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You Finally Received a Venture Capital Term Sheet

Lerch Early & Brewer's Legal Update

What do the terms mean for your business?

Congratulations, your company has just received a term sheet for Series A Preferred Stock from a venture capital (VC) firm! What began as an inspiring vision and has involved several years of late nights and weekends of work, now has resulted in an exciting new product and a growing customer base and revenue stream. It has been supported by a group of existing investors that includes family, friends and angel investors who provided early funding.

You eagerly review the VC term sheet and immediately are struck by a number of unfamiliar legal terms. In this article, we will review two of these provisions.
 

  • Price Per Share on a Fully-Diluted Pre-Money Basis
  • Liquidation Preference/Participating Preferred (vs. Non-Participating)

Price Per Share on a Fully-Diluted Pre-Money Basis

The first term you probably look for is the value the VC firm is giving your business. This typically is expressed as a Fully-Diluted Pre-Money valuation. The term Pre-Money means that the venture capital firm is calculating the value of your business before taking into account the new money it plans to invest. The term Fully-Diluted means that for purposes of calculating the share price, the VC firm will include the total number of shares that would be outstanding if all possible sources of conversion such as stock options, convertible notes and warrants were exercised. Stock options include all stock options authorized for issue under an equity inventive plan, which a VC will often require to be increased pre-closing. This enables the VC firm to avoid having its shares diluted later on when these instruments convert, often at a price lower than the price being paid by the VC firm.


Liquidation Preference; Participating Preferred (vs. Non-Participating)

The Liquidation Preference is a mechanism by which the VC firm seeks to recoup its original investment or a multiple thereof, plus any declared and unpaid dividends, before there are any distributions to the common stockholders. This Liquidation Preference usually is defined to occur upon a liquidation, dissolution or winding up of the company, a merger, or a sale of the company or its assets.

Participating Preferred is a means for the VC firm, to receive further distributions along with the common stockholders after receiving the Liquidation Preference, as if it had converted its preferred stock into common stock after receiving the Liquidation Preference. Non-Participating Preferred limits the VC Firm to its liquidation preference. In practice, a VC firm with Non-Participating Preferred will have and exercise its right to convert its preferred stock into common stock and give up its Liquidation Preference if it would get a larger return as a common stockholder.
 

These are just a few of the terms you may encounter in a VC term sheet. For more information on the additional terms below, please visit "Venture Capital Term Sheet Glossary."

  • Anti-Dilution Provisions
  • Conversion Rights
  • Registration Rights
  • Redemption Rights
  • Dividend Rights
  • Protective Provisions
  • Voting Rights

The attorneys in the Business & Tax practice at Lerch, Early & Brewer in Bethesda, Maryland provide a range of services for emerging businesses, including   formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. For more information about how to review a term sheet,  formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. For more information about how to review a term sheet, contact Lerch Early's Business & Tax department at (301) 986-1300 or visit the Business & Tax practice page.

 

 

This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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