• Valuation. During the bubble, a variety of industry factors contributed to high first-round premoney valuations, including competition for deals among investors, expectations for quick returns from frothy public markets, pressure to pursue “get big fast” operating strategies, and the need by mega-funds to put money to work. In that climate, first-round premoney valuations could range from $10-$100 million. Although valuation in early-stage investing is as much an art as a science, in 2003 investors will apply a more rigorous valuation methodology tied to specific operating variables. For example, investors will focus carefully on quantitative metrics such as the target market size, realistic penetration projections, any customer traction, any beta or production product revenues, margin and cost analyses, the sales pipeline, and so on. The will also dig deep into qualitative variables such as the management team, validated customer needs, sales and pricing strategy, and competitive landscape. This careful investor diligence should stimulate a healthy dialogue between entrepreneur and investor, should serve to align expectations, and should result ultimately in appropriate company valuations. Based on these factors, entrepreneurs and early stage investors should expect to triangulate around first-round premoney valuations in the $2-$5 million range in 2003.

• Investment Amount. Consistent with the high valuations seen during the bubble, total first round investments during such times commonly ranged from $5-$30 million. In 2003, a number of factors will contribute to lower first round investments. First, as valuations decrease, first round valuations naturally follow – for example, a company raising $4 million on a $2 million premoney valuation leaves very little equity for hiring and retaining top management and employees. Second, as the perceived risk of building a successful company increases, investors and entrepreneurs alike tie capital needs to achievable company milestones. This staging allows everyone to monitor the probability of success without over-committing and possible wasting scarce resources. Finally, in today’s challenging economic climate, startup companies must have “survival DNA” - in other words, successful entrepreneurs are doing more with less by keeping burn rates low, spending wisely, and focusing on achieving sustainable profitability. In seeking this balance between the corollary dangers of over-funding and under-funding a startup company, investors will likely put from $.5-$4 million to work in first round financings in 2003.

• Number of Investors. With some exceptions, the days when investment rounds contained only one venture investor are gone. In recent years, investors often sought to capture all of the investment upside of a successful startup; in 2003, investors will be unwilling to shoulder all of the risk that a startup will not succeed. Therefore, in 2003 entrepreneurs can expect venture investors to syndicate rounds with at least one additional investor, if not more. Having additional venture resources – whether funding, recruiting, or operating experience - will help to mitigate risk for both investor and entrepreneur.

• Funding Cycle. The process of going out and raising a financing round will take longer in 2003 due to several factors. Syndicating rounds extends funding cycles, as entrepreneurs may have to manage relationships with several venture investors (proverbially, “herding cats”). This factor is compounded by the slower investment pace at many venture firms - entrepreneurs may have to present to a larger number of funds before securing an investor. Investors are also taking a harder look at investment opportunities, doing more diligence, and working harder to get deals approved internally. Finally, more investors can mean more work by lawyers and other professionals, all of whom may need to review and sign off on the deal. Instead of 1-2 months, investors should plan on needing up to four months to diligence, syndicate, and close a financing round, and entrepreneurs as well as investors should take this additional time into consideration when planning a fundraising timeline. Although funding cycles will be extended in 2003, the good news is that this creates more time to build an optimal match between investor and entrepreneur and to eliminate any surprises through diligence, which can help to ensure the future success of the startup.

• Liquidation Preference. Generally, liquidation preferences offer preferred investors assurance that they will get some of their investment back if the company is sold for much less than originally planned or shut down altogether. If a startup company is successful, then the liquidation preference becomes irrelevant and preferred stock will convert into common shares. During the bubble, investors were less concerned about liquidation preferences because of the success rate of so many startups. In those prior years, investors often sought a liquidation preference of 1x the purchase price, with participation rights up to 3x the purchase price. Predictably, in 2003, as investors will perceive additional risk in backing a startup company and bringing it to liquidity, they will focus more on capping downside risk. Therefore, investors will seek a greater liquidation preference in the range of 3-4x the purchase price, in some cases with no cap on participation rights.

• Anti-dilution Protection. In previous years, investors were generally satisfied with standard broad-based, weighted-average anti-dilution protection. Several factors explain this level of protection; for example, a company could reach liquidity on one or two investment rounds, with a very high first round premoney valuation and a small subsequent follow-on round. Moreover, follow-on rounds were often made at significantly higher valuations than the earlier round – “down rounds” were almost unheard of during the bubble. In 2003, investors will be more concerned about being diluted by multiple successive funding rounds, and are especially concerned about subsequent rounds at a lower valuation. Therefore, entrepreneurs can expect investors to seek a full-ratchet adjustment for at least a period of time, later converting to weighted-average, in order to protect their initial investments in a company.

• Pay-to-Play Provisions. Pay-to-play provisions are related to anti-dilution as they typically provide that preferred investors will lose their anti-dilution protection if they do not participate in a later financing that occurs at a lower price. In a climate where down-rounds were the exception, not the norm, these provisions were relatively uncommon. In the current climate, investors are more concerned about down rounds and are also concerned about mitigating funding risk if the portfolio company needs additional capital. Therefore, investors use pay-to-play provisions to ensure that the current syndicate investors continue to support the portfolio company through both easy and tough times. In 2003, entrepreneurs should expect investors to include such provisions in term sheets. Some pay-to-play provisions may additionally provide that preferred stock will automatically convert to common if the investor does not participate in a subsequent down round. Although these provisions may seem harsh, they can benefit the company by mitigating future fundraising risk.

• Founder Vesting. During the bubble, it was not uncommon for companies to go from founding to liquidity in less than two years - or even in months. By tying the entrepreneur/founder to the startup, founder vesting recognizes the integral role a founder plays in the life of a startup, and investors traditionally sought four-year vesting provisions. In the current startup environment, where investment return horizons have returned to the more traditional period of three to six years, investors recognize more than ever the importance of a visionary, world-class founder/entrepreneur to the success of a startup venture. Therefore, in 2003, investors will continue to seek standard four-year founder vesting provisions, commonly with some up-front vesting, although some investors may seek a slightly longer vesting period.

• Board Composition. Early stage board composition is a significant strategic factor in a startup. Generally, there has been a preference for a small, five-person board containing two company directors (usually the CEO and the founder/entrepreneur, if different), two venture investors, and one outside industry director. The board is small to keep things orderly, simple, and focused; the odd number helps to avoid deadlocked votes; and the outside industry director should bring key contacts, an insider’s informed opinion, and an outsider’s unbiased perspective. As rounds are syndicated, entrepreneurs may see boards grow; in addition, there are many exceptions to the standard composition. However, entrepreneurs in 2003 can expect the preference for this traditional board composition to remain relatively unchanged.

• Employment Agreements. In prior years, investors generally sought to put employment agreements in place with key operators. In 2003, as discussed, investors will use all the tools available to them to mitigate the perceived increased risk of early stage funding in this economic environment. Therefore, entrepreneurs should expect to see investors pay careful attention to this issue and continue to seek employment agreements with founders and key employees.

• Protective Provisions. Protective provisions carve out decisions that will specifically require investor approval. Investors in past years generally used these provisions to address a limited set of decisions, including the approval of any senior securities, the sale of the company, the payment of dividends, and any change in shareholder rights. Consistent with the use of other mechanisms to mitigate risk, entrepreneurs can expect investors in 2003 to require investor approval of an expanded set of events that include: the approval of any senior or pari passu (equal) securities; a change of the business; the incurrence of debt over a specific limit; annual budgets and variances; acquisitions of other businesses; and the appointment and termination of the CEO. This heightened involvement could appear intrusive; however, good early-stage investors are hands-on company builders, and entrepreneurs should make sure they are getting value from their investors. Taking part in operational or strategic decisions helps lower agency costs by engaging the investor with the operations of the portfolio company.

• Preemptive Rights. A preemptive right gives an investor the ability to invest at least enough capital in a later round to maintain their pro-rata ownership. In today’s economic climate, as the number of successful investments in a venture investor’s portfolio decreases, there will be a corollary, increasing desire to put more money into the portfolio companies that show signs of success. In this sense, venture investors use preemptive rights to allow them to leverage their early-stage efforts and capture the upside potential of their work. In 2003, entrepreneurs can expect investors to seek preemptive rights, and in some cases up to 2x their pro-rata ownership in later financings.

This summary of common term sheets provisions is by no means comprehensive or definitive, and it is nearly impossible to take a static snapshot of such a dynamic industry. In addition, entrepreneurs should diligence venture firms to understand how they each differ in their approach. Nevertheless, entrepreneurs need to understand the investment climate, how it has evolved over recent years, and how it will impact them.

At Catamount Ventures, we have always sought to partner with our entrepreneurs to build world-class companies. Therefore, we believe that the exercise of assembling a term sheet is an attempt to codify a working relationship that will completely align the incentives and interests of the investor group with the entrepreneur. We will seek this alignment in each term discussed in this article, and anticipate building the basis for a deep, long-term and successful relationship with our entrepreneurs. Once we have successfully achieved that goal, the fun can really begin: the process rolling up our sleeves together to take innovation and build a meaningful, powerful, and sustainable technology company.

-Stefan Reyniak