Preparing your Company for Investment – Angel and VC Term Sheet Negotiations – Post-Deal Relations

To get investment, company must put its house in order including capital, employee, IP issues. VC term sheet negotiations involve financial and control issues.


TiE SRA Leadership Workshop , June 21, 2008

By Robert A. Adelson

Business Due Diligence – Business Plan

  1. Market and customers
    • Sales Pipeline Documents
    • Customer references: validate need, willingness to pay
    • Growth and size of market
    • Sales cycle: revenue velocity
    • Distribution channel, channel partners
  2. Product and Service offering
    • Business plan, marketing literature
    • Customers – functionality; Technical Assessment & Demo
  3. Management team
    • Leadership, coachability, commitment, rolodex
    • Weaknesses or gaps in the team
    • Are they financeable by VCs?
  4. Competition
    • Customer & Alliance references and industry experts
    • Assess threats of players to company; positioning; strength focus, lead-time, financing, management team
    • Valuation – What are other deals priced at?
  5. Financials
    • Follow-on capital needs & likely sources; Milestones & valuations
    • Robustness of business model; sensitivity to driving assumptions
    • Capital structure; Previous investors
    • Realistic path to exit (time and valuation)
  6. Valuation
    • Determining the value of an asset or company
    • Size of the round? Tranches
    • Who gets diluted? Stock option pool
    • How does this fit into the overall plan of the company?

Legal Due Diligence 1 – Entity & Capital

  1. Form of entity
    • Choice of legal structure: Corporation or LLC
    • Domicile: Delaware or Local
  2. Corporate Records
    • Minute Book, Stock Ledger
    • Corporate Filing, Good Standing, Qualifications
  3. Corporate Governance
    1. Board of Directors: Size, Selection
    2. Board of Directors: Independence and Quality
    3. Board of Advisors
    4. Conflicts, Avoidance, and Disclosure of Directors’ Interests
  4. Equity structure
    • Founders’ Equity
    • Equity and Options for Employees, Contractors
    • Equity Pricing
    • Earlier Investor Equity – Preferred, Warrants, Debt
    • Shareholder Agreements
    • Securities Law compliance
    • Equity held by non-participants
    • Claims for Equity – documented / undocumented
  5. Debt Structure
    • Founder Loans
    • Friends, Family and other Loans
    • Bank Loans Collateral / Security Agreements
    • Factoring /Royalty Agreement

Legal Due Diligence 2 – IP and Other Assets

  1. Intellectual Property (IP) Rights & Protection
    • Protected Technology – Patents/Inventions
    • Protected Information – Trade Secrets – Copyrights
    • Protected Goodwill – Trademarks, Service Marks
    • Assignment of Ownership
    • Licensing Agreements
    • IP Prosecution; Vigilance against Infringement
  2. Company IP and Owner IP
    • Applications relevant to company business
    • Applications and platforms not related – Founder retention
    • Founders’ Assignment of inventions – clear demarcation
    • Investors like Focus on company
    • Founders’ Retention of post-exit IP rights
  3. Claims or potential claims against IP
    • Independent contractors – work for hire
    • Software development and distribution
    • Client & alliance contracts – IP clauses
  4. Other Assets
    • Real Estate
    • Franchises
    • Equipment, fixtures and inventory
  5. Other Liabilities
    • Claims against the assets or business
    • Litigation pending or threatened
    • State or Federal regulatory issues

Legal Due Diligence 3 – Employees & Contracts

  1. Recruitment, Retention, Incentives
    • Stock Options – ISOs and NQSOs
    • Restricted Stock
    • Phantom Stock
    • Pricing and Exercise Features
    • Employee stake in enterprise
    • Performance & loyalty incentives
    • Incentives for success events
    • Employee attrition
  2. Employee/Labor Due Diligence
    • Employment Agreements for Executives
    • NDAs, Confidentiality, Assignment of Inventions
    • Offer Letters and Hiring
    • Outsourcing/Staffing
  3. Employment Claims against company
    • History and pattern of claims, if any
    • Pending claims with MCLE or courts
  4. Commercial Contract Rights
    • Customer, Supplier Agreements
    • Warranties and warranty liability
    • Advertising or other service agreements
    • Office and Equipment Leases
  5. Strategic Contracts
    • Strategic Alliances and Partnerships
    • Strategic investment or revenue source
    • Rights of first refusal in sale of company

Negotiating the Angel / VC Term Sheet: Deal Terms – Financial

  1. Liquidation Preferences
    • Investor priority
    • Recoup principal (& often dividends)
    • “Participating Preferred” – return & upside share
    • Impact on Founders if insufficient IRR
  2. Dividends
    • Built in return – rates vary
    • Cumulate quarterly until paid out
    • No dividend on common until paid
    • Forfeiture on IPO/ voluntary conversion to common
  3. Anti-Dilution
    • If later rounds price dilutive, investor gets to re-price
    • Weighted Average – adjustment based on impact of new shares
    • Full Ratchet – if 1 share at lower price, all re-priced
  4. Participation Future Rounds / “Play or Lose”
    • Pre-emptive rights to participate, keep pro-rata share
    • Lose anti-dilution protection if not play – incentive to support
    • First offer – Go to current investors first
    • First refusal – Get to prevent new blood / Limits flexibility
  5. Redemption / “Put” Rights
    • Investor cash-out right – principal & return or appraised value
    • VC often seek redemption right within fixed time – 5-7 years, depends on stage of company, VC fund
  6. ROFR /Co-Sale on Founder Shares
    • Co-Sale – buyer must offer investors same cashout terms
    • First offer – Go to current investors first
    • First refusal – Get to scoop shares – chill offers to founders
  7. Drag-Along /Tag-Along Rights
    • Drag-Along: requires approval and sale of all stockholders on sale approval by % of preferred
    • Tag-Along: requires common to be allowed to also cash-out on preferred sale
  8. Vesting Founders Stock
    • Founders with cheap stock forced “re-earn” – vesting schedule
    • Forfeiture (repurchase at cheap price) unvested on termination
    • Effect of termination for cause or without cause, death, disability
    • Valuation of common & tax effect – income on re-earned shares
    • IRC §83(b) election – whether to take into income vesting shares
  9. Registrations Rights
    • Investor gains liquidity by “piggy-back” on to public offering
    • VCs include rights to demand registration of shares
  10. Board Composition
    • Investor representation follows the money
    • Importance of outside & independent directors
    • Management representation / “Martini” rule & board size
  11. Voting Rights/ Organic Changes
    • Investors rights to block mergers, stock issues, organic changes
    • Block rights should end if fall below fixed percent of shares
  12. Management Team/ Hiring Firing Rights
    • Pool of management shares
    • CEO and other hiring
    • Noncompete and post-termination covenants

Post-Term Sheet Documents To Complete Angel or VC Financing Deal

  1. Stock purchase Agreement
    • Preferred stock terms
    • Pricing
    • Company warranties
    • Founder shareholder warranties
    • Employment agreements
    • Post closing covenants
    • Conditions to the stock purchase
  2. Registration Rights Agreement
  3. Stock Restriction and Stockholders Agreement
    • Among founders and employee stockholders
    • Vesting terms
    • Restrictions on transfer
    • Co-sale and ROFL rights
  4. Disclosure Issues
    • State, Federal Security Laws
    • Preliminary Business Plans
    • Accredited Investors
    • Limit on Offers
  5. Disclosure Documentation
    • Private Placement Memorandum
    • Investor Questionnaires
    • Subscription Agreement and Documents
    • Audited Financials
  6. Standstill Agreement
  7. Key-person insurance & other closing conditions

Post Deal Relationship

  1. Angel Investors
    • Board seat or board observer seat – to actively advise company
    • Exploiting the Angel Group’s Network
      • Raise subsequent rounds of financing – either angel or VC
      • Recruit employees, establish customer/partner contacts
  2. Venture Capital
    • Board Seat & Help recruit key management
    • Introduce company to sources of follow-on financing
    • Guidance on financial strategy
    • Make key contacts for strategic partnerships / customers
    • Configure the company for an IPO or acquisition
    • Introduce bankers/lawyers/accountants
  3. Highlights importance of “Smart Money”
    • What besides money does investor bring to table
    • Experience of investor in helping companies like yours
    • Choosing investor value not necessarily highest valuation
  4. Operation as Angel or VC backed company
    • Collegial approach with board members
    • Importance of informed and engaged board – kept current
    • Financial statements and expected reporting
  5. Exit strategy – Implementation
    • Replacement of Founder CEO
    • Milestones to be met – consequences if not met
    • Positioning for IPO or Acquisition exit strategy
  6. Founder’s personal exit strategy
    • Role in CEO succession, post-CEO role in company
    • Protection of Founder’s equity & financial stake in company
    • Employment and Severance terms
    • Non-compete, non-solicitation
    • Retained rights and back-licenses of technology


These materials were prepared by Robert A. Adelson, Esq., Partner at Engel & Schultz, LLP, 265 Franklin Street, Suite 1801, Boston, MA 02110, (617) 951-9980. Fax (617) 951-0048. E-mail: Website: Mr. Adelson is a graduate of Boston University, Phi Beta Kappa and Northwestern University Law School in Chicago where he was a member of Law Review. He also has an LL.M. degree in Taxation from New York University and is a member of the Massachusetts, New York and US Tax Court Bars.

Robert Adelson began his legal career in 1977 as an associate at major New York City law firms, first Dewey Ballantine and later Weil Gotshal & Manges, before returning home to Massachusetts in 1985, where he has been a partner at several Boston firms before joining his present firm as senior business law partner in 2004. Mr. Adelson is specialized in corporate, taxation, finance, commercial and technology contracting law. In those areas, he frequently represents startup and smaller companies in software, and other technology-based fields. He also represents executives or consultants in executive compensation and stockholder arrangements, incorporation and liability protection, intellectual property protection, and in vendor, client and subcontractor contracting arrangements.

Mr. Adelson’s law firm, Engel & Schultz, LLP, is a small but broad service law firm of 6 attorneys in Boston. The firm complements Mr. Adelson’s work in business and tax law with seasoned attorneys in litigation, real estate, family and probate matters.

Mr. Adelson is a frequent speaker at business forums. Additional information on the subjects on which he speaks is shown at – Further information on Mr. Adelson’s background, including many of his past published articles, is available at his law firm website

The speaker thanks Hooman Hodjat, founder of iRelai, LLC for the invitation to speak,  for the TiE SRA Leadership Workshop on the topic of “Term Sheet Basics and Negotiating a deal” with my further prepared materials covering the “Fundraising Process: Due Diligence, Angel and Venture Capital Term Sheet Negotiations, Post-deal Relationships” at the 930 Winter Street, Waltham, Massachusetts, on June 21, 2008.

The purpose of these materials is to supplement class materials and offer rough outlines on the subject matter of the presentation to aid entrepreneurs seeking angel or early stage venture capital investment for early stage technology based or non-technology or service based businesses. Thus, it is hoped these materials will be informative to those in attendance. These materials are not legal advice and not intended as any substitute for professional advice or counsel in a particular case.

Author: radelson

Robert Adelson has been a corporate and tax attorney since 1977. He began as an associate at nationally prominent New York City “mega” law firms, first at the Wall Street firm Dewey Ballantine Bushby Palmer & Wood and later at the Park Avenue firm Weil Gotshal & Manges. In 1985, Adelson returned home, where he has since established himself as a respected Boston business attorney. He has attained partner at several small and midsize Boston law firms, most recently at Lawson & Weitzen LLP and then Zimble Brettler LLP, where he was a partner from 1994 to 2004 before becoming a partner at Engel & Schultz LLP.

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