holding a significant equity interest in the company. A significant equity interest is often viewed as 5% or more of the issued and outstanding equity. Alternatively, the venture capital firm may insist that the holders of at least two-thirds, sometimes three-quarters, of the voting equity be made parties to the term sheet, in order to ensure that the parties can effectively pass special resolutions of the company.

Dividend Rights

Because the venture capital firm expects to derive most of its financial return in the form of capital appreciation of its preferred shares, the term sheet will often provide that such shares are to be dividend-free for a while. The company’s cash flow, if any, can then be dedicated to funding future growth. However, the venture capital firm may argue for inclusion in the term sheet of a dividend to be made payable in the event of later stage or expansion financing when the company’s projected cash flow is strong enough to provide investors with a current, as opposed to a deferred capital, return.

The venture capital firm will most likely require the company in the term sheet to first pay dividends to the holders of the preferred shares before paying dividends to the holders of the common shares. This preference is designed to encourage managers holding only the common shares to use the company’s retained earnings for working capital purposes. The term sheet may provide that the preference apply to the payment of dividends in whatever amount may be declared by the company’s board of directors, or apply only to a fixed dollar amount, usually between 5% to 10% of the original purchase price of the preferred shares, before dividends can be paid on the company’s common shares.

In addition to creating a preference for dividends on the preferred shares, the term sheet might also make the dividends participating, so that the venture capital firm is entitled to receive additional dividends rateably with the holders of the company’s common shares once all of the preferences have been satisfied.

Depending upon how the company’s financial future is regarded by the venture capital firm, the term sheet might also require the company’s preferred shares to have cumulative as well as preferential and participating dividends, so that dividends accumulate from year-to-year, and that all cumulative dividends must first be paid to the holders of the preferred shares before dividends can be paid to the holders of the common shares.

The imposition in the term sheet of preferential, participating or cumulative dividend requirements isn’t necessarily onerous on the company. These requirements place a burden on the company only when the directors want to pay dividends to the holders of the common shares, and are prevented from doing so unless they also pay the holders of the preferred shares. However, the term sheet can place a heavy burden on the company if it imposes mandatory cumulative dividends, requiring the company to accumulate and make periodic dividend payments on the preferred shares. Such a requirement may be imposed if the venture capital firm believes its investment in the company carries considerable risk, even though the requirement may not be enforceable, depending upon the ability of the company to satisfy any prescribed solvency tests under corporate law such as subsection 38 (3) of the Ontario Business Corporations Act. In the absence of statutory prohibition, such a requirement may be justified if the venture capital firm foresees little likelihood of an initial public offering or outside takeover of the company.

Redemption Rights

Although the preferred shares can be made redeemable by either the company, in calling the shares for repurchase, or by the venture capital firm, in putting the shares to the company to receive cash back, it would be extremely unusual if the term sheet allowed for optional redemption by the company. However, it is quite usual for the venture capital firm to insist that the company redeem the preferred shares under certain conditions, if the venture capital firm so elects. The redemption price is normally comprised of the original purchase price of the preferred shares, adjusted for any stock dividends, combinations or splits, plus all accrued and unpaid dividends, and, in many cases, a redemption premium.

However, mandatory redemption of the preferred shares by the company on specified dates or upon specified events is not generally prescribed in the term sheet since it deprives the parties of the flexibility they may need to address the company’s future capital needs. Mandatory redemption discourages other investors from participating in future rounds of company financing and can make it difficult for the company to obtain bank loans and trade credit.

Although the conditions under which a company may be required to redeem the preferred shares at the option of the venture capital firm are far from standard in a term sheet, redemption is often permitted only after a sufficiently long period has elapsed, usually around five years. Payment upon such redemption is often required to be made in installments spread out over a number of months or even years. However, redemption may be accelerated in the event of a sale of a majority of the company’s shares, or an initial public offering.

As an alternative to, or in addition to, prescribing redemption rights for the preferred shares, the term sheet might provide a “put” which gives the venture capital firm the right, after a certain period of time if no other event permitting redemption has occurred, to sell its shares back to the company at a price equal to their fair market value as determined by an outside appraiser or upon application of a prescribed formula.

However, whether provided as “puts” or rights of redemption, these terms can be of limited practical value should the company be unable to pass the solvency tests prescribed under corporate law, such as subsections 30 (2) and 32 (2) of the Ontario Business Corporations Act.

Liquidation Preference

Although the venture capital firm may not succeed in having early redemption rights inserted into the term sheet, it will certainly argue that it is entitled to a preference in getting its investment back in the event that the company is liquidated, either upon insolvency or a sale of substantially all of the company’s assets. The term sheet therefore provides that out of the liquidation proceeds, and after payment is made to secured and unsecured creditors, payment must then be made to the venture capital firm before any payment can be made to the company’s common shareholders. The amount of the payment to be made to the venture capital firm is usually set as the original purchase price of the preferred shares, adjusted for any stock dividends, combinations or splits. The obligation to increase this amount to include any accrued but unpaid dividends, or, in the absence of cumulative dividends, a guaranteed return often between 5% and 10% of the original purchase price, can be the subject of intense negotiation.

In addition to this preferential amount, the term sheet may also allow the venture capital firm to participate rateably in the distribution of the company’s remaining proceeds of liquidation with the common shareholders. A frequent point of contention is whether the common shareholders should first receive back their own purchase price before the venture capital firm then participates with the common shareholders in the remaining proceeds.

Another point of contention is whether the liquidation preference enjoyed by the venture capital firm should be subordinated in any subsequent round of venture capital financing so that new venture investors will have a senior position on liquidation or at least rank pari passu with the venture capital firm. This debate can be complicated if liquidation is defined in the term sheet to include the acquisition of the company or its merger into another entity.

Voting Rights

The venture capital firm is ordinarily granted in the term sheet the same number of votes as the votes carried by the common shares into which its preferred shares are convertible, generally on a one vote per share basis. However, in order for the venture capital firm to carry out the special rights it might enjoy in electing directors and vetoing certain company decisions (described in more detail under the headings “Board of Directors” and “Management and Control” below), the term sheet may provide that certain actions require the approval of the preferred shareholders voting as a separate class. Practically speaking, a written shareholder resolution approving a proposed action which is signed by the venture capital firm as the sole preferred shareholder is the same as a written formal consent to such action signed by the venture capital firm.

Conversion Rights

There may not be much debate over when the preferred shares can be converted into common shares of the company, although the conversion rate can represent a contentious issue in the negotiation of the term sheet. Ordinarily the preferred shares are convertible into common shares at the option of the venture capital firm at any time and are automatically converted into common shares on a mandatory basis in the event that the company makes an initial public offering or an offer is received to buy not less than a majority of its shares. Automatic conversion in the event of an IPO is seldom debated because the company is able to simplify its capital structure as a pre-requisite to the IPO, and the venture capital firm is able to participate in it. Because the special voting rights and other terms of the preferred shares are often inconsistent with the terms, or absence of terms, of public market securities, the preferred shares are designed to simply disappear on an IPO through conversion.

There may be some debate, however, on the size of an IPO which triggers the conversion. The parties to the term sheet generally try to establish a size sufficient to create an adequate "float" when the common shares trade publicly. Furthermore, as part of the conversion, the venture capital firm may argue for payment of accrued but unpaid dividends, either in cash or shares, although accrued dividends are often waived. In the case of automatic conversion on a takeover offer, a minimum share price might also be required by the term sheet.

The conversion rate, along with the percentage ownership of the company which the venture capital firm wants to acquire, depends on the “pre-money valuation” of the company, which is the value of the company before the funds of the venture capital firm are contributed, and the dollar amount of the funds to be contributed. The rate also depends on the projected value of the company, and the likelihood of the venture capital firm receiving its required rate of return on invested capital in the event of a future sale of its shares in the company.

Determining the conversion rate can become quite complex, especially when later rounds of financing from other investors are anticipated and the percentage ownership of the venture capital firm is diluted as a result. Generally speaking, the conversion rate of the preferred shares into the company’s common shares is calculated by dividing the original purchase price of the preferred shares by a “conversion price" which is initially set at the original purchase price to achieve a 1-to-1 conversion of preferred shares into common shares.

Anti-dilution

This conversion price is then automatically adjusted for any stock dividends, combinations or splits, in order that the preferred shares will convert into the number of common shares which will maintain the venture capital firm’s percentage of equity in the company. This provision in the term sheet is seldom debated.

What is usually debated is an adjustment to the conversion price should the company need to issue additional equity in subsequent rounds of financing at less than the original purchase price paid for the preferred shares by the venture capital firm. The term sheet will often give the venture capital firm the right to obtain more common shares on conversion, without additional aggregate consideration, in the event that the company subsequently issues new common shares or equivalent securities at a price below the then current conversion price. The conversion price of the preferred shares is effectively decreased, resulting in more common shares per preferred share being issued upon conversion.

In requesting this anti-dilution protection, the venture capital firm ordinarily argues that because there is no readily available, independent market price for the company’s shares, it should be protected against having overpaid. Furthermore, the company’s founders and managers holding common shares should have to pay through dilution if they don’t succeed in increasing the value of the company by the next round of financing. From their point of view, however, any decrease in the value of the company could result from events beyond their control. In conceding to the inclusion of such anti-dilution protection, the company is arguably denied the flexibility it may need in a downturn to raise new financing at a lower price.

If anti-dilution protection is to be included in the term sheet, the debate then shifts to whether a "weighted average" formula or "ratchet" formula should apply. The weighted average formula uses the discounted price and number of the new common shares sold in adjusting the conversion price of the preferred shares downwards. Under this formula, the sale by the company of a large number of common shares at a price slightly lower than the conversion price, and the sale of a small number of common shares at a much lower price, collectively result in a relatively small adjustment to the conversion price of the preferred shares. The ratchet formula, on the other hand, automatically decreases the conversion price of the preferred shares to the lowest price at which the new common shares have been issued, regardless of the number of new shares issued.

The company’s founders and managers holding common shares generally want the weighted average formula to apply if discount stock is offered in the future, given the greater dilution of their shares if the ratchet formula is applied instead. To arrive at a formula for the term sheet, a hybrid of both the weighted average and the ratchet formulas may end up being used, such as applying the ratchet formula for the first two years of the venture capital firm’s investment and the weighted average formula thereafter in an effort to discourage the early issuance of discount stock. Alternatively, the ratchet formula might apply only if the discount stock is issued at a price below a specified threshold price.

Exceptions to these anti-dilution provisions are often set out in the term sheet. The most common exception relates to the pool of shares, ranging somewhere between 5% and 20% of the outstanding fully-diluted shares of the company, which is set aside for issuance to key employees. The size of this pool may be adjusted from time to time to accommodate any future share issuances which have been approved by the venture capital firm.

Depending upon the bargaining power of the company in negotiating the term sheet, a venture capital firm may end up with anti-dilution protection only if it makes a pro rata investment in any future company financing. Such qualified protection, sometimes called a "pay-to-play" provision, encourages future investment and assistance by the venture capital firm in helping the company to grow. A pay-to-play provision in a term sheet can force a non-participating venture capital firm to convert its preferred shares into common shares or into a parallel series of preferred shares lacking price-based anti-dilution protection, or to simply waive any anti-dilution adjustments it might otherwise be entitled to as a participating shareholder.

Board of Directors

The general approach of the venture capital firm, as mentioned above, is to leave the managers free to operate the company on a day-to-day basis so long as the company is complying with its business plan and meeting the milestones that have been agreed upon. However, the venture capital firm will usually insist that it be given the right in the term sheet to nominate one or more directors to the company’s board, or at least be given the right to have a nominee attend board meetings as an observer. Observers are usually entitled to receive notice of and to attend meetings of the board of directors, but are not entitled to vote. The venture capital firm may prefer to limit the involvement of its nominees to observer status if the board already consists of nominees of other institutional investors, or as a way of avoiding director liability or the policies of certain stock exchanges which place escrow requirements during an IPO on shareholders having board representation.

In addition to the venture capital firm’s nominees, the term sheet will normally give the founders and key managers holding common shares the right to nominate a certain number of directors. The term sheet may then include a provision requiring the parties to vote in favour of the election of the nominees of the other parties to the board of directors and to fill any vacancy on the board with the nominee of the party who was represented by a vacating director. The parties may also be required to remove any nominee director who contravenes or votes against the wishes of the party nominating him. A related provision may limit the number of directors so that the right to nominate directors is equal to the right to control a specified portion of the board.

The term sheet may also require that audit and compensation committees of the board be established, comprised solely of directors unrelated to the founders and managers, and that directors’ and officers’ liability insurance be put into place. The venture capital firm will usually require board meetings to be held quarterly, if not more frequently, and will insist that the quorum requirements will not allow such meetings to proceed in the absence of its nominee director.

To provide the venture capital firm with the right to become more involved should the company’s financial position deteriorate, the term sheet may contain “voting switch provisions”. These provisions give the venture capital firm the right to elect more directors, even a majority of the company’s board, upon the occurrence of certain materially adverse events, such as the failure by the company to meet specified milestones or the breach by the company of a covenant in any of the definitive agreements. These provisions may even include the right to remove any of the current managers upon relatively short notice without cause, but subject to an obligation to pay appropriate severance and buy back any company shares the managers may hold.

Management and Control

In addition to its right to elect directors, the venture capital firm ordinarily wants to play some role, possibly by exercising veto rights, in important management matters. These matters generally include operating budgets, major capital expenditures, executive hiring and firing, compensation levels, equity and debt financings, material strategic alliances, larger acquisitions and sales, dividend payments, share redemptions, and other significant actions out of the ordinary course of the company’s business.

The term sheet may specify that control over these particular matters be implemented by the venture capital firm as a preferred shareholder voting on them as a separate class, or by establishing super-majority voting rules at the board level, or by simply requiring written approval of the venture capital firm. The venture capital firm may even insist that the right to vote on such matters as a separate class be incorporated into the terms of the preferred shares and reflected in the company’s articles or other charter documents, instead of being merely reflected in a shareholders agreement. However, depending upon the nature of such terms and the need of the parties for confidentiality, it may not be appropriate for the terms to be placed in the company’s articles and thereby subject to possible public scrutiny.

In an effort to reduce the extent of the venture capital firm’s potential veto, especially if exercisable by way of mandatory written approval of the prescribed matters, the company may argue that the veto should disappear once the venture capital firm’s equity ownership in the company is reduced below a certain percentage.

Employees

To ensure that the company’s key management positions are filled by people with suitable skills and experience, the venture capital firm may name in the term sheet the specific individuals who are to be, for example, the chief financial officer or chief marketing officer. The term sheet will usually require that all of the company’s top managers enter into comprehensive employment agreements not only setting out their respective duties, compensation (including bonus entitlement and participation in stock purchase and option plans), and rights on termination, but also their assignment of intellectual property rights and their non-disclosure, non-competition and no “moonlighting” obligations. The maintenance of “key person” insurance for them will also be a requirement.

The treatment of options and shares held by the company’s managers is often subject to considerable debate during the negotiation of the term sheet. Ordinarily any rights to acquire discounted shares or options will be vested in the managers over a three to five year period. Any shares acquired will usually be subject to transfer restrictions, as well as call rights, in favour of the company upon the termination of employment, death or permanent disability of the managers. The venture capital firm will want to be assured that current management of the company will be motivated through appreciation in the value of the company’s shares to stay and work, and will be discouraged from leaving by means of the call provisions.

Information Rights

The term sheet will usually require the company to provide ongoing financial information to the venture capital firm directly on a regular basis and not simply by way of its nominee director at board meetings. The information to be provided will include monthly or quarterly management financial statements and audited annual financial statements. Other information generally to be provided will include management budgets, forecasts and variance reports, along with research and development reports and certificates from the chief financial officer that all statutory deductions and other amounts for which directors may be personally liable have been appropriately withheld and remitted.

The venture capital firm will usually be granted ongoing inspection and audit rights which permit it to visit and inspect the company's properties, examine the company's accounts and records, and discuss the company's affairs and finances with company officers. Such rights, however, are often qualified in the term sheet to exclude the provision of any information which the company reasonably believes to be trade secrets or other confidential information unless the company is satisfied with the confidentiality arrangements made with the inspecting parties.

As with the veto rights and many of the other rights discussed in this paper, the company may argue that the information rights granted to the venture capital firm in the term sheet should disappear once the venture capital firm’s equity ownership in the company is reduced below a certain percentage.

Pre-emptive Rights

In order to maintain its percentage of equity ownership in the company, the venture capital firm will insist that the term sheet provide it with a right of first refusal on the purchase of any shares, and any securities exchangeable or convertible into shares, including rights, options and warrants, which may be offered by the company in the future. This right, commonly called a pre-emptive right, normally entitles the venture capital firm to receive notice of the offering and to subscribe for a portion of the offering that is equal to its existing percentage of the company’s outstanding equity under the same terms offered to other investors.

This right may also entitle the venture capital firm to purchase shares not purchased by other investors under their own rights of first refusal. If less than all of the holders of such rights elect to participate, or if they participate for less than their full entitlement, the term sheet may provide for the reallotment of the unsubscribed portion among those already taking up their full entitlement. The available shares are simply pro-rated among the buying shareholders in proportion to their pre-existing shareholdings.

Exemptions from these pre-emptive rights are often provided in the term sheet. They may cover shares issued to employees, officers, directors and consultants pursuant to incentive compensation arrangements, or to shares issued upon conversion of other company securities or in connection with stock dividends or stock splits, or to shares issued to commercial lenders and equipment lessors in the ordinary course of business. They may also cover shares issued pursuant to the company’s acquisition of another entity, although the venture capital firm may wish to restrict such exemption to only certain specified acquisitions.

Rights of First Refusal

The venture capital firm will usually also insist that the term sheet provide it with a right of first refusal on the transfer of any company shares proposed by any other shareholders in the future. In contrast to pre-emptive rights which are intended to maintain its percentage of equity ownership in the company, rights of first refusal are intended to increase its equity ownership in the company in the event that any of the other shareholders decides to sell. As with pre-emptive rights, rights of first refusal often apply to any shares, or securities exchangeable or convertible into shares, including rights, options or warrants, and not just to the preferred shares or other shares of the same class as are already held by the venture capital firm.
Certain transfers are ordinarily exempt from the rights of first refusal in the term sheet. Such exemptions include transfers to a registered retirement savings plan or other trust of which the shareholder is the beneficial owner, or to a shareholder’s spouse, or to a shareholder’s personal holding company provided that the shareholders of the holding company agree not to transfer their shares in the holding company unless they concurrently transfer the shares of the company to another exempt party.

In the case of corporate shareholders, exemptions from rights of first refusal may be available to cover transfers to affiliates, and in the case of the venture capital firm, permitted transfers will include transfers to other funds or corporations managed by the firm, and possibly to distributions of shares in specie to the investors of such funds.

Debate may occur over which events specifically trigger the right of first refusal. Some term sheets require that a “bona fide offer” must be received by the selling shareholder from a third party before notice is to be given to the other shareholders of their purchase rights. Obviously this requirement deters potential third party purchasers from incurring the time and expense involved in preparing a serious offer which may be ignored if any one of the other current shareholders elects to exercise its purchase rights.

As an alternative, the term sheet may provide what is commonly called a right of first offer, which permits the selling shareholder to simply give notice to the other shareholders of its intention to sell at an acceptable price. This alternative, however, may encourage the selling shareholder to specify an inflated price with the expectation that the other shareholders will elect to purchase at the inflated price rather than risk a third party becoming a shareholder.

Co-sale Rights

As a way of achieving liquidity of its investment as well as denying the founders and managers holding company shares an exit from the company before the venture capital firm is able to exit, the term sheet often provides for “co-sale” rights. These provisions generally allow the venture capital firm, and usually any other significant investors, to participate in a shareholder’s proposed sale of company shares on a basis proportional to their respective percentage of equity ownership in the company. Ordinarily only a sale resulting in a change of control of the company, or a sale by the founders or managers of all or a substantial portion of their holdings of company shares, will trigger co-sale rights under the term sheet.

In contrast to “piggyback” rights which often allow other shareholders to have included all of their shares in a third party purchase offer, “co-sale” rights provide for the inclusion of only such portion of their shares which, when added to the portion held by the founders or managers, equals the number of shares which the third party wishes to purchase. The number of shares that the founders or managers can sell is effectively reduced and replaced by the number of shares that the venture capital firm elects to sell to the third party. In the event that the third party wishes to purchase all of the company’s outstanding shares, the difference between piggyback rights and co-sale rights disappears in practice.

Drag Along Rights

The term sheet will often provide the venture capital firm with “drag along” rights enabling it to force the founders and managers to participate in a sale of company shares by the venture capital firm to a third party. Such rights increase the marketability of the venture capital firm’s shares since a third party purchaser may be more likely to want all of the shares of the company rather than have to deal with other company shareholders after its purchase. While drag along provisions can also require the venture capital firm to participate in a sale by the founders and mangers, such provisions are not ordinarily found in term sheets.

Registration Rights

Many term sheets, particularly those prepared by U.S. based venture capital firms or those involving companies likely to become eligible to list on NASDAQ or other American exchanges, will include “registration rights” provisions. These provisions grant the venture capital firm the right to “demand” that the company qualify the venture capital firm’s shares in the company for public distribution, and thereby dictate the timing of a public offering. They also provide the venture capital firm with “piggyback” rights under which its shares are included in any "primary registration", when the company files a registration statement to permit the sale of its shares from treasury, or in any "secondary registration", when the company files a registration statement to permit other shareholders to sell.

These provisions are intended to give the venture capital firm liquidity on an IPO when the perceived return from maintaining an ongoing investment in the company is below the venture capital firm’s threshold return requirements. The venture capital firm is given the right to liquidate its investment in the company and reinvest its funds elsewhere in the hope of earning a greater return.

Demand registration rights in a term sheet often entitle the venture capital firm to require the company to register the company’s shares after a certain period of time, usually 3 to 5 years, with the Securities and Exchange Commission by filing a registration statement. The number of "demands" prescribed in the term sheet is usually negotiated, with the company insisting that one is enough and the venture capital firm arguing for two or more. Granting demand registration rights can place a significant burden on the company given the time and cost involved if those rights are exercised. All expenses incurred in demand registrations are normally paid by the company. In practice, exercising the demand doesn’t necessarily mean that a public offering will happen. Since management has to go on the "road show" and make convincing presentations to the fund managers and brokers who will be buying the company’s shares, management can usually resist the demand to register if business conditions are not favourable.

Piggyback registration rights obligate the company to use its best efforts to include the venture capital firm’s shares in any public registrations the company intends to make. However, such rights are always subject to the underwriter's discretion to exclude the venture capital firm’s shares from the offering. Such rights are also usually excluded from any offering of shares in the context of a corporate acquisition or employee stock option or purchase plan.

Representations and Warranties

Most of the representations and warranties to be given by the company, and possibly by the founders and managers, are to be contained in the definitive agreements, most likely the subscription or share purchase agreement. However, the term sheet may describe the representations and warranties expected to be given in fairly general language.

The term sheet often requires the company to warrant (a) its good standing; (b) its capital structure; (c) the proper approval of the proposed financing; (d) the ownership of its technology and other assets; (e) the accuracy of its financial statements; (f) the absence of litigation or probable claims against the company; and (g) that full disclosure has or will be made to the venture capital firm of all material information relative to making an informed investment decision.

As an alternative to these general descriptions, the term sheet may simply require that “standard” representations and warranties as are used in “generally comparable transactions” be given. This alternative “standard” wording may be resisted by the company in an effort to determine at the outset if the venture capital firm is looking for warranties which the company is unable or unprepared to give. Whichever way the term sheet refers to representations and warranties, the company may also want to explore at the outset the preparedness of the venture capital firm to permit “actual knowledge” or “material” qualifiers.

In support of the representations and warranties made by the company concerning its capital structure, the proper approval of the proposed financing, and the issuance of the shares in conformity with applicable securities laws, the term sheet will usually require delivery of an opinion from the company’s legal counsel to the venture capital firm at closing on such items.

The company will often insist that the venture capital firm warrant in the term sheet (a) the proper approval of the proposed financing; (b) its qualification to purchase the company’s shares under applicable securities laws; and (c) that it has had sufficient access to company information and has had the opportunity to ask all questions material to making an informed investment decision.

Personal Liability

One of the more contentious issues in negotiating the term sheet is the extent to which any of the founders or managers holding shares in the company should be personally liable to the venture capital firm for any breach of the company’s representations or warranties, and perhaps even covenants, in the term sheet or in any of the definitive agreements. The founders and managers are ordinarily prepared to accept personal liability only under the shareholders agreement as well as under any employment agreements and additional non-competition and confidentiality agreements which they may sign in their personal capacities.

However, few founders and managers are prepared to be jointly and severally liable with the company under any indemnity given to cover any losses the venture capital firm may suffer as a result of the company’s breach of the term sheet or definitive agreements. Despite the venture capital firm’s argument that some of the risk of unknown company liabilities should be placed under an indemnity upon the founders and managers who are in a better position to know or at least find out, the founders and managers already bear, and will continue to bear, such risk by holding company shares.

Given that the issuance of company shares to the venture capital firm does not result in the founders or managers receiving funds personally from the venture capital firm, as they might if they were selling their own shares directly, most founders and managers are able to argue convincingly that they receive no reward for taking on the extra risk of a personal indemnity for the company’s potential breach. Should their refusal to provide such an indemnity cause the venture capital firm to deny funds, the founders and managers may offer, as an alternative, personal indemnities for which they are only severally liable to the extent of their respective proportionate holdings of company shares, collectively capped at the amount of the venture capital firm’s investment.

Due Diligence Period

The term sheet will ordinarily set out the rights and obligations of the parties on a legally binding basis covering the time after signing of the term sheet when the venture capital firm undertakes its due diligence investigations of the company. Completion of the transaction will usually be stated as being dependent upon the venture capital firm being satisfied with the results of the investigations. During such investigations, legal counsel will work together in preparing the initial drafts of the definitive agreements which attempt to reflect the provisions of the term sheet. Negotiations often continue during this period, especially when the investigations reveal information which cause either party to request amendments to any of the provisions in the term sheet.

Rights of access during normal business hours to the company’s various properties to review its accounts and records, interview certain employees and inspect the business being carried on are generally given to the venture capital firm in the term sheet, subject to a duty to maintain confidentiality. The venture capital firm may also be given a right of introduction to the company’s customers, suppliers, and consultants, all with a view to verifying the company’s financial statements and projections of performance, as well as the representations and warranties made in the term sheet and to be made in the definitive agreements.

Lock-up

Often the venture capital firm will insist that the company agree in the term sheet on a legally binding basis to be bound by a “lock-up” during which the company will not discuss its funding needs with any other parties. The lock-up provision is intended to encourage both parties to focus on completing the transaction and not be distracted by other possible deals. Despite the potential recovery of its own expenses whether the transaction is completed or not, as discussed below, the venture capital firm has to consider its “opportunity cost” when working on a deal. Because the venture capital firm invests a lot of time in carrying out due diligence and in negotiating the term sheet, it wants to ensure that the company won’t be soliciting other financial firms at the same time and increasing the likelihood of the company switching to one of them.

The lock-up is often stated to be in effect until the closing of the transaction, or until a date by which the transaction is reasonably expected to close, whichever is earlier. However, as discussed below, there may well be more than one closing, and the venture capital firm may argue that the lock-up should subsist until the final closing. Since the amount of time which the venture capital firm ordinarily invests in the company is relatively greater up to the date of the initial closing, and relatively less when approaching subsequent closings (despite unexpected time required for ongoing monitoring and crisis management), the company often succeeds in having any lock-up in the term sheet restricted to the period prior to the initial closing. However, the venture capital firm is nonetheless protected thereafter through the veto rights it usually may exercise over future share issuances and significant company borrowing.

Time of Closing

The term sheet may specify that the closing of the transaction may take place immediately upon the execution of the definitive agreements, or within a certain time after their execution. The length of time after the execution of the definitive agreements which is required in order to close may depend upon whether the venture capital firm will need more time to complete additional due diligence instead of relying upon the representations and warranties made by the company in the definitive agreements. It may also depend upon the perceived difficulty in obtaining any internal approvals from the parties themselves or any consents required from third parties. Closing is usually dependent upon board of director or investment committee approval in the case of the venture capital firm, and on board of director as well as shareholder approval in the case of the company. The company, on the other hand, may resist such a delay in closing, depending upon its own financial needs. It may simply not have sufficient cash reserves to continue operating between the time the definitive agreements are executed and a subsequent closing date.

Many venture capital firms prefer to advance monies in installments, or tranches, over time upon completion of certain milestones. Consequently the term sheet may provide for an initial closing, at which all of the definitive agreements are executed and delivered and an initial payment made in exchange for a certificate for a certain portion of the overall number of shares being purchased. The term sheet may then also provide, at one or more subsequent closings to take place within a certain period of time following applicable milestones, that the balance of the purchase price be paid in exchange for share certificates and other documents delivered in order to update any information given in a previous closing which has become stale or misleading. The term sheet will often provide that subsequent closings are subject to the discretion of the venture capital firm, whether the applicable milestones have been met or not.

Use of Proceeds and Expenses

The term sheet will usually provide that the proceeds to be paid on each closing are to be used for the company’s ongoing working capital requirements and any pre-approved capital expenditures, but are not to be used to pay any existing debts, particularly any monies owed to the founders or managers under any previously made loans or on account of past services rendered to the company. The venture capital firm may even resist allowing payment of the company’s transaction costs out of the proceeds.

As a legally binding provision, the term sheet will often require the company to pay the reasonable legal expenses incurred by the venture capital firm in negotiating and drafting the term sheet and the definitive agreements, and in conducting due diligence, whether the transaction closes or not. While the company is usually unable to avoid having to pay for these legal expenses, it may succeed at having them capped at a specific dollar amount. The term sheet may also require the company to provide a cash retainer to the lawyers acting for the venture capital firm, although the company may be able to negotiate this requirement away. The legal fees charged by the venture capital firm’s lawyers are generally deducted from the purchase price before being paid over to the company.

Conclusion

Despite the possible variations of the term sheet provisions discussed above, there is a remarkable similarity among the forms of term sheets that circulate around venture capital marketplaces, both domestic and foreign. Even the term sheet precedent attached as Schedule A was recently used for two separate financing rounds, one American-led and one Swiss-led. As these similar forms get greater usage, there is a greater likelihood that they may converge into a few “standard” forms reflecting the prevailing practice for venture capital investments in many different markets. They may come to represent, in other words, the “benchmark” or “going rate” against which the terms of all venture capital investments may be measured, and limit the range within which any venture capital firm may be prepared to negotiate. Companies may then need a lot of bargaining power to achieve what they feel are only minor variations to the terms being proposed. And business lawyers acting for such companies in search of venture capital may have less original drafting to do.

© 2002 A. Paul Mahaffy. All rights reserved. A. Paul Mahaffy practises business law with Bennett Best Burn LLP of Toronto, with particular emphasis on purchase and sale agreements, technology transfers, Internet commerce, joint ventures and financing. He can be reached by e-mail at pmahaffy@bbburn.com, and his recent publications can be viewed online at http://paulmahaffy.com.

SCHEDULE A

Description of Terms

ABC Venture Capital Firm (“VC”) proposes to invest $_________ in XYZ Company (“Company”) based on a pre-closing valuation of Company of $_________ (the capitalization for such purpose to include the 5% option pool described below). The investment will be made in the form of convertible preferred stock (“Preferred Stock”), with an initial advance of $_________, and future advances to be made in VC’s sole discretion based on Company achieving the milestones described in Schedule A hereto, which advances shall be made in consideration for the simultaneous issuance by Company of Preferred Stock. The following is an outline of the terms of the proposed investment. This outline is merely an agreement in principle, which will become binding only upon both parties entering into mutually acceptable, definitive documents.

At the initial closing, VC shall receive a warrant of Company to purchase, at an exercise price equal to VC’s initial purchase price for the Preferred Stock (the “Purchase Price”), such number of shares of Preferred Stock as equals $_________ divided by the Purchase Price. The warrant will expire ten years from its issuance. The warrant will have (a) full ratchet anti-dilution protection and (b) a cashless exercise provision. The number of warrant shares will be reduced by one-half if, within 18 months from the initial closing, Company has raised at least an additional $_________ in equity from institutional investors and Company’s valuation, based on the valuation utilized in connection with its then most recent bona fide, arms’ length equity financing with an institutional investor of at least $_________, is at least $___________.

1. Terms of Convertible Preferred Stock