Homework #4：Draft an Angel Investor Term Sheet

Draft Dan Rosen & Associates Page 1

Draft Term Sheet for Alliance of Angels

This draft term sheet, by Dan Rosen, CEO Dan Rosen & Associates, is for use by Alliance of Angels

members as a starting point in negotiating seed stage deals. The AoA lead investor is noted as <<AoA

Investors>> in the document. Each party in such deals should seek appropriate legal counsel. Except for

the section titled “Exclusivity,” this term sheet does not create a legally binding obligation on any person

or entity.

Company name

Acme, Inc

Location

<<Company Address>>

Type of Entity

Washington State C Corporation

Type of Equity

Series A Preferred Stock

Size of Offering

$750,000

Minimum to close

$500,000

Closing

On <<Date>> (“the Closing Date”) or when minimum to close

is committed

Valuation

Pre-money

$2,000,000

Post-money

$2,750,000

Price per share

$1.0256

Investors

Various members of the Alliance of Angels, who are Accredited

Investors acting on their own account, and/or other Accredited

Investors only (as defined in SEC Rule 501)

Comment [DR1]: Some prefer Delaware incorporation. Washington state and Delaware have parallel laws, but Delaware has greater case law and therefore better protection for company Directors.

Comment [DR2]: At times, Angels are asked to buy either common stock or S-Corp stock. Common makes sense in a limited situation: where an experienced entrepreneur has put lots of their own money into a company and you trust (based on experience with that individual) that they will treat investors well. S Corps cannot give preferred shares and should be avoided.

Comment [DR3]: Might also want to specify a latest close date for the round. If not met, it forces the company to come back to investors.

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Investor Incentives

Investors who invest by the Closing Date will receive the

following incentive:

Discount or

Warrants

25% Warrant Coverage

Stock Options

The company will increase the authorized pool of options prior

to the financing to bring the total unallocated options to at

least the following percent

Total Unallocated

options

24% in the post money

New options issued

200,000

Pre and Post-Financing Capitalization (assuming all shares issued)

Pre-Financing

Post Financing

Type of stock

Number of shares

% Fully Diluted

Number of shares

% Fully Diluted

Common

1,000,000 51%

1,000,000 35%

Stock Options Granted

250,000 13%

250,000 9%

Pre-financing Stock Options Avail

500,000 26%

500,000 17%

New Stock Options

200,000 10%

200,000 7%

Series A Pfd Stock

731,250 26%

Warrants

182,813 6%

Total Shares

1,950,000 100%

2,864,063 100%

Comment [DR4]: Discounts or Warrants are an incentive to invest. If granted, it is almost always one or the other, but not both. They must be considered with the price per share as to their reasonableness to current market conditions. It is, of course, cleaner to just lower the price per share, but often there are reasons (e.g. a higher priced friends and family round) not to do so.

Comment [DR5]: With warrant coverage, the post money will technically be higher than the pre- money plus the amount invested, because these shares are issued. In reality, given that the warrants are usually priced the same as the shares issued, they are “out of the money” and therefore do not actually effect the post money.

Comment [DR6]: The unallocated option pool depends largely on the state of the company’s current management team and positions that still need to be filled. This usually ranges from about 10% to 25%, and must be considered in the post- money cap table, not the pre-money cap table.

Comment [DR7]: Note that the post money price is more than the pre-money + new money, because of the warrants, which go into the post.

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Terms of the Series A Stock

Liquidation

Preference

1x participating preferred. The Series A Preferred shall receive an amount

equal to one times (1x) the Purchase Price, plus any declared and unpaid

dividends, prior to the payment of any sums to any other equity security

holders in the event of (i) a liquidation, dissolution, or winding up of the

Company; or (ii) “Change in Control,” which means a merger or

consolidation (other than one in which the stockholders of the Company

own a majority by voting power of the outstanding shares of the surviving

or acquiring corporation) and a sale, lease, transfer, or other disposition of

all or substantially all of the assets of the Company. Thereafter, all of the

proceeds shall be ratably distributed to the holders of Preferred and

Common Stock, on an as converted basis.

Dividends Dividends only when declared, and not cumulative. The holders of

Series A Preferred will be entitled to receive dividends only when and if

declared by the Board and in preference to holders of Common Stock.

Voting Rights Except as set forth in “Protective Provisions” below, the Series A Preferred

shall vote together with the Common Stock on an as converted to

Common Stock basis, and not as a separate class

Board

Participation

The holders of a majority of the Series A Preferred shall be entitled to elect

one member of the board of directors, who shall initially be ________. At

the time of the closing of this financing, the board of directors shall be 5

members: 1 from management, 1 from Series A, and 3 independent

directors acceptable to both common and Series A directors. The Series A

director shall be compensated with stock options on a standard basis.

D&O Insurance Prior to the closing, the company shall obtain a Directors & Officers

insurance policy that is at least $1M.

Comment [DR9]: In the past, it was often argued that Angels should not request 1x participating preferred without a cap, because larger follow-on rounds would then get the same. While a small angel round doesn’t change the “liquidation overhang,” a large VC round might. Capping the liquidation preference in future, larger rounds does make sense.

Comment [DR8]: In the past, it was often argued that Angels should not request 1x participating preferred without a cap, because larger follow-on rounds would then get the same. While a small angel round doesn’t change the “liquidation overhang,” a large VC round might. Capping the liquidation preference in future, larger rounds does make sense.

Comment [DR10]: Cumulative dividends do make sense in the case of a redemption provision, as outlined below.

Comment [DR11]: Depending on the circumstances, having all of the directors selected by the closing might not be possible. This could read that within XXX days of closing, with the agreement of the Series A director, this can be delayed.

Comment [DR12]: Note that five is an arbitrary number and should be adjusted to the circumstances. The goal is to provide excellent guidance to the entrepreneur and bring the investors’ knowledge to bear. Often an initial board of 3 is sufficient.

Comment [DR13]: It is also reasonable that the Series A director be on compensation committee and must agree to executive compensation.

Comment [DR15]: This amount is a minimum, but generally adequate for a seed stage company. If there is a large amount of investment, real property, or intellectual property, it should be more.

Comment [DR14]: This amount is a minimum, but generally adequate for a seed stage company. If there is a large amount of investment, real property, or intellectual property, it should be more.

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Conversion

Rights

The holders of the Series A Preferred shall have the right to convert the

Series A Preferred into shares of Common Stock at any time. The initial

conversion rate for the Series A Preferred shall be 1-for-1, subject to

adjustment as indicated below.

Automatic

Conversion

The Series A Preferred shall automatically be converted into Common

Stock, at the then applicable conversion rate, upon: (i) the closing of a

firmly underwritten public offering of not less than $25,000,000 (before

payment of underwriters’ discounts and commissions) (a “Qualified IPO);

or (ii) the written consent of holders of the majority of the outstanding

preferred stock.

Antidilution

Rights

Broad based weighted average. The conversion price of the Series A

Preferred will be subject to proportional adjustment for stock splits, stock

dividends, and the like, and to adjustment on a broad-based weighted

average basis for issuances at a purchase price less than the then-effective

conversion price, subject to customary exclusions.

Founder's Stock

Right of

Repurchase

Common stock owned by any founder with more than 2% of the post

financing equity is subject to the right of repurchase by the company at the

lower of (a) the fair market value (FMV) at the time of agreement or the

FMV at the time of repurchase; or (b) $0.01 per share (if no FMV has been

determined), if the founder leaves the company within the first four years.

Such a right expires over four years on a monthly basis after the Initial

Closing (2.083% per month for 48 months).

Protective

Provisions

The consent of the holders of a majority of the outstanding Series A

Preferred shall be required to: (i) amend the Articles of Incorporation in a

manner that would alter, change, or repeal any of the rights, preferences,

privileges or restrictions of the Series A Preferred so as to adversely affect

the Series A Preferred (it being understood that the authorization or

issuance of shares of a new series of preferred stock that is senior to or

pari passu with the Series A Preferred will not be deemed to adversely

affect the Series A Preferred if the rights, preferences, privileges or

restrictions of the Series A Preferred are not otherwise affected); (ii)

increase the total number of authorized shares of Series A Preferred by

more than 10%; (iii) approve a sale or merger of the Company.

Drag Along

If the Company’s Board of Directors and a majority-in-interest of the

Comment [DR16]: This percentage can be modulated depending on the circumstances; 2-10% is the reasonable range..

Comment [DR17]: This is an important term that is often missing in Angel term sheets. In essence, it converts the founders shares to restricted shares. Having 100% of the founders’ shares subject to right of repurchase is a term that can be negotiated. Depending on the state of the company and the value contributed to date, and the value of the founder to the company, this number can be set at less than 100%. However, sufficient shares should be subject to this right to ensure that the founders are bound to the company. Note that sometimes the founders have invested capital as well as sweat equity. In those cases, the “purchased shares” should be excluded from this provision.

Comment [DR20]: Some favor a 60% or 2/3 rd

vote. While more protective of investors, it can put a company into a position where it can’t move forward.

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Rights holders of Series A Preferred and Common approve a Change of Control

Transaction or issuing New Securities, each Holder agrees (i) to vote all

shares held by such Holder in favor of such Change of Control Transaction

or issuing New Securities, and (ii) to sell or exchange all shares of Common

Stock then held by such Holder pursuant to the terms and conditions of

such a transaction.

Registration Rights

The holders of Series A Preferred will be entitled to receive registration

rights pari passu with and substantially the same as any registration rights

granted to holders of equity securities of the Company in the next round of

financing of the Company.

Rights of First

Offer

Keep pro rata share. Each Investor who purchases at least $25,000 of

Series A Preferred will have a right of first offer, subject to certain

limitations, to purchase its pro rata portion of any new equity securities

offered by the Company, subject to standard exclusions. The right of first

offer will terminate immediately prior to the earliest to occur of: (i) the

Company’s initial public offering; (ii) such time as the Company otherwise

becomes subject to the reporting provisions of the Securities and Exchange

Act of 1934, as amended; or (ii) a Change in Control. This right expires for

any investor who does not exercise this right at each opportunity.

Proprietary

Information and

Inventions

Agreements

The Company will cause each person previously, now, or hereafter

employed or engaged as a consultant to enter into an acceptable

proprietary information and inventions agreement.

Information Rights

The Company will share with the <<AoA Investors>> (i) audited annual

financial statements no later than 90 days after the end of each fiscal year,

(ii) unaudited quarterly financial statements no later than 45 days after the

end of each quarter and a comparison of such quarter's results with the

results projected by the Company's annual budget, (iii) unaudited monthly

financial statements no later than 30 days after the end of each month and

a comparison of such quarter's results with the results projected by the

Company's annual budget, and (iv) an annual budget for the upcoming

fiscal year promptly following approval by the Board. <<AoA Investors>>

will be entitled to standard rights to inspect the properties and the books

and records of the Company at reasonable times and upon reasonable

notice to the Company. The obligation of the Company to furnish such

information and to permit such inspection will terminate at the earliest of

such time as the Company consummates a Qualified IPO, becomes subject

Comment [DR19]: In order to ensure flexibility and rapid decision making, once a majority of the common and preferred A shareholders agree to a decision, getting the others to agree is a meaningless exercise. So, notification, rather than the complete vote is all that is required. This term can be important in WA law, where if not otherwise specified, the number is 2/3 and not a simple majority.

Comment [DR18]: In order to ensure flexibility and rapid decision making, once a majority of the common and preferred A shareholders agree to a decision, getting the others to agree is a meaningless exercise. So, notification, rather than the complete vote is all that is required. This term can be important in WA law, where if not otherwise specified, the number is 2/3 and not a simple majority.

Comment [DR21]: Best practice is that the Company CEO sends out a quarterly letter or holds a meeting with investors at least quarterly to update them on progress, plans, and future financings. General rule – no surprises.

Comment [DR23]: Audits can be expensive, especially for a company that is early in its development. It is OK to allow the board to waive this requirement for a period of time.

Comment [DR22]: Audits can be expensive, especially for a company that is early in its development. It is OK to allow the board to waive this requirement for a period of time.

Comment [DR24]: Some favor making this 120 days to save money.

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to the reporting provisions of the Securities Exchange Act of 1934, as

amended, or the closing of a Change of Control.

Investor’s Counsel

Company agrees to pay $5,000 (or $5,000 per each $1M, or fraction thereof, raised) for Investors’ Counsel expenses to review this term sheet and ensure that the final agreement reflects the terms agreed.

Redemption

Rights (used only if

the Company is or

might be a

“lifestyle

business”)

After five years, if not previously converted, the Series A Preferred Stock is to be redeemed in three equal successive annual installments beginning <<Date>>. Redemption will be at the purchase price plus a <<4-12%>>% per annum cumulative return.

Due Diligence

The transactions contemplated by this Term Sheet are subject to the

satisfactory completion of due diligence by each Investor.

Expiration of

Letter:

This letter expires at 5 p.m., Pacific Daylight Time, <<Date>>, unless the

Company executes it below and returns an original or faxed executed

version to <<AoA Investors>> by that time.

Exclusivity:

From the date of acceptance of this Memorandum of Terms until the

earliest to occur of (a) consummation of the financing, (b) the formal

termination of negotiation by both <<AoA Investors>> and Company or (c)

<<Date>>, the Company will not directly or indirectly solicit, initiate or

participate in any discussions or negotiations with, or encourage or

respond to any inquiries or proposals by any persons, company or group

other than the Investors, concerning any financing or sale of the Company

without prior approval of <<AoA Investors>>. The Company will promptly

notify <<AoA Investors>> if any person, company or group seeks to initiate

any other discussions or negotiations and contemplated in the

immediately preceding paragraph, makes any proposal or inquiry, or

requests any information with respect to any proposed financing or sale of

the Company.

Confidentiality:

This term sheet is confidential to the parties and is for the use of the

Company’s management and their advisors. Accordingly, the information

contained in this document may not be disclosed to any third party or used

Comment [DR25]: This is a term that is particularly useful for an Angel deal, where capital requirements are low and anticipated cash flow might be high. In those cases, the entrepreneurs might choose to award themselves high salaries and bonuses, stripping the company of cash (which could go to dividends) and find that a sale is less attractive. The investors need a mechanism to force this issue. In growth investments, this kind of hammer might cause the company to not invest in growth to ensure that they can meet the redemption provision, so it must be used carefully.

Comment [DR26]: This percentage needs to be adjusted for the circumstances. It needs to be sufficient to give the investor a reasonable return, if the entrepreneur wants to maintain the business as a “lifestyle business,” but not so high as to make the company ill-liquid.

Comment [DR27]: This provision is not generally recommended nor necessary. This is not generally part of an angel term sheet, but some more sophisticated Angels do not want their terms “shopped” to others. It is included for completeness.

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to facilitate negotiations with any third party without <<AoA Investor>>’s

and the Company’s prior approval.

Not an Offer

This Term Sheet is not a complete description of the financing and does

not constitute either an offer to sell or an offer to purchase securities.

On Behalf of the Company:

On Behalf of the Investors:

__________________________________ __________________________________

Name of Company Investor Group (if applicable)

__________________________________

__________________________________

Signature Signature

__________________________________

__________________________________

Name Name

__________________________________

__________________________________

Phone Phone

__________________________________

__________________________________

Email Email