As my Microsoft Web Only diet continues, I found myself using Live.com Image Search today to put together a presentation.  I hate text heavy Powerpoint presentations so I try to go to the Seth Godin school of Powerpoint and limit myself to six words per slide (e.g. lots of pictures.)  Historically, Google Image Search has been my friend when I put a presentation together.

I loved Live.com Image Search – it’s substantially better than Google’s.  The actual image search is about the same, but the UI is dramatically better.  It’s very Ajaxy – resize bar, mouse over to enlarge image and get image detail, drag and drop image to other apps, infinite scroll (rather than next, next, next), and overall nice / fast presentation.  Someone on the Google Image Search team needs to take a look.

As an entrepreneur, the way to get the best deal for a round of financing is to have multiple options.  If you’ve been a studious reader of our term sheet series, you are painfully aware that there are many other terms – beside price – that help define what “the best deal” actually is.  However, there comes a point in time where you have to choose your investor and shift from “search for an investor” mode to “close the deal” mode.  Part of this involves choosing your lead investor and negotiating the final term sheet with him.

A “no shop agreement” is almost always part of this final term sheet.  Think of it as serial monogamy – your new investor to be doesn’t want you running around behind his back just as you are about to get hitched.  A typical no shop agreement is as follows:

“No Shop Agreement:  The Company agrees to work in good faith expeditiously towards a closing.  The Company and the Founders agree that they will not, directly or indirectly, (i) take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company, or (ii) enter into any discussions, negotiations or execute any agreement related to any of the foregoing, and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing.  Should both parties agree that definitive documents shall not be executed pursuant to this term sheet, then the Company shall have no further obligations under this section.”

At some level the no shop agreement – like serial monogamy – is more of an emotional commitment; it’s very hard to “enforce a no shop agreement” in a financing, but if you get caught cheating, your financing will probably go the same way as the analogous situation when the groom or the bride to be gets caught in a compromising situation.

At some level, the no shop agreement reinforces the handshake that says “ok – let’s get a deal done – no more fooling around looking for a better / different one.”  In all cases, the entrepreneur should bound the no shop by a time period – usually 45 to 60 days is plenty (and you can occasionally get a VC to agree to a 30 day no shop.)  This makes the commitment bi-directional – you agree not to shop the deal; the VC agrees to get things done within a reasonable time frame.

I’ve written about liquidation preferences (and participating preferred) before, as have most of the other VC bloggers (and several entrepreneur bloggers.) However, for completeness, and since liquidation preferences are the second most important “economic term” (after price), Jason and I decided to write a post on it. Plus – if you read carefully – you might find some new and exciting super-secret VC tricks.

The liquidation preference determines how the pie is shared on a liquidity event. There are two components that make up what most people call the liquidation preference: the actual preference and participation. To be accurate, the term liquidation preference should only pertain to money returned to a particular series of the company’s stock ahead of other series of stock. Consider for instance the following language:

Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).

This is the actual preference. In the language above, a certain multiple of the original investment per share is returned to the investor before the common stock receives any consideration. For many years, a “1x” liquidation preference was the standard. Starting in 2001, investors often increased this multiple, sometimes as high as 10x! (Note, that it is mostly back to 1x today.)

The next thing to consider is whether or not the investor shares are participating. Again, note that many people consider the term “liquidation preference” to refer to both the preference and the participation, if any. There are three varieties of participation: full participation, capped participation and non-participating.

Fully participating stock will share in the liquidation proceeds on a pro rata basis with common after payment of the liquidation preference. The provision normally looks like this:

Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. Sample language is below.

Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

One interesting thing to note in the section is the actually meaning of the multiple of the Original Purchase Price (the [X]). If the participation multiple is 3 (three times the Original Purchase Price), it would mean that the preferred would stop participation (on a per share basis) once 300% of its original purchase price was returned including any amounts paid out on the liquidation preference. This is not an additional 3x return, rather an addition 2x, assuming the liquidation preference were a 1 times money back return. Perhaps because of this correlation with the actual preference, the term liquidation preference has come to include both the preference and participation terms. If the series is not participating, it will not have a paragraph that looks like the ones above.

Liquidation preferences are usually easy to understand and assess when dealing with a series A term sheet. It gets much more complicated to understand what is going on as a company matures and sells additional series of equity as understanding how liquidation preferences work between the series is often mathematically (and structurally) challenging. As with many VC-related issues, the approach to liquidation preferences among multiple series of stock varies (and is often overly complex for no apparent reason.) There are two primary approaches: (1) The follow-on investors will stack their preferences on top of each other: series B gets its preference first, then series A or (2) The series are equivalent in status (called pari passu – one of the few latin terms lawyers understand) so that series A and B share pro-ratably until the preferences are returned. Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon.

Most professional, reasonable investors will not want to gouge a company with excessive liquidation preferences. The greater the liquidation preference ahead of management and employees, the lower the potential value of the management / employee equity. There’s a fine balance here and each case is situation specific, but a rational investor will want a combination of “the best price” while insuring “maximum motivation” of management and employees. Obviously what happens in the end is a negotiation and depends on the stage of the company, bargaining strength, and existing capital structure, but in general most companies and their investors will reach a reasonable compromise regarding these provisions. Note that investors get either the liquidation preference and participation amounts (if any) or what they would get on a fully converted common holding, at their election; they do not get both (although in the fully participating case, the participation amount is equal to the fully converted common holding amount.)

Since we’ve been talking about liquidation preferences, it’s important to define what a “liquidation” event is. Often, entrepreneurs think of a liquidation as simply a “bad” event – such as a bankruptcy or a wind down. In VC-speak, a liquidation is actually tied to a “liquidity event” where the shareholders receive proceeds for their equity in a company, including mergers, acquisitions, or a change of control of the company. As a result, the liquidation preference section determines allocation of proceeds in both good times and bad. Standard language looks like this:

A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.

Ironically, lawyers don’t necessary agree on a standard definition of the phrase “liquidity event.” Jason once had an entertaining (and unenjoyable) debate during a guest lecture he gave at his alma mater law school with a partner from a major Chicago law firm (who was teaching a venture class that semester) that claimed an initial public offering should be considered a liquidation event. His theory was that an IPO was the same as a merger, that the company was going away, and thus the investors should get their proceeds. Even if such a theory would be accepted by an investment banker who would be willing to take the company public (no chance in our opinion), it makes no sense as an IPO is simply another funding event for the company, not a liquidation of the company. However, in most IPO scenarios, the VCs “preferred stock” is converted to common stock as part of the IPO, eliminating the issue around a liquidity event in the first place.

That’s enough for now – I’m going to go get a drink and have my own personal liquidity event (sorry – the punmaster got control of my keyboard for a moment.)

Every now and then I run into a new VC term in a term sheet that I’ve never seen before. My legs tremble with excitement as I stare at the words to dissect what they mean.  On Friday, a long time friend sent me the following new and exciting term.

Compelled Sale Right: So long as VC (together with its permitted transferees) continues to hold at least 10% of the outstanding common shares (on an as-converted basis), and so long as an IPO has not been completed, then, at any time from and after the seventh anniversary of the transaction, if VC or the Company shall receive a bona fide offer from an unaffiliated third party to purchase 100% of the equity of the Company, VC shall have the right to cause each other stockholder to sell such stockholder’s equity securities on the same terms and conditions applicable to VC.

My first reaction was “what the fuck?”  My second reaction was “eh – this is just a different twist on redemption rights.”  But – then I thought about it some more and thought “you’ve got to be kidding me!”

So – after seven years, if there hasn’t been a liquidity event, a VC that owns at least 10% of the company can force all the other shareholders to sell their shares to an unaffiliated third party.  Read it slowly and think about it.  Basically, this term gives a minority shareholder the right to sell the company after 7 years, with no input from any other shareholders.

Be forewarned – this is not a nice term.

In 2005, Jason Mendelson (my partner and co-author of AsktheVC) wrote what has become an extremely popular series dissecting the “term sheet.”  The feedback we got from it encouraged us to write several more series of blogs and ultimately led to us deciding to start writing AsktheVC to answer random questions from entrepreneurs.

Last Friday I pointed to a post from Dave Naffzinger (Judy’s Book) about Stock Options from an Entrepreneurs Point of View.  I woke up today to two more great entrepreneur posts on term sheets.  The first is from Dick Costolo (FeedBurner) titled Venture Terms – Liquidation Preferences and Participation.  The second was titled Term Sheet Hacks was on a new blog titled Venture Hacks and written by Naval Ravikant (Vast.com) and Nivi (EIR at Atlas Ventures.) 

When I started this blogging thing back in May of 2004, I stated that I was motivated by Fred Wilson’s post on Transparency.  I love that smart entrepreneurs are adding to the body of knowledge out there around the funding process.  I’ve always been befuddled that a financing (both angel and VC) and the “term sheet” are such as mysterious thing.  It has been rewarding to get thousands of emails over the past two years thanking me / Jason for what we’ve written – and it is fun to see some smart entrepreneurs continuing to add to the demystification of the term sheet.

For some time Jason and I have felt that VC’s have had an unfair advantage when it comes to understanding term sheets. So a few years back we wrote a whole series of blog posts (the Term Sheet series) which became the basis for the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. Our goal with all of this was to help put entrepreneurs on a more even footing in negotiating a deal with a VC.

In some ways, I’ve always seen writing (both books and this blog) as a form of personalized teaching. It let’s me efficiently share whatever knowledge I have. But a few months back while I was visiting TechStars NYC, I had the chance to meet the guys over at Veri and pretty quickly realized they have a really interesting format for teaching things like how a term sheet works in an even more personalized way.

The result is Veri’s Understanding Term Sheets. The experience works like it would if we were learning it together one on one, namely that I ask you a series of question to figure out what you do and don’t know. When you know the material you get to quickly prove you’re a champ. When you don’t know something, I help bring you to the exact snippet of information you need to know. In other words, we figure out what you know, and help you learn only what you don’t. And hopefully have some fun in the process.

Let me know you think about Understanding Term Sheets, especially if there are ways to improve it.

Jason and I are planning to finish strong with some serious stuff in our term sheet series, but we figured we’d put one more term in that has us sniggling whenever we see it (a “sniggle” is a combination “sneer-giggle” – sort of like how I reacted to Kidman / Ferrell in Bewitched last night). The last sniggle term is as follows:

“Initial Public Offering Shares Purchase:  In the event that the Company shall consummate a Qualified IPO, the Company shall use its best efforts to cause the managing underwriter or underwriters of such IPO to offer to [investors] the right to purchase at least (5%) of any shares issued under a “friends and family” or “directed shares” program in connection with such Qualified IPO. Notwithstanding the foregoing, all action taken pursuant to this Section shall be made in accordance with all federal and state securities laws, including, without limitation, Rule 134 of the Securities Act of 1933, as amended, and all applicable rules and regulations promulgated by the National Association of Securities Dealers, Inc. and other such self-regulating organizations.”

We firmly put this in the “nice problem to have” category.  This term really blossomed in the late 1990’s when anything that was VC funded was positioned as a company that would shortly go public. However, most investment bankers will push back on this term if the IPO is going to be a success as they want to get stock into the hands institutional investors (e.g. “their clients”).  If the VCs get this push back, they are usually so giddy with joy that the company is going public that they don’t argue with the bankers.  Ironically, if the VC doesn’t get this push back (or even worse, get a call near the end of the IPO road show) where the bankers are asking the VC to buy shares in the offering, the VC usually panics (because it means it’s no longer a hot deal) and does whatever he can not to have to buy into the offering.

Sniggle.  Our recommendation – don’t worry about this one or spend lawyer time on it. 

If you go to Feld Thoughts, you’ll see a little widget on the right hand side that looks like the following:

This is my “badge” for the FeedBurner Venture Capital network.  This a network of all of the Venture Capital bloggers that I could find – I’m the coordinator so if you are a VC blogger and not part of the network, drop me an email.  There are now 62 VC bloggers in the network with a daily subscriber reach of over 150,000 people (if you are an advertiser and want to target this audience, my friends at FeedBurner will be happy to help.)

This morning, I noticed a new shiny box in the widget that says “search this network.”  That’s the integration of Lijit and FeedBurner which allows you to search across the entire network of VC bloggers.  Type “term sheet” in “search this network” and hit go to see how it works.  Or try “Apple DRM”.  Or maybe “Google Youtube” (or ”Sequoia Envy”).  Or even “Suck” (a favorite word of several VC bloggers – ostensibly linked to one of my favorite mottos – “We Suck Less.”)

Vertical search across venture capital blogs.  Automagically brought to a computer near you by Lijit and FeedBurner.

As Judy’s Book has shifted from a Local Search site to a Deal site, several interesting vertical search opportunities have emerged.  The first one is online coupons – and the folks at Judy’s Book have rolled out a vertical site called CouponLooker.

Dave Naffzinger has a great overview of CouponLooker.  While the web is full of “coupon sites”, no one does the hard work to search across them, dedupe them, rank them, and make it easy to find online coupons for specific items.  Oh – and the coupons expire quickly so keeping the database fresh and current is non-trivial.

Of course, what would a vertical search site be without a widget.  

Earlier this week I did a brief post on the “no shop agreement” that is a common feature in a term sheet.  I compared signing a no shop to the construct of serial monogamy in a relationship.  I had a couple of comments (one that was intellectual, one that was a little harsher and painted VCs as “duplicitous.”)  I was mulling over my obviously (in hindsight to me) asymmetric view when Tom Evslin very clearly and coherently articulated why my analogy was really unilateral monogamy (e.g. the VC isn’t signing up for serial monogamy – only the entrepreneur is.)

Tom – and the comments I received – are correct (although I don’t agree with the generalization that “VCs are duplicitous.”)  After reading Tom’s post, I thought about my own behavior (at least my perception of my own behavior) vs. the general case and realized I’ve mixed the two up.  I’ve been on the giving and receiving side of unilateral no shops many times and – when on the receiving side – have usually been sensitive to why the other party wouldn’t sign a reciprocal no shop.  In most cases, I simply don’t put a lot of weight behind the no shop due to the ability to bind it with time (30 – 45 days), plus whenever I’m on the receiving end, I’ve done my best to test commitment before signing up to do the deal. 

In addition to Tom’s post, Rick Segal wrote up his thoughts in a post titled “The Handshake Clause” where he makes the point that his firm doesn’t sign a term sheet until they are committed to doing a deal.  His explanation of how he approaches this is useful, but it is important to acknowledge that there is a wide range of behavior among VCs – the group that doesn’t put a term sheet down until they are committed are at one end of the spectrum; the group that puts down a term sheet to try to lock up a deal while they think about whether or not they want to do it is at the other.  I’d like to think that we are at the “good” end of this spectrum (e.g. we won’t issue a term sheet unless we are ready to do a deal.)  Obviously, your mileage will vary with the VCs you are dealing with – hence the value of doing your own due diligence on your potential future partners.

As I mulled this over, I came up with a couple of examples in the past 10 years where the no shop had any meaningful impact on a deal in which I was involved.  I could come up with an edge case for each situation, but this was a small number vs. the number of deals I’ve been involved in.  In addition, when I thought about the situations where I was a VC and was negatively impacted by not having a no shop (e.g. a company we had agreed with on a term sheet went and did something else) or where I was on the receiving end of a no shop and was negatively impacted by it (e.g. an acquirer tied me up but then ultimately didn’t close on the deal), I actually didn’t feel particularly bad about either of the situations since there was both logic associated with the outcome and grace exhibited by the participants.  Following are two examples:

1. We signed a term sheet to invest in company X.  We didn’t include a no shop in the term sheet – I don’t think there was a particular reason why.  We were working to close the investment (I think we were 15 days into a 30–ish day process) and had legal docs going back and forth.  One of the founders called us and said that they had just received an offer to be acquired and they wanted to pursue it.  We told them no problem – we’d still be there to do the deal if it didn’t come together.  We were very open with them about the pros and cons of doing the deal from our perspective and – given the economics – encouraged them to pursue it (it was a great deal for them.)  They ended up closing the deal and – as a token – gave us a small amount of equity in the company for our efforts (totally unexpected and unnecessary, but appreciated.)
2. I was an existing investor in a company that was in the process of closing an outside led round at a significant step up in valuation. The company was under a no shop agreement with the new VC.  Within a week of closing, we received an acquisition overture from one of the strategic investors in the company.  We immediately told the new lead investor about it who graciously agreed to suspend the no shop and wait to see whether we wanted to move forward with the acquisition or the financing.  We negotiated with the acquirer for several weeks, checking regularly with the new potential investor to make sure they were still interested in closing the round if we chose not to pursue the acquisition.  They were incredibly supportive and patient.  The company covered their legal fees up to that point (unprompted – although it was probably in the term sheet that we’d cover them – I can’t recall.)  We ended up moving forward with the acquisition; the new investor was disappointed in the outcome but happy and supportive of what we did.

As I said earlier, these are edge cases – in almost all of my experiences the no shop ended up being irrelevant.  But – as both of these example show – the quality and the character of the people involved made all the difference.  Near the end of his post, Tom makes the point that it’s “good negotiating advice to make sure that every clause which can be mutual is mutual.”  I completely agree.