Of Cap Tables and VC Term Sheets

Unless you are operating a sole proprietorship, you should maintain and understand your capitalization table, which you can maintain as an Excel spreadsheet calculating how much you and others own of your company. For those of us that want to appear too busy and sophisticated to spell it out, we call it our Cap Table. Your company may be structured as some form of Partnership, S-corp, or LLC, in which case your cap table may consist of general partners, common stock owners, or LLC members holding stakes of similar class. Conversely if you have a C-corp, you may have stakeholders with common stock, different classes of preferred stock, stock options and warrants. If your cap table is still fairly simple—but you plan to raise venture capital—get ready for your cap table to become more complex and frequently misleading.

Venture capitalists typically structure their investments as preferred stock, and each VC firm has their own boilerplate Term Sheet they like to use. Many terms that define this preferred stock can chip away at the value of your common stock and your employees’ stock options. These terms can be difficult to plug into your cap table calculations. Liquidation preferences, ratchets, convertible cumulative dividends, redemption rights, rights of first refusal, and escrowing of founders equity are not term sheet legalese you can gloss over; you must understand the impact these terms may have in various scenarios.

The complexity only increases if you have more than one round of investment and/or more than one VC involved. If you are not careful, you can find your common stock devalued to the point of worthlessness in all but the rosiest of liquidity scenarios. To be clear, many of these terms are necessary for all but the most foolhardy VCs. You must remember that VCs are not in the business of awarding grants and they have a fiduciary duty to protect the investors in their funds as best they can. Nevertheless, every term sheet is a starting point from which to negotiate terms that may impact the value, ownership, and control you expect to maintain, and you need to focus on more than just the valuation and size of the proposed check.

You should consult your financial advisor, investment banker, corporate attorney, medicine man and mystic before negotiating or signing a term sheet; however, anyone whom you ask for advice MUST have experience with venture capital term sheets… and most I-bankers and attorneys do not. You must find advisors who have been down this road before.

Here are some things to consider regardless of how confident you are in your ability to understand and negotiate terms:

• Raise more money than you think you need for the next 12 months; rule of thumb is about 50 percent more;
• Control the board as long as possible; consider what voting rights a VC may have without board control as well as what board decisions should require a super-majority;
• Insist on employment contracts with cash and equity guarantees upon termination or a liquidity event;
• Encourage competition among interested lead investors; the easiest way to negotiate terms is to have more than one term sheet in hand.