1 See www.canadavc.com, "VC Resources", "Stats".

Quite often, entrepreneurs are in a state of shock when receiving a term sheet containing most or all of the provisions listed above. The entrepreneur may feel that the VC is not sharing in the risk of the company’s success or that the VC is trying to control the company’s day-to-day operations. With respect to the first point, entrepreneurs must understand that the VC has a portfolio of companies, many of which will generate little or no return to the VC. As such, the VC must take extended rights in each deal so that the small portion of successful investments will make up for the others. With respect to the second point, the VC will respond that such financial controls are necessary to ensure the company engages in a focused and reasoned spending program. As an entrepreneur, you don’t have to accept these arguments as being reasonable, but you need to understand the VC’s point of view.

Despite these onerous terms, there are a number of strategies that entrepreneurs can employ to try to retain some independence over operations after a financing. These include:

• Negotiate a management bonus pool: Create a cash reserve payable to senior management and, perhaps, key employees, in the event of a liquidation event. The purpose of the pool is to keep management motivated to build the company and its technology. In today’s market, very few companies will complete an initial public offering or a sale of the company at a price that will provide any return to the common shareholders after payment to the VC investors of a 5 to 10 times return on the preferred share purchase price and a double dip participation. To compensate for this, the bonus pool is payable to the recipients prior to any distribution to the shareholders.

• Negotiate away the double dip: Depending on the preferred share rate of return requested by the investor, the entrepreneur may wish to offer a slightly higher rate in exchange for the investor giving up its double dip right. This way, there is a greater residual value in the common shares that will provide an incentive to the management shareholders. The benefit of this strategy is that it avoids the tax issue with the use of a management bonus pool. However, one problem with the use of these pools is that under Canadian tax laws, the pool monies are treated as income in the hands of the recipient, not capital gains.

• Negotiate a "pay-to-play" provision: This type of provision forces existing investors to participate in subsequent rounds or lose some of the rights given to them in the current round (e.g., anti-dilution rights, right to appoint directors, pre-emptive rights to participate in other future rounds of investment). In some cases, the failure to participate results in the automatic conversion of the investor’s preferred shares into common shares, effectively removing the liquidation preference afforded to the preferred shareholders. Many VCs will also like this type of provision because it forces their co-investors to keep investing in the company.

• Negotiate the veto rights: If the entrepreneur is going to negotiate the long list of veto rights demanded by the VC, then he or she must consider the list as a whole and select only a few key points to challenge. Keep in mind the VC’s rationale for wanting these controls. Generally speaking, the veto rights are divided into two categories, share control matters (e.g., dividend rights, approvals for further share issuances, share capital changes or share repurchases) and management control matters (e.g., borrowing money, capital expenditures and salaries and bonuses to senior management). In most cases, the VC will not concede any of its share control matters. However, in some situations, the entrepreneur may get the VC to accept a more relaxed control over management matters. One way to achieve this is to require the approval of such matters at the board level (rather than at the shareholder level), either on a case-by-case basis or by including known expenditures in a budget to be approved by the board. Unlike decisions made by shareholders, the investor’s board nominee must respect his or her legal duties to the company when granting or refusing approvals on matters referred to the board.

• Appoint independent directors to the board: Independent directors bring distance to the decisions being made by the company because their judgement is not subject to influence by their investment in the company. Having a number of strong, independent board members will give the company some credibility if it challenges some of the veto rights requested by the VC.

• Ask for more money: If the investor is offering to advance the monies in tranches and is exercising strong control over the expenditure of those funds, then the entrepreneur should ask for more money. This is not a bad strategy in any event because the closing of a subsequent round of financing may take longer than anticipated and the extra money will be a significant benefit. Of course, any request for an increase in funding must be supported by a business case that reflects fiscal prudence.

• Get existing investors and significant common shareholders on side: The creation of the preferred shares for the new investment will require the approval of the existing shareholders. If, as is usually the case, the rights and restrictions of the new shares will be superior to those of the existing shares, then each existing class of shares must approve the new share rights by a separate vote. If the existing investors and significant common shareholders do not buy-in to the new deal, it may be impossible to get the new money.

• Retain experienced legal advisors: The company should retain a lawyer that has experience in negotiating venture finance transactions. Ideally, the lawyer should be consulted before the term sheet is signed. Although by its provisions the term sheet is a non-binding document, the investor will be more likely to negotiate on the points listed above before the company signs the term sheet. Experienced legal counsel will also know how best to trade-off the various points under negotiation in order to get the company the fairest deal possible.

In the next issue of TechFAQs, we will review the key provisions contained in the preferred share rights issued to the investors. For more information on the issues raised in this or any other TechFAQs issue, please contact Brock Smith at 604.643.3186 or bhs@cwilson.com.