FIN 711 Week 5 Angel and Venture Capital Investment Example

Reading the Term Sheet Like an Investor: Liquidation Preferences, Board Control, Staging and Vesting in TerraSorb's Series A, and What Venture Capitalists Add Beyond Money

[Student Name]

University of Phoenix

FIN/711: Financial Measures of Value Added

Week 5 Assignment

[Instructor Name]

[Date]

TerraSorb, its investors and all figures are composites written for a model paper; contract features and research findings come from the sources listed and are stated generally.

TerraSorb, the composite soil carbon sensor company, has two offers for its Series A. A climate and agriculture venture fund offers to invest $8 million, valuing the company at $20 million before the money, on standard terms. A fertilizer company's corporate venture arm offers $8 million at a $24 million pre-money valuation, with a right of first refusal on any sale of the company and an exclusive distribution agreement in the Midwest. The higher price is easy to see; the rights that come with it, and what the other offer's contract is designed to do, take more reading. This paper reads both.

How Venture Funds Work

Venture funds are typically limited partnerships with a life of about ten years. Limited partners, such as pensions and endowments, provide the capital. The general partners manage it, usually earning an annual management fee near 2 percent of committed capital and carried interest of about 20 percent of profits above the capital returned. Because a few large successes produce most of a fund's returns, general partners seek investments that could return many times their cost and favor terms that protect them in the many cases that fail (Metrick & Yasuda, 2010).

Liquidation Preferences at Four Exits

The venture fund's term sheet gives the Series A a 1 times nonparticipating liquidation preference, as does the seed round. After the round, the founders hold about 48 percent, seed investors about 14 percent, Series A about 29 percent and the option pool about 9 percent. If TerraSorb sold for $12 million, Series A would take its $8 million preference and seed investors their $2.4 million, leaving $1.6 million for common holders, of which the founders would receive about $1.3 million. At $25 million, Series A would still take $8 million, because converting would give it only about $7.2 million, seed investors would convert and receive about $3.4 million, and the founders would receive about $11.4 million. At $60 million and above, all preferred converts and proceeds follow ownership: at $300 million, the founders would receive about $143 million.

Why Preferences Exist

Preferences address a problem of information and incentives. Founders know more than investors about the company's prospects, and without a preference, founders could sell the company soon after funding at a low price and capture much of the investors' money. A preference protects the investor in low outcomes and encourages founders to pursue large ones. A participating preference, which TerraSorb's term sheet does not include, would let investors take their preference and then share in the rest, a far less founder-friendly term.

Board Control and Protective Provisions

The board would have five seats: two founders, one Series A investor, one seed investor and one independent director chosen jointly. Protective provisions require Series A approval for selling the company, issuing senior securities, changing the charter and taking on significant debt. Kaplan and Strömberg (2003) studied actual venture contracts and found that cash flow rights, board rights, voting rights and liquidation rights were allocated separately and often shifted toward investors when performance was poor and toward founders when it was good. TerraSorb's terms follow that pattern, with a balanced board that could tilt if milestones are missed.

Staging and Vesting

The fund will invest the full $8 million at closing but expects to lead or join later rounds only if milestones are met. Gompers (1995) found that venture capitalists stage their investments more frequently in companies with greater uncertainty and intangible assets, using each round as an option to continue. Founders' shares, already partly vested, will vest over four years with a one-year cliff from the Series A, so a founder who leaves early forfeits unvested shares, protecting remaining owners.

What Venture Capitalists Add

Hellmann and Puri (2002) found that venture-backed startups were faster to professionalize, hiring marketing and human resources leaders, adopting stock option plans and replacing founders as chief executives when needed. Kerr et al. (2014) found benefits from angel investment for firm survival and growth. For TerraSorb, the venture fund brings experience scaling hardware companies and relationships with later-stage investors, while the angels bring farm industry contacts.

The Strategic Offer

The fertilizer company's higher valuation saves the founders about 3 percentage points of ownership. Its right of first refusal, however, would let it match any acquisition offer, discouraging other buyers from bidding and likely lowering the eventual sale price. The exclusive distribution agreement would tie TerraSorb's Midwest sales to a single channel whose owner sells fertilizer, a business that may conflict with soil carbon measurement if results show less fertilizer is needed. Corporate investors can add distribution and credibility, but their goals may diverge from the company's.

The Fund's Clock and the Company's Timeline

The venture fund raised its capital four years ago, so it has about six years left before it must return money to its limited partners, with possible extensions. That timeline matters to TerraSorb: an investor nearing the end of its fund may push for an earlier exit than founders prefer. The fund's partners said they reserve capital for follow-on investments in their best companies, which would let them support TerraSorb through a Series B, but the founders should understand that the fund's clock, not only the company's progress, will shape the investor's views on timing in later years.

Information Rights and Reporting

The term sheet also grants the Series A investor monthly financial statements, an annual budget for approval and inspection rights. Those rights reduce the information gap that makes early-stage investing risky and give the board the data it needs to judge milestones. For the founders, they impose a reporting discipline that later investors will expect anyway.

Angels in the Round

The seed angels hold pro rata rights to invest in the Series A. Three will invest about $400,000 together, preserving goodwill and showing continued insider support, which new investors read as a signal of confidence.

Recommendation

TerraSorb should accept the venture fund's term sheet with two changes: place the option pool expansion in the post-money capitalization and add a second independent director as the board grows. It should decline the strategic offer as structured but invite the fertilizer company to invest a smaller amount without a right of first refusal or exclusivity, keeping its distribution relationship commercial rather than contractual.

Research Questions

How do strategic investors' rights affect later exit values compared with financial investors' terms? Do participating preferences predict lower founder effort? How has the allocation of control rights changed as more capital flows into later-stage rounds?

Conclusion

TerraSorb's Series A term sheet allocates cash flows, control and the option to continue in ways contracting theory predicts, with preferences that matter most in modest exits. The venture fund's standard terms, adjusted for the option pool, serve the company better than the strategic offer's higher price, whose rights could depress the eventual sale and tie the company to a conflicted channel.

References

Gompers, P. A. (1995). Optimal investment, monitoring, and the staging of venture capital. The Journal of Finance, 50(5), 1461-1489. https://doi.org/10.1111/j.1540-6261.1995.tb05185.x

Hellmann, T., & Puri, M. (2002). Venture capital and the professionalization of start-up firms: Empirical evidence. The Journal of Finance, 57(1), 169-197. https://doi.org/10.1111/1540-6261.00419

Kaplan, S. N., & Strömberg, P. (2003). Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. The Review of Economic Studies, 70(2), 281-315. https://doi.org/10.1111/1467-937X.00245

Kerr, W. R., Lerner, J., & Schoar, A. (2014). The consequences of entrepreneurial finance: Evidence from angel financings. The Review of Financial Studies, 27(1), 20-55. https://doi.org/10.1093/rfs/hhr098

Metrick, A., & Yasuda, A. (2010). Venture capital and the finance of innovation (2nd ed.). John Wiley & Sons.