Week 5 ENT 640: Structuring

The deal has been sourced, evaluated and valued, now it is investment time.  In Winning Angels, structuring is the fourth fundamental which angel investors must look at carefully and fully understand the consequences of their investment. Structuring defines the ownership within the startup.  Common stock, preferred stock, and convertible notes are different ways the entity’s capital may be structured. (Kloss) The structure of the deal can affect both future rounds of fundraising and the exit.   Let’s look at each one.

First, there is common stock. This type of equity provides the investor with shares in the company that typically have no special rights.  This type of arrangement is often done with friends and families and it gives an entrepreneur the most freedom. (Amis and Stevenson) Investors obtaining only common stock typically have no rights to invest in later rounds of financing. To limit some of the entrepreneur’s freedom and provide for the possibility of future investment, common stock may be structured with pre-emptive rights, allowing the investor to invest in future rounds to keep the same ownership percentage, and/or tag-along rights, allowing the investor to sell shares when anyone else sells shares. (Amis and Stevenson) When structuring a deal using common stock method, there is no impact on the exit.

Preferred stock provides the investor with shares in the startup with rights that common stock holders do not have.  This is important in the event of a bankruptcy or liquidation. It is also important in the context of an ongoing business because the investor holding preferred stock can get its capital and any unpaid dividends back before the common stock holders receive any distribution. (Kloss) There are a variety of rights available to the investor holding preferred stock– board seats, dividends, an opportunity to invest in future rounds of financing, and conversion rights. (Amis and Stevenson) Both VCs and angel investors use preferred stock structures.  The difference is often the complexity of the terms. VCs typically will be in for a longer investment term than angel investors. (Amis and Stevenson) If terms are too complicated, then exiting the investment could be more complicated as compared to a situation where the capital structure for both the investor and the entrepreneur are simpler, which could lead to a positive future exit for both. (Amis and Stevenson)

Convertible notes are debt instruments, which often are used by investors who want a shorter investment time frame.  (Amis and Stevenson) Convertible notes have the right to convert into equity when a defined event happens; for example, a minimum amount of capital is raised at a minimum value.  (Kloss).  Convertible debt may have fixed or variable rates of conversion and some may be structured with a discount. Similar to preferred stock, convertible notes may have terms which allow the investor to be part of future fundraising rounds.  Using convertible notes to structure a deal often leads to a VC round and VCs are experts at exiting. (Amis and Stevenson)

Regardless of which structure the angel investor uses, all structures will be set forth in a term sheet.  Investopedia defines a term sheet as “a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made.”  In other words, the economic details of the structure the angel and entrepreneur decide upon are written up in the term sheet.  Marianne Hudson in an article about term sheets believes the negotiation of the term sheet is a very important part of the equity investment process. Hudson believes that if “done well,” it will lead to more binding contracts, deals that actually close, and companies and relationships that get off to a good start. (Hudson) As Amis and Stevenson wrote in Winning Angels, VCs may have 40 terms and 100 pages whereas angels may have five terms and 10 pages.  Hudson discusses the improvement that angels have made with term sheets by limiting the number of terms and all the legalese.  Entrepreneurs and early investors will have their needs and requirements better aligned this way. (Hudson) Dan Rosen has developed a less complicated term sheet for angels to use, he calls it “plain vanilla.”(Hudson) Rosen’s goal was to make the term sheet amenable to both the angel and the entrepreneur with only the terms an angel needs and nothing unnecessary added. Those terms could still include terms that are also included in a VC term sheet: pricing, board and information rights, participation, liquidation, and redemption rights. (Hudson) Here is a Rosen example and it is only seven pages: https://www.angelcapitalassociation.org/data/Documents/Resources/1%20-%20Resources/Draft%20Term%20Sheet%20for%20Alliance%20of%20Angels.pdf

Hudson suggests this standard term sheet is catching on because it takes less time, is easier to understand and lessens some of the legal costs to prepare the document.  In the end, angels and entrepreneurs both want success for themselves, the product or service and the investment.  It seems that using a document which everyone can understand and agree on would be a win win for both sides, eliminating complicated terms which might have adverse future funding and exiting implications.

For a bit more on term sheets here are two short videos.  The first one is about economics and control and the second one discusses an initial term sheet for an investment in Snapchat.

https://www.youtube.com/watch?v=PgtWWB5-SCo&list=PLxNPEV4OmF-p6py_e1Wpm1A5T4IIXRn6F&index=8

https://www.youtube.com/watch?v=W1bJHErAXUk&list=PLxNPEV4OmF-p6py_e1Wpm1A5T4IIXRn6F&index=9

Resources:

Amis, David, and Howard H. Stevenson. Winning Angels: The Seven Fundamentals of Early-stage Investing. London: Financial Times Prentice Hall, 2001. Print.

Hudson, Marianne. “Simple Term Sheets Align Angel Investors And Entrepreneurs For More Successful Deals.” Forbes. Forbes Magazine, 10 Sept. 2014. Web. 07 June 2017. <https://www.forbes.com/sites/mariannehudson/2014/09/10/simple-term-sheets-align-angel-investors-and-entrepreneurs-for-more-successful-deals/#72b0c2f824a5>.

Institute, Angel Resource, and Ann-Marie Koss. “Best Practice Guidance for Angel Groups – Deal Structure and Negotiation.” SSRN Electronic Journal (2007): n. pag. Angel Capital Association. Angel Capital Education Foundation, July 2007. Web. 7 June 2017. <https://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_BEST_PRACTICES_Deal_Structuring.pdf>.

Saddington, John. “Term Sheets: Economics and Control (Intro) ||| Venture Capital ||| Bite-Sized VC.” YouTube. YouTube, 24 Feb. 2017. Web. 07 June 2017. <https://www.youtube.com/watch?v=PgtWWB5-SCo&list=PLxNPEV4OmF-p6py_e1Wpm1A5T4IIXRn6F&index=8>.

Saddington, John. “A Snapchat IPO Story: A Lesson on Term Sheets, Economics and Control.” YouTube. YouTube, 03 Mar. 2017. Web. 07 June 2017. <https://www.youtube.com/watch?v=W1bJHErAXUk&list=PLxNPEV4OmF-p6py_e1Wpm1A5T4IIXRn6F&index=9>.

Staff, Investopedia. “Term Sheet.” Investopedia. Investopedia, LLC, 29 July 2015. Web. 07 June 2017. <http://www.investopedia.com/terms/t/termsheet.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186&lgl=myfinance-layout-no-ads>.

9 thoughts on “Week 5 ENT 640: Structuring

  1. Cece,

    Very interesting blog and videos. From what I understand the term sheet seems to be the first step and it is not binding for either investor or entrepreneur. The term sheet can be signed and is a legal document but it is not binding meaning you are not guaranteed to get money back. But the term sheet does create economic control by having it signed. Make sure to find founder friendly venture capitalists and not one that will take advantage of the entrepreneur.

    Thanks,
    Mackensie

  2. Cece,
    Until this chapter I had not heard of a term sheet. Thanks for sharing the term sheet example from Rosen and the two videos. These may be a useful tool to have down the road.
    John

  3. Hi Cece,

    The term sheet seems like such a helpful thing, I could see using it in a business when I start one. As far as structure goes, for me at least, I would hire a lawyer to handle that if I didn’t have a lawyer among my close circle of friends or partners. Leave something out and it could end up costing you dearly, but leave something in and the deal might not happen.

    Austin

  4. Hi Cece,

    You’ve provided a solid summary of the structuring phase of Angel Investment. Thanks for the additional information, particularly the term sheet video on Snapchat.
    Interestingly, I use a variation on this kind of term sheet for my work in brand and trademark licensing. I do agree that they simplify the process and can get the ball rolling much faster than a protracted negotiation right from the beginning. This does not mean negotiation is now off the table, it just means that there’s basic understanding of how things will move forward at a certain point in time.

    -David

  5. The term sheet is the deal. I think about signing mortgage documents that we don’t read completely. We just want to know the most important details, how much , how long, interest rate, payment, and if there is an early payment penalty. But investing is not the same and the term sheet does need to be clear and concise. I wouldn’t want to get lost in technical terminology. Confusion is a deal breaker. Trust is so important here as well-trusting your partner, your lawyer and trusting what you know to know get caught up and make an impulsive decision.

  6. Like others have mentioned, I appreciate you highlighting the term sheet in this post. Of all these financial instruments, I can see why a convertible note is favored by so many investors…it has a lot of flexibility that helps the investor make a decision based on the developing situation instead of having to engage in speculation on something that is largely unforeseeable.

    Thanks,
    Nick

  7. Great post!
    Who knew there was so much happening during a start up! You def. have to do your homework and see which investment is best for you. And, thank you for talking about the term sheet, I think this will catch on and be very useful.
    ~Christina

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